MM Hypothesis
Core Idea: In a perfect capital market with no taxes, a firm's market value and its cost of capital
are independent of its capital structure. This means whether a company finances its operations
through debt, equity, or a combination of both, its total value remains the same.
Assumptions:
Perfect Capital Markets:
o No transaction costs (e.g., brokerage fees, underwriting costs).
o No bankruptcy costs.
o No agency costs.
o Investors and firms can borrow and lend at the same risk-free rate.
o No information asymmetry (all investors have the same information as the firm's
management).
o Rational investors.
No Taxes: No corporate or personal taxes.
Homogeneous Risk Classes: Firms can be grouped into homogeneous risk classes,
meaning firms within the same class have similar business risk.
Constant Operating Income: The firm's earnings before interest and taxes (EBIT) are
not affected by its capital structure.
No Growth: The firm's cash flows are a perpetuity with no growth.
Full Payout of Earnings: All net income is distributed as dividends.
Propositions (Without Taxes):
Proposition I (Value Irrelevance): The value of a levered firm (VL) is equal to the
value of an unlevered firm (VU) if they are in the same risk class.
o VL=VU
o This implies that the firm's total value is determined by its operating assets and
their expected cash flows, not by how those cash flows are distributed between
debt and equity holders.
Proposition II (Cost of Equity): The cost of equity for a levered firm (re) increases
linearly with the debt-to-equity ratio, offsetting the benefit of using cheaper debt. The
weighted average cost of capital (WACC) remains constant regardless of the capital
structure.
o re=r0+(r0−rd)∗(D/E)
Where:
re = cost of equity for a levered firm
r0 = cost of equity for an unlevered firm (or cost of capital for an
all-equity firm)
rd = cost of debt
D/E = debt-to-equity ratio
Arbitrage Argument: MM argued that if the value of a levered firm was different from an
unlevered firm, investors could engage in "homemade leverage" to exploit the difference,
thereby driving the values back to equality. For example, if a levered firm was valued higher, an
investor could sell their shares in the levered firm, borrow personally, and buy shares in an
unlevered firm to achieve the same return with less initial investment, thus pushing down the
price of the levered firm.
MM Hypothesis With Taxes
Core Idea: When corporate taxes are introduced, the MM hypothesis states that using debt can
increase a firm's value due to the tax deductibility of interest payments (the "interest tax shield").
Propositions (With Taxes):
Proposition I (Value with Taxes): The value of a levered firm (VL) is equal to the value
of an unlevered firm (VU) plus the present value of the interest tax shield.
o VL=VU+(Tc∗D) (assuming perpetual debt)
Where:
Tc = corporate tax rate
D = market value of debt
o This implies that debt financing provides a tax advantage, making levered firms
more valuable than unlevered firms, suggesting that firms should aim for as much
debt as possible to maximize value.
Proposition II (Cost of Equity with Taxes): The cost of equity for a levered firm still
increases with leverage, but at a slower rate than in the no-tax case because of the tax
shield. The WACC decreases as debt increases, reaching a minimum at 100% debt.
o re=r0+(r0−rd)∗(1−Tc)∗(D/E)
Implications of the MM Hypothesis:
Capital Structure Irrelevance (No Taxes): In a perfect world without taxes, financial
decisions (capital structure) do not affect firm value. The focus should be on real
investment decisions.
Tax Advantage of Debt (With Taxes): Debt is preferred over equity due to the tax
deductibility of interest payments. This suggests that a firm's value increases with
leverage.
No Optimal Capital Structure (No Taxes): Under the initial assumptions, there's no
ideal debt-equity mix.
Optimal Capital Structure at 100% Debt (With Taxes, ignoring other frictions): If
only taxes are considered, the MM theorem implies that a firm should be 100% debt-
financed to maximize value.
Criticisms and Real-World Limitations:
The MM Hypothesis, especially the no-tax version, is often criticized for its unrealistic
assumptions. However, it provides a crucial theoretical benchmark for understanding the factors
that do influence capital structure decisions in the real world. The "reverse MM theorem"
suggests that if capital structure does matter, it must be due to the violation of one or more of
MM's assumptions.
Real-world factors that make capital structure relevant and lead to deviations from MM's
predictions include:
Taxes (already addressed in the second version): Corporate income taxes make debt
attractive.
Bankruptcy Costs: As debt increases, the probability of financial distress and
bankruptcy rises. These costs (direct like legal fees, and indirect like lost sales or
employee morale) can offset the tax benefits of debt, leading to an optimal capital
structure that is not 100% debt. This forms the basis of the Trade-Off Theory of capital
structure.
Agency Costs: Conflicts of interest between shareholders and managers, or between
shareholders and debt holders, can influence capital structure.
Asymmetric Information: Managers typically have more information about the firm's
prospects than outside investors. This can lead to signaling effects (e.g., issuing debt
might signal confidence, while issuing equity might signal that management thinks the
stock is overvalued). This is a key element of the Pecking Order Theory.
Transaction Costs: Costs associated with issuing new securities (e.g., flotation costs)
can make capital structure decisions relevant.
Different Borrowing Rates: Individuals and corporations may not be able to borrow at
the same rates.
Financial Flexibility: Firms may prefer to maintain a certain level of unused debt
capacity for future investment opportunities.
Despite its simplifying assumptions, the Modigliani and Miller Hypothesis remains a cornerstone
of financial theory, providing a powerful framework for analyzing the complex relationship
between capital structure, firm value, and cost of capital.
