Editing Modigliani–Miller theorem (section)

==The theorem==
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Consider two firms which are identical except for their financial structures. The first (Firm U) is '''unlevered''': that is, it is financed by '''equity''' only.  The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani–Miller theorem states that the enterprise value of the two firms is the same. Enterprise value encompasses claims by both creditors and shareholders, and is not to be confused with the value of the equity of the firm.

The operational justification of the theorem can be visualized using the working of [[arbitrage]]. Consider that the two firms operate in a perfect capital market: both the firms are identical in all aspects except, one of the firms employ debt in its capital structure while the other doesn't. Investors of the firm which has higher overall value can sell their stake and buy the stake in the firm whose value is lower. They will be able to earn the same return at a lower capital outlay and hence, lower perceived risk. Due to arbitrage, there would be an excess selling of the stake in the higher value firm bringing its price down, meanwhile for the lower value firm, due to the increased buying the price of its stake will rise. This corrects the market distortion, created by unequal risk amount and ultimately the value of both the firms will be leveled.

According to the MM Hypothesis, the value of levered firm can never be higher than that of the unlevered firm. The two must be equal. There is neither an advantage nor a disadvantage in using debt in a firm's capital structure.