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Capital Structure Theory

Business Finance (University of Strathclyde)

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 lOMoARcPSD|1277595

Capital Structure Theory

1. Studied intensely by Miller & Modigliani (1950s professors)
2. Hypothesised that in perfect markets - does not matter what financial
structure a company uses to finance operations
3. Market value determined by earning power & risk of assets
4. Value = independent of way it chooses to finance/distribute dividends
5. Key assumptions
⁃ No taxes
⁃ No transaction costs
⁃ No bankruptcy costs
⁃ Symmetry of market information
⁃ No effect of debt on company’s earnings before interest and taxes
7. M&M’s capital structure irrelevance proposition
8. WACC remains constant w/ changes in companies capital structure
9. No matter how a company borrows, there are no tax benefits
10. Stock price also no influenced by capital structure
11. In latter papers, taxes and bankruptcy costs are included by M&M
12. M&M tradeoff theory of leverage
13. Benefits of leverage until optimum capital structure is reached
14. Recognises tax benefits from interest payments (tax deductible)
15. In summary
⁃ Theory w/out taxes says firms relative proportions of debt & equity do not
matter
⁃ W/ taxes it says firms with greater proportion of debt is more valuable
because of the tax shield
16. In summary 2
⁃ Capital structure is irrelevant so changes in debt-equity do not affect WACC
(no taxes)
⁃ W/ taxes it does
⁃ Greater proportion of debt = lowers company’s WACC

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