Modigliani–Miller theorem

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is a theorem on capital structure, arguably forming the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

The key Modigliani-Miller theorem was developed in a world without taxes. However, if we move to a world where there are taxes, when the interest on debt is tax deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used. And the source of additional value is due to the amount of taxes saved by issuing debt instead of equity.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William F. Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem.

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