Revisiting M&M with Taxes: An Alternative Equilibrating Process

Modigliani and Miller present an equity-quantity shifting equilibrating process to achieve an optimal firm value in the presence of corporate taxes. However, in the era in which they derived their various propositions regarding the relation between a firm's value and its capital structure, well-capitalized takeover specialists including private equity firms and sovereign funds did not exist, at least by today's standards. In this paper we develop a simple arbitrage strategy, made viable by the presence of takeover firms, which presents an alternative equilibrating process to achieve the same optimal firm value. This alternative process is markedly different from that of the Modigliani and Miller theorem in terms of its predictions for debt use and restores the prospect of capital structure irrelevancy despite the existence of corporate taxes.