This lesson examines the theory and practice of capital structure decisions—the mix of debt and equity used to finance the firm.

6.1 The Modigliani-Miller Propositions

The Modigliani-Miller (MM) propositions are foundational to corporate finance theory . MM Proposition I states that, in a perfect market with no taxes, bankruptcy costs, or information asymmetries, the value of a firm is independent of its capital structure. MM Proposition II states that the cost of equity increases with leverage.

6.2 Capital Structure in the Real World

In the real world, capital structure matters due to market frictions :

  • Taxes: Interest payments are tax-deductible, creating a tax shield that increases firm value.

  • Financial Distress Costs: Higher leverage increases the risk and cost of financial distress.

  • Agency Problems: Debt can act as a disciplinary device.

  • Asymmetric Information: The pecking-order theory suggests a hierarchy of financing choices, with internal funds preferred over debt and debt over equity .

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