Investment Decisions by the Firm

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 investor’s perspective, it does not matter if the company’s 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 firm’s long-term interest