The MM Capital Structure vs. The Tradeoff Theory of Leverage

CFA Level 1 - Corporate Finance

Modigliani and Miller's Capital-Structure Irrelevance Proposition

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations.

The MM study is based on the following key assumptions:

• No taxes
• No transaction costs
• No bankruptcy costs
• Equivalence in borrowing costs for both companies and investors
• Symmetry of market information, meaning companies and investors have the same information
• No effect of debt on a company's earnings before interest and taxes

Look Out The MM capital-structure irrelevance proposition assumes: (1) no taxes and, (2) no bankruptcy costs.

                  
In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to the WACC. Additionally, since there are no changes/benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.
The MM Capital-Structure Irrelevance Proposition

The MM capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. As a result, MM states that the capital structure is irrelevant and has no impact on a company's stock price.
The Tradeoff Theory of Leverage


The tradeoff theoryassumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure. This benefit comes from tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the trade-off theory of leverage, where taxes and thus the tax benefit of interest payments are recognized.

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