What Is the Irrelevance Proposition Theorem?
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.
The irrelevance proposition theorem was introduced in 1958 by Nobel Prize-winning economists Merton Miller and Franco Modigliani, and was a premise for their book, “The Cost of Capital, Corporation Finance, and Theory of Investment.”
Their theorem is also referred to as the capital structure irrelevance principle or the Modigliani-Miller theorem.
Borrowing money and issuing stock are the two main ways that any corporation raises funds, above and beyond the revenue it earns.
Key Takeaways
- The irrelevance proposition theorem states that taking on debt does not affect a company's value as long as it does not encounter distressed loan costs or income taxes.
- The theorem has been highly influential since it was introduced in the mid-1980s.
- It is often criticized because it does not consider real-world factors including income tax and distress costs.
- The theorem also does not take into account other variables, such as profits and assets, which influence a company's valuation.
Understanding the Irrelevance Proposition Theorem
In developing their theory, Miller and Modigliani first assumed that firms have two primary ways of obtaining funding: equity and debt. While each type of funding has its own benefits and drawbacks, the ultimate outcome is a firm dividing up its cash flows to investors, regardless of the funding source chosen. If all investors have access to the same financial markets, then investors can buy into or sell out of a firm’s cash flows at any point.
This means that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and assuming an efficient market, the value of a firm is unaffected by how that firm is financed.
Miller and Modigliani used the irrelevance proposition theorem as a starting point in their trade-off theory, which states that a company chooses how much debt finance and how much equity finance to use by balancing the potential costs (bankruptcy) and potential benefits (growth).
Criticisms of the irrelevance proposition theorem focus on the lack of realism in removing the effects of income tax and distress costs from a firm’s capital structure.
Because many factors influence a firm’s value, including profits, assets, and market opportunities, testing the theorem is difficult. For economists, the theory clarifies the importance of corporate financing decisions rather than providing a real-world view of how financing operations work.
Example of the Irrelevance Proposition Theorem
Suppose company ABC is valued at $200,000. All of this valuation is derived from the assets of an equivalent amount that it holds. According to the irrelevance proposition theorem, the valuation of the company will remain the same regardless of the net amounts of cash, debt, or equity that it holds in its account books.
The role of interest rates and taxes, external factors that could significantly affect its operational expenses and valuation, is eliminated.
As an example, consider that the company holds $100,000 in debt and $100,000 in cash. The interest rates associated with debt servicing or cash holdings are considered to be zero, according to the irrelevance proposition theorem. Now suppose that the company makes an equity offering of $120,000 in shares and its remaining assets, worth $80,000, are held in debt. After some time, ABC decides to offer more shares, worth $30,000 in equity, and reduce its debt holdings to $50,000.
This move changes its capital structure and, in the real world, would become cause to reassess its valuation. But the irrelevance proposition theorem states that the overall valuation of ABC will remain the same. The possibility of external factors affecting its capital structure has been eliminated.
How Can Investors Apply the Irrelevance Proposition Theorem?
The theorem might be used to simplify the buy or sell decision for an investor. The market value of a stock is based on its earnings potential and its level of risk. The mix of debt and equity that finances the company is deemed irrelevant to its market value.
What Is the Irrelevance Proposition Theorem in Simple Terms?
The irrelevance proposition theorem states that the market value of a company is not affected by its capital structure. Capital structure refers to the mix of debt and equity that a company uses to fund and expand its operations.
Is the Irrelevance Proposition Theorem Realistic?
Critics say that the irrelevance proposition theorem is not realistic because it fails to consider the usual costs of debt (as opposed to the costs of distressed debt.) It also does not take taxes into account.
The Bottom Line
The irrelevance proposition theorem has had a strong impact on American corporate governance since it was introduced in the 1950s. Fundamentally, it states that debt is as good a way as equity to finance a company's growth.
However, some economists say that its omission of a number of real-world factors makes an imperfect decision-making tool.
