THEORY

Members of the Group

• RUTH MUTHONI

• DANIEL MPAKUO

• DAISY MUKARU

• KERAGO MBUGUA

• DAVINA KAYITARE
 Definition

• A theory proposed by Franco Modigliani and Merton Miller in the 1950s,

• states that in the absence of taxes, bankruptcy costs, and asymmetric information, the value of a firm is
unaffected by its capital structure

• meaning that the value of a company is determined solely by its ability to generate profits from its
assets, regardless of how those assets are financed.
 Explanation of The Theory

• In simpler terms, MM theory suggests that the way a company chooses to finance its operations,
whether through equity or debt shouldn't affect its overall value in a perfect market.

• argues that the option or combination of options that a company chooses has no effect on its real
market value.

• However, factors like taxes, bankruptcy costs, and information asymmetry do exist and can
influence a firm's capital structure decisions .
Deeper understanding…
 The Impact of MM Theory on Financial Innovation

• Capital Market Efficiency: MM theory assumes perfect capital markets where information is freely
available and there are no transaction costs. While real-world markets may not meet these assumptions,
the idea of capital market efficiency has influenced financial innovation by encouraging the
development of financial products and strategies aimed at exploiting market inefficiencies.

• Corporate Finance Strategies: Innovations such as share buybacks, dividend policies, and mergers and
acquisitions (M&A) are influenced by the principles of MM theory, as firms seek to optimize their
capital structure and enhance shareholder wealth.

• Risk Management: MM theory provides insights into the relationship between risk and return, which
has influenced the development of risk management techniques and financial instruments. Innovations
such as Value-at-Risk (VaR) models, risk-adjusted return measures, and portfolio optimization
strategies draw on the principles of MM theory to help investors and firms better understand and
manage their exposure to risk.
 The impacts…
• Securitization: MM theory suggests that in a perfect market, the value of a firm is determined solely
by its underlying assets, regardless of its capital structure. This insight has led to the development of
securitization, where financial assets such as mortgages, auto loans, or credit card debt are pooled
together and sold to investors as securities

• Structured Finance: Building on the concept of securitization, structured finance involves the creation
of complex financial instruments with cash flows that are derived from a pool of underlying assets.
MM theory provides a framework for understanding the underlying principles of structured finance,
particularly in terms of how different capital structures can impact risk and value.

• Derivatives: MM theory suggests that in a perfect market, investors can replicate the cash flows of
any security using a combination of other securities. This insight has led to the development of
derivative instruments such as options, futures, and swaps, which allow investors to hedge risk,
speculate on price movements, and manage their exposure to various financial assets.
Thank You!

Any qns?