M&M 1963: An Alternative Equilibrium

Abstract

Invoking the same assumptions as Modigliani and Miller (1963), we demonstrate that their debt-only corner solution is not a unique equilibrium and furthermore that an alternative equilibrium exists in which capital structure is irrelevant for determining shareholder value. Our equilibrium follows from a simple and feasible arbitrage trading strategy and is sustainable in the sense that it is neither dominated by nor dominates the M&M solution in an inter-temporal setting. Our equilibrium has potentially significant implications for topics ranging from the under-leverage puzzle to the cost of capital to assessing fund performance, and beyond.