ABSTRACT
Since Modigliani and Miller's pioneering 1958 study, a voluminous literature on corporate capital structure has sprung up. Assuming perfect capital markets, fixed investment policy, and an absence of taxes, Modigliani and Miller argued that capital structure will not affect the value of the firm. When they introduced corporate taxes in their 1963 study, however, they concluded that the value of a levered firm is higher than the value of an unlevered firm by the present value of the tax shield. This result has the unrealistic implication that the optimal capital structure for a firm is one that is entirely debt-financed. Because most firms actually employ a mix of retained earnings and new equity issues in addition to debt finance, the focus in financial theory shifted to the search for factors that offset the tax advantages of leverage. Baxter (1967) introduced bankruptcy costs as a disadvantage of debt finance that counteracts the tax advantage. By including personal taxes in a model that he developed on his own, Miller (1977) showed that if the personal tax rate on bond interest is higher than the personal tax rate on equity income in the form of capital gains, the corporate tax advantage of debt finance is completely eliminated. DeAngelo and Masulis (1980) explained the presence of internal funds and new equity issues in a firm's capital structure by including in their model nontax debt shields, such as depreciation allowances and investment tax credits, that reduce the tax shield from borrowing. Using the agency cost approach first developed by Jensen and Meckling (1976), Myers (1977) explained the limited use of debt finance by showing that a firm with risky debt in its capital structure may invest less than the optimal amount; the consequent reduction in firm value sets an upper limit to the amount of new debt that the firm can issue.
