ABSTRACT
In their seminal work, Franco Modigliani and Merton Miller (1958) established the proposition that there was no optimum leverage for a perfectly competitive firm. Durand (1952, 1959) (whose original view was further clarified and certainly upheld in the most convincing fashion by Modigliani and Miller) and Brewer and Michaelson (1965) questioned the realism and adequacy of the postulates behind the Modigliani-Miller analysis. 1 But, soon after those criticisms, numerous studies (for example, Hirschleifer, 1966; Stiglitz, 1969, 1973; Fama and Miller, 1972; Baron, 1974; Hamada, 1969; Rubinstein, 1973) reestablished the validity of the celebrated result under more general and less restrictive conditions. In their original work, Modigliani and Miller (1958) pointed out that if the firm's cost of borrowing fell short of the investors’ cost of borrowing, then the value of the firm would rise with an increase in its debt. Baumol and Malkiel (1967) also contended that a firm was not leverage-indifferent if investors incurred transaction costs in arbitrage activities. A few years later, Stiglitz (1972) showed that if debt capital was traded in markets in which equity investors held superior prospect on the firm's performance to that of the firm's creditors, then a sufficiently high level of debt could induce a drop in the value of the firm. Rubinstein (1973) demonstrated that if security markets were partially segmented and that if debt was traded in a separate market where traders were more risk averse than investors in the firm's equity capital, then the value of the firm and its debt level were inversely related. Having introduced corporate income taxes and bankruptcy costs in tandem, however, several authors (such as Baxter, 1967; Jensen and Meckling, 1976; Kim, 1978; Turnbull, 1979, 1981; Lee and Barker, 1977; Kraus and Litzenberger, 1973; Scott, 1976; Robichek and Myers, 1965; Bierman and Thomas, 1972) proved the existence of the optimum capital structure for a firm.
