Modigliani–Miller theorem

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure.

[3] The additional value equals the total discounted value of future taxes saved by issuing debt instead of equity.

Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William F. Sharpe, for their "work in the theory of financial economics", with Miller specifically cited for "fundamental contributions to the theory of corporate finance".

Miller and Modigliani derived and published their theorem when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University.

Despite limited prior experience in corporate finance, Miller and Modigliani were assigned to teach the subject to current business students.

Finding the published material on the topic lacking, the professors created the theorem based on their own research.

Miller and Modigliani published a number of follow-up papers discussing some of these issues.

This corrects the market distortion, created by unequal risk amount and ultimately the value of both the firms will be leveled.

The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true under the following assumptions: These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important.

Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%.