Modigliani-Miller Theory

It is common questions which rises  in finance that how do firms  finances their operations.  Is there any factor or factors which influence these choices or not?  In the  last fifty years a large number of ideas and theories have been proposed to answer these questions. Most of the studies concentrated on the proportions of debt and equity in business balance sheet. There is no universal theory of the debt equity choice because of its dynamic nature.

The pioneer of modern theory of capital structure is always consider  MM (Professors Franco Modigliani and Merton Miller)  who proved by their  proposition  that financing has no material effects on the value of the firm or on the cost of capital. Before MM (1958), there was no generally accepted theory of capital structure. They started by assuming that capital markets are frictionless, individual can borrow and lend at the risk free rate, there are no bankruptcy cost, firms  can issue only two types of claims i.e. risk free debt and risky equity and  all firms are assumed to be in the same risk class. MM also assumed that cash flow streams are perpetuities and corporate insiders and outsiders have the same information and managers always maximize shareholder’s wealth. No doubt that some of these assumptions are impractical, but even relaxing them does not really change the major conclusion of the model of firm behavior that MM provide.

When the firm chooses a certain proportion of debt and equity to finance its assets, all that it does is to divide up cash flows among investors. Investors and firms are assumed to have equal access to financial markets, which allows for homemade leverage. The investor can create any leverage that was wanted but not offered, or the investor can get rid of any leverage that the firm took on but was not wanted. As a result the leverage of the firm has no effect on the market value of the firm. In a related study Frank Z. Murray and Goyal (2005) called it as a theory of business financing. However, it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision.

MM’s results suggest that the value of the firm is irrelevant to its way of financing. Consider the simplified form of market value based balance sheet. We know that the market values of the firm’s debt (D) and equity (E),  add up to total firm value (V).

MM (1958) proposition 1 says that (V) is a constant, regardless the  proportions of debt and equity  we are using in business. This is only achievable when assets and growth opportunities on the left hand side of the balance sheet are held constant. Proposition 1 also says that each firm’s cost of capital is  constant, irrespective of debt ratio. The cost of capital is a standard tool of practical finance. Refer to formula given below, r_D is the cost of debt and r_E is the cost of equity that is, the expected rates of return demanded by investors in the firm's debt and equity securities, r is the expected return on a portfolio of all the firm's outstanding securities. It is also the discount or "hurdle rate" for capital investment. The weighted average cost of capital (WACC) depends on these costs and the market value ratios of debt and equity to overall firm value  (Myers, 2001) so we may call it weighted average cost of capital or more simply only  cost of capital.

• WACC = r = r_D D/V + r_E E/V

According to MM, WACC or r is constant. Because debt has a prior claim on the firm's assets and earnings, so the cost of debt is always less than the cost of equity. In other words, the cost of equity or say   is the expected rate of return demanded by equity investors, increases with the debt-equity ratio D/E. Substituting "cheap" debt for "expensive" equity fails to reduce the overall cost of capital because it makes the remaining equity still more expensive, just enough more expensive to keep the overall cost of capital constant. This is the reason that firm can not develop any magic through debt financing (Myers, 2001).

Myres (2001) states in his article that MM (1958) theory maybe intuitive, but consumers are willing to pay more for the several slices than for the equivalent whole. Myres (2001) stated that value of the firm does depend on how its assets, cash flows and growth opportunities are sliced up and offered to investors as debt and equity claims.

We see constant innovation in the new financing schemes. Innovation proves that financing can matter. If it doesn’t, then there would be no incentive to innovate. Various researches were being conducted to disprove the irrelevance proposition by MM which shows that the assumptions taken by MM also show the grounds where this irrelevance proposition fails (Frank and Goyal, 2005). However researchers also agree that even after relaxing the assumptions imposed by MM (1958) the core point of their model is still valid that in case of perfect market and no taxes economy, how debt and equity divided by firm does not make any difference in the overall value of the firm.