Capital Structure Theory

Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton Miller (hereafter MM) published what has been called the most influential finance article ever written.¹¹ 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 results suggest that it does not matter how a firm finances its operations, so capital structure is irrelevant. However, MM’s study was based on some unrealistic 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 some clues about what is required for capital structure to be relevant and hence to affect a firm’s value. MM’s work marked the beginning of modern capital structure research, and subsequent research has focused on relaxing the MM assumptions in order to develop a more realistic theory of capital structure. Research in this area is quite extensive, but the highlights are summarized in the following sections.

The Effect of Taxes

MM published a follow-up paper in 1963 in which they relaxed the assumption that there are no corporate taxes.¹³ The tax code allows corporations to deduct interest payments as an expense, but dividend payments to stockholders are not deductible. This differential treatment encourages corporations to use debt in their capital structures. Indeed, MM demonstrated that if all their other assumptions hold, this differential treatment leads to a situation which calls for 100 percent debt financing.

However, this conclusion was modified several years later by Merton Miller (this time without Modigliani) when he brought in the effects of personal taxes.¹⁴ He noted that all of the income from bonds is generally interest, which is taxed as personal income at rates going up to 39.6 percent, while income from stocks generally comes partly from dividends and partly from capital gains. Further capital gains are taxed at a maximum rate of 28 percent and this tax is deferred until the stock is sold and the gain realized. If stock is held until the owner dies, on capital gains tax whatever must be paid. So, on balance, returns on common stocks are taxed at lower effective rates than returns on debt.

Because of the tax situation, Miller argued that investors are willing to accept relatively low before-tax returns on stock relative to the before-tax returns on bonds. For example, an investor might require a return of 10 percent on Bigbee’s bonds, and if stock income were taxed at the same rate as bond income, the required rate of return on Bigbee’s stock might be 16 percent because of the of the stock’s greater risk. However, in view of the favorable treatment of income on the stock, investors might be willing to accept a before-tax return of only 14 percent on the stock.

Thus, as Miller pointed out, (1) the deductibility of interest favors the use of debt financing, but (2) the more favorable tax treatment of income from stocks lowers the required rate of return on stock and thus favors the use of equity financing. It is difficult to say what the net effect of these two factors is. Most observers believe that interest deductibility has the stronger effect, hence that our tax system still favors the corporate use of debt. However, that effect is certainly reduced by the lower capital gains tax rate.

One can observe changes in corporate financing patterns following major changes in tax rates. For example, in 1993 the top personal tax rate on interest and dividends was raised sharply, but the capital gains tax rate was not increased. This could be expected to result in a greater reliance on equity financing, especially through retained earnings, and that has indeed been the case.