According to many research of corporate finance, the capital structure decision is one of the most

fundamental issues facing to the executives and management level. The capital structure of a
company refers to a combination of debt and equity of finance that it uses to fund its long-term
financing. Equity and debt capital are the two major sources of long-term funds for a firm. The
theory of capital structure is closely related to cost of capital of firms. As the enterprises to obtain
funds need to pay some costs, the cost of capital in the investment activities is also the main
consideration of rate of return. The weighted average cost of capital (WACC) is the expected rate
of return on the market value of all of the firm's securities. The decision regarding the capital
structure is based on the objective of achieving the maximization of shareholders wealth and
irrelevant to the firms investment decision.

In 1958, Miller and Modigliani published the theory stated that in perfect capital market the
value of a company does not depend on its financing structure. The value of assets does not
increase if the firms raise the weight of debt in its financing structure, as the WACC of company
stays constant independent of the weights of debt and equity in its financing structure. Miller and
Modigliani made up two proposition are: the overall cost of capital and the value of the firm are
independent of capital structure and the financial risk increase with more debt content in the
capital structure.
The first view of capital structure assumptions in a perfect market is that no existence of taxes
either at a personal or a corporate level, no transaction costs, no asymmetric information and no
agency cost. Firms and investors can borrow or lend at the same rate. The costs of capital and the
value of the firm are not affected by the changed in capital structure. The proposition is that the
firm use gearing is equal to ungearing firm. Ordinary shareholders are relatively indifferent to the
addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as
a company gears up. As gearing up continues, the cost of equity increase to include a financial
risk premium and the WACC reaches a minimum value. Beyond this minimum point, the WACC
increases due to the effect of increasing financial risk on the cost of equity and at higher levels of
gearing due to the effect of increasing bankruptcy risk on both the cost of equity and cost of debt.
Continuing to ignore taxation but assuming a perfect capital market, miller demonstrated that the
WACC remained constant as a company geared up, with the increase in the cost of equity due to

financial risk exactly balancing the decrease in the WACC caused by the lower before tax cost of
debt. Since a perfect capital market the possibility of bankruptcy risk does not arise, the WACC
is constant at all gearing levels and the market value of the company is also constant, therefore
the market value of a company depends on its business risk alone and not on its financial risk.
Therefore, the firm cannot reduce its WACC to a minimum
The shortcoming of this argument is still has some drawbacks mainly to the unrealistic nature of
their assumptions. First, the assumption that individuals can borrow at the same rate as
companies can be challenged. The costs of personal debt and corporate debt cannot the same,
because companies have higher credit ratings than the majority of individuals. Personal
borrowing is seen as riskier, and therefore more costly than corporate borrowing. Secondly, their
assumption that there are no transaction costs associated with the buying and selling of shares is
clearly untrue. High personal borrowing rates and transaction cost both undermine the ability of
investors to make risk-free profit from arbitrage, therefore creating the possibility of identical
companies overvalued and undervalued.
In the second paper on capital structure, miller later modified their earlier model to take account
of corporate tax and argued that companies should gear up in order to take advantage of the tax
shield of debt. When corporate tax was admitted into the analysis of miller in imperfect market,
the interest payments on debt reduce by tax liability, which meant that the WACC fell as gearing
increased due to the tax shield given to profits. On this view, firm could reduce its WACC to a
minimum by taking on as much debt as possible. A perfect capital market is not available in the
real world and at high levels of gearing the tax shield offered by interest payment is more than
offset by the effects of bankruptcy risk and other costs associated with the need to service large
amounts of debt. The firm can see an optimal capital structure emerging. At the high levels of
gearing, additionally to bankruptcy costs, there are costs associated with the problems of agency.
If gearing levels are high, shareholders have a lower stake in a company and have fewer funds at
risk if the company fails. Another reason why the firms fail to adopt higher levels of gearing is
that many companies have insufficient profits from which to derive all available tax benefits as
they increase their gearing level as tax exhaustion.

The effect of miller model considers the relationship between gearing levels, corporate taxation,
the rate of personal taxation on debt and equity return, and the amount of debt and equity
available for investors to invest in.