The three ways that a firm can select to finance the investments are - borrowing outside capital, issuing the shares and reinvesting the profits. According to the theory, under some market assumptions whether or not the firm investments are financed with equity or debt makes no difference.
The Modigliani-Miller theorem is very often called as the capital structure irrelevance principle. Economist Modigliani was awarded Nobel Prize in Economics in the year of 1985 for introducing this theory and his other contributions to economic studies.
Merton Miller explains the theorem with an example. Let us compare the firm with a huge tub of whole milk. The farmer, who owns it, can sell the whole milk entirely or can separate the cream from the milk and then sell the cream with a higher price. The skim milk that is left can be sold by the farmer at a relatively lower price than the whole milk. This practice relates to levered equity concept of the firms. Now, according to the Modigliani-Miller Theorem, if the separation of milk does not contain any cost then selling the cream milk and the skim milk will bring the same price, as the whole milk would do.
The Modigliani-Miller theorem is considered to construct the modern thinking base for the capital structure of a firm. According to the theorem, the firm's market value is independent of the decisions regarding how the firm is financed under certain assumptions, which are -no bankruptcy cost, no corporate tax, no asymmetric information and efficient market.
