The Seamy Side of the MM Irrelevance Propositions: A Break-Through Through the Haze

Abstract

This paper reexamines MM's dividend and capital structure irrelevance theorems, refuting the first and confirming the latter from the inside out framework. The paper cooperates with Garry and Linda DeAngelo's papers on the irrelevance of the MM's dividend irrelevance theorem and refutes arguments of MM dividend irrelevance theorem advocates. The paper provides alternative proofs to MM's Propositions I and II for the capital structure irrelevance absent taxes and exclusive costs and benefits for shareholders, which holds even for two-way deals in an uninhabited island in the absent of markets. The argumentation is built upon the differences in time value of money and risk redistribution mechanism for the firm's stakeholders. The proofs presented take away the necessity in arbitrage and possibilities for shareholders to produce homemade leverage or escape from leverage for the capital structure irrelevance to hold in perfect markets and relax a long number of non-realistic assumptions. The only assumption that keeps is the investors' rational behavior that is endeavoring for net benefits and avoiding losses. The paper also considers firm valuation under imperfect market conditions and derives extended universal formula for estimating cost of levered equity, which includes MM's Proposition II formula as a special case. This formula addresses to internal causes of value relevance-irrelevance and is able to catch financial leverage value effect and is well-suited also for imperfect markets and unequal transactions. The implications of uncritical application of idealized models and valuation techniques are discussed as well. The paper investigates the shortcoming of CAPM, WACC, NPV and conventional proxies for capital budgeting and valuation in the light of new insights into MM's Propositions and suggests precautionary measures and improvements for financial applications.

Keywords: financial leverage, dividend irrelevance, capital structure irrelevance, value creation, mean-variance analysis, risky cash outflows, NPV, MNPV, M&M theorems, WACC, CoE, investment projects evaluation, EVA, Residual Income, MVA

JEL Classification: G10, G12, G30, G31, G32, G35