A Study On Capital Structure Theory

1997 Words Jul 10th, 2015 8 Pages
Literature Review

Capital structure theory has long been a controversial issue in the finance literature.
The two Novel laureates, Franco Modigliani and Metron Miller (here after called M-M) were the first to present a formal model in 1958 on valuation of capital structure in corporate finance theory and is still the cornerstone of modern corporate finance. MM were the first to take a sharp look at the relationship between Capital Structure and the cost of capital. In their seminal papers (1958, 1963), they states some propositions. In proposition I they postulated that debt has no value for firms in a tax free world. In a no tax scenario the investors can offset the debt by replicating its financial actions. This proposition got the name “MM theory of irrelevance”. Though their proposition theoretically sounds good but it is only valid under perfect market conditions (no tax is one of them) which were not actually possible in real world. They corrected this proposition in 1963 incorporating the effect of tax on value and cost of the capital of the firm (Modigliani and Miller 1963). Their new proposition II contends that, in the world of corporate tax, the value of the firm depends on the variation of the debt level and tax shield benefit on interest payments.

When corporate taxes are taken into consideration, the value of a firm increases linearly with debt-equity ratio because of interest payments being tax exempted. M-M’s work has been at the centre stage of the…
Open Document