Modigliani-Miller Propositions I and II
The Modigliani-Miller propositions I and II hold that when computing market value, the method of how a company finances its operations is essentially irrelevant, regardless of whether it does so by borrowing from a bank or by selling bonds, selling stock, or by reinvesting its profits (Chen, 2022). Instead, value is reflected in the current value of future earnings and assets (Chen, 2022). From the investors perspective, it does not matter if the companys debt is held by the investor him or herself, or by an outside entity; the second proposition states that the cost of debt is less than the cost of equity, but the cost of capital cannot be exchanged by trading equity for debt, because of the cost of borrowing (Modigliani-Miller theorem, 2022).
The first and second propositions start with the assumption that there are no transaction costs or taxes, and that all borrowing takes place at the same rate (Modigliani-Miller theorem, 2022). However, with taxation, firms can increase their value by increasing debt, because they pay less in taxes while still using the invested capital to generate long-term wealth for the firm. Without taxes, however, there is no benefit to debt-based financing (Modigliani-Miller theorem, 2022).
Thus, according to abstract theory, firms should capitalize upon favorable corporate taxation and reinvest, versus focusing on keeping debt low. This suggests greater value in reinvesting profits in the firm and selling shares and bonds to keep the company afloat. However, in the real world, there are many potential detriments to this strategy. First of all, influential shareholders demand to see high levels of performance, and may use their financial leverage upon the firm to encourage decision-making that may not be in the firms long-term interest
Secondly, reinvesting in the firm may result in longer versus short-term gains, depending upon the industry. Investing in manufacturing, research and development, and raw materials may be much more costly and uncertain for an organization which produces labor-intensive physical goods, for example, even with the factor of taxation taken into consideration. Firms must do industry-specific research and also analyze the current economic and political landscape, as well as assess how changes in technology may affect the firm.
References
Chen, J. (2022, March 23). Modigliani-Miller theorem. Investopedia.
https://www.investopedia.com/terms/m/modigliani-millertheorem.asp
Modigliani-Miller theorem (2022). 5minutefinance.
https://www.5minutefinance.org/concepts/modigliani-and-miller-propositions
