What is the Irrelevance Proposition Theorem?

The irrelevance proposition theorem is a theory of corporate capital structure that was developed by Merton Miller and Franco Modigliani in 1958. This theory states that the capital structure of a company does not affect its value. This is, even amidst the financial leverage of a company such as loans and debts, the value of the company remains unchanged so far there are no distress costs or income tax that must be paid by the same company. The irrelevance proposition theorem is very influential and serves as the core of modern thoughts when it comes to capital structure.

How Does the Irrelevance Proposition Theorem Work?

The irrelevance proposition theorem is otherwise called the "capital structure irrelevance principle (theory)" According to the proponents of this theory, Miller and Modigliani, a company can obtain funding through equity and debt. While both equity and debt have their pros and cons when used to finance a company, Miller and Modigliani theorized that the form of financing a company does not affect its value. The main idea behind this theory is that the capital structure of a firm does not have an impact on its overall value, especially if the company is not in financial distress (has no difficulty in paying back loans and debts) and if there are no income tax payments to be made by the company. 

Criticisms

Miller and Modigliani developed the first version of the irrelevance proposition theorem under the assumption of a perfect and efficient market. It was in the second version that concepts like distressed costs, bankruptcy costs, asymmetric information, income taxes, and others were considered. The major criticisms of the irrelevance proposition theorem include;

• The absence of realism in theory as it excludes the effects of income tax and distress costs from a company's capital structure.
• Testing the theorem is quite difficult given that factors that affect the value of a company are excluded.
• The theorem also fails to describe the financial operations of a company and hoe the work.