The fundamental concepts that shape modern capital structuring theory were first put together by Modigliani and Miller [M&M] (1958) in a series of propositions. These propositions have, for many years, dominated the thought process by which firms choose their leverage ratio to enhance value. Moreover, the appeal that these concepts have had to academics is enormous, as they are open ended and highly controversial.
A major contribution of M&M’s propositions is that they allow one to select, via a formalised process, the right balance between debt, equity and assets that raises the overall value of a firm [i.e. firm’s value, FV]. This increase is brought on by the interest tax shield, which enables FV to grow indefinitely with leverage. The negative impact of leverage was later added to demonstrate that FV reaches a maximum before it begins to fall, owing to the rising cost of debt overtaking the positive attributes of the tax shield. Thus, what this combination produces is a unique optimal capital structure, where FV is at its peak.
Unfortunately, things are not so simple in real life, as evidenced by the large number of studies on how firms generally tend to optimise their capital structure.
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