Modigliani-Miller Theorems Research Papers

In the realm of corporate finance, no single work has effected such widespread and revolutionary changes as the Modigliani-Miller Theorems, initially developed by a pair of Carnegie Mellon economists in 1958. Although not all of the tenets underlying the famed Modigliani-Miller Theorems (MM-theorems) are still universally accepted by economists, the innovative thinking and non-paradigmatic thinking embodied in the theorems have earned them canonical status in the field. Much of the rationalization behind the MM-theorems is still applied in corporate finance today .

In this paper, the strengths and weaknesses of the MM-theorems will be assessed. First, an overview of the theories set forth by Modigliani and Miller will be presented. Then, the strengths and weaknesses of the theorems will be discussed. Finally, the continuing relevance of the MM-theorems in current-day corporate finance will be evaluated.

Basically, the problem that Modigliani and Miller set out to address in their early research dealt with what the optimum financing structure would be for a firm. In addition, the researchers sought to delineate the relationship between a firm’s financial decisions and activity and their total stock market value.

In their formal expression, there is actually a single MM-theorem that is described with two related equations. The first, (VL = Vu) merely states that there is no essential difference in value between a leveraged and an unleveraged firm. As a result, it can also be stated that a particular firm’s weighted average cost of capital (WACC) is the same regardless of its composition of debt and equity. Further, it can be stated from the first proposition of the MM-theorem that the capital structure of a firm is wholly irrelevant.

The second proposition of the MM-theorem is stated thusly: RE = RA + (RA - RD) X D/E. In this formula, RA represents the firm’s WACC, RD is the cost of debt, and D/E represents the debt/equity ratio. According to this proposition, it follows that the cost of equity actually rises as the firm increases its use of debt financing. Further, this proposition implies that the risk of equity is dependent upon the risk of firm operations, and simultaneously upon the amount of financial leverage carried by the firm.

Ultimately, the MM-theorems put into wide circulation the notion that it is the degree of risk and the predicted rate of return that will coincide to determine a firm’s value, rather than the method that it has employed in raising capital and securing finance .

The strengths of the MM-theorems are manifold. Because some of the most ardent criticism of the MM-theorems has had to do with the bedrock belief that financing decisions most certainly do affect firm value, it is useful to remember that Modigliani and Miller sought to delineate the value of a firm under very strict operational parameters .

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A research paper is an in-depth examination of Modigliani-Miller Theorems. More than just an overview of what was learned on Modigliani-Miller Theorems, like a term paper is, a research paper contains analysis of Modigliani-Miller Theorems along the lines of organizational theory and relevant published material. Research papers are highly analytical and can often be more than 8 to 10 pages. The key to a good research project is the examination of recently published journal articles and peer-reviewed material on the Modigliani-Miller Theorems chosen. Like the name implies, research papers are exactly that, a paper that examines the information that can be found on Modigliani-Miller Theorems.