Irrelevance Proposition Theorem

AAA

DEFINITION of 'Irrelevance Proposition Theorem'

A theory of corporate capital structure that posits financial leverage has no effect on the value of a company if income tax and distress costs are not present in the business environment. The irrelevance proposition theorem was developed by Merton Miller and Franco Modigliani, and was a premise to their Nobel Prize winning work, “The Cost of Capital, Corporation Finance, and Theory of Investment.”

INVESTOPEDIA EXPLAINS 'Irrelevance Proposition Theorem'

In developing their theory, Miller and Modigliani first assumed that firms have two primary ways of obtaining funding: equity and debt. While each type of funding has its own benefits and drawbacks, the ultimate outcome is a firm dividing up its cash flows to investors, regardless of the funding source chosen. If all investors have access to the same financial markets, then investors can buy into or sell out of a firm’s cash flows at any point.

Criticisms of the irrelevance proposition theorem focus on the lack of realism in removing the effects of income tax and distress costs from a firm’s capital structure. Because many factors influence a firm’s value, including profits, assets and market opportunities, testing the theorem becomes difficult. For economists, the theory instead outlines the importance of financing decisions more than providing a description of how financing operations work.

Miller and Modigliani used the irrelevance proposition theorem as a starting point in their trade-off theory.

RELATED TERMS
  1. Search Theory

    A study of buyers and sellers who cannot instantly find a commerce ...
  2. Optimal Capital Structure

    The best debt-to-equity ratio for a firm that maximizes its value. ...
  3. Optimum Currency Area Theory

    A currency thoery based on geographical area that adopts a fixed ...
  4. Freudian Motivation Theory

    A sales theory which surposes that consumers choose whether or ...
  5. Rational Choice Theory

    An economic principle that assumes that individuals always make ...
  6. Labor Theory Of Value

    An economic theory that stipulates that the value of a good or ...
Related Articles
  1. Evaluating A Company's Capital Structure
    Bonds & Fixed Income

    Evaluating A Company's Capital Structure

  2. Modern Portfolio Theory vs. Behavioral ...
    Investing Basics

    Modern Portfolio Theory vs. Behavioral ...

  3. The Optimal Use Of Financial Leverage ...
    Investing Basics

    The Optimal Use Of Financial Leverage ...

  4. What is the chaos theory?
    Investing

    What is the chaos theory?

comments powered by Disqus
Hot Definitions
  1. Market Segmentation

    A marketing term referring to the aggregating of prospective buyers into groups (segments) that have common needs and will ...
  2. Effective Annual Interest Rate

    An investment's annual rate of interest when compounding occurs more often than once a year. Calculated as the following: ...
  3. Debit Spread

    Two options with different market prices that an investor trades on the same underlying security. The higher priced option ...
  4. Odious Debt

    Money borrowed by one country from another country and then misappropriated by national rulers. A nation's debt becomes odious ...
  5. Takeover

    A corporate action where an acquiring company makes a bid for an acquiree. If the target company is publicly traded, the ...
  6. Harvest Strategy

    A strategy in which investment in a particular line of business is reduced or eliminated because the revenue brought in by ...
Trading Center