Enhancing Student Understanding of the 1958 Modigliani-Miller Propositions

Abstract

In their 1958 paper, Franco Modigliani and Merton Miller show that, in a theoretical “perfect world,” a company’s value and its cost of capital do not vary across levels of leverage. As a consequence, a linear relationship must exist between the debt-to-equity ratio and the cost of equity. Most textbooks first explore these fundamental theoretical relationships before transitioning on to “real world” issues such as corporate taxes and bankruptcy. In this teaching note, we suggest that textbook presentations of the 1958 MM propositions allow for confusion on the part of students because of ambiguity in discussions and graphical representations. To help avoid confusion on the students’ part in this regard, we present a series of exercises that instructors may use to supplement and enhance textbook content