Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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CHAPTER 9

Capital Structure Irrelevance:

The Modigliani-Miller Model

SERGEI V. CHEREMUSHKIN

Assistant Professor, Mordovian State University

INTRODUCTION

Before Modigliani and Miller’s (1958) (hereafter MM) seminal article, the conven-

tional finance wisdom was that a moderate amount of debt increases the value of

a firm’s common stock because debt is less expensive than equity, which implies

U-shaped cost of capital function of leverage. In contrast, MM assert that with-

out taxes the value of the firm is completely independent of its capital structure.

Thus, all capital structures are equivalent because the cost of capital in their model

remains unchanged, regardless of the capital structure. MM also explain the rea-

sons for this independence. When considering corporate income tax results, they

recognize that firm value increases with financial leverage.

Modigliani and Miller (1958) pose the following question: What is the cost of

capital to a firm in a world in which it uses funds to acquire assets whose yields

are uncertain? They assert that under certainty the two criteria of rational decision

making—the maximization of profits and the maximization of market value—are

equivalent. Under uncertainty, however, this equivalence vanishes. According to

MM, using debt instead of equity to finance a given venture may increase the

expected return to the owners but only at the cost of increased dispersion of

the outcomes. ...