Modigliani-Miller Capital Structuring Theorem

From WilmottWiki

The Modigliani-Miller Capital Structuring Theorem is built around the notion that, in the absence of tax, as well as transaction and other costs, no matter how one divides up a firm, its value as a whole should remain the same. Several analogies to this are generally provided in the literature, one being that a pizza divided up into several pieces should have the same value as its whole counterpart. Another example is that crude oil should have the same value, whether it’s taken as a whole or separated into its various components.

This theorem has at least two important implications. One is that it helps to reconcile a firm's value, whether it's computed from the income statement or balance sheet. The other, which then follows naturally, is that in the presence of tax, leverage creates an added value via the interest tax shield. The incremental value added, dV, due to an incremental added debt or leverage, dD, is simply TdD, where T is the tax rate.

References

• Cohen, R An Implication of the Modigliani-Miller Capital Structuring Theorems on the Relation between Equity and Debt [Download]