- M&M relaxed assumption of perfect capital market by considering corporate taxation.
- If we relax perfect market assumption further by considering bankruptcy risk, an optimal capital structure emerges.
- Companies have to balance the tax efficiency of debt with the risk of bankruptcy.
- As company gears up, tax shield from interest payments increases the value of the company.
- At gearing level X, shareholders start to want higher return to compensate for increasing bankruptcy risk and agency.
- Beyond gearing level Y, tax benefits are more than outweighed by bankruptcy and agency costs and so Y is the optimal level of gearing.
Optimal capital structure
- Traditional approach: OCS exists
- Miller and Modigliani I: no OCS is found
- Miller and Modigliani II: OCS is 100% debt
- Market imperfections: OCS exists
- In practice, rather than one optimal capital structure existing for each firm, a range of optimal capital structures may exist.
A practical view
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