Modigliani–Miller Theorem For Capital Structure Stabilization

On the personal front, how do you manage your household finances? By practical and economic thinking, of course, to reduce your expenses. Then you add to it some measures for increasing the savings such as investment with returns, securities, deposits etc. This is an efficient way to manage the finances of one micro-setup where the cash flow is limited to one or two income and expenditure slots. What about a big corporation where revenues arise from multiple sources and in different forms, expenditure has to be channeled into numerous departments of the company operations and profitability is influenced by many financial decisions?

The culmination of various factors influencing and influenced by each other and other related external forces result in the development of tried and experimented theories. Finance is no less compared to science in the availability and use of such theories.

Modigliani–Miller Theorem

For a Corporate to have a smooth functioning by integrating its various departments, it is essential to backup its assets by external funding options such as securities, bonds, equities etc and stabilizes its capital structure. The value of an organized capital structure and its funding sources are integrated into the Modigliani–Miller Theorem proposed by Franco Modigliani and Merton Miller.

The theorem states that the financing resources of a corporate need not be considered in a perfect market and only its value matters. A perfect market is one in which there is no information asymmetry, no bankruptcy costs involved, no handling costs, no expenditure for transactions, taxes, no costs for agents or brokers like Crypto Code etc. In such a market, borrowers get debt without any interest, can utilize complete income without paying taxes, there are no stock market crashes and the investors need not worry about any kind of financial instability.

The theorem is based on two propositions in a perfect market:

  1. Value of a corporate is independent of its capital structure
  2. Cost of equity is same for a leveraged and an unleveraged firm with an added value for premium risk

The total risk of the firm remains constant because of risk shifts from one investor class to another with an increase in leverage. When debts and taxes are included in it, tax wavering due to the interest of debt offsets the extra cost of capital and the value remains the same.

 

In order to match the imperfect real-world situation, certain assumptions yield relaxation to the theory, revealing the relevance of capital structure to a stable corporate.