A Test Of The M&M Capital Structure Theories

Abstract

Modigliani and Miller (1958, 1963) predict two very specific relationships between firm value and the amount of debt in the firm’s capital structure, depending on whether or not the firm pays corporate income taxes. Although there has been some testing of the implications of these equations, I have been unable to find anyone who has tested them in the exact forms specified by MM. In this paper, the MM equations are tested exactly as specified. The results of these tests indicate that neither the MM tax nor the no-tax valuation equations are accurate predictors of firm value. Specifically, the value of the unlevered firm accounts for much less of firm value than predicted and the sign of the coefficient of the interest tax shield variable is negative, instead of positive as MM predict. These results are robust to the inclusion of control variables for firm growth, earnings variability, and the existence of other tax shields.