This lesson explores the impact of introducing corporate taxes into the capital structure decision. It examines how the tax deductibility of interest creates a tax shield that makes debt financing more attractive, and introduces the Trade-Off Theory that balances this benefit against the costs of financial distress.

• MM with Corporate Taxes (1963): Modigliani and Miller later revised their theorem to incorporate corporate taxes. The key insight is that interest payments are tax-deductible, creating a tax shield that makes debt a less expensive form of financing than equity. The value of a levered firm is now the value of an unlevered firm plus the present value of the interest tax shield.

  • VL = VU + (Tax Rate × Debt)

  • This suggests that the optimal capital structure is 100% debt.

• The Trade-Off Theory: The static trade-off theory states that firms determine their optimal debt-equity ratio by balancing the benefits of debt (tax shield) against the costs (financial distress and bankruptcy). The theory recognises that while debt provides tax advantages, excessive leverage increases the probability of financial distress, which imposes significant direct costs (legal and administrative costs of bankruptcy) and indirect costs (loss of customers, suppliers, and key employees).

• The Optimal Capital Structure under Trade-Off Theory: The optimal capital structure is theoretically the point at which the marginal benefit from the tax shield of an additional dollar of debt is precisely equal to the marginal cost associated with the increased probability of financial distress. At this point, the firm’s value is maximised and its WACC is minimised.

• Target Debt Ratios: The trade-off theory implies that firms have optimal or target debt ratios, which they aim to achieve over time. Survey evidence suggests that many firms do target their debt ratios, although the target is often flexible.