You better cut the pizza into four slices because I'm not hungry enough to eat six – Yogi Berra
Does it matter if a firm is financed with debt, equity, or a digital token? Does a firm's financial policy create value?
The Miller-Mogdiliani ("MM" for short) Theorem1 says no – under certain conditions. The conditions for the MM theorem are:
- Perfect markets – no arbitrage or no transaction costs
- No taxes
- No additional costs to bankruptcy
- No conflicts of interests
- Symmetric information
But wait – none of these are true in the real world.
The MM theorem is interesting because it gives us the base case that we can contrast with the real world to help us understand where the value in financial policy exists. That's why there's an optimal ratio of equity/debt for companies2 and why it's important to think about financial policy.
The MM theorem explains a lot:
- The value of a debt tax shield and the cost of too much debt
- Why startups finance mostly with equity rather than debt
- Dividends, stock repurchases, stock splits
- Yield-farming in web3: subsidizing new users through new tokenized equity grants
1Merton Miller and Franco Modigliani won the 1985 Nobel Prize in Economics for the MM theorem.
2See Taking on Good Technical Debt for a metaphor of how this works in software development.