By way of a conventional start, perhaps it would be worth our while to look at what "capital structure" actually means. In broad terms, it is essentially the firms' mix of debt and equity but it would be wrong to assume that this is all there is to it. These two terms belie the complexity that lies beneath, from the viewpoint of the decisions that any firm must take - that is to say, what kind of debt and which type of equity. Capital structuring would then, deal with how a concern splits its cash flows into the relatively safe stream that goes to the debt holders, and the riskier stream that goes to the stock holders. The aim of any exercise within the purview of this is simple: find the combination that maximizes the firms' market value.
It could first be argued that the firms' value is not altered by the method by which it is split because the value is determined by its real assets, and not by the securities issued. This total separation of investment and financing implies that given a firm which uses a mix of debt-equity financing, its value will be exactly the same as it would have been had it opted for all equity financing. The aforesaid is the essence of what Modigliani and Miller showed as their Proposition I'. Thus, Modigliani and Miller, in their seminal work, espoused that in a perfect market the combinations of debt and equity are all at par in essence, the market value of any firm is capital structure independent. Here, the law of value conservation operates, wherein an asset value is preserved irrespective of the claims that might arise on it. This is precisely where the question of practicality presents itself, for if debt policy was of no consequence, then this fact cannot adequately explain actual debt ratios varying significantly across the board in various industries, be it airlines or banks.
Modigliani and Miller went on to say, as Proposition II' that the value of the firm increases with an increase in debt due to the presence of tax shields on the interest payment on debt. Looking back at the concept of unchanging value of the firm, it now must be understood that apart from the various claims on the securities by various stakeholders, the government is also a consideration now. Anything that the firm can do to reduce the governments claim, would consequently add to share holders wealth. Thus, by borrowing money and thereby reducing its tax bill, the firm is in a position to increase its after tax value by the present value of the tax shield. Considering all the factors just mentioned, the propositions can now reflect these new variables. The value of a firm can now be dealt with as the sum of the firms' value if it were all equity financed and the PV of the tax shield. In proposition III, Modigliani and Miller refine their hypothesis by introducing an important element of reality- that of inability to absorb interest tax shields due to non-availability of profits and the possibility of financial distress at extreme debt equity ratios. The cost of the firm in such a case the value of the firm is equal to the value of the all equity firm plus the PV of the tax shield on interest less the PV of costs of financial distress.
The figure above depicts how the trade off between costs of distress and tax benefits determines optimal capital structure. The tax shield increases as the firm borrows more. At lower levels the costs of distress are low, and tax advantages are significant, but with additional borrowing, this changes and at some debt ratio, the costs of financial distress begin to outweigh the benefits of a tax shield to affect the firms' value to a large extent.
The trade-off theory balances the tax advantages of borrowing against the costs of financial distress. Corporations are expected to target a capital structure that maximizes firm value. Firms with safe, tangible assets and plenty of taxable income that can...