Fifty Years Since Modigliani and Miller: Is Capital Structure Really Relevant for Firm Value?

Abstract:     
More than fifty years ago, Modigliani and Miller proposed that, in the absence of taxes, capital structure is irrelevant in the sense that it does not affect firm value. Since then, three sets of theories (signaling, agency, and tradeoff models) have reasserted the relevance of capital structure. In this paper, I show that capital structure does not affect firm value in any of these theories under a set of assumptions not precluded by these theories. I reach three main conclusions. First, signaling through capital structure only conveys a priori unknown information about firm value – it does not affect it. Second, an important reason why existing agency‐cost theories and tradeoff theories proved capital structure irrelevance is that they started with an inefficient allocation of project‐choice control, i.e., inefficient governance; if project‐choice control can be efficiently allocated (and I show it can under a general set of assumptions), then capital structure is irrelevant. Third, I also show that, despite the value irrelevance of capital structure, it is possible to explain observed patterns in the data, such as the higher use of leverage by firms with more tangible assets.

Number of Pages in PDF File: 41

working papers series