Peer Response 1 – Tanika Anderson
It is interesting that it is called the M&M propositions. It can be a sweet formula for some
companies if it could be practiced. According to the CFI research, there are two
propositions. The first one states that a companyàcapital structure does not impact its
value. Since the value of a company is calculated as the present value of future cash flows, the
capital structure cannot affect it. This theory is based on a perfectly efficient market. Therefore,
it is full of limitations. One such limitation is that there are no taxes. Another limitation is there
are no bankruptcy costs. Thirdly, there is asymmetric information. Anyone can see the flaws in
this theorem. In the real world, companies will pay taxes; companies file bankruptcy more often
than we think and incur the costs. There will always be one party that knows more information
than the other party. Equal information is extremely difficult to maintain in such a fluctuating
market. Information changes too quickly. This is not reality.
Based on these limitations Miller and Modigliani developed the second version of their theory
to include taxes, bankruptcy costs and asymmetric information. It states that the cost of equity
has a direct relationship with the leverage level. An increase in leverage level induces a higher
default probability for a company. Therefore, investors tend to demand a higher cost of equity to
be compensated for the higher risk. Even though proposition two is more accountable, they both
lack real world expectations.
Bhattacharya, S. (1988) says in summary, with the absence of taxes a firmàcapital structure
is not important. Therefore, a company with 100% leveraged capital structure does not benefit
from tax deductible interest payments. In the real world of corporate finance, everything affects
the bottom line. In fact, the theory demonstrates that how a manufacturing company funds its
activities is less important than the profitability of those activities. Firms use the theory to
estimate how debt or equity costs can change if more or less debt is used in the capital structure.
Investors use the MM theory to determine if firms are fairly valued and if the rate of
return is sufficient for the risk.
References
CFI team. (2022). M&M Theorem: Overview, Assumptions, and Propositions.
Retrieved: November 22, 2022, From: www.corporatefinanceinstitute.com
Bhattacharya, S. (1988). Corporate Finance and the Legacy of Miller and Modigliani. Journal of
Economic Perspectives, 2(4), 135-147. Retrieved: November 22, 2022. From: www.Journal of
Economic Perspectives
Peer Response 2 – Jamie Rohrbaugh
Merton Miller and Franco Modigliani won the Nobel Prize for Economics in part for their
collaborative work on the relevance of capital structure to a firmàvalue (Berk & DeMarzo,
2019). In short, Miller and ModiglianiàProposition I is that, in a perfect market without taxes, it
is not relevant to the overall value if a firm is highly leveraged or has very little debt. The choice
of the capital structure does not make a difference to the firmàvalue. The underpinning of this
finding is the idea that if a leveraged firm and an unleveraged firm had different values, investors
would be able to take advantage of an arbitrage opportunity by buying the unleveraged firm on
margin which would make the firm a leveraged firm and raise its value and create a profit for the
investor (Milken Institute, 2022). If this happened, the Law of One Price would cause the
arbitrage to quickly evaporate as the market corrected itself.
Modigliani and MilleràProposition II concedes that the cost of debt is generally cheaper than
the cost of equity. As such, it seems that it would make sense to more heavily use debt to take
advantage of the disparity. Modigliani and Miller pointed out that using debt causes a firm to
have to pay more on its equity. The savings from using debt will be exactly offset by the increase
in the equity payments (Milken Institute, 2022). This correlates nicely to their first proposition in
that it confirms there is no perfect mix of debt and equity when considering a capital structure for
a firm.
Modigliani and Milleràwork has been reviewed and researched for nearly fifty years. It is solid
and has withstood the test of time but it is not without imperfections. One complaint is the fact
that it, like the Law of One Price, these propositions assume a perfect market which does not
exist in reality. This is true but understanding how markets would work if an ideal was possible
allows us to understand the causes of imperfections in the operation of actual markets (Berk &
DeMarzo, 2019). Much like the discussion in the text about the importance of Galileoàtheories
which only work in a vacuum. Another complaint is that equity and debt are not actually
equivalent in that a default on debt could have catastrophic implications for a firm (Milken
Institute, 2022). Operating in an unleveraged structure would eliminate that chance but is much
more costly as firms get larger and larger. This idea gives us some indication that the extremes of
either 100% leverage or 0% leveraged are likely not ideal.
References
Berk, J. B., & DeMarzo, P. M. (2019). Corporate finance: The Core (5th ed.). Boston, MA:
Pearson. ISBN: 9780135161159
Milken Institute. (2022). The Modigliani and miller propositions: 5-Minute finance.
www.5minutefinance.org. Retrieved November 24, 2022, from
https://www.5minutefinance.org/concepts/modigliani-and-miller-propositions

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