THE REVERSE M&M THEOREM

              The explanatory power of the M&M Theorem comes from turning it upside down: If capital structure can affect the value of the firm, it must work through one or more of the four M&M assumption. That is to say, the only ways that the capital structure can increase value are by lowering taxes, providing acces to cheaper borrowing, releasing valuable information, or improving cash flow. We call this idea the Reserve M&M Theorem.

            The crucial insight provided by the M&M Theorem is that it tells us where to look to understand capital structure. If we want to understand how the firms raise capital, we need to look at taxes, borrowing cost, information and cash flows. Any explanation why some firms tend to use or avoid particular capital structures must, therefore, focus in exploiting the failures to satisfy the M&M assumption. In this way, the reserve M&M Theorem is an important organizing pricnciple for modern corporate finance because it tells us what types of arguments can explain capital structures policies. At very general level, the most commonly invoked explanations for capital stucrtures are as follows:

            Taxes: Relaxing the assumption of no taxes implies that capital structure can value by reducing taxes. This opens the way for explanation based on tax asymmetries.

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            Inefficient markets: Relaxing the efficiency assumption implies that individuals can have dufferent information and different opinions as to how much a security is worth. This has  led to explanations based upon signaling and heterogeneous expectations.

            Imperfect markets: Relaxing the assumption of perfect capital markets means that capital structure can create value by changing investment policy. This has led to explanations based on agency costs.

APPLICATIONS

Capital structure is more than simply the firm’s selection of debt-to-equity ratio. Generally speaking, it is the decision of how to raise the funds to pay for the corporation’s assets. It addresses the following questions: What securities shouldnthe firm issue? How much of each security should the firm issue? To whom should such securities be issued? And what right should different classes of security holder have? The rest of this section will describe several important capital structure development and offer explanations for those structures using the Reverse M&M Theorem.