Why Capital Structure is Important

Abstract

A corporate financial officer who has conscientiously deciphered the academic literature to determine what decisions should be made relative to capital structure (the mixture of debt and equity financing) would have had an interesting time over the past 50 years. Prior to 1958, a CFO would have begun by concluding that there was an optimum capital structure (the so-called classical position). In 1958 they would have been shocked by the Miller-Modigliani 1958 article, which informed the finance community that the value of a firm was invariant to capital structure decisions. Later modifications of the M-M position indicated that in the presence of corporate income taxes a firm should have as close to 100% debt as it can achieve. Eventually, just as the assumption behind these recommendations were being understood, the theoretical finance literature suggested that perhaps the optimum capital structure is somewhere between 0 and 100% debt. The classical position was reasonable.