Modigliani and Miller Theory

The earliest theorist in capital structure theory is Modigliani and Miller (1958); this is the

first generally accepted theory in capital structure. This early theory has developed since

1958, and still fuels current research today. This Modigliani and Miller (M&M) theory

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provide a realistic model on how companies make financial decisions, it provides a way

of finding reasons as to why the choices surrounding finance are important in companies

(Frank and Goyal, 2009). M&M form their theory based on numerous restrictive

assumptions. The assumptions vary in their degree of reality to the world in which

companies operate, and allow the development of less complex theories to evolve, which

contain a high number of complex variables. The first assumption states that there are no

taxation costs, an assumption that is unrealistic and later modified in 1963 to incorporate

taxes. However, the inclusion of personal taxation is excluded from both M&M models

(1958, 1963). The second assumption is in relation to capital markets, and surrounds the

idea that firstly, perfect capital markets exist. Secondly, access to information is freely

available to everybody, and the information available has no cost in terms of money or

time. The third assumption is in relation to companies taking on high levels of debt. As

debt levels increase, the risk of liquation increases and financial distress costs appear; the

M&M model assumes that there are no financial distress costs. The fourth assumption

states that companies can be classified into distinct risk classes; whilst this may be

possible, the practicalities and constantly changing levels of risk make this implausible.

The fifth and last assumption is that individuals can borrow as cheaply as corporations,

the availability of different types of capital and terms associated with these ensure the

assumption becomes invalid. Access to financial markets is assumed to be equal between

investors and companies, this allows for homemade leverage to exist. If a company

decides to take on a higher level of leverage than the investor is comfortable with, the

investor is able to remove this, and vice versa. According to Frank and Goyal (2009),

leverage has no impact on the market value of the company. These are the assumptions

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Proposition 1

The (Modigliani and Miller, 1958) first proposition states that a company’s leverage level is irrelevant to the overall value of the firm, which remains constant, regardless of the

amount of debt, i.e. the company could have 50% debt or 1% debt, and the shareholder

wealth would not change.

“The market value of any firm is independent of its capital structure and is given by capitalising its expected return at the rate appropriate to its class” (Modigliani and Miller, 1958:268).

If the percentage of debt should change because of the increased risk that debt attributes

to a company, the cost of equity will rise as shareholders demand a higher return for the

additional risk they are effectively taking on, which will be offset, leaving the WACC

unchanged. If the capital structure decision becomes irrelevant, then the only factor that

could influence the value of a company is the cash flows that it generates; this is as a

result of making good investment decisions and is independent of the capital structure.

This proposition is based on two key concepts; arbitrage and the homemade dividend

(Modigliani and Miller, 1958). Arbitrage occurs in situations where there are two

companies who have different capital structures, yet their performance must be the same

and is unable to be influenced by leverage levels. The second situation is the homemade

dividend. An investor decides to sell their equity in a company that contains debt, and

this money is then used to raise a personal loan for the same amount, and the investor can

invest an identical amount into a company that contains zero debt. Therefore, the process

of the investor increasing their income without incurring any cost occurs; this

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expected return, and are therefore perfect substitutes for each other (Modigliani and

Miller, 1958).

Proposition 2

The Modigliani and Miller (1958) second proposition is the expected rate of return on

equity increases proportionately with the leverage ratio. The increase in debt that is taken

on by companies equates to more risk, and results in the equity holders demanding a

higher level of return.

“The expected yield of a share of stock is equal to the appropriate capitalization rate for a pure equity stream in the same risk class, plus a premium related to financial risk equal to the debt-equity ratio times the spread between the capitalization rate and the cost of debt” (Modigliani and Miller, 1958:271).

The capital structure does contain debt and the debt that companies take out is assumed to

be risk free; however, there is a point whereby debtholders require a higher return as debt

levels increase, which forces the increase from the equity holders to slow down

(Modigliani and Miller, 1958).

Proposition 3

The (Modigliani and Miller, 1958) third proposition surrounds the cut-off rate of return

for new projects, and states this should be equal to the WACC. The WACC remains

constant, irrespective of leverage, therefore implying that the type of security that is used

to finance an investment is irrelevant. The value of an unlevered company is the

unlevered company plus the present value of the tax shields, which are as a result of

taking out debt (Solomon, 1963). The optimal point of debt is the point where by the

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In 1963 Modigliani and Miller relaxed the assumption of no taxes in order to consider the

tax shield that is generated in those companies whose capital structure contains debt; the

result is the modification of the theory that was developed in 1958. Tax rates do vary

across the world; on average UK listed companies pay a corporate tax rate of 30%,

demonstrating the material impact this assumption has, therefore concluding that

companies should contain as much debt as they are able to service, without risking

financial distress.

The M&M theory still holds true today, despite the unrealistic assumptions (Modigliani

and Miller, 1958:1963). If we assume that UK companies adhere to the M&M theory,

then the decisions between choosing debt or equity in their capital structure is dependent

on other factors. The firm specific factors, such as company size and tangibility, have

already been researched in a UK context and will be used as control variables in this

study. Other variables, such as CEO personal characteristics, board characteristics, and

ownership structure are identified in Chapter 3 in the context of previous studies; these

can be analysed in an attempt to identify the reasons behind a company’s choice in

relation to their capital structure. A statistician, Box (1979), concludes that “All models are wrong, but some are useful.”

The M&M theory has withstood the test of time, despite the numerous unrealistic

assumptions, and remains a key theory behind explaining how companies choose their

capital structure. Whilst a unified capital structure theory has been unobtainable so far,

the ongoing research surrounding capital structure incorporates the M&M theory.

Current research, including this study, looks to extend the number of variables that enable

the decision-making process between debt and equity to be more transparent. For

example, does corporate governance mechanisms such as the number of board meetings

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of debt in the capital structure? Can the attributes of the CEO play a role in the selection

of debt or equity? A multi-factor model is often not preferred due to the complexities it

creates. These models are often beyond reach, the identification of core factors in the

capital structure decision enable a robust model to evolve. Therefore, the selection of the

key independent variables (Discussed in detail in Chapter 3) surround how corporate

governance protects the shareholders of a company, and debt acts as a control

mechanism.