Financial Management: Principles and Applications, 13/e

Appendix: Demonstrating the Modigliani and Miller Theorem

To illustrate conditions under which the Modigliani and Miller (M&M) theorem is true, assume there are two firms, Firm A and Firm B, that are identical in every respect except that they are financed differently. Firm A is financed completely by equity, whereas Firm B has borrowed a portion of its capital.

Because of the first assumption of the M&M theorem, we know that even though the two firms have different capital structures, they generate identical cash flows, which are uncertain and depend on the overall state of the economy. As we state in Panel A of Figure 15A.1, the total cash flows of the two firms in a recession equal $50 million, in normal times equal $100 million, and in booming ...