Modigliani and Miller's Capital-Structure Irrelevance Proposition
Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations.

The MM study is based on the following key assumptions:

  • No taxes
  • No transaction costs
  • No bankruptcy costs
  • Equivalence in borrowing costs for both companies and investors
  • Symmetry of market information, meaning companies and investors have the same information
  • No effect of debt on a company's earnings before interest and taxes


Look Out
The MM capital-structure irrelevance proposition assumes:
(1) no taxes and, (2) no bankruptcy costs.

In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to the WACC. Additionally, since there are no changes/benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.

The MM Capital-Structure Irrelevance Proposition
The MM capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. As a result, MM states that the capital structure is irrelevant and has no impact on a company's stock price.

The Tradeoff Theory of Leverage
The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure. This benefit comes from tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the trade-off theory of leverage, where taxes and thus the tax benefit of interest payments are recognized.



Signaling Prospects Through Financing Decisions

Related Articles
  1. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  2. Investing

    Understanding the Modigliani-Miller Theorem

    The Modigliani-Miller (M&M) theorem is used in financial and economic studies to analyze the value of a firm, such as a business or a corporation.
  3. Small Business

    Financial Leverage In Corporate Capital Structure

    Corporate management uses financial leverage to increase earnings per share and return-on-equity.
  4. Investing

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  5. Investing

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
  6. Investing

    Modern Portfolio Theory vs. Behavioral Finance

    Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions ...
  7. Managing Wealth

    4 Structured Product Types Wealthy Clients Love

    High-net-worth investors find structured products appealing for a variety of reasons. Here's a look at four types.
  8. Small Business

    Capital Structure

    Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
  9. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  10. Investing

    Growth Investing: 3 Tips to Consider

    Learn the basics of growth investing, and discover three tips for avoiding the risk of losing money while employing a growth investment strategy.
Frequently Asked Questions
  1. What is considered a healthy operating profit margin?

    Operating profit margin is one of the key profitability ratios that investors and analysts consider when evaluating a company. ...
  2. What is the difference between preference and ordinary shares?

    Preference shares, or preferred shares, have the advantage of a higher priority claim to the assets of a corporation in case ...
  3. What's the difference between "top-down" and "bottom-up" investing?

    Top-down investing looks at the economy and tries to forecast which industry will generate the best returns. A bottom-up ...
  4. Why is business ethics important?

    No matter the size, industry or level of profitability of an organization, business ethics are one of the most important ...
Trading Center