Table of Contents

Understanding the Modigliani-Miller Theorem: An Investor's Guide

By

James Chen

Updated September 19, 2025

Reviewed by

JeFreda R. Brown

Fact checked by Kirsten Rohrs Schmitt

Definition

The Modigliani-Miller theorem is a financial principle stating that a company's market value is determined by the present value of its future earnings and assets, regardless of its capital structure.

What Is the Modigliani-Miller Theorem?

The Modigliani-Miller theorem (M&M) was developed in the 1950s by Merton Miller and Franco Modigliani. This important and still relevant theory states that the market value of a company is calculated as the present value of its future earnings and underlying assets. They believed that taxes and government regulations do not contribute to capital structure, and that market value is independent of a company's capital structure.

Key Takeaways

The Modigliani-Miller theorem, developed by Merton Miller and Franco Modigliani, posits that a company's market value is unaffected by its capital structure; instead, it's determined by the present value of its future earnings and underlying assets.
Initially crafted under the assumption of a perfect market with no taxes or transaction costs, the M&M theorem later evolved to consider the impact of taxation and real-world financial factors on capital structure.
The theorem challenges traditional beliefs by suggesting that debt does not directly enhance or diminish a company's value, contrary to the idea of an "optimal" capital structure.
The "reverse M&M theorem" implies that certain elements like transaction costs and taxes can affect a company's value, showcasing the complexity of real-world financial environments.

Modigliani-Miller Theorem (M&M) — Investopedia / Candra Huff

The Evolution of the Modigliani-Miller Theorem

Modigliani and Miller, professors at Carnegie Mellon University, taught corporate finance but found the course material inconsistent and flawed. Merton Miller and Franco Modigliani published their theorem in an article, "The Cost of Capital, Corporation Finance and the Theory of Investment," which appeared in the American Economic Review in the late 1950s.

The information was compiled into the M&M theorem. They realized it initially ignored taxes and financing costs, assuming a "perfectly efficient market." Later versions of their theorem addressed these issues in "Corporate Income Taxes and the Cost of Capital: A Correction," published in the 1960s.

Important

M&M challenged the belief that debt was cheaper than equity and that companies could strive for an optimal capital structure. The theorem argues that debt does not directly impact a firm's value.

Key Assumptions of the Modigliani-Miller Theorem

Companies can finance growth by borrowing money, issuing bonds, or getting loans. They can also reinvest profits or issue new stock shares. The Modigliani-Miller theorem argues that a company's value stays the same when adjusting leverage, based on these assumptions:

Efficient markets: All investors agree on the market value of all cash flow streams.
Frictionless markets: Contracts can be written and enforced without incurring any cost.
No taxes or regulations: Taxes and government regulations do not affect capital structure.
Cash flow: Investors care only about the cash flow generated by an investment.

Merton Miller analogized their proposition to slicing a pizza. When a pizza is cut into many slices, the size of the pizza does not change. The two economists argued that when a firm’s capital structure divides its cash flows, without changing the nature of those cash flows, it does not affect the company's value, which remains the present value of all of its cash flows.

What Is the Reverse M&M Theorem?

Modigliani and Miller wrote their original article to negate the idea that capital structure affects a firm's value. However, by denoting which aspects of capital structure do not affect value, the theorem showed the opposite, a reverse theorem. The reverse M&M theorem argues that capital structure can affect a company's value by increasing or decreasing corporate information, transaction costs, taxes, and regulations.

Were Modigliani and Miller Recognized Economists?

Merton Miller was awarded the Nobel Prize in Economics in 1990 “for their pioneering work in the theory of financial economics.” Franco Modigliani was awarded the Nobel Prize in Economics in 1985 “for his pioneering analyses of saving and financial markets."

What Is a Company's Capital Structure?

Capital structure is how a company funds its overall operations and growth. It represents the debt and equity used to finance a company's operation and growth.

The Bottom Line

The Modigliani-Miller theorem asserts the irrelevance of a company's capital structure to its market value, based on the present value of future earnings and underlying assets. Merton Miller and Franco Modigliani developed the theorem in the 1950s, earning significant recognition, including Nobel Prizes in Economics, for their contributions to financial theory.

The theorem challenges traditional views on the cost-effectiveness of debt vs. equity by suggesting that an optimal capital structure does not exist in perfectly efficient markets. The original theorem required certain assumptions to be made, such as efficient markets and the absence of taxes and costs, but subsequent versions accounted for certain factors like taxes.

While the theorem provides a foundational theory for corporate finance, real-world conditions such as taxes, transaction costs, and regulations can impact capital structure decisions.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Michael Joseph Dempsey. "Stock Markets and Corporate Finance," Page 8. World Scientific Publishing Company, 2017.
Modigliani, Franco, and Merton H. Miller. "The Cost of Capital, Corporation Finance and the Theory of Investment." The American Economic Review, vol. 48, no. 3, Summer 1958, pp. 261-297.
Modigliani, Franco, and Merton H. Miller. "Corporate Income Taxes and the Cost of Capital: A Correction." American Economic Review, vol. 53, no. 3, Summer 1963, pp. 433-443.
Yale University. "The Modigliani-Miller Theorem at 60: The Long-Overlooked Legal Applications of Finance’s Foundational Theorem."
The Nobel Prize. "Merton H. Miller."
The Nobel Prize. "Franco Modigliani."

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