Market imperfections

  • 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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