We began our discussion of the capital structure decision by arguing that the particular capital structure that maximizes the value of the firm is also the one that provides the most benefit to the stockholders.
In a world of no taxes, the famous Proposition I of Modigliani and Miller proves that the value of the firm is unaffected by the debt–equity ratio. In other words, a firm's capital structure is a matter of indifference in that world. The authors obtain their results by showing that either a high or a low corporate ratio of debt to equity can be offset by homemade leverage. The result hinges on the assumption that individuals can borrow at the same rate as corporations, an assumption we believe to be quite plausible.
MM's Proposition II in a world without taxes states that
This implies that the expected rate of return on equity (also called the cost of equity or the required return on equity) is positively related to the firm's leverage. This makes intuitive sense because the risk of equity rises with leverage, a point illustrated by Figure 15.2.
Although the above work of MM is quite elegant, it does not explain the empirical findings on capital structure very well. MM imply that the capital structure decision is a matter of indifference, whereas the decision appears to be a weighty one in the real world. To achieve real-world applicability, we next considered corporate taxes.
In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage. The formula for the value of the firm is
Here, value is positively related to leverage. This result implies that firms should have a capital structure almost entirely composed of debt. Because real-world firms select more moderate levels of debt, the next chapter considers modifications to the results of this chapter.
