November 26, 2025
5 mins read
If you’ve ever wondered whether the way a company raises money really changes what it’s worth, the Modigliani-Miller theorem — or M&M theorem — is the idea you need to know. It basically says: how a company finances itself doesn’t change its value.
A company usually raises money from two sources:
Equity: money invested by shareholders, which gives them ownership.
Debt: money borrowed from lenders, which must be repaid with interest.
The capital structure is just the mix of these two. According to the M&M theorem, whether a company uses 80% equity and 20% debt or flips that around, the total value of the business stays the same. What really matters is how well the company runs its business, not how it funds it.
Let’s rewind to 1958. Economists Franco Modigliani and Merton Miller introduced this theorem, turning corporate finance thinking on its head. Their key idea was simple — a company’s value depends on its performance, not how it’s financed.
But there was a catch. The original version assumed a world that doesn’t really exist. It worked only if:
There were no taxes.
There were no bankruptcy costs.
Everyone had equal access to information.
This is far from reality, though. Companies do pay taxes, bankruptcies cost money and damage reputations, and information is rarely distributed evenly.
Because of these gaps, Modigliani and Miller later revised their theory. The updated version added more realistic elements like taxes, bankruptcy costs, and information asymmetry, making it more relevant to actual market conditions.
The key takeaway is that the value of a company is driven by the operations of the business, regardless of the method of financing. If a company produces high-quality products, operates effectively, and generates cash flow, then it will not matter how the business is financed from a value perspective.
Consider two companies that provide the same service; one finances itself with 70% debt and the other finances itself with 30% debt. Assuming they both have the same operations and cash flow, the theorem suggests that the value of Company A or Company B will be the same.
As with most things, there are some big underlying assumptions here:
No tax considerations.
No bankruptcy costs.
Everyone has access to the same information.
In the real world, debt has a downside: interest payments reduce taxable income. Further, if the company is unable to repay the debt, it can enter bankruptcy, which tends to be both costly and damaging.
The theorem effectively ignores these elements; the theorem is a useful concept to analyse the basic relationship between financing a business and the related value.
The reverse version flips the idea around. It says that if you tweak the assumptions of the original theorem, capital structure can affect value.
Here’s how that plays out:
If you change tax policies, you change how much profit a company keeps.
If you share or withhold information, investor decisions (and valuations) shift.
If bankruptcy costs rise, the risk of taking on debt changes the company’s worth.
The reverse theorem basically shows that when you step into the real world — with taxes, costs, and information gaps — the financing mix starts to matter.
Absolutely. Both Modigliani and Miller became some of the most respected names in finance.
Franco Modigliani won the Nobel Prize in Economics in 1985 for his work on saving and financial markets.
Merton Miller received the same honour in 1990 for his contributions to financial economics.
Their research still shapes how companies, investors, and policymakers think about capital structure today.
The capital structure of a company is analogous to a recipe for funding its operations. It is a mixture of two primary components: equity and debt.
Equity comes from shareholders who put their money into the business. There are different categories of equity:
Common equity confers voting privileges but does not provide payment of guaranteed dividends.
Preferred equity will provide dividends, but usually does not offer voting privileges.
Debt refers to a loan taken from banks or institutions. The company is responsible for interest payments and eventual repayment of the principal. More debt exposes the company to greater risk for bankruptcy and financial distress, but it can also decrease taxable income.
The specific mix has an impact on various factors such as risk tolerance for company owners, flexibility, and potential return for the owners - yet it does not change the total value of the firm in a frictionless world according to M&M.
Take a moment to recognise the limitations of this theory. The M&M theorem offers great utility, but it is predicated on assumptions that are not always true.
No taxes: Real organisations do pay taxes. Debt financing results in interest payments that are tax-deductible, which means that the money used to finance your debt is worth more than the money you would use to pay for capital.
No costs of bankruptcy: Bankruptcy creates legal fees, damages your reputation, and, in itself, equity is not
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As per the Modigliani-Miller theorem, a firm’s capital structure does not affect its business’s value. In other words, the proportion of debt and equity in a company’s capital structure does not impact its value. Instead, the theorem argues that a firm’s value depends upon its business operations.
The Modigliani-Miller theorem says that a firm’s capital structure does not impact its value in a perfect world where there are no taxes, no bankruptcy costs, and no asymmetric information. In the real world, these assumptions do not hold true. However, a decision maker can analyse how a firm’s value gets impacted if he relaxes these assumptions, which can help him make capital structure decisions.
This theorem assumes that there are no taxes, no bankruptcy costs, and no transaction costs. It also assumes that all investors have equal access to information.
The Modigliani-Miller theorem in finance proposes an idealized view of financial markets. For example, it says that taxes do not exist. However, companies raise debt because interest expense is tax deductible, which reduces the tax burden of companies. Hence, a manager can check how much value he can generate for his business by raising debt and relaxing this assumption of the theorem.
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