The purpose of this article is to review the Modigliani-Miller financial theorem and understand its significant to the capital structure and financial economics as a whole. As a part of the research, study will look in to the strengths and weaknesses of the theory and how the MM theory impacting the way of companies are funded.

1. A Study to Understand the significance of Modigliani-Miller Theorem 1
A Detailed Study to Understand the significance of Modigliani-Millar Proposition and its Impact
on the Capital Structure
Charm Rammandala
California Intercontinental University

2. A Study to Understand the significance of Modigliani-Miller Theorem 2
Abstract
The purpose of this study is to review the Modigliani-Miller financial theorem and understand its
significant to the capital structure and financial economics as a whole. As a part of the research,
study will look in to the strengths and weaknesses of the theory and how the MM theory
impacting the way of companies are funded.

3. A Study to Understand the significance of Modigliani-Miller Theorem 3
A Detailed Study to Understand the significance of Modigliani-Millar Proposition and its Impact
on the Financial Economics
The Modigliani-Millar Theorem is a financial theory first introduced in early 1958 as an
article published in American Economic Review. The theory states that the market value of a
firm is determined by its earning power and the risk of its underlying assets and is independent
of the way it chooses to finance its investments and distribute dividends. According to the theory
if a firm is 100% funded by equity and another firm is funded through debt and equity, value of
both companies are remain the same. (Glickman 2008)
Primarily there are three methods to financing a firm. Those are, issuing bonds, borrowing
from financial institutions or spending profits without paying the dividends to the shareholders.
A firm may choose to use one or combination of methods to fund its operations. Modigliani-
Millar theory encourages managers to decide which is the best method to fund the firm without
having to concentrate on the impact to the value of the company
Modigliani-Miller propositions
In order to apply the theory, Modigliani-Millar theory proposes two different propositions
(Glickman 2008). Those are,
1. Proposition 1 - Value of the firm
2. Proposition 2 - WACC (Weighted average cost of capital)
Proposition 1 argues that the value of the firm not affected by changes in the capital
structure. Logic behind this argument is as cash flow doesn’t get affected by the capital structure,
value of the firm remains the same.

4. A Study to Understand the significance of Modigliani-Miller Theorem 4
In order to prove the argument, M&M use the PIE Model.
Chart 1
According to the PIE Model, it doesn’t matter how many slices pie is divided to, the overall
size of the pie remains the same. Similarly, regardless of how the firm is financed would not
have an impact on the overall value of the firm (John 2015)
Proposition 2 explains that the weighted average cost of capital of the firm is not affected by
the capital structure. Diagram 2 explains that the changes in the capital structure weights (E/V
and D/V) is exactly offset by the change in the cost of equity so the WACC stays the same
(Mitra 2011)
Diagram 2

5. A Study to Understand the significance of Modigliani-Miller Theorem 5
Criticisms of M&M Theorem
The problem that Modigliani and Miller set out to address through their early research dealt
with what the optimum financing structure would be for a firm. In addition, the researchers
sought to delineate the relationship between a firm’s financial decisions and activity and their
total stock market value.
The Modigliani-Miller theorems put into wide circulation the notion that it is degree of risk
and the predicted rate of return that will coincide to determine a firm’s value, instead of the
method it uses to raise capital and secure financing (Glickman 2008).
The strengths of the Modigliani-Miller propositions are manifold. Some of the most ardent
criticism of the M&M theory has had to do with the bedrock belief that financing decisions most
certainly do effect firm’s value.
Conclusion
The Modigliani-Miller theorem is a key pillar in modern finance. The theory has
revolutionized corporate finance since it was introduced. The capital structure decision affects
financial risk and hence the value of the company. Modigliani-Miller capital structure theory
helps to understand the factors most important in the relationship between capital structure and
the value of the company. While it is critical to understand the theorem, Modigliani-Miller make
a set of assumptions that render the results of their work only partially applicable to real life
situations.

6. A Study to Understand the significance of Modigliani-Miller Theorem 6
References
Glickman, M (2008) Modigliani-Miller Capital Structure, Journal of International Trade &
Finance. Retrieved from ProQuest virtual reference library http:/gale. proquest.com (06/01/2016)
Mithra, S (2011) Revisiting WACC. Journal of Management & Business Research
Retrieved from ProQuest virtual reference library http:/gale. proquest.com (06/01/2016)
John, R, (2015) Making better Investment Decisions. Journal of portfolio management.
Retrieved from ProQuest virtual reference library http:/gale. proquest.com (06/02/2016)
Millard, A, (2008) Analyzing the fair market value of assets & the stakeholder’s investment
decisions. ProQuest dissertation publishing. Retrieved from ProQuest virtual reference library
http:/gale. proquest.com (06/02/2016)
Sharon, D, (2015) Evaluating Investment Decisions. Journal of Business Management
Retrieved from ProQuest virtual reference library http:/gale. proquest.com (06/01/2016)