MM assumptions and Proposition I without taxes

Assumptions of MM theory

1. There are no corporate taxes.
2. Capital markets are perfect: information is free and available to all, there are no transaction costs, and investors can borrow and lend on the same terms as firms.
3. Investors act rationally.
4. Firms can be grouped into classes of equal business risk: the expected earnings of all firms in a class have identical risk characteristics.
5. All earnings are distributed to shareholders (100% payout).

Proposition I (without taxes). The total market value of a firm is independent of its capital structure: it equals its expected net operating income capitalised at the overall rate (ko) appropriate to its risk class, V = NOI ÷ ko, so the value of a levered firm equals that of an identical unlevered firm. The overall cost of capital is likewise unaffected by the debt-equity mix.

Why: the arbitrage process. If two firms identical except in capital structure had different values, investors would sell the shares of the higher-valued firm and buy those of the lower-valued firm, substituting personal leverage (borrowing on their own account) for corporate leverage. They would earn the same income with less outlay, and their selling and buying would continue until the two firms had the same total value.

How capital structure affects value. Under Proposition I it does not. Debt is cheaper than equity, but as more debt is used the cost of equity rises (Proposition II: ke = ko + (ko − kd) × D/E) exactly enough to offset the advantage of the cheaper debt, so ko and the firm's value stay constant. MM's view without taxes is thus the same as the net operating income approach.