The Modigliani-Miller theory, proposed in 1958, was created by American scientists in finance Franco Modigliani and Merton Miller. The idea assumed the value of a company depends on the amount of the profit and is not influenced by market mechanisms. Moreover, the source of financing is not essential in this case; the company’s market price will not change. This theory caused a broad resonance in the scope of finances and corporate finance management.
The theory of Modigliani-Miller is about the absence of any relations between the market value of the company and its capital structure; instead, owners use leveraged equity. It is essential to determine several key features, strengths and weaknesses, and the circumstances in which the theory of Modigliani-Miller will work efficiently.
It becomes apparent that the theory provoked a severe dissonance in the financial world. It happened because the model could not be accepted as a standard for all firms. For instance, for the theory to exist, the market must be perfect. In this sense, there should not be any taxes and other business services such as transactional, information, bankruptcy business services. What is more, each participant of the economic system must possess an equal number of tools. They should also be in identical conditions, such as attracting and placing capital at the same rate, maintaining similar information, and behaving in the same manner. The initial point of Modigliani and Miller is a perfect market condition, and this is almost impossible to create and hold due to the constantly changing circumstances.
Despite the resonance and conditions created for the theory, it has several advantages. Modigliani and Miller proposed that borrowed money increases the company’s cost. It can be justified because financing using borrowed sources might be profitable for several reasons. For example, the company uses only its own money; the gross profit of the agency consists of profit reduced by the cost of sources (materials, human resources, services), which are fully paid. If the company borrows funds, for instance, revenues and expenses, but the services are not paid, the profit will be more prominent. It is possible to pay off debts after dividend payments, and the company benefits from the increased earnings because of borrowed sources.
However, it might not be safe for the companies to lend money for these purposes in practice. For instance, Stephen A. Ross commented on the theory of Modigliani-Miller and proposed that high debt can result in increased risk. For example, the original propositions of the idea did not consider risks connected to the borrowings. However, further work was slight changes, and the new proposal appeared. It stated that with an excessive increase in the share of borrowed capital, the company’s costs start to grow to maintain this risky structure of property sources. Therefore, the higher risk, the higher the interest on loans.
Stephen A. Ross also proposed his view on the profits of two homogenous firms. For instance, for the same profit, one company costs more than another, and if the first agency uses equity and debt capital, the second one uses joint stock. For example, the owners of the first company will sell their shares and add personal loans. Then they will buy shares of the second company, as they are cheaper because the company uses only its capital. As a result, the market prices of these companies will become similar, as the value of the first company will decrease, while the second agency will increase in its value. In the end, the values of both companies are supposed to become equal. Therefore, the return on equity in the first company will be higher, but this increased profit results in declined firm financial stability. It is apparent that the risk taken for expanding the revenue can undermine the overall financial background of the company.
It is relatively doubtful to agree with the arguments and ideas of the model. According to the theory, all companies in the market are equally subject to risk, there are no restrictions on the purchase and selling of securities, and there are no fees. However, this is not reality, and the theory will work perfectly only in certain conditions. This model was proposed for firms, which are meant to attract investors but use joint-stock capital. It means that the company would borrow money to increase its value to engage investors.
Besides, as Ross stated, it is essential to consider leverages because the renewed theory also analyzed them. The main idea is that to save taxes; the firm should be leveraged or create homemade leverage. In theory, it would reduce costs on taxation and various fees. However, in reality, the model is difficult to realize because income tax is charged on the interest paid only, not on the entire borrowed capital. It becomes one more disadvantage found in theory.
In conclusion, the theory of Modigliani-Miller is interesting to examine but almost impossible to apply in practice. The model was modified several times because of constantly arising dissonances and struggles. However, the theory will work only in perfect market conditions; it was assumed to work for companies and firms which used their own funding. The model’s flaws outweigh its advantages, as the theory does not apply to all companies and existing realities.