4.1 Bank Capital Structure and the
Modigliani-Miller TheoremAccording to the so-called
Modigliani-Miller theorem, changes in the leverage ratio or any other type of change in the mix of securities outstanding cannot alter the total market value of the firm (the sum of all its securities, whether debt or equity) (Modigliani and Miller 1958; Miller 1988; Titman 2001) The key insights here are that the individual investor could have replicated on his own any change in leverage or more generally capital structure that the company could achieve.
Modigliani-Miller theorem, in agreement with the net operating income thesis, contended that capital structure, being a mere detail, does not influence value.
The
Modigliani-Miller theorem (Modigliani and Miller, 1958) assumes that internal and external financing are fully substitutes in the presence of complete capital and credit markets, so that the financial structure of firms is independent from investment decisions.
Within this context, a generalization of Proposition II of the
Modigliani-Miller theorem (Modigliani and Miller, 1958) is obtained.
He reviews the literature on capital requirements, then analyzes the
Modigliani-Miller theorem whereby capital structure is irrelevant, discussing it within the context of US banks; the benefits and costs of higher bank capital and the optimal capital ratio; total loss-absorbing capacity requirements, in terms of the literature and new evidence on the losses of the largest US banks in the recession, to determine whether they had engaged in excessive risk taking as a result of too big to fail incentive distortions; the literature claiming that there is already too much finance, based on statistical correlations of growth with indicators of financial depth; and how the optimal capital ratio is about one-third larger than the target set in Basel III.
In corporate finance, the well-known
Modigliani-Miller theorem of leverage irrelevance implies that the value of a firm does not depend on its leverage.
The
Modigliani-Miller theorem and entrepreneurial firms: an overview.
Notably, Slemrod (2000) recognized that the most empirically studied form of income shifting concerning corporate taxes involved assessments of issuing debt as a means to reduce the firm's taxable income, hence building upon the seminal
Modigliani-Miller Theorem of capital structure.
Baron, David (1974), "Default Risk, Homemade Leverage, and the
Modigliani-Miller Theorem", American Economic Review 64(1): 176-182.
Coincidentally, around the same time others were suggesting that the
Modigliani-Miller theorem was a special case of the Coase theorem (see, for example, Fama 1978).