The Modigliani-Miller theorem of capital structure states that, assuming no bankruptcy costs, taxes, and asymmetric information, and capital markets are perfect and complete, a company’s value will not be affected by the way it is financed, irrespective of whether the company’s capital comprises of debt or equities, or both, or dividend policy in use (Brealey et al., 2008). This theorem is commonly referred to as capital structure irrelevance principle.
There are a number of principles associated with this theorem which applies the assumption of both ‘no taxation’ and ‘taxation’. The most important principles include (a) assuming there are no taxes, leverage increment will bring no benefits regarding value creation, and (b) assuming there are taxes, when leverage is increased or introduced such benefits accrue, by a way of an interest tax shield (Brealey et al., 2008).
This theorem tries to affirm its argument by comparing two companies in which one is levered and the other unlevered, and states that if they are similar in everything; their value is the same (Brealey et al., 2008). To illustrate that the above statement is true, consider a situation whereby an investor is intending to buy one of either a levered company or an unlevered company. In this context, an investor is able to purchase the shares of the unlevered company, or purchase the shares of the levered company and borrow money equivalent to that borrowed by the levered company. Whichever case, return on investment will be equal.
Therefore, the levered company price must be equal to the unlevered company price minus the borrowed money, which is the debt of the levered company. This is a clear assumption that the investor’s cost of borrowing money is considered to be the same as that of the levered company, in real sense, this is not necessarily correct in absence of efficient markets or in the presence of asymmetric information. In case of a company with risky debt, the weighted average cost of capital remains constant as the ratio of debt-equity increases, on the other hand a higher return on equity is required due to the higher risk necessitated for equity holders in a company with debt.