What is Modigliani-Miller Theorem?
The Modigliani-Miller (M&M) theorem states that, under perfect-market assumptions (no taxes, no bankruptcy costs, no asymmetric information), the value of a firm is independent of its capital structure. In the real world the assumptions fail, and the theorem becomes a framework to analyze why capital structure does matter.
How It Works
- Proposition I (no taxes): firm value is the same whether financed by debt or equity
- Proposition II: cost of equity rises linearly with leverage to offset cheaper debt
- With corporate taxes added: debt creates a tax shield, raising firm value with leverage
- Adding bankruptcy costs and agency costs: an optimal capital structure exists
- Foundation for the trade-off theory and pecking-order theory of capital structure
Saudi Context
Saudi finance professionals reference M&M when analyzing why CMA-listed companies pick particular debt-equity mixes. The 20% corporate income tax (non-Saudi shareholders), Zakat (Saudi shareholders), and ZATCA interest-deductibility rules under transfer pricing all shift the practical optimum.
Example
A Saudi finance director compares two capital structures for a new subsidiary: 100% equity (WACC 12%) vs 40% debt / 60% equity (debt cost 6%, equity rises to 14%, WACC 10.8% after tax shield). M&M with taxes confirms the levered structure is cheaper — but extreme leverage would invite covenant pressure, financial distress costs and rating downgrades.