Modigliani and Miller's Capital-Structure Irrelevance Proposition

The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In
this simplified view, the weighted average cost of capital (WACC) should remain constant with
changes in the company's capital structure. For example, no matter how the firm borrows, there
will be no tax benefit from interest payments and thus no changes or benefits to the WACC.
Additionally, since there are no changes or benefits from increases in debt, the capital structure
does not influence a company's stock price, and the capital structure is therefore irrelevant to a
company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock
price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy
costs.

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 firms cash flows at any point.

Criticisms of the irrelevance proposition theorem focus on the lack of realism in removing the
effects of income tax and distress costs from a firms capital structure. Because many factors
influence a firms 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.

M&M Proposition I

M&M Proposition 1 states that the value of a firm does NOT depend on its capital structure. For
example, think of 2 firms that have the same business operations, and same kind of assets. Thus, the
left side of their Balance Sheets look the same. The only thing different between the 2 firms is the right
side of the balance sheet, ex, the liabilities and how they finance their business activities.
In the first diagram, stocks make up 70% of the capital structure while bonds (debt) make up for
30%. In the second diagram, it is the exact opposite. This is the case because the assets of both
capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporation
is irrelevant. The value of the firm is determined by Real Assets and not its capital structure.

M&M Proposition II

M&M Proposition II states that the value of the firm depends on three things:

1).Required rate of return on the firm's assets (Ra)

2).Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula for WACC
is:

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

The WACC formula can be manipulated and written in another form:

Ra = (E/V) x Re + (D/V) x Rd

The above formula can also be rewritten as:

Re = Ra + (Ra - Rd) x (D/E)