Modigliani-Miller Theorem
Why capital structure is irrelevant in frictionless markets, and what the frictions change.
Definition
The capital-structure irrelevance theorem: in frictionless markets, a firm's value is independent of its debt-equity mix, leverage only reslices the same cash-flow pie.
Key equation
MM I: V(levered) = V(unlevered); MM II: rE = rA + (rA − rD)·D/E
The intuition
Borrowing more makes equity riskier, so shareholders demand exactly enough extra return to cancel the cheap-debt gain, the WACC never moves. The theorem's realrealAdjusted for inflation, measured in actual purchasing power. use is a checklist of what DOES matter: taxes, bankruptcy costs, agency, information.
Exam tip
MM II is the workhorse: cheap debt does NOT lower the cost of capital, it raises the cost of equity one-for-one.
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