Corporate Finance  The MM Capital Structure vs. The Tradeoff Theory of Leverage
Modigliani and Miller's CapitalStructure Irrelevance Proposition
Modigliani and Miller, two professors in the 1950s, studied capitalstructure theory intensely. From their analysis, they developed the capitalstructure 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 capitalstructure 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 CapitalStructure Irrelevance Proposition
The MM capitalstructure 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 capitalstructure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes and thus the tax benefit of interest payments are recognized.
Signaling Prospects Through Financing Decisions
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Modigliani And Miller's Capital Structure Theories
These theories deal with how capital structure interacts with corporate taxes. 
Investing Basics
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. 
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Tax and Bankruptcy Costs
CFA Level 1  Tax and Bankruptcy Costs. Learn what effects taxes and bankruptcy costs have on capital structure. Contrasts the benefits of tax with the costs of possible bankruptcy. 
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Factors that Influence a Company's CapitalStructure Decision
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Dividend Theories
CFA Level 1  Dividend Theories. Learn the basics behind dividend theories and calculations. Covers various theories regarding the relevance of dividend policy. 
Economics
Financial Leverage In Corporate Capital Structure
Corporate management uses financial leverage to increase earnings per share and returnonequity. 
Professionals
Bankruptcy Costs And Optimal Capital Structure
We look at how debt and equity work together to form the optimal capital structure. 
Professionals
Introduction To Financial Leverage And Capital Structure Policy
We introduce you to capital structure and bankruptcy. 
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Financial Leverage And Capital Structure Policy
We look at the details of a firm's capital structure, financial leverage, the optimal capital structure and realworld capital structures. 
Investing Basics
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.

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Irrelevant Cost
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Traditional Theory Of Capital Structure
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