irrelevancy theory Flashcards
(12 cards)
What is the core idea behind the M&M Theorem (1958)?
n a perfect market (no taxes, no transaction costs, perfect information), a firm’s value is independent of its capital structure.
What is the purpose behind M&M’s perfect market assumptions?
To create a controlled environment where they could prove irrelevance, making it easier to later identify what makes capital structure relevant in the real world.
What does M&M Proposition I (without taxes) state?
The value of a leveraged firm is equal to the value of an unleveraged firm:
VL=VU
What is the logic behind Proposition I?
Investors can create their own leverage (“homemade leverage”), so a firm’s financing mix doesn’t affect its value.
What changes in Proposition I when taxes are introduced (1963)?
Debt creates a tax shield, so:
VL=VU+Tc×D
→ The firm’s value increases with more debt.
What is M&M Proposition II (without taxes)?
As leverage increases, the cost of equity increases linearly, but WACC stays the same.
Ke=K0+(Ko−Kd)×ED
What happens to WACC under Proposition II (with taxes)?
With taxes, increasing debt lowers WACC because interest is tax-deductible → increasing firm value.
What does M&M Proposition III state?
Dividend policy is irrelevant in a perfect market; the firm’s value depends on earnings and risk, not how profits are distributed.
What are the main assumptions of the M&M model?
No taxes
No transaction or bankruptcy costs
Perfect information
Equal borrowing opportunities
Same risk class for firms
Why is the M&M theorem important despite being unrealistic?
It provides a theoretical benchmark that helps identify which real-world factors (taxes, costs, information asymmetry) make capital structure relevant.
What is the tax shield in M&M’s model?
The interest on debt reduces taxable income, making debt financing more attractive and increasing firm value.
What is a major criticism of M&M’s assumptions?
They are too idealized; in reality, taxes, transaction costs, bankruptcy risk, and unequal access to credit exist and affect firm value.
