By Arnold Kling
I describe the famous theorem here.
Before MM, the conventional wisdom was that highly-levered firms (firms that issue a lot of debt relative to equity) offered their investors higher risks and higher expected returns than less-levered firms. MM said that financial structure was essentially irrelevant. [NOTE: “investors” includes both shareholders and bondholders. As Daniel Davies pointed out, I incorrectly used the term “shareholders” in the original article. I hope to run a correction to the article soon. Also, the “conventional wisdom” is probably better described as a view that firms could better appeal to risk-averse investors by using less leverage, and that is the conventional wisdom that MM overturned.]
Let us return to our Food Court economy, in which investment projects consist of developing and testing new recipes. A low-risk project might be an attempt to find a recipe for sesame noodles that tastes good without using peanuts. A high-risk project might be an attempt to grow meat in a lab, which would reduce the need to kill animals for meat.
What MM says is that you cannot turn the sesame noodle project into a high-risk, high-return investment by funding it with debt. Conversely, you cannot turn the cultured meat project into a low-risk, low-return project by funding it with equity. Investors must bear the underlying risk of the project, regardless of how it is financed.