'Modigliani-Miller's Proposal' Demasque

23 Pages Posted: 1 Nov 2004 Last revised: 10 Jun 2016

Date Written: November 16, 2006

Abstract

Modigliani and Miller studied the effect of leverage on the firm's value, but their famous Proposition I (1958, equation 3), stating in the absence of taxes, the firm's value is independent of its debt is abundantly not true. The so-called proof given by Modigliani and Miller is not a mathematical proof. It was and is a statement, which cannot stand the test. Proposition I is not true. Consequently everything based on Proposition I is not true either.

This paper presents a close inspection upon the Modigliani-Miller's Proposal. Although Franco Modigliani and Merton Miller (MM for short) were awarded the Nobel Prize in Economics, their Proposition I appears to be clearly incorrect. The basic MM's idea is that the value of the firm does not depend on how the stakeholders finance it. This revolves around stockholders (equity) and creditors (liabilities to banks, bondholders, etcetera). MM proposed that under perfect market conditions (complete information, no taxes, etcetera), the capital structure does not affect the value of the firm. The equity holder can borrow freely and thus determine the amount of leverage. The capital structure of the firm is the combination of debt and equity in it. What has been argued by MM, that is, VL the value of the levered firm is equal to VU the value of the unlevered firm, is not true, as is outlined in this paper. An exemplary problem quoted by Pablo Fernandez is worked out in detail in order to demonstrate the MM's proposal failure.

Keywords: Firm Valuation, VTS, Weighted Average Cost of Capital, WACC, Equity Cost of Capital, Return On Equity, ROE, Total Capital Return, TCR

Suggested Citation

Jacobs, Jan F., 'Modigliani-Miller's Proposal' Demasque (November 16, 2006). Available at SSRN: https://ssrn.com/abstract=609102 or http://dx.doi.org/10.2139/ssrn.609102

Jan F. Jacobs (Contact Author)

Independent ( email )

Netherlands

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