Capital Structure: Lessons from Modigliani and Miller

Abstract

Franco Modigliani and Merton Miller provided a theory of capital structure that provides a framework for the discussion of the factors most important in a company's capital structure decision: taxes, financial distress, and risk. Though this theory does not provide a prescription for capital structure decisions, it does offer a method of examining the role of these important factors that provides the financial manager with the basic decision-making tools in analyzing the capital structure decision. Within their theory, Modigliani and Miller demonstrate that without taxes and costs of financial distress, the capital structure decision is irrelevant to the value of the company. The capital structure decision becomes value-relevant when taxes are introduced into the situation, such that an interest tax shield from the tax deductibility of interest on debt obligations encourages the use of debt because this shield becomes a source of value. Financial distress becomes relevant because costs associated distress mitigate the benefits of debt in the capital structure, offsetting or partially offsetting the benefit from interest deductibility. Keywords: capital structure decision; Modigliani-Miller theory; interest tax shield; cost of financial distress; optimal capital structure; irrelevance proposition