The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.Miller was awarded the 1990 Nobel Prize in Economics.//copy->paste from wikipedia

so what is the problem mr bullbear ?

knowledge comes, wisdom lingers

QuoteOriginally posted by: daveangelso what is the problem mr bullbear ?A)1. leverage2. dumb assumptions................B)Taxes: The theorem uses the lousy regulation on corporate taxes to show how to screw the State in favor of corporations, i.e., wealth transfer from the State/individuals to Corporations!C)I can try to reformulate [metaphorically] the theorem to a more current theme, as follows:Consider 2 otherwise equally "wealthy" countries:a. Country A with no debt [e.g. China]b. Country B almost bankrupt and hence with a pile of debt [e.g. UK]Theorem: The debt/savings mix is irrelevant when an investor is deciding where to put his money / savings... So an investor should be indifferent while choosing to invest his savings in China or in the UK.

Last edited by BullBear on January 25th, 2010, 11:00 pm, edited 1 time in total.

Actually, I'm finding it quite similar to the debate of fractional-reserve banking system vs. full-reserve banking ^ ^It's not irrelevant. It's a Ponzi Scheme. Fractional-reserve banking is a cancer!

Last edited by BullBear on January 25th, 2010, 11:00 pm, edited 1 time in total.

- giordanobruno
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Funnily enough, There IS a problem in this theorem...but it's not that much in what Bullbear just wrote. It's in this line: "It does not matter if the firm's capital is raised by issuing stock or selling debt"How??? How???Yes, some of the things Miller has written are stupid...but I can't believe that he can't write such thing. Probably it's wikipedia and all their "teenage contributors". If someone here yet wonders what the problem is...well selling stocks is nothing but selling a part of your business. That is, there is a counterparty risk, no obligations, etc. Selling debts is completely another procedure whereas the purchaser will need obligations(speaking of financial crisises...). So the net income in both cases is definitely different. Finally, I avoid reading Miller, Samuelson, Merton, Scholes, Black. Better read:Thorp, Ziemba...WIlmott.

not sure if i would call it foolish. it makes assumptions and leads to a conclusion. that s what theorems do. if these assumptions are totally out of the world, you may call it the most useless theoem ever (although there is probably some fierce competition for that title). the fool is then the guy that uses the theorem w/o taking that into consideration

are there any good resources to read to learn more about the impact of the assumptions to this model?

QuoteOriginally posted by: CEexsnot sure if i would call it foolish. it makes assumptions and leads to a conclusion. that s what theorems do. if these assumptions are totally out of the world, you may call it the most useless theoem ever (although there is probably some fierce competition for that title). the fool is then the guy that uses the theorem w/o taking that into considerationBut if you state foolish assumptions it becomes just a foolish mathematical equation meaningless to its field of knowledge. [Finance and Economics] It's like assuming we live in the wonderland just to get a useless paper article in a scientific journal.Anyway, I agree that the greater fools are the academic journals and professionals that teach such a rabish and even awarded them a Nobel prize.

QuoteOriginally posted by: giordanobrunoFunnily enough, There IS a problem in this theorem...but it's not that much in what Bullbear just wrote. It's in this line: "It does not matter if the firm's capital is raised by issuing stock or selling debt"How??? How???Yes, some of the things Miller has written are stupid...but I can't believe that he can't write such thing. Probably it's wikipedia and all their "teenage contributors". If someone here yet wonders what the problem is...well selling stocks is nothing but selling a part of your business. That is, there is a counterparty risk, no obligations, etc. Selling debts is completely another procedure whereas the purchaser will need obligations(speaking of financial crisises...). So the net income in both cases is definitely different. Finally, I avoid reading Miller, Samuelson, Merton, Scholes, Black. Better read:Thorp, Ziemba...WIlmott.Proposition I (without taxes): V_U = V_L; hence the capital structure of the firm is irrelevant to its valuation

Last edited by BullBear on January 25th, 2010, 11:00 pm, edited 1 time in total.

- giordanobruno
**Posts:**59**Joined:**

QuoteOriginally posted by: phubabaare there any good resources to read to learn more about the impact of the assumptions to this model?Harvard:http://isites.harvard.edu/fs/docs/icb.t ... University of New York:http://pages.stern.nyu.edu/~adamodar/Ne ... later.htmI admit, last time I read these 2 docs was like...3 years ago...I am sure they defend it though .

The Modigliani-Miller theorem in the form that states that firm cost does not depend on capital structure really could confuse. Indeed if a new car(firm) cost is say 20 000 and another exactly the same car(firm) in which (debt=) engine should be replaced and 5 000 also is selling for the same 20 000 then I would prefer to buy the first one though my choice contradicts The Modigliani-Miller theorem. I hope this choice will not upset those who believe in the MMT.

So how can one make money out of the situation that it's wrong ?QuoteOriginally posted by: BullBearThe Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.Miller was awarded the 1990 Nobel Prize in Economics.//copy->paste from wikipedia

QuoteOriginally posted by: BullBearQuoteOriginally posted by: daveangelso what is the problem mr bullbear ?A)1. leverage2. dumb assumptions................B)Taxes: The theorem uses the lousy regulation on corporate taxes to show how to screw the State in favor of corporations, i.e., wealth transfer from the State/individuals to Corporations!C)I can try to reformulate [metaphorically] the theorem to a more current theme, as follows:Consider 2 otherwise equally "wealthy" countries:a. Country A with no debt [e.g. China]b. Country B almost bankrupt and hence with a pile of debt [e.g. UK]Theorem: The debt/savings mix is irrelevant when an investor is deciding where to put his money / savings... So an investor should be indifferent while choosing to invest his savings in China or in the UK.I think you have a fundamental misunderstanding of M&M I (or more likely you dont and are just trying to be provocative). all this says is that the value of a firm or enterprise is independent of the way it is financed. the firm consists of assets (factories, people, brands) on the one side and liabilities and equity on the other. if there are no taxes and bankruptcy laws then the lhs (asset side) is independent of the mix of equity and debt. in most places interest expense comes above the line ie it is tax deductible meaning that there is an advantage to issuing bonds and int he limit the fim should be 100% debt financed. bankruptcy laws give the debt holders valuable rights but also give equity holders significant optionality. In reality, the conditions udner which M&M I hold cannot be observed anywhere so it is a moot theorem. however, it is a good framework to udnerstand capital structure.

Last edited by daveangel on January 26th, 2010, 11:00 pm, edited 1 time in total.

knowledge comes, wisdom lingers

BullBear> You obviously didn't bother to look through recent research in Corporate Finance.CEesx > if these assumptions are totally out of the world, you may call it the most useless theoem everNot necessarily. If we have A => B, where B is a good "reference point" then we also have !B => !A, which can be quite useful.M&M states that if condition A holds (1) no taxes 2) no bankruptcy costs 3) fixed investment policy) then we have B (capital structure does not affect firm's value; actually this can also be said about risk management and hedging policy). Shortly, A => B. In reality we know that B is not true. Hence A must be false or formally !B => !A.The starting point for all modern models is dropping one or more M&M assumptions.> are there any good resources to read to learn more about the impact of the assumptions to this model? I have started a course now taught by one of the leaders in this field, I'll try to make a summary closer to the end of the course (end of feb).

QuoteOriginally posted by: daveangelI think you have a fundamental misunderstanding of M&M I (or more likely you dont and are just trying to be provocative). all this says is that the value of a firm or enterprise is independent of the way it is financed. the significance of the theorem is enormous in business. quant people don't know much about corp finance world, unfortunately.in the simplest form it says: make first business decisions, then think of financing. i.e. your financing choice shouldn't dictate what you do. it was a great insight, regardless of the assumptions and the maths. i also encourage to read the actual paper. it's one of the examples of great economic writing, very short, and easy to read. one needs some business background though to understand it.

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