MM Irrelevance proposition
The relationship between leverage and the cost of debt capital was discussed for the first time by Franco Modigliani and Merton Miller in 1958. In the absence of taxes, Modigliani and Miller (MM) argue that a firm’s market value and the cost of capital remain unchanged. Based on MM’s analysis, a firm’s market value is determined by capitalizing its expected return at an appropriate capitalization rate regardless of its capital structure.
A firm’s capital structure cannot change the total value of its outstanding shares, according to MM. From the perspective of shareholders, there is no such thing as a better or worse capital structure. Their argument is that a firm’s total value depends on its underlying profitability and risk, so how it divides its total value into debt and equity is irrelevant. Therefore, the irrelevance proposition of MM states that two firms must have the same total value despite their differences in capital structure. It will restore equilibrium between the two firms if the arbitrage does not occur. It is an action taken by profit-seeking investors in which the shares of overvalued firms are sold and the shares of undervalued firms are bought, thereby forcing the two firms into equilibrium.
The MM argument argues that how leverage has been used by a corporation does not matter. By substituting personal leverage for corporate leverage, investors of unlevered firms can benefit from debt capital. By creating homemade leverage, the investors of such a company can make their personal position levered in the event that the company has not used debt capital. An ideal capital market does not value capital structure changes.
Rational investors will simply borrow on their own accounts to buy shares in unlevered firms and sell the shares in levered firms if levered firms are priced too high. Homemade leverage refers to this substitution. Individuals can duplicate the effects of corporate leverage on their own if they borrow on the same terms as the firms. Therefore, the capital structure change has no impact on the firm’s value.
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