Question

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on the capital structure of a firm. The MM theorem represents what could possibly be the most important theory in respect of the effects of the Capital structure of a firm and the value of that firm. Despite the enormous efforts by Modigliani and Miller and the entire time spent by numerous scholars critiquing this theory, the MM theorem remains unclear and faces many objections. Critically discuss. word limit 500 - 1000

Answer 1

I agree with the statement that MM theorem remains unclear to a large extent and even faces many objections.

There is no denying the fact that the MM theorem is one of the most influential elements of economic theory as it forms the underlying basis on which the modern thinking on capital structure is based. The basic premise of the theorem is that the value of the firm is not affected by how it is financed i.e. whether by debt or equity. This, however, holds under assumptions of absence of taxes, of bankruptcy costs, of agency costs, and of asymmetric information.

Despite this the MM theorem largely remains unclear and even faces significant and large amounts of objections. First of all there were not very clear grounds and basis that the MM theorem uses while building the assumptions for the theorem. It is because of this that all three propositions and the basis of them remain unclear. The first proposition states that a firm’s total market value is independent of its capital structure. The second proposition states that cost of equity increases with debt-equity ratio. The third proposition states that total market value of a firm is independent of its dividend policy. The critics point out that markets of today are not the same as the markets that existed in the past and due to the largely changed dynamics of the capital market and the stock market there are instances in which we witness dramatic movement in stock prices. Also the data from the stock market of the last 25 years to 30 years shows us that corporate values are affected both by the changes in capital structure as well as the changes in dividends. Another objection of the MM theory is that it does not have any analytical power and that it only has theoretical power.

Many other experts in the field of finance and economics have raised objections to the MM theory on the grounds that the theory is, at large, unrealistic. The assumption that each company meet to a risk class, firms with same or similar income within states across the globe is not a vital assumption. It does not coincide with reality in any manner and this dilutes its vitality. Other key objections and areas which lack clarity are – risk classes are important, implication of objective prospect allocation over possible outcomes and basing the assumption on partial equilibrium analysis.

With the changing nature of the markets and with the developments of new conditions that premise on which the MM theorem were based became all the more irrelevant and diluted in importance and application. Now the reality is that individuals and firms can never borrow at the same market rate and that bankruptcies do exist and is a start reality.

Thus we can say that despite all the accolades and despite the significance and importance of the MM theorem it still remains a general concept. The controlled environment that was envisaged and that was the basis of the theorem is not a real world phenomenon and hence the real world is completely different from the imaginary and assumed world in which the MM theorem was crated.

(529 words)