The Circular Justification in the MM Proposition: A Rethink

Perfect Market, Arbitrage, and Value Creation in the MM Proposition, PDF ver 2020-02-17

Abstract: The real contributions of the MM Proposition are its central assumptions of perfect capital markets and the associated arbitrage argument. In this text, we review the perfect market assumptions and no-arbitrage principle. Then, to explain the evolution of the understanding of arbitrage from a deterministic world into an uncertain world, we restate and comment on the proofs of the MM Proposition in current perspectives. With the no-arbitrage principle in mind, we clearly read the circular justification in the MM Proposition and the misleading concept of cost of equity. From the perspective of the distribution of a corporation’s value creation, we find that shareholders prefer a maximum degree of debt. However, we believe that the capital structures are mainly constrained by industry characteristics and the market timing of equity and debt financing.

Keywords: Perfect Market, No-Arbitrage Principle, MM Proposition, Capital Structure, Cost of Equity

It is a long-established principle in finance that the evaluation of an investment should not depend on the way it is funded. The WACC, “the most measured number in finance”, is an accompaniment of expectation-pricing. Although the WACC valuation method is prevalent, just as the expectation-pricing method has been abandoned by actuaries for centuries, we firmly believe that the WACC will eventually be abandoned. As a legacy of expectation-pricing, with the skin gone, what can the hair adhere to? Using the WACC to guide investment decisions, and minimizing the WACC for the optimal capital structure, both are following faulty ideologies. As brainchildren of deterministic and isolated thinking, just as the scientific community finally abandoned the “phlogiston” and “aether” doctrines, we must discard the hypothetical cost of equity capital and renounce the postulated WACC as soon as possible.