What is the Irrelevance Proposition Theorem
The irrelevance proposition theorem is a theory of corporate capital structure that posits financial leverage does not affect 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.”
It is not uncommon to see the expression adapted to the "capital structure irrelevance principle" or "capital structure irrelevance theory," in the popular press.
BREAKING DOWN 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. This means in the absence of taxes, bankruptcy costs, agency costs and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.
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, which describes the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs (bankruptcy) and benefits (growth).