Modigliani-Miller Theorem (M&M)

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Definition of 'Modigliani-Miller Theorem (M&M)'

The Modigliani-Miller theorem (M&M) is a set of propositions in corporate finance that describe the relationship between a firm's capital structure and its value. The theorem states that, in a perfect market, the value of a firm is independent of its capital structure. This means that the firm's capital structure does not affect its cost of capital or its risk.

The M&M theorem was first proposed by Franco Modigliani and Merton Miller in a 1958 paper titled "The Cost of Capital, Corporation Finance, and the Theory of Investment." The theorem has been influential in the field of corporate finance, and it has been used to explain a number of empirical observations about the relationship between capital structure and firm value.

The M&M theorem is based on a number of assumptions, including the following:

* There are no taxes.
* There are no transaction costs.
* Investors are rational and have perfect information.
* There are no bankruptcy costs.

Under these assumptions, the M&M theorem states that the value of a firm is equal to the present value of its future cash flows. The firm's capital structure does not affect its value because the cash flows that the firm generates are unaffected by its capital structure.

The M&M theorem has been criticized on a number of grounds. One criticism is that the assumptions on which the theorem is based are unrealistic. For example, taxes and transaction costs are a reality in the real world, and they can affect the value of a firm's capital structure.

Another criticism of the M&M theorem is that it ignores the risk of bankruptcy. In the real world, firms that have more debt are more likely to go bankrupt. This increased risk of bankruptcy can reduce the value of a firm's equity.

Despite these criticisms, the M&M theorem remains an important contribution to the field of corporate finance. The theorem provides a useful framework for understanding the relationship between capital structure and firm value.

The M&M theorem has also been used to develop a number of other theories in corporate finance, such as the pecking order theory and the trade-off theory. The pecking order theory states that firms prefer to finance their investments with internal funds, followed by debt, and then equity. The trade-off theory states that firms trade off the benefits of debt (such as tax shields) against the costs of debt (such as bankruptcy risk).

The M&M theorem is a complex and controversial topic. However, it is an important concept in corporate finance, and it is worth understanding the basic principles of the theorem.

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