Lesson 4 of 6 · All lessons in this module
- The cost of capital and WACCVideo lesson
- How much financing, and what kind: business model and life cycle
- What drives the costs of debt and equity
- Modigliani-Miller without taxes: capital structure irrelevanceVideo lesson
- Modigliani-Miller with taxes, and the cost of financial distressVideo lesson
- Optimal and target capital structures, pecking order and agency costsVideo lesson
Lesson 4 of 6 · 13 min
Modigliani-Miller without taxes: capital structure irrelevance
In a perfect market with no taxes, a firm's value depends only on its cash flows: swapping equity for cheaper debt raises the cost of equity just enough to leave WACC and firm value unchanged.
In short
- MM assumptions: homogeneous expectations; perfect markets (no transaction costs, no taxes, no bankruptcy costs, same information); borrow and lend at the risk-free rate; no agency costs; financing and investment decisions independent.
- Proposition I (no taxes): . Value comes from expected cash flows, not from the debt/equity mix; WACC is unaffected.
- Proof idea: homemade leverage (investors can borrow or lend themselves) and arbitrage between identical firms.
- Proposition II (no taxes): . The cost of equity rises linearly with D/E and exactly offsets cheaper debt.
- Bankruptcy is not assumed away, only assumed to be costless.
Unlock this lesson free for 7 days
Create a free account to get 7 days free: every lesson, video and flashcard, and the question bank. No card needed.