Traditional views on capital structure point to the existence of an optimal capital structure.

Critique the analysis of the traditional views on capital structure in light of the competing
views offered by Modigliani and Miller along with their assumptions.
Capital structure refers to the way a corporation finances its assets through some combination of
equity, debt, or hybrid securities. Stewart C. Myers argues that there is no magic in leverage
and there is nothing supporting a presumption that more debt is better. He adds that debt maybe
better than equity in some cases, worse in others or it may be no better and no worse. Thus, all
financing choices are equally good. A firm's capital structure is then the composition or
'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in
debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total
financing, 80% in this example is referred to as the firm's leverage. There are many views on
capital structure including the traditional views as well as the competing views offered by
Modigliani and Miller.
Traditional views on capital structure point to the existence of an optimal capital structure. An
optimal capital structure is simply a mix of debt and equity which maximizes the value of the
firm or minimizes the cost of capital. According to the traditional views on capital structure,
changes in capital structure benefit the stockholders if and only if the value of the firm
increases. Conversely, these changes hurt the stock holders if and only if the value of the firm
decreases. This result holds true for capital structure changes of many different types. Thus,
managers should choose the capital structure that they believe will have the highest firm value
because the capital structure will be most beneficial to the firms stockholders. Apart from that, a
change in the debtequity ratio affects the value of the firm because it would change the risk
shareholders bear. Under the traditional views, the fundamental principle is that individuals
require higher returns in compensation if the risk they bear rises. If a rise in the debtequity
ratio increases risk, firms should offer shareholders higher return and it is important to realize
that an increase in the debtequity ratio increases the firms cost of capital. Thus, all corporations
should determine their capital structure bearing that in mind. In the article by Stewart C. Myers,
the author points out that the search for optimal capital structure is like the search for Truth or
Wisdom and that it is impossible to completely attain either goal but progress has been seen in
the past few years.
Apart from the traditional views on capital structure, there are competing views offered by
Modigliani and Miller along with their assumptions. The Modigliani-Miller(MM) theorem,
proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on
capital structure, though it is generally viewed as a purely theoretical result since it assumes
away many important factors in the capital structure decision. Modigliani and Miller (1958)
demonstrated that the firms overall cost of capital cannot be reduced as debt is substituted for
equity, even though debt appears to be cheaper than equity. The reason for this is that as the firm
adds debts, the remaining equity becomes more risky. As this risk rises, the cost of equity capital
ISRA AFRIDI FM MM THEORY

Page 1

also rises as a result. The increase in the cost of the remaining equity capital offsets the higher
proportion of the firm finance by low-cost debt. In fact, MM prove that the two effects exactly
offset each other, so that both the value of the firm and the firms overall cost of capital are
invariant to leverage. In addition, MM say that there is no optimal debt-equity ratio and the
amount of debt issued by the firm is irrelevant.

There are two propositions that MM have pointed out. MM Proposition 1 focuses on the value
of the firm and states that the value of the levered firm is the same as the value of the
unlevered firm. Basically, the market value of any firm is independent of its capital structure
and is given by capitalizing its expected return at the rate appropriate to its risk class. Thus, each
firms cost of capital is constant regardless of the debt equity ratio. Before MM, the effect of
leverage on the value of the firm was considered complex and convoluted. MM showed a
blindingly simple result: If levered firms are priced too high, rational investors will simply
borrow on their personal accounts to buy shares in unlevered firms. This substitution is
called homemade leverage. As long as individuals borrow (and lend) on the same terms as the
firms, they can duplicate the effects of corporate leverage on their own and can earn a higher
return on equity without changing his/her risk profile. Apart from the first MM proposition, MM
Proposition 2 focuses on expected return on equity of a company with various capital
structures and states that the expected return on equity increases linearly as the amount of
debt increases-provided that the debt remain risk free. But if increases debt levels increase
ISRA AFRIDI FM MM THEORY

Page 2

the cost of debt, this also causes the rate of increase in the expected return on equity to
decline. This is shown in figure 1.

Since the sum of the returns to debt and equity must equal the total return generated by
the asset of a company, it is possible to write the return on assets as follows:

ISRA AFRIDI FM MM THEORY

Page 3

Thus proposition II shows mathematically that the expected return on equity increases as
the amount of financial leverage increases, unless the expected return on debt rises. This
rise in expected return on debt will only happen when the debt holders fell they have lent
more than can be justified at the risk free rate.

Thus, a higher debt-to-equity ratio leads to a higher required return on equity, because of the
higher risk involved for equity-holders in a company with debt. These propositions are true
assuming the following assumptions: no taxes exist, no transactions costs exist and
individuals and corporations borrow at the same rate. Propositions 1 and 2 are based on a
number of simplifying assumptions and in the real world, those assumptions are not valid.
However, the theorem is still taught and studied because it tells us something very important.
That is, if capital structure matters, it is precisely because one or more of the assumptions is
violated. It tells us where to look for determinants of optimal capital structure and how those
factors might affect optimal capital structure.

On the other hand, MM conclusions are changed when real world conditions differ from their
assumptions. One important real world phenomenon is the existence of corporate and personal
taxes which treat different forms of income differently. In this situation, MM Proposition 1 states
ISRA AFRIDI FM MM THEORY

Page 4

that because corporations can deduct interest payments but not dividend payments,
corporate leverage lowers tax payments and the firms value increases with leverage. The
key concept for understanding the impact of corporate taxation is the present value of the
interest tax shield or, in other words, the present value of the tax saving that is obtained
through the firm having to make interest payments to its debt-holders. Apart from the first MM
proposition, MM Proposition 2 states that the cost of equity rises with leverage because the
risk to equity rises with leverage. If we consider the impact of corporate taxes alone, the
conclusion would be to observe 100% debt in the capital structure of firms. Thus the existence
of taxes combined with the ability to reduce taxable incme by the amount of interest
expense results in increased cash flowing out of the company with more debt. This implies
that having debt results in a higher value to the owners.
In 1977, Miller suggested that the important result is not solely how much money flows out
of the company, but how much the owners retain after being taxed on cash received from
the company.. If the personal tax rate is higher that the corporate rate, it is clear that
income at the personal level due to equity is more favorable than income from holding
debt. On the other hand, if the personal tax rate is lower than the corporate rate, it would
be better if personal income was derived by holding debt in lieu of equity.
This further consideration of the tax issues involved in maximizing shareholders wealth
leads to an examination of the clientele effect. Some shareholders prefer a capital
structure with more equity while others prefer one with more debt. The choice depends on
the tax structure of the shareholders. It is also possible that owners will have to pay tax on
their equity income, further complicating the analysis.
Therefore, each individual investor will assess which particular capital structure best suits
their needs making it impossible to formulate a general rule for an optimal structure.
(Dividend is partially influence by clientele effect)
According to the above information, it is clear that the choice of capital structure boils down to
taxes, risks and asset type. These three factors give managers a framework for thinking about
optimal capital structure and will enable managers to make good decisions that will improve the
long run performance of the company. In the article The Search for optimal capital
structure, Stewart C. Myers, argues that there is no presumption that borrowing is a good
thing, even if debt is kept to moderate levels. He adds that there is a moderate tax advantage
to corporate borrowing for companies that are reasonably sure they can use the interest tax
shields. However, the costs of possible financial distress may limit borrowing. These costs are
particularly valid for risky firms and for firms whose value depends on intangible assets. In
addition, growth firms should borrow less, other things equal.
Conclusion
ISRA AFRIDI FM MM THEORY

Page 5

References
ISRA AFRIDI FM MM THEORY

Page 6

ISRA AFRIDI FM MM THEORY

Page 7