🎓 Modigliani and Miller (MM) Theory of Capital Structure

 

🎓 Modigliani and Miller (MM) Theory of Capital Structure

📌 Introduction: What is Capital Structure?

Imagine you're starting a lemonade stand. You need money to buy lemons, sugar, cups, and a stand. You can get this money in two main ways:

1. Borrow it (debt) – like taking a loan from your parents.
2. Use your own savings (equity) – like using your piggy bank money.

How much money you borrow vs. how much of your own you use is your capital structure.

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🧠 Meet the Brains Behind the Theory

In the 1950s, two smart economists, Franco Modigliani and Merton Miller, asked a big question:

“Does it matter how a company raises money – through debt or equity – when it comes to the value of the company?”

And guess what? Their answer changed how businesses think about financing forever.

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🧾 MM Theory – The Two Big Ideas

💡 Proposition I: Capital Structure Doesn’t Affect Value (No Taxes)

Imagine two companies:

• Company A uses only its own money (equity).
• Company B borrows money and also uses equity (a mix of debt and equity).

MM Proposition I says: Both companies will be worth the same if:

• There are no taxes,
• Everyone has the same information,
• There are no bankruptcy costs.

🔍 Why?
Because investors can create their own "home-made" leverage. If one company borrows, you as an investor can do the same and get similar returns.

📊 Example:

You invest $100 in Company A (equity only).
Your friend invests $50 in equity and borrows $50 to invest in Company B.

In a perfect world (no taxes or risk), you both end up with the same profit.

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💡 Proposition II: Risk and Return Are Connected

This part says:

"The more debt a company uses, the riskier it becomes for equity holders—and they’ll demand more return."

🔺 More Debt = More Risk
When a company borrows more, paying interest becomes a must. If profits go down, there might not be enough to pay both interest and shareholders.

So, shareholders say: "Hey, you're taking on more debt, so I want a bigger reward (return) for the risk I'm taking!"

📈 Example:

• Company A (no debt) has shareholders expecting a 10% return.
• Company B (with debt) has shareholders expecting 15% because it's riskier.

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🧮 When You Add Taxes: MM Theory with Tax Shield

Real life isn’t perfect. Companies pay taxes—but there's a twist.

🧾 Interest on debt is tax-deductible.

That means borrowing actually helps a company save money on taxes.

So Modigliani and Miller updated their idea:

"In the real world with taxes, using more debt can increase the value of a company."

✅ Why? Because interest on debt reduces the taxable income. Less tax = more money left for the owners.

📊 Example:
Company X earns $100,000 and pays 30% tax = $30,000 in taxes.

But if it pays $20,000 in interest, it only pays tax on $80,000:

• New tax = $24,000.
• That’s $6,000 saved thanks to debt.

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🧱 Real-World Limits: Why Not Use All Debt?

If debt saves money on taxes, why don't companies borrow all the money they can?

Because of three big risks:

1. Bankruptcy Risk – Too much debt can lead to default.
2. Agency Costs – Managers might make bad decisions with borrowed money.
3. Loss of Flexibility – Heavy debt can limit future options.

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📝 Summary of MM Theory

Assumptions (Original Theory)	Implications
No taxes, no transaction costs	Capital structure does not affect value
Perfect information and no bankruptcy risk	Investors can create personal leverage

With Taxes:

• Debt becomes attractive because of tax savings.
• More debt can increase firm value, up to a point.

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🔄 Real-Life Application

• Startups: Often avoid debt early, because they are risky.
• Large Corporations: Balance debt and equity to maximize value while managing risk.
• Banks and Airlines: Often use more debt, but must manage carefully to avoid collapse.

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🧠 In Simple Words:

Modigliani and Miller taught us that how you finance a company is important, but only when the real world is considered — like taxes, bankruptcy, and market imperfections.

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📚 References (APA Style)

• Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261–297.
• Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. American Economic Review, 53(3), 433–443.
• Ross, S. A., Westerfield, R., & Jaffe, J. (2019). Corporate finance (12th ed.). McGraw-Hill Education.

 

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