Definition for : Modigliani-Miller theorem

Modigliani-Miller theorem, put forward in 1958, showed that in perfect markets and in the absence of taxation there is no such thing as an Optimal capital structure; the overall Cost of capital remains the same regardless of the firm's Debt policy. Thus, the Value of the levered company is equal to the Value of the unlevered company. This is the first proposition of the Modigliani-Miller theorem. Second proposition of the Modigliani-Miller theorem states that the Cost of equity in a world without taxes rises with the increase in Leverage. It can be computed as follows: KE = K0 + (K0-KD) x VD/VE, where KE is the Cost of equity, K0 is the Cost of equity of an all-Equity financed company, KD is the Cost of debt, VD is the Value of Debt, and VE is the Value of Equity.

(See Chapter 33 Capital structure, taxes and organisation theories of the Vernimmen)

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