• Global Frameworks: CFA Level 2 (Corporate Issuers), Corporate Finance Theory (Berk & DeMarzo standards).

1. Modigliani-Miller (MM) Proposition I and II (No-Tax Baseline)
In 1958, Franco Modigliani and Merton Miller published their irrelevance proposition under strict idealized market conditions (no taxes, no transaction costs, no bankruptcy risks, and symmetric information).
  • MM Proposition I: The market value of a company is determined solely by its operating assets and earning power, making its capital structure choices irrelevant
    V_levered = V_unlevered
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  • MM Proposition II: As a firm substitutes cheap debt for expensive equity, the risk to equity holders rises. This causes the required return on equity
    r_e to increase linearly, keeping the overall WACC completely constant:

    r_e = r_0 + (Debt / Equity) × (r_0 − r_d)

2. Modigliani-Miller with Corporate Taxes
In 1963, MM relaxed the no-tax assumption. Because interest payments are tax-deductible, debt financing creates an interest tax shield that increases corporate cash flows.
  • MM Prop I (with Tax): The value of a levered firm equals the value of an unlevered firm plus the present value of the tax shield (t × Debt):

    V_L = V_U + tD

This model suggests that to maximize firm value and minimize WACC, a company should choose a capital structure composed entirely of debt.
3. Trade-Off Theory: Balancing Tax Shields and Financial Distress Costs
In practice, firms rarely fund themselves entirely with debt. The Trade-Off Theory adds financial distress costs (such as legal fees during bankruptcy and lost sales from worried customers) to the model.
As leverage increases, the probability of financial distress grows. The optimal capital structure is achieved at the exact point where the marginal benefit of the interest tax shield matches the marginal cost of potential financial distress:

V_L = V_U + tD − PV of Financial Distress Costs
 
4. Peaking Order Theory and Information Asymmetry
Developed by Stewart Myers, Pecking Order Theory drops the assumption of perfect information. Corporate managers generally know more about their company’s prospects than public investors do.
If managers issue new equity, the market often interprets this as a sign that the stock is overvalued, causing the share price to drop. To avoid this negative market signal, firms follow a strict financing hierarchy:
  1. Internal Equity: Retained earnings (no signaling distortion).
  2. New Debt Issuance: Viewed as a confident signal that the firm can meet fixed obligations.
  3. New Equity Issuance: Used only as a last resort.

 
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