The core propositions
MM Proposition I (without taxes): The total value of a firm is determined by its real assets and operating cash flows, independent of how those assets are financed. Adding leverage doesn’t create value — it just rearranges the claims. MM Proposition II (without taxes): The cost of equity rises as leverage increases, exactly offsetting the benefit of cheaper debt. The WACC remains constant at all debt levels. The equity holders demand a higher return to compensate for the additional financial risk from leverage. The two effects cancel precisely.
MM with taxes — the debt tax shield
MM Proposition I with taxes: the value of a levered firm equals the value of an unlevered firm plus the present value of the tax shield on debt (T × D, where T is the corporate tax rate and D is the market value of debt). Because interest payments are tax-deductible but equity dividends are not, each pound of debt generates T pence of value through reduced tax payments. At a 25% corporate tax rate, £100m of debt creates approximately £25m of value through the tax shield. This creates a theoretical optimum: 100% debt financing maximises firm value from a tax perspective.
Why firms don’t use 100% debt
Reality introduces three countervailing forces that limit optimal leverage. Financial distress costs: high leverage increases the probability of financial distress, which imposes direct costs (legal, restructuring) and indirect costs (loss of customers, employees, suppliers who won’t commit to relationships with a potentially failing firm). Agency costs: heavily indebted firms have incentives to take excessive risk (debt overhang) or underinvest (because equity holders bear all downside while debt holders capture all upside). Asymmetric information: managers know more about firm prospects than investors; capital structure signals information to the market (Pecking Order theory). These three real-world frictions create an interior optimum below 100% debt.
“MM is the most important theorem in corporate finance not because it describes the world, but because it defines what we need to explain. Without the assumptions, you cannot understand why they matter.”
What this means for you
MM provides the intellectual framework for understanding corporate capital structure decisions. When a company issues debt to buy back equity (a leveraged recapitalisation), MM tells you it should create value equal to the tax shield — and you can calculate it. When a company is over-leveraged, MM’s distress cost logic explains why deleveraging creates value even though it reduces the tax shield. The Pecking Order theory (companies prefer internal financing, then debt, then equity issuance) explains why equity issuance typically depresses share prices — it signals management believes the stock is overvalued. All of these are direct applications of the MM framework extended to real-world conditions.