Modigliani Miller Theorem

As I was reviewing chapter 21, the Modigliani Miller Theorem was used quite extensively, but since this theorem originated in chapter 14, we never really reviewed this theorem in class. After some brief research, it really seems like this theorem revolutionized how the value of a firm is viewed.

I first wondered what exactly the theorem stated, so I went to my trusty source, Wikipedia. "The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.1 It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle" (Wikipedia.com, December 2, 2007).

Also, I found that this theorem is relatively new, the Nobel peace prize was awarded to Modigliani in 1985 for this theorem.

What this theorem does is greatly simplify the valuation of firms. How a firm acquires it's value, does not matter, all that matters is what that value is. Of course, this theorem might over simplify valuation because it assumes the absence of taxes, among other things, that we all know exist. But, this theorem allows economists to much more quickly and easily estimate the value of a firm then was possible without this theorem.