A first look at the Modigliani and Miller Capital Structure theorem.

Modigliani and Miller showed that, under idealistic conditions, the level of debt in its capital structure
does not matter. The theory relies on two basic assumptions:

1. The cash flows that a firm generates are not affected by how the firm is financed.
2. Financial Markets are perfect.

Assumption 2 of perfect market implies that the packaging of cash flows, that is whether they are
distributed to investors as dividends or interest payments, is not important.

When the two assumptions hold, the value of the firm is not affected by how it is financed.

Assumption 1: Cash Distributions to Bondholders and Stockholders are not affected by financial
leverage.

Debts or Bonds
20% or $100,000

Debt or bonds 40%

Total cash flow is
or $200,000
the same
reagrdless
Equity or Common Stock
of the Financing mix Equity or Common
60%
Stock 80% or $400,000
or $300,000
Total Cash Flow under Total Cash Flow under
Finanacing mix A Finanacing mix B

Financial managers care a great deal about how their firms are financed. Indeed, there can be negative
consequences for firms that select an inappropriate capital structure, which means that, in reality, at
least one of the two M&M Assumptions is violated.

Violations of Assumption 2

Transaction costs can be important and because of these cost, the rate at which investors can borrow
may differ from the rate at which firms can borrow. When this is the case, firm values may depend on
how they are financed.

Violation of Assumptions 1

There are three reasons why capital structure affects the total cash flows available to a firm’s debt and
equity holders:

1. Interest is a tax- deductible expense, while dividends are not. Thus, after taxes, firms have more
money to distribute to their debt and equity holders if they use debt financing.

2. Debt financing creates a fixed legal obligation. If the firm defaults on its payments, the firm will
incur the added cost that the bankruptcy process entails.

3. The threat of bankruptcy can influence the behavior of a firm’s executives as well as its
employees and customers.