Modigliani and Miller's Theorem of Capital Structure in Corporate Finance

This article discusses Modigliani and Miller's Theorem of Capital Structure in Corporate Finance. It explains the three main pillars of the theorem and how it affects the overall value of companies. The article also discusses the assumptions made in the first version of the theory and how the second version takes into consideration taxes, bankruptcy costs, and asymmetric information.

CORPORATE FINANCE

The work of Modigliani and Miller, namely the “The Cost of Capital, Corporation Finance
and the Theory of Investment” (1958), has been phenomenal in context of laying down the
foundation of doctrine of modern financial theory that demonstrates the effect of the capital
structure on the overall value of companies. The three main pillars of the theorem are listed
as follows. Firstly that there is no correlation between the total market value of a firm and the
capital structure. Secondly, that there is an increment in cost of equity with the increment in
the debt equity ratio. Lastly, that the dividend policy of the company has no impact on the
firm’s total market value and both concepts are independent of each other. Thus, the authors
stated in their work that the market value of the firm is dependent upon on the net operating
income and the incidental risk associated activities, and not on the sources of financing
(Sekhar and Gudimetla, 2013).
One of the major assumptions of the said theory in the first version of the said theory was the
absence of the tax and the absence of the bankruptcy costs of asymmetric information
(Ahmeti, and Prenaj, 2015). However, in the real world, the absence of taxation is not
possible and the most of the countries if not all impose corporate tax on the companies. Thus,
the second version was developed taking into consideration the taxes, bankruptcy costs, and
asymmetric information. The interest payments on the borrowed funds are subjected to the
tax deduction, unlike the payments of the dividend in respect of the equity source of finance
(Ani, 2016). Thus, the first preposition of the theory can be stated that the tax shield availed
by the virtue of tax-deductible interest payments result in the increment of the value of a
levered company as compared to the value of an unlevered company. The formula for the
first proposition has been provided as follows.

For the second proposition, when applied in context of the real world conditions, states that
there is a directly proportional relationship in between the cost of equity with the leverage
level of the entity. Thus, the presence of the tax shield renders lesser sensitivity to the cost of
equity to the level of the leverage. However, it must also be noted that extra amount of debt
enhances the chances of the company to make default against the payment of the debts. The
formula for the second proposition, as per the refined version has been provided here under.
Thus, as per the discussions conducted in the previous parts it can be concluded that the
companies can capitalize their finance requirements with the borrowed funds till the cost of
bankruptcy is higher than the value of the tax benefits. Thus, it can be rightly stated that the
increment in the debts will lead to the value addition in a company until a given threshold.

References
Ani, G. (2016) “Dividend irrelevance theory” [online]
https://www.dividend.com/dividendeducation/dividend-irrelevance-theory/ [Accessed on:
27/07/2019].
Ahmeti, F. and Prenaj, B. (2015) A critical review of Modigliani and Miller’s theorem of
capital structure. International Journal of Economics, Commerce and Management (IJECM),
3(6).
Sekhar, S. and Gudimetla, V. (2013) Theorems and theories of financial innovation: models
and mechanism perspective. Financial and Quantitative Analysis, FQA, 1(2), pp. 26-29.