Modigliani-Miller model
The Modigliani-Miller theory forms the foundation for modern thinking on capital structure. The basic theory states that, under a identified market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a business firm is unaffected by how that business firm is financed. It does not subject if the business firm's capital is raised by issuing stock or selling debt. It does not count what the business firm's dividend policy is. Thus , the Modigliani-Miller theory is also oftentimes called the capital structure irrelevance principle.
Modigliani was presented the 1985 Nobel Prize in Economics for this contribution. Along with Harry Markowitz and William Sharpe, he was given the 1990 Nobel Prize in Economics, for their "work in the theory of financial economics," and in distinction from others, quoted for "fundamental contributions to the theory of corporate finance."
It is a financial theory stating that the market value of a business firm is ascertained by its earning power and the risk of its fundamental assets, and is autonomous of the way it chooses to finance its investments or distribute dividends. Keep in mind, a business firm can select between three methods of financing: borrowing, spending profits or issuing shares as opposed to disseminating them to shareholders in dividends. The theory gets much more complicated, but the basic idea is that, under identified assumptions, it makes no difference whether a business firm finances itself with debt or equity.
In "Financial Innovations and Market Volatility" Merton Miller explains the conception employing the following analogy:
"Think of the business firm as a gigantic tub of whole milk. The farmer can trade the whole milk as is. Or he can take out the cream and trade it at a substantially higher price than the whole milk would bring. That's the analog of a business firm selling low-yield and from that fact high-priced debt securities. But, of course, what the farmer would have left would be cream milk with low butter fat content and that would trade for much less than whole milk. That represents to the levered equity. The M and M proposition says that if there were no monetary value of separation and, of course, no government dairy-support programs, the cream milk plus the cream would bring in the same price as the whole milk."
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