The Modigliani-Miller Second Proposition is Dead; Long Live the Second Proposition

12 Pages Posted: 12 Apr 2016

See all articles by Kuo-Ping Chang

Kuo-Ping Chang

National Tsing Hua University - Department of Quantitative Finance

Date Written: March 11, 2016

Abstract

By using the binomial option pricing model, this paper proves that with no arbitrage and no transaction costs, (i) under riskless debt, increasing the debt-equity ratio increases the variance of the rate of return on equity; and (ii) under risky debt, increasing the debt-equity ratio increases the variance of the rate of return on debt but does not affect the probability density function of the rate of return on equity. This finding refutes the Modigliani-Miller second proposition that the expected rate of return on the equity of the levered firm increases in proportion to the debt-equity ratio.

Keywords: The Arbitrage Theorem, capital structure irrelevancy

JEL Classification: G13, G32

Suggested Citation

Chang, Kuo-Ping, The Modigliani-Miller Second Proposition is Dead; Long Live the Second Proposition (March 11, 2016). Available at SSRN: https://ssrn.com/abstract=2762158 or http://dx.doi.org/10.2139/ssrn.2762158

Kuo-Ping Chang (Contact Author)

National Tsing Hua University - Department of Quantitative Finance ( email )

Hsin Chu, Taiwan 300
China
+886 3 574 2730 (Phone)
+886 3 571 5403 (Fax)

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