Abstract:
Financial theory revolves around rational participants who want to maximize their utility or wealth for a given level of risk. This maximization, in the first place, calls for the optimality of available resources, making capital financing decisions critical for corporations. Any discussion on optimal capital structure leads back to Modigliani and Miller’s classical capital structure irrelevance hypothesis (1958), according to which, in an efficient market, the value of the firm is unaffected by its choice of capital structure in the absence of taxes, bankruptcy costs, and asymmetric information. This irrelevance makes the firm’s managers indifferent to opting for debt or equity in the firm’s capital structure.
Modigliani and Miller’s proposition was criticized primarly for ignoring the tax shield that would be available if a firm was financed by debt. Later, Modigliani and Miller (1963) relaxed the assumption of zero taxes and demonstrated that debt financing might contribute toward the value of the firm, due to the available tax shield, but the impact was shown to be lower. Moreover, the use of debt financing leveraged the capital structure, consequently raising the cost of capital. The Modigliani and Miller propositions have had important implications for the theory of investment decisions. First, they demonstrate that such decisions can be separated from the corresponding financial decisions. Second, the rational criterion for investment decisions is a maximization of the market value of the firm. Last, the rational concept of capital cost refers to total cost, and should be measured as the rate of return on capital invested in shares of firms in the same risk class.
Building on the foundations of the Modigliani and Miller capital structure notion, an exhaustive body of literature on alternative theories of capital structure has emerged, debating the existence of an optimal capital structure and its impact on the cost of capital and, ultimately, on the value of the firm. These theories have been widely tested but contradictory empirical results raise questions about their validity. This note briefly discusses these theories of capital structure, along with some empirical findings
