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The Modigliani-Miller theorem*, a foundation of modern corporate finance, basically states that, in a no-frictions world, two identical firms have the same enterprise value, regardless of their financial structure.

Given a firm A, whose liabilities are 50% equity, and 50% debt, and a firm B which is financed 100% by equity, the value of firm A and the value of firm B are the same.

Isn't it just obvious? What am I missing?

* - Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review 48 (3): 261–297. JSTOR 1809766.

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People, particularly business leaders, seem to remain confused about this issue even today. At the core of is the question Is equity finance expensive?. We certainly observe in the data that the realized returns on firm debt are much lower than the realized returns on firm equity. Does this mean that firms have too much equity?

If equity capital always costs 9 percent per year and debt always 3 percent then a firm would be worth more if management kept equity to a minimum and used as much debt as possible. But in the real world there are lots of complications that might make debt cheaper than equity. Monitoring costs are real, default is costly, tax wedges are large, equity is riskier, and contracts are incomplete. It may be that factoring in these costs, which are hard to measure, provides a complete explanation for the differences in return between debt and equity. Or maybe not. If observable characteristics fail to explain this difference does this mean that firms should take on more debt? Or does it mean that these characteristics are poorly measured?

Modigliani-Miller provide a clear way of thinking about this question. In the absence of frictions, as you shrink the amount of equity and offset it with more debt the required returns adjust to leave the firm's cost of capital unchanged. But even so, there is no problem with return on debt being lower than the return on equity. So in and of itself, there is nothing to learn from the lower cost of debt compared with equity. This is a surprisingly robust result:

The two Modigliani-Miller theorems hold good, irrespective of individual differences between shareholders' valuations of risk, leverage effects, durability of loans, etc. The logic of the theorems rests in fact upon the assumption of perfect markets, namely that a shareholder can always, through his own borrowing or lending, compose his asset portfolio as he sees fit and that he can, without costs, give it the composition he desires with respect to risk, leverage, etc. If for instance the risk level of a firm's assets is increased, the shareholders can neutralize this by lowering the risk of other assets in their portfolios.

Press Release: 15 October 1985 THIS YEAR'S ECONOMICS PRIZE AWARDED FOR PIONEERING STUDIES OF SAVING AND OF FINANCIAL MARKETS

This is an extremely valuable insight. The explanation is also clear and powerful. So good and powerful that it is hard to see the world any different once you hear it. In one of the Sherlock Holmes stories, Holmes says "The world is full of obvious things which nobody by any chance ever observes." In TV tropes this is called Seinfeld Is Unfunny:

It wasn't old or overdone when they did it. But the things it created were so brilliant and popular, they became woven into the fabric of that show's genre. They ended up being taken for granted, copied and endlessly repeated. Although they often began by saying something new, they in turn became the status quo.

Additionally, it is hard to remember from the perspective of the present how devoid of theory was corporate finance in the period before Modigliani and Miller. Here's a quote from an award ceremony speech related to the Nobel award:

Until the latter part of the 1950s, no viable theory of corporate financing of investment, debt, taxes, and so forth had been developed. It was not till Modigliani and Miller presented their theorems that more stringent theorizing began to appear in this field. By treating financing decisions within the framework of a theory of financial-marketplace equilibrium, Modigliani and Miller provided the general guidelines for continued research in this area.

Award Ceremony Speech: Presentation Speech by Professor Ragnar Bentzel of the Royal Academy of Sciences

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Just think to one main point: there is a good example about "the farmer and the milk" made by Merton Miller (a man that has no need to be presented). If a farmer has a huge quantity of milk to sell, and it sells the whole milk it earns N. Another farmer, with the same amount and kind of milk, decides to sell milk cream at an higher price but the skim milk at much lower price than the cream. If you sum the two you will have N again. So, according to theorem's assumptions, selling whole milk (Unlevered) or milk cream + skim milk (Levered) let these two farmers earn the same.

It would surely sound you abstract, but it reflects a lot about capital structure! You will learn while advancing your skills in Corporate Finance and related topics.

EDIT:

source: http://www.investopedia.com/terms/m/modigliani-millertheorem.asp

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This has important policy consequences that seem to be widely misunderstood. In the book The Bankers' New Clothes by Admati and Hellwig, the authors argue, fundamentally realying on MM, that higher equity requirements for Banks may reduce their profits, but will not reduce economic investment. This very much contradicts the story lobbyists for banks like to tell.

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