Invariance Propositions

An application of the law of one price to corporate finance. These propositions, put forth by Merton Miller and Franco Modigliani, argue that the value of a firm is invariant to its capital structure and dividend policy. If a leveraged firm is undervalued, investors can purchase its debt and its shares. The interest paid by the firm is offset by the interest received by the investors, so the investors end up holding a pure equity stream. Alternatively, if an unleveraged firm is undervalued, investors can borrow funds to purchase its shares. The substitutability of individual debt for corporate debt guarantees that firms in the same risk class will be valued the same, regardless of their respective capital structures. Dividend policy is irrelevant because repurchasing shares has the same effect as paying dividends; thus issuing shares and paying dividends is a wash. Although the cash component of an investor's return may differ as a function of dividend policy, the investor's total return, including price change, should not change with dividend policy. Also called Modigliani-Miller Hypothesis.

Glossary * I