Franco Modigliani and Merton Miller’s propositions – MM without taxes

Franco Modigliani and Merton Miller (MM) developed a set of propositions known as the Modigliani-Miller propositions, which provide insights into the relationship between capital structure and firm value under certain assumptions. The original propositions formulated by MM assume a world without taxes. Let’s discuss these propositions:

1. MM Proposition I (Without Taxes): MM Proposition I states that, in a world without taxes and bankruptcy costs, the value of a firm is independent of its capital structure. This means that the total market value of a firm is determined solely by its underlying cash flows and the risk of its assets, regardless of whether the firm is financed through debt or equity. The proposition implies that investors can replicate the capital structure of a firm by combining debt and equity in their own portfolios, achieving the same risk and return profile.
2. MM Proposition II (Without Taxes): MM Proposition II states that, in a world without taxes and bankruptcy costs, the cost of equity is directly proportional to the firm’s leverage. The proposition suggests that the cost of equity increases as the proportion of debt in the capital structure increases. This is because investors perceive higher financial risk associated with greater leverage, requiring a higher return to compensate for the increased risk. The cost of debt remains constant under this proposition, as it is determined by external factors such as interest rates and the creditworthiness of the firm.