Lesson 4 of 6 · 13 min

Modigliani-Miller without taxes: capital structure irrelevance

In a perfect market with no taxes, a firm's value depends only on its cash flows: swapping equity for cheaper debt raises the cost of equity just enough to leave WACC and firm value unchanged.

In short

  • MM assumptions: homogeneous expectations; perfect markets (no transaction costs, no taxes, no bankruptcy costs, same information); borrow and lend at the risk-free rate; no agency costs; financing and investment decisions independent.
  • Proposition I (no taxes): VL=VUV_L = V_U. Value comes from expected cash flows, not from the debt/equity mix; WACC is unaffected.
  • Proof idea: homemade leverage (investors can borrow or lend themselves) and arbitrage between identical firms.
  • Proposition II (no taxes): re=r0+(r0−rd)DEr_e = r_0 + (r_0 - r_d)\frac{D}{E}. The cost of equity rises linearly with D/E and exactly offsets cheaper debt.
  • Bankruptcy is not assumed away, only assumed to be costless.

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Modigliani-Miller without taxes: capital structure irrelevance · Capital Structure