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