Modigliani-Miller Theorem (M&M)
What Is the Modigliani-Miller Theorem (M&M)?
The Modigliani-Miller theorem (M&M) states that the market value of a company is accurately calculated as the current value of its future earnings and its underlying assets, and is independent of its capital structure.
At its most essential level, the theorem contends that, with certain presumptions in place, it is irrelevant whether a company finances its growth by borrowing, by giving stock shares, or by reinvesting its profits.
Developed during the 1950s, the theory fundamentally affects corporate finance.
Grasping the Modigliani-Miller Theorem
Organizations have just three methods for fund-raising to finance their operations and fuel their growth and expansion. They can borrow money by giving bonds or acquiring advances; they can re-put their profits in their operations, or they can issue new stock shares to investors.
The Modigliani-Miller theorem contends that the option or combination of options that a company picks significantly affects its real market value.
Merton Miller, one of the two originators of the theorem, makes sense of the concept behind the theory with a similarity in his book, Financial Innovations and Market Volatility:
"Consider the firm a monstrous tub of whole milk. The rancher can sell the whole milk with no guarantees. Or on the other hand he can separate out the cream and sell it at a significantly higher price than the whole milk would bring. (That is the simple of a firm selling low-yield and thus expensive debt securities.) But, of course, what the rancher would have left would be skim milk with low butterfat content and that would sell for considerably less than whole milk. That relates to the levered equity. That's what the M and M proposition says assuming that there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring a similar price as the whole milk."
History of the M&M Theory
Merton Miller and Franco Modigliani conceptualized and developed this theorem, and distributed it in an article, "The Cost of Capital, Corporation Finance and the Theory of Investment," which showed up in the American Economic Review in the late 1950s.
At that point, the two Modigliani and Miller were teachers at the Graduate School of Industrial Administration at Carnegie Mellon University. Both were required to show corporate finance to business understudies yet, despondently, neither had any experience in corporate finance. Subsequent to perusing the course materials that they were to utilize, the two teachers found the data conflicting and the concepts imperfect. Along these lines, they cooperated to address them.
Later Additions
The outcome was the weighty article distributed in the economic journal. The data was at last arranged and organized to turn into the M&M theorem.
Right off the bat, the two financial specialists realized that their initial theorem left out a number of significant factors. It left out such matters as taxes and financing costs, effectively contending its point in the vacuum of a "entirely efficient market."
Later forms of their theorem resolved these issues, including "Corporate Income Taxes and the Cost of Capital: A Correction," distributed during the 1960s.
Features
- Market not entirely set in stone by the current value of future earnings, the theorem states.
- The theorem has been profoundly powerful since it was presented during the 1950s.
- The Modigliani-Miller theorem states that a company's capital structure isn't a factor in its value.
