What is the Modigliani-Miller Theorem - M&M
The Modigliani-Miller theorem (M&M) states that the market value of a company is calculated using its earning power and the risk of its underlying assets and is independent of the way it finances investments or distributes dividends. There are three methods a firm can choose to finance: borrowing, spending profits (versus handing them out to shareholders in the form of dividends), and straight issuance of shares. While complicated, the theorem in its simplest form is based on the idea that with certain assumptions in place, there is no difference between a firm financing itself with debt or equity.
BREAKING DOWN Modigliani-Miller Theorem - M&M
Merton Miller provides an example to explain the concept behind the theory, in his book "Financial Innovations and Market Volatility" using the following analogy:
"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk."
History of the M&M Theory
During the 1950s, Franco Modigliani and Merton Miller conceptualized and developed this theorem and wrote "The Cost of Capital, Corporation Finance and the Theory of Investment," which was published in the American Economic Review in the late 1950s. During this time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration (GSIA) at Carnegie Mellon University. Both were set to teach corporate finance to business students, though, neither had any experience in corporate finance. After reading the concepts and material that were to be presented to the students, the two professors found the information inconsistent, so together, the two worked to correct what they felt was flawed. The result was the groundbreaking article published in the review journal, information that was eventually compiled and organized to become the M&M theorem. Modigliani and Miller also had a number of follow-up papers published that also discussed these issues, including "Corporate Income Taxes and the Cost of Capital: A Correction," published in the 1960s.