Modigliani–Miller theorem

The Modigliani -Miller theorems were presented by Franco Modigliani and Merton Miller, 1958 in their article, The Cost of Capital, Corporation Finance and the Theory of Investment. They treat the influence of the level of debt of a company on its cost of capital.

First theorem

Irrelevance of the capital structure for the market value of a company:

In frictionless markets, that is, where it

• No taxes,
• No bankruptcy costs,
• No asymmetric information and
• A perfect capital market

Are, on which a company is financed, the market value of the firm is independent of the form of financing of the company thus in particular also independent of the level of indebtedness of the company.

Although these conditions are never true in practice, it can be concluded that: If the capital structure for a company has meaning, because at least one of the above assumptions does not apply. That is, if we optimize our capital structure, we need to check the influence of the determinants of the capital structure.

Second theorem

The cost of equity as a linear function of the debt ratio:

If

• The first Modigliani -Miller theorem for a company applies
• A company whose liabilities consist only of senior debt and subordinated capital,

Then

Provided that the market values ​​of equity and debt are considered.

This relationship can be represented simply by an appropriate cost of capital curve. This means that, contrary to the traditional business studies, that there is no optimal level of debt for a company (or that the optimal level of debt a corner solution, ie 1 ).

Third theorem

The constancy of the average cost of capital:

" The method of financing an investment is irrelevant with regard to the question whether the investment is worthwhile. " (Original text: . The type of instrument used to finance on investment is irrelevant to the question of whether or not the investment is worth while) makes the irrelevance illustrated in the first theorem of capital structure on the market value of a company on the irrelevance of the capital structure of a single project extend. Although increases with increasing level of debt, the expected return on equity, but at the same time also increases the risk. Thus, the average cost of capital remain constant, that is, that even a single project due to increased debt financing is not profitable.