Modigliani-Miller (MM) theory Flashcards
MM Proposition I: Capital Structure Irrelevance
IN A PERFECT MARKET
The capital structure (mix of debt and equity) does not affect the total value of the firm.
The value of a firm is determined solely by its underlying assets, not how it is financed.
* So the assets ability to generate cash flows
The value of assets = value of liabilities (debt + equity).
MM Proposition I: Intuition
If debt increases, equity becomes riskier, requiring a higher return. This offsets any cost advantage from using debt.
Implication
Financing decisions (e.g., issuing more debt or equity) do not create value for shareholders in perfect markets.
MM Theorem II: Cost of Equity
The expected return on equity increases with leverage because equity becomes riskier as debt increases:
