Perfect Market, Arbitrage, and Value Creation in the MM Proposition

Abstract

The real contributions of the Modigliani-Miller (MM) Proposition are its central assumptions of perfect capital markets and the associated arbitrage argument. To explain the evolution of the understanding of arbitrage from a deterministic world into an uncertain world, we restate and comment on the proofs of the MM Proposition in current perspectives. With the no-arbitrage principle in mind, we clearly read the circular justification in the MM Proposition and the misleading concept of cost of equity. From the perspective of the distribution of a corporation's value creation, we find that shareholders prefer a maximum degree of debt.

Keywords: Perfect Market, No-Arbitrage Principle, Capital Structure, Value-Added Ratio, Cost of Equity

JEL Classification: G12, G32, D24