ABSTRACT
Modigliani and Miller (1958) showed the irrelevance of capital structure choice in a frictionless world. In their world, a firm is a mere machine that generates cash flows automatically. Then, a firm’s capital structure choice is a mere choice of how to divide up cash flows across claim holders. Meanwhile, the Arrow–Debreu model suggests any claim on cash flows is valued in an additive and unique manner in the presence of market completeness and the absence of arbitrage opportunities. Therefore, the sum of prices paid into a firm, which is equivalent to firm value, is identical regardless of how cash flows are divided up among claim holders if there is a complete market without arbitrage opportunities. To examine this hypothesis, I start from describing the Arrow–Debreu model, then, derive the additivity and uniqueness of security price in the presence of market completeness and the absence of arbitrage opportunities, and finally show the irrelevance of capital structure.
