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Mm Theory and Jm Theory of Capital Structure Essay

In 1958, Modigliani and Merton Miller in their classical paper “The Cost of Capital, Corporation Finance and the Theory of Investment”, talked something about capital structure as follow: Consider any company j and let Xj stand as before for the expected return on the assets owned by the company (that is, its expected profit before deduction of interest). Denote by Di the market value of the debts of the company; by Sj the market value of its common shares; and by V j = Sj + Dj the market value of all its securities or, as we shall say, the market value of the firm. Then, our Proposition I asserts that we must have in equilibrium: Vj = (Sj + Dj ) = Xj /ρk, for any firm j in class k.

That is, the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rateρk appropriate to its class. This proposition can be stated in an equivalent way in terms of the firm’s “average cost of capital,” Xj / Vj, which is the ratio of its expected return to the market value of all its securities. Our proposition then is: Xj / (Sj + Di) = Xj / Vj =ρk, for any firm j, in class k.

That is, the average cost of capital, to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class. This theory based on a perfect market assumption, which means: 1. No cost of capital market: no transaction costs, no government constraints can be traded freely, and capital asset can be divided. 2. Neutral personal income tax: no personal income tax or tax on dividends, dividends and capital gains are equal. 3. Fully competitive market: no matter how investors and the behavior of enterprises, enterprises can according to constant price convertible securities at any time; another enterprise cannot influence the market structure of interest rates. 4. Borrowing Equality: investors and companies can borrow, lend money and the issuance of securities.

5. The same expectation: everyone has the same expectations. 6. No information costs: enterprises and individuals can use the information is the same, but the information is no cost. No financial crisis cost: enterprises and individuals have occurred if the financial crisis or bankruptcy, no financial crisis cost (such as the liquidation expenses, enterprise restructuring charges, etc.) MM theorem laid the foundation of modern enterprise capital structure, from the enterprise operator’s target and the behavior of investors and the target and the behavior Angle, explore in certain market under the environment of the target and the behavior of the mutual conflict and consistent, is the history of the capital structure of a milestone. However, the MM theorem of perfect market hypothesis and the enterprise actual business environment difference, restricted its practical value, economists constantly relax assumptions, make it more close to reality, so as to promote the modern enterprise capital structure theory development.


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