No Optimal Capital Structure

We have just argued that debt has advantages, relative to equity, as well as disadvantages. Will trading off the costs and benefits of debt yield an optimal mix of debt and equity for a firm? In this section, we will present arguments that it will not, and the resulting conclusion that there is no such optimal mix. The seeds of this argument were sown in one of the most influential papers ever written in corporate finance, containing one of corporate finance's best-known theorems, the Modigliani-Miller Theorem.

When they first looked at the question of whether there is an optimal capital structure, Miller and Modigliani drew their conclusions in a world void of taxes, transactions costs, and the possibility of default. Based upon these assumptions, they concluded that the value of a firm was unaffected by its leverage and that investment and financing decisions could be separated. Their conclusion can be confirmed in several ways; we present two in this section. We will also present a more complex argument for why there should be no optimal capital structure even in a world with taxes, made by Miller almost two decades later.

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