Modigliani-Miller Theorem
AdvancedThe Modigliani-Miller theorem is a foundational principle of corporate finance stating that, under certain ideal conditions, a company's value is not affected by how it is financed, whether by debt or equity.
The theorem was developed by economists Franco Modigliani and Merton Miller in 1958. It assumes a perfect market with no taxes, no bankruptcy costs, no transaction costs and equal information for everyone. Under these conditions, the value of a company depends only on its assets and the cash flows they generate, not on the mix of debt and equity.
The intuition is that if borrowing could increase a company's value, investors could create the same effect themselves by borrowing personally. Using more cheap debt also makes the remaining equity riskier, so shareholders demand higher returns, leaving the overall cost of capital unchanged.
Later work added corporate taxes. Because interest is tax-deductible, debt creates a tax shield that adds value. In a simple version with permanent debt, the value of this shield equals the tax rate multiplied by the debt: with a 25% tax rate and 400,000,000 of debt, about 100,000,000.
Real markets do not meet the ideal conditions, but the theorem is valuable because it shows exactly which factors, such as taxes and distress costs, make capital structure matter.
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