CAPITAL STRUCTURE THEORY

Modern Capital Structure theory began in 1958, when Professors FRANCO MODIGILANI and MERTON MILLER (hereafter MM) published an article ” The Cost of Capital ,Corporation Finance and The Theory of Investment”, what has been called the most influential finance article ever written.MM proved, under a very restrictive set of assumptions, that a firm’s value is unaffected by its capital structure. Put another way, MM’s result suggest that it does not matter how a firm finances its operations, hence Capital Structure is irrelevant. However, MM’s study was based on some strong assumptions, including the following:

1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future investment opportunities.
6. EBIT is not affected by the use of debt.

Despite the fact that some of these assumptions are obviously unrealistic, MM’s irrelevance result is extremely important. By indicating the conditions under which capital structure is irrelevant, MM also provided us with clues about what is required for capital structure to be relevant and hence to affect a firm’s value.