Discussion of the theories on Optimal Capital Structure Essay

Discussion of the theories on Optimal Capital Structure - Essay ExampleThe study by Modigliani and milling machine was based on the following assumptions1.There atomic number 18 no brokerage costs.2.There are no taxes.3.There are no bankruptcy costs.4.Investors trick borrow at the same rate as corporations.5.All investors have the same in smorgasbordation as management about the pisseds prox investment opportunities.6.EBIT is not affected by the use of debt.This theory says that if these assumptions hold true, the value of the firm is not affected by the capital structure. This situation is verbalized as followsVL = VU = SL + D.Here VL is the value of a levered firm, VU is the value of an identical, unlevered firm, SL is the value of the levered firms stock and D is the value of its debt.As we know that WACC is a combine of cost of debt and cost of equity. The cost of debt is lower than the cost of equity. As a company raises capital through debt, the weight of debt increases a nd hence, it drives up the cost of equity as equity gets riskier. According to the assumptions by Modigliani and Miller, the cost of equity increases by an amount to keep the WACC constant. In other words, under these assumptions it does not matter whether the firm uses debt or equity to raise capital. So, capital structure decisions are irrelevant in such conditions. Modigliani and Miller The Effect of Corporate Taxes In 1963, Modigliani and Miller relaxed the assumption that thither are no corporate taxes. The corporate tax laws favour debt financing over equity financing because the tax laws allow companies to deduct interest payments as expense and on the other hand dividends are not deductible. So this treatment encourages debt financing. Interest payments reduce the amount the firm pays to the government in the form of taxes and more of its cash is available for its investors. Hence, tax deductibility of the interest payments acts as a shield for the firms income before tax. M odigliani and Miller presented this concept as follows VL = VU + measure out of side effects = VU + PV of tax shield. They further simplified the concept as VL = VU + TD. Here T is the corporate tax rate and D is the amount of debt. This consanguinity is expressed in the graph below. If the corporate tax rate is 40%, then this formula implies that every dollar of debt will increase the value of the firm by 40 cents. Hence, the optimal capital structure is 100% debt. Under this theory, the cost of equity increases as the amount of debt increases but it does not increase as fast as it does under the assumption that there are no taxes. As a result, under this theory the WACC falls as the amount of debt increases. This kinship is shown in the following graph. Miller The Effect of corporate and personal taxes Later Miller brought in the aspect of personal taxes in this model. He said that income from the bonds is considered as interest which is taxed as personal income at a particular rate (Td). On the other hand, income from stocks comes in the form of dividends and capital gains. The tax on semipermanent capital gains is deferred until the stock is sold and the gain is realized. Of the stock is held until the owner dies no capital gains tax is paid. So he concluded that the returns on stock are taxed at a lower effective tax rate (Ts) than returns on debt. Looking gat this, Miller argued