The Modigliani and Miller(1958) theory developed the proposition that in perfect markets, with absence of taxes, transaction costs, bankruptcy costs and asymmetric information, the value of the firm is not affected by how it is financed by its capital structure, also the weighted average cost of capital (WACC) will remain the same even if the firm's capital structure changes. For example, regardless of how much loan the firm borrows from its creditors, there will be no tax benefit gained from the interest payments it received, therefore there will be no changes made to the WACC. Since there is no benefit receiving from increases in debt, it means the capital structure does not affect a company's share price, thus the capital structure is unrelated to a company's share price.
Modigliani and Miller (1963) adjusted the theory by adding company tax and adjusted again by Miller (1977) by adding personal tax in the theory. After including company and personal tax in the theory, the interest payments made from debt by the firm will be tax deductible and it will reduce the income tax for the firm. According to Eriotis et al., (2007), the tax shield would let the firm to pay lower taxes when it use its debt than when…show more content… Therefore, if a company adopts the Modigliani and Miller theory, it would not be able to determine a firm’s capital structure appropriately. And the firm would not be able to measure its correct value, and the correct WACC. Also, the stock price of the firm would not be appropriate. The Modigliani and Miller theory ignores the company tax and personal tax and it also ignores personal sector of financing with retained earnings. In reality, firms do not give out the whole amount of retained earnings in form of dividends. Also, investors would not be very interested in buying low priced shares issuing by highly geared