This chapter describes the classic Modigliani and Miller (MM) propositions concerning the capital structure of business firms. MM’s proposition I states that under perfect market conditions the value of a firm is unaffected by the financing mix of debt and equity used by the firm. Proposition II, which is the corollary of the first proposition, states that the required rate of return on the equity increases with an increase in proportion to debt such that the weighted-average cost of capital does not change. The implication of these two propositions is that the choice of debt-equity mix or capital structure is irrelevant and has no effect on the value of the firm. Debt policy does not matter and investment and financing decisions can be separated.

The chapter focuses on MM's propositions, the conditions under which their case is made, and the counter argument put forth by the traditional view that financial leverage has some intrinsic advantage. MM views are clearly difficult to challenge, once the perfect market conditions are accepted. The primary logic of the MM propositions is that a firm’s value is based only on the stream of cash flows produced by its assets. The claims to this cash flow can be packaged in different ways, but unless there are market imperfections, arbitrage across these claims will ensure that the value of the firm is unaffected by the capital structure changes.

In practice, capital structure matters because deviations from perfect market conditions are present in the real world. These deviations are discussed in Chapter 18. The significance of the MM propositions is not that they depict a realistic picture of the world, but a clear understanding of the propositions enables you to understand why capital structure decisions are important and why one capital structure may be better than another.