Capital Structure

Modigliani and Miller argued that capital structure is irrelevant, all other things being equal, but in the real world those other things are never equal. The factors that are ruled out of MM are neutral taxes, no capital market frictions, symmetric access to credit markets, and that firm finance policy reveals no information. Normally, arguments against the irrelevance of capital structure are based on these factors that MM assumed away (Villamil, n.d.). In the U.S., taxes on dividends are very different from the taxes paid on loan interest. There are transaction and bankruptcy costs; firms cannot borrow and lend at the same rate, and financial policy does reveal information. As such, MM does not hold in the real world, and this implies that capital structure does matter.

That capital structure does matter implies that for every firm there is an optimal capital structure. What that structure might be,...
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