The irrelevance proposition theorem is a theory of corporate capital structure that was developed by Merton Miller and Franco Modigliani in 1958. This theory states that the capital structure of a company does not affect its value. This is, even amidst the financial leverage of a company such as loans and debts, the value of the company remains unchanged so far there are no distress costs or income tax that must be paid by the same company. The irrelevance proposition theorem is very influential and serves as the core of modern thoughts when it comes to capital structure.
How Does the Irrelevance Proposition Theorem Work?
The irrelevance proposition theorem is otherwise called the "capital structure irrelevance principle (theory)" According to the proponents of this theory, Miller and Modigliani, a company can obtain funding through equity and debt. While both equity and debt have their pros and cons when used to finance a company, Miller and Modigliani theorized that the form of financing a company does not affect its value. The main idea behind this theory is that the capital structure of a firm does not have an impact on its overall value, especially if the company is not in financial distress (has no difficulty in paying back loans and debts) and if there are no income tax payments to be made by the company.
Criticisms
Miller and Modigliani developed the first version of the irrelevance proposition theorem under the assumption of a perfect and efficient market. It was in the second version that concepts like distressed costs, bankruptcy costs, asymmetric information, income taxes, and others were considered. The major criticisms of the irrelevance proposition theorem include;
- The absence of realism in theory as it excludes the effects of income tax and distress costs from a company's capital structure.
- Testing the theorem is quite difficult given that factors that affect the value of a company are excluded.
- The theorem also fails to describe the financial operations of a company and hoe the work.
FAQs
The irrelevance proposition theorem states that a company's market value is not affected by a reliance on borrowing money rather than issuing stock as long as it is not burdened by the costs of distressed debt or by income taxes.
What are the three assumptions that lie behind the Modigliani-Miller theory? ›
The Modigliani-Miller Theory only holds with four assumptions (no taxes, no bankruptcy costs, symmetric information, and equal borrowing costs). Later work by Modigliani and Miller relaxed the tax assumption and went on to capture the relationship between the cost of debt and equity.
Does the M&M proposition says that the capital structure is irrelevant to the value of a firm in a perfect market? ›
The Modigliani-Miller (M&M) theory states that capital structure has no impact on a company's value, and is irrelevant in perfect markets where there are no taxes. This is due to the fact that a company's value is based on its earning power along with the risk of its underlying assets.
What is the Modigliani-Miller MM Irrelevance theorem? ›
The Modigliani-Miller theorem impacted corporate financing, arguing that a company can finance growth by borrowing, issuing stock shares, or reinvesting its profits and that its capital structure is not a factor in its value.
What are the assumptions of the irrelevance theory? ›
Dividend Irrelevance Theory is a financial theory that claims that the issuing of dividends does not increase a company's potential profitability or its stock price. It suggests that investors are not better off owning shares of companies that issue dividends than shares of those that do not.
What is the irrelevance theory? ›
Understanding Dividend Irrelevance Theory
Dividend irrelevance theory suggests that a company's payment of dividends should have little to no impact on the stock price. If this theory holds true, it would mean that dividends do not add value to a company's stock price.
What is the key assumption of the Miller and Modigliani mm dividend irrelevance argument? ›
Miller and Modigliani's (MM) dividend irrelevance argument has the key assumption that new shares are sold at a fair price.
What are the criticisms of the MM model? ›
Miller & Modigliani (MM) proposed a theory on dividend irrelevance. it is distributed. MM theorem is criticized on the account that in real world the markets are not perfect, there are different types of investors, there is an existence of taxes, floatation costs,etc.
What is the MM theory without tax? ›
MM Proposition I (No Taxes)
By doing so investors create leveraged firms, which increases the values of these firms, earning the investors profits. The key here is that it does not matter to the investor if the debt is held by the company or by the investor herself. The latter case is termed homemade leverage.
Why does M&M proposition 1 without taxes not hold in the presence of corporate taxation? ›
However, this proposition does not hold in the presence of taxes because the interest on debt is tax-deductible and hence, the firm with the presence of debt i.e., levered firm, will pay lesser in tax than the unlevered firm.
Proposition I: This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not be affected by choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings.
What are the limitations of the M&M approach? ›
Here are some other criticisms of the Modigliani and Miller Model such as. The model does not take into account the risk of the firm. The model does not take into account the cost of capital. The model does not take into account the time value of money.
What is the policy irrelevance proposition? ›
The policy irrelevance proposition implies that any anticipated policy will have no effect on the level of real GDP.
What value of a firm is irrelevant to Modigliani and Miller? ›
Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing shares or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.
What is the MM model irrelevance of capital structure is based on? ›
Cost of Debt and Equity.
What is the proposition theorem? ›
A theorem is a statement that has been proven to be true based on axioms and other theorems. A proposition is a theorem of lesser importance, or one that is considered so elementary or immediately obvious, that it may be stated without proof.
What is the principle of irrelevance? ›
The order-irrelevance principle refers to the understanding that the order in which objects are counted is not important. As long as every object is counted, then it does not matter if objects are counted from left to right, right to left or from any other point.
What is the basic proposition theorem? ›
Basic Proportionality theorem was introduced by a famous Greek Mathematician, Thales, hence it is also called Thales Theorem. According to him, for any two equiangular triangles, the ratio of any two corresponding sides is always the same. Based on this concept, he gave theorem of basic proportionality (BPT).
What is the irrelevance of motive principle? ›
The irrelevance-of-motive maxim-the longstanding principle that a defendant's motives are irrelevant to criminal liability-has come under attack. Critics of this maxim claim that "motives," under any plausible conception of the term, are in fact relevant in the criminal law.
