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

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  2. 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.
  3. 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.
  4. 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.
  5. Small Business

    Value Proposition

    A value proposition is a company’s promise to its customers of a unique and relevant benefit. The value proposition is often the heart of a company’s advertising campaigns.
  6. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  7. Investing

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  8. Trading

    Manipulating Facts to Fit a Theory: A Dangerous Trading Practice

    This practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
  9. Investing

    Understanding the Random Walk Theory

    The random walk theory states stock prices are independent of other factors, so their past movements cannot predict their future.
Frequently Asked Questions
  1. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  2. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
  3. What's the most expensive stock of all time?

    The most expensive publicly traded stock of all time is Warren Buffett’s Berkshire Hathaway.
  4. What is a "socially responsible" mutual fund?

    As the name suggests, socially responsible mutual funds invest exclusively in socially responsible investments.
Trading Center