MM Thesis

The MM Theory

The full form of the MM Theory is the Modigliani-Miller Theory. As the name suggests, it was derived by two people named Modigliani and Miller.

Franco Modigliani and Merton Miller were economists whose work set a great milestone in corporate finance theory.

The MM Theory in corporate taxes is considered a great milestone in the finance sector. In the MM Theory, the firm’s value does not depend on the dividend policy. The value also does not depend on whether or not the firm raises capital by selling the debt or issuing stocks. Another name for the Modigliani-Miller Theory is the capital structure irrelevance principle. It is based on the reasons stated above.

For the work on the MM Theory,

Modigliani was awarded the Nobel prize for Economics in the year 1985. His other contributions also factored into his Nobel prize.

Merton Miller was a professor of economics at the University of Chicago. Five years after Modigliani received the Nobel prize, Miller was also awarded a Nobel prize in economics in 1990. He received the Nobel prize along with William Sharpe and Harry Markowitz.

The Theorem

The MM Theory is stated for two firms that are exactly similar to each other except for their financial structures. Their financial structures differ from each other. Let’s call it firm U, one of the firms is only financed by equity and is unleveled. The second firm, let’s call it firm L, is levered. Debts finance it to some extent, and the rest of the finance is brought in by equity.

According to the Modigliani-Miller Theory, the enterprise value of firm U and firm L are the same. However, this value should not be confused with the equity values of the firm.

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Assumptions of MM Theory 

Let’s understand the Assumptions of the MM Theory. 

• Under the MM Theory, the implication of tax is not present
• All the transaction cost and bankruptcy cost is zero in the MM Theory
• The investors and the corporation will get the same details and information
• Based on this information, investors make decisions
• The borrowing cost will be the same for both corporations and investors
• Floatation cost is not present
• Dividend tax on the corporation is not present

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MM Theory in Corporate Taxes 

MM Theory plays an essential role in explaining corporate taxes.

Propositions of the MM Theory without taxes

The Modigliani-Miller Theory is presented in the form of two propositions.

First proposition

The first proposition of the MM Theory states that the V(U) is the value of an unlevered firm equal to the firm’s buying price, which only constitutes equity. The V(L) is the firm’s value, which is levered, and the buying price is a mix composed of the equities and debts. The levered firm is also called the geared firm.

The MM Theory states that:

V(U) = V(L)

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Explanation

Consider that an investor wants to buy one of the two firms, the U firm or the L firm. Instead of buying all the shares of firm L, which is levered, he could buy some shares of firm U and borrow the amount of money the same as the L firm does. The returns on both of these investments would remain the same.  

Hence, the price of L must be equal to the price of firm U after subtracting the money borrowed. This money is equal to the amount of firm L’s debt.

Second proposition

The second proposition of the Modigliani-Miller Theory is a little more complicated. It states that the cost of equity of the leveraged firm equals the sum of the cost of equity of a firm with no leverage, the cost of debt and the debt to equity ratio.

The first, and the second propositions hold under the following conditions.

• There is no cost for the transaction
• The corporations and individual buyers buy at the same rates

However, none of these conditions is satisfied in the real world. So, the results of these propositions aren’t practically applied anywhere. But this theorem conveys a very important thing. It conveys that the practical structure matters because one or more conditions are violated. It shows us the places to look for determinants of optimal capital structure. It also tells us how the optimal structure is affected by various factors.

The basic concept covered in the first proposition is that the company’s value is not impacted by its capital structure.

Conclusion

MM Theory is essential in the economic field as it states what factors affect the optimal capital structure and how they affect it. Modigliani and Miller proposed the MM Theory. Both of them won Noble prizes in the economy for this contribution. Modigliani won the Nobel in 1985, and Miller won in 1990.

The MM Theory suggests that two firms, one of which is levered and the other one is unlevered, will have the same enterprise value and will return the same returns on investment after some time. However, this value isn’t the same as the firm’s equity.