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In perfect and complete markets Miller and Modigliani (1958) show that there is no advantage to...

In perfect and complete markets Miller and Modigliani (1958) show that there is no advantage to debt vs equity in the capital structure. That is, the value of the firm is determined by its income from operations, not from its capital structure.

What do Miller and Modigliani mean by perfect and complete markets?

How did their argument change with the introduction of corporate taxes into their model?

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Answer #1

According to the hypothesis, a perfect market is the one where,

  • No investor can cause any significant changes to the the market price of shares
  • There are no costs incurred for buying and selling of shares
  • There are no transaction costs
  • Information is easily and freely available to each investor

Imperfections arise in the markets when corporates are subject to taxes. Interest payable on debt can be deducted for tax purposes. However dividends and Retained profits do not enjoy such a benefit. Thus, the firm prefers employing debt so that they can enjoy benefits of leverage. Moreover the value of the levered firm will exceed the unlevered firm by an amount equal to the debt multiplied by the rate of tax.

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