The Contribution of the Miller Modigliani Theorem

It is unlikely that capital structure is irrelevant in the real world, given the tax preferences for debt and existence of default risk. In spite of this, Miller and Modigliani were pioneers in moving capital structure analysis from an environment in which firms picked their debt ratios based upon comparable firms and management preferences, to one that recognized the trade-offs. They also drew attention to the impact of good investment decisions on firm value. To be more precise, a firm that invests in poor projects cannot hope to recoup the lost value by making better financing decisions; a firm that takes good projects will succeed in creating value, even if it uses the wrong financing mix. Finally, while the concept of a world with no taxes, default risk, or agency problems may seem a little farfetched, there are some environments in which the description might hold. Assume, for instance, that the U.S. government decides to encourage small businesses to invest in urban areas by relieving them of their tax burden and providing a back-up guarantee on loans (default protection). Firms that respond to these initiatives might find that their capital structure decisions do not affect their value.

Finally, surveys of financial managers indicate that, in practice, they do not attach as much weight to the costs and benefits of debt as we do in theory. In a survey by Pinegar and Wilbricht, managers were asked to cite the most important inputs governing their financial decisions. Their responses are ranked in the order of the importance managers attached to them in Table 7.8.

Table 7.8: Inputs into Capital Structure Decisions
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