MM Proposition I (without taxes, 1958)

Assumptions

• No taxes
• No bankruptcy costs
• No transaction costs
• Debt is risk-free
• Investors and firms borrow at the same rate
• Same business risk

\[ V_L = V_U \quad \text{if } t_c=0. \]

In a perfect no-tax world (no distress costs, no information asymmetry), financial structure does not affect firm value:

The market value of any firm is independent of its capital structure and is given by capitalizing expected return at the rate appropriate to its risk class.

Because of arbitrage (homemade leverage), if one capital structure were priced higher, investors could replicate leverage and eliminate the price difference.