What is the Modigliani-Miller model?

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What is the Modigliani-Miller model?

The Modigliani-Miller model summarizes three theorems that the two American economists Franco Modigliani and Merton Miller have presented in an essay in 1958. Their paper deals with the influence of a company’s debt-equity ratio on its capital costs and market value. This article has strongly influenced modern financial theory and has been discussed controversially.

A model with ideal-typical assumptions

Modigliani and Miller base their model on ideal-typical assumptions. They assume,

  • the existence of a complete/perfect capital market (rational market participants, homogeneous expectations, perfect competition, no transaction costs),
  • that there is no asymmetrical distribution of information, which means that there is full information transparency;
  • that there is tax neutrality regarding financing or that there is abstraction from taxes;
  • that there are no insolvency costs.

In addition, they always base comparisons on companies that are in the same risk class and only differ in terms of financing. Based on these assumptions, the authors derive three theorems in relation to the debt-equity ratio. The debt-equity ratio is understood as the ratio of debt capital to equity capital.

Theorem I:

The market value of a company is independent of the debt-equity ratio. If there were differences in market value between companies with the same investment plans and expected returns, market participants would always immediately offset them by appropriate share purchases or sales. This is also known as arbitrage. Under these assumptions, the financing is therefore irrelevant for the market value. Therefore, this theorem is also referred to as the irrelevance thesis. The only decisive factor for the market valuation thus remains the expected return from investments.

Theorem II:

A company’s cost of equity can be presented as a linear function depending on the debt-equity ratio. The cost of equity is therefore calculated from the total cost of capital plus the spread between the total cost of capital and the cost of debt, multiplied by the debt-equity ratio. The higher the debt-equity ratio, the higher the return on equity expected by the market.

Theorem III:

The average cost of capital – the total cost of capital – always remains the same, independently of the debt-equity ratio. Although the return on equity increases as the leverage effect increases, so does the risk for investors. The market mechanism ensures that the financing does not affect the overall cost of capital.

Contrary to the traditional theory

The statements of Modigliani and Miller were and are contrary to the traditional theories of financial economics. Those argue that there is an “optimal” capital structure that minimizes a company’s financing costs and maximizes its market value. The goal should therefore be to replace “expensive” equity capital with “cheaper” debt capital until the optimal ratio is achieved. The traditional theory only assumes a disproportionate increase in the cost of debt capital when the proportion of debt capital is very high, then a further increase would be counterproductive. To a certain extent, the Modigliani-Miller model deprived this theory of its basis.

Relevant or irrelevant?

Nevertheless, it must be said that the theorems are only valid under the ideal-typical assumptions mentioned above. However, these are not given in reality. Two examples to illustrate this:

  • there is an asymmetric distribution of information. Usually, the company management is more informed than the market. With its financing policy, it can set targeted signals and influence the market. The way of financing then may have an influence on the valuation;
  • taxation is not neutral with regard to financing. Equity and debt capital costs are treated differently in terms of taxation. The average capital costs are therefore “net” determined by the financing structure;

The capital structure can therefore indeed be relevant for the market value. But only thanks to Modigliani and Miller and their model it has been possible to show why.

Further links

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