# Modigliani–Miller theorem

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The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. [1] The basic theorem states that 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. [2] Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

Franco Modigliani was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–Champaign, Carnegie Mellon University, and MIT Sloan School of Management.

Merton Howard Miller was an American economist, and the co-author of the Modigliani–Miller theorem (1958), which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic Sciences in 1990, along with Harry Markowitz and William F. Sharpe. Miller spent most of his academic career at the University of Chicago's Booth School of Business.

Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

## Contents

The key Modigliani-Miller theorem was developed in a world without taxes. However, if we move to a world where there are taxes, when the interest on debt is tax-deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used. [3] And the source of additional value is due to the amount of taxes saved by issuing debt instead of equity.

Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and credits. The difference between deductions, exemptions and credits is that deductions and exemptions both reduce taxable income, while credits reduce tax.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William F. Sharpe, for their "work in the theory of financial economics", with Miller specifically cited for "fundamental contributions to the theory of corporate finance".

The University of Chicago is a private research university in Chicago, Illinois. Founded in 1890, the school is located on a 217-acre campus in Chicago's Hyde Park neighborhood, near Lake Michigan. The University of Chicago holds top-ten positions in various national and international rankings.

Harry Max Markowitz is an American economist, and a recipient of the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.

William Forsyth Sharpe is an American economist. He is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business, and the winner of the 1990 Nobel Memorial Prize in Economic Sciences.

## Historical background

Miller and Modigliani derived and published their theorem when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. Despite limited prior experience in corporate finance, Miller and Modigliani were assigned to teach the subject to current business students. Finding the published material on the topic lacking, the professors created the theorem based on their own research[ citation needed ]. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem.

The Tepper School of Business is the business school of Carnegie Mellon University. It is located in the university’s 140-acre (0.57 km2) campus in Pittsburgh, Pennsylvania, US.

Carnegie Mellon University (CMU) is a private research university based in Pittsburgh, Pennsylvania. Founded in 1900 by Andrew Carnegie as the Carnegie Technical Schools, the university became the Carnegie Institute of Technology in 1912 and began granting four-year degrees. In 1967, the Carnegie Institute of Technology merged with the Mellon Institute of Industrial Research to form Carnegie Mellon University. With its main campus located 3 miles (5 km) from Downtown Pittsburgh, Carnegie Mellon has grown into an international university with over a dozen degree-granting locations in six continents, including campuses in Qatar and Silicon Valley, and more than 20 research partnerships.

Miller and Modigliani published a number of follow-up papers discussing some of these issues. The theorem was first proposed by F. Modigliani and M. Miller in 1958.

## The theorem

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani–Miller theorem states that the value of the two firms is the same.

## Without taxes

### Proposition I

${\displaystyle V_{U}=V_{L}\,}$

where

${\displaystyle V_{U}}$is the value of an unlevered firm = price of buying a firm composed only of equity, and ${\displaystyle V_{L}}$is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning. [4]

To see why this should be true, suppose an investor is considering buying one of the two firms, U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile than the firm.

### Proposition II

${\displaystyle r_{E}({\text{Levered}})=r_{E}({\text{Unlevered}})+{\frac {D}{E}}(r_{E}({\text{Unlevered}})-r_{D})}$

here

• ${\displaystyle r_{E}}$is the expected rate of return on equity, or cost of equity.
• ${\displaystyle r_{D}}$is the expected rate of return on borrowings, or cost of debt.
• ${\displaystyle {\frac {D}{E}}}$is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true under the following assumptions:

• no transaction costs exist, and
• individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

## With taxes

### Proposition I

${\displaystyle V_{L}=V_{U}+T_{C}D\,}$

where

• ${\displaystyle V_{L}}$is the value of a levered firm.
• ${\displaystyle V_{U}}$is the value of an unlevered firm.
• ${\displaystyle T_{C}D}$is the tax rate (${\displaystyle T_{C}}$) x the value of debt (D)"
Derivation of ${\displaystyle T_{C}D}$-  Amount of Annual Interest= Debt x Interest Rate Annual Tax Shield= Debt x Interest Rate x Tax Rate Capitalisation Value (Perpetual Firm) = (Debt × Interest Rate x Tax Rate) ÷ Interest Rate
• the term ${\displaystyle T_{C}D}$ assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

### Proposition II

${\displaystyle r_{E}=r_{0}+{\frac {D}{E}}(r_{0}-r_{D})(1-T_{C})}$

where:

• ${\displaystyle r_{E}}$is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.
• ${\displaystyle r_{0}}$is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).
• ${\displaystyle r_{D}}$is the required rate of return on borrowings, or cost of debt.
• ${\displaystyle {D}/{E}}$is the debt-to-equity ratio.
• ${\displaystyle T_{c}}$is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula, however, has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%.

The following assumptions are made in the propositions with taxes:

• corporations are taxed at the rate ${\displaystyle T_{C}}$ on earnings after interest,
• no transaction costs exist, and
• individuals and corporations borrow at the same rate.

## Notes

1. Titman, Sheridan (2002). "The Modigliani and Miller Theorem and the Integration of Financial Markets". Financial Management. 31 (1): 101–115. doi:10.2307/3666323. JSTOR   3666323.
2. MIT Sloan Lecture Notes, Finance Theory II, Dirk Jenter, 2003[ unreliable source? ]
3. Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 82.
4. Arnold G. (2007)