Miller-Modigliani (MM) Hypothesis

The Miller-Modigliani (MM) Hypothesis, also known as the Modigliani-Miller theorem, is a theory in corporate finance that states that, in the absence of taxes, bankruptcy costs, and information asymmetry, the value of a company is independent of its capital structure.

In other words, the MM hypothesis suggests that the market value of a firm is determined by its underlying earning power and risk, and not by how it chooses to finance its operations. According to this hypothesis, investors are assumed to be rational and capable of arbitrage, which means that they can adjust their investment portfolios to account for any differences in the expected returns and risks of various investment options.

The MM hypothesis has several implications for corporate finance, including the following:

apital structure does not affect the total value of the firm, but it does affect the distribution of that value between debt and equity holders.

When taxes are introduced, debt financing becomes advantageous because interest payments on debt are tax-deductible.

When bankruptcy costs are considered, there is an optimal capital structure that balances the benefits of debt financing against the costs of financial distress.

The MM hypothesis provides a framework for understanding how changes in interest rates, tax policies, and other economic variables can affect a company’s value and capital structure.

Overall, the MM hypothesis remains an important theoretical concept in corporate finance, and it continues to influence research and practice in the field.