Implication of the Modigliani Miller Capital Structure Theories

We illustrate here the effects of the Modigliani-Miller theorems on capital structuring, emphasizing especially on the relationship between equity and debt. This is carried out numerically via a simplified financial statement, which takes us through the methodology that leads to the ROE, WACC and firm’s value, all plotted against leverage.

The Modigliani and Miller (M&M) theorems on capital structuring have, inarguably, laid down the foundations for modern corporate finance. There are several principles that underlie these theorems and two of these, which are most relevant to this paper, May, very simply, be reiterated as follows:

1. In the absence of taxes, there are no benefits, in terms of value creation, to increasing leverage.

2. In the presence of taxes, such benefits, by way of interest tax shield, do accrue when leverage is introduced and/or increased. The Modigliani-Miller Theorem is a cornerstone of modern corporate finance. At its heart, the theorem is an irrelevance proposition: The Modigliani-Miller Theorem provides conditions under which a firm’s financial decisions do not affect its value. The Theorem makes two fundamental contributions. In the context of the modern theory of finance, it represents one of the first formal uses of a no arbitrage argument (though the “law of one price” is longstanding). More fundamentally, it structured the debate on why irrelevance fails around the Theorem’s assumptions: (i) neutral taxes; (ii) no capital market frictions (i.e., no transaction costs, asset trade restrictions or bankruptcy costs); (iii) symmetric access to credit markets (i.e., firms and investors can borrow or lend at the same rate); and (iv) firm financial policy reveals no information. Modigliani and Miller (1958) also assumed that each firm belonged to a “risk class,” a set of firms with common earnings across states of the world, but Stiglitz (1969) showed that this assumption is not essential. The relevant assumptions are important because they set conditions for effective arbitrage: When a financial market is not distorted by taxes, transaction or bankruptcy costs, imperfect information or any other friction which limits access to credit, then investors can costlessly replicate a firm’s financial actions. This gives investors the ability to ‘undo’ firm decisions, if they so desire. Attempts to overturn the Theorem’s controversial irrelevance result were a fortiori arguments about which of the assumptions to reject or amend. The systematic analysis of these assumptions led to an expansion of the frontiers of economics and finance.

The Modigliani and Miller (1961) and Miller (1977) result that firm value is independent of dividend policy has also been examined extensively. Bhattacharya (1979) and others show that firm dividend policy can be a costly device to signal a firm’s state, and hence relevant, in a class of models with: (i) asymmetric information about stochastic firm earnings; (ii) shareholder liquidity (a need to sell makes firm valuation relevant); and (iii) deadweight costs (to pay dividends, refinance cash flow shocks or cover under-investment). In a separating equilibrium, only firms with high anticipated earning pay high dividends, thus signaling their prospects to the stock market. As in other costly signaling models, why a firm would use financial decisions to reveal information, rather than direct disclosure, must be addressed. As previously, taxes are another important friction which effect dividend policy.