The Modigliani-Miller model (MM model) is based on the theory that the market value of a firm is not affected by how it is financed or the way in which it distributes its dividends.
The Modigliani-Miller model is also known as the capital structure irrelevance principle because according to the theory, whether a company raises funds through debt or equity, a company’s value would be the same. The theory is based on a number of key assumptions.
- no taxes,
- no transaction costs,
- no bankruptcy costs,
- equivalence in borrowing costs for both companies and investors,
- companies and investors have the same information and
- no effect of debt on a company’s earnings before interest and taxes.
None of the conditions are met in the real world but the theorem is still taught and studied because it tells us that capital structure matters precisely because one or more of these assumptions is violated. It shows where to look for factors that determine optimal capital structure, and how they affect it.
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