CONTEMPORARY THEOY IN SUPPORT OF CAPITAL STRUCTURE’S DECISION: Miller

Modigiliani Hypothesis:

Miller Modigiliani hypothesis states that at a set particular price level the value of a firm is

unaffected by how that firm is financed in the absence of the taxes, agency and bad debt costs, as

well as asymmetric information,. It does not matter whether the firm is financed by debt or

equity. Moreover, this hypothesis talks about two propositions for the relation between a firm’s

capital structure, its market value and cost of capital. Due to this, Miller Modigiliani hypothesis

is termed as “capital structure irrelevance principle.”

The book “Financial Theory and Corporate Policy” written by Thomas E Copeland, Fred

Waston and Kuldeep Shastri discusses the modern theories concerning the determination of the

corporate financing sources. It discusses trade off theory in detail which allows for the existence

of bankruptcy and bad debt costs. It states that there are both benefits and costs of financing with

debt. An increase in debt results in a marginal decline in further addition in debt while the

marginal costs rises. Therefore, a firm that is attempting to optimize its value will go about

making a tradeoff between debt and equity. Moreover the book also explains the pecking order

theory which tries to focus on the costs of the asymmetric information. The companies try to

prioritize their sources of financing by law of least resistance. This theory by Myers says that

equity is a less preferred means to raise capital and investors place a lower value to equity

issuance. The neutral mutation hypothesis, market timing and accelerated investment hypothesis

also influence the capital structure decisions of a firm.

On the basis of the above mentioned arguments, it can be concluded that debt is less

risky to be used as a source of financing than equity. The major reason being debt financing

reduces the after tax payments whereas equity is doubly taxed; once corporation profits are taxed

and then dividend received by stockholders is taxed. Therefore, it would be wiser for UK Plc to

opt for debt financing.

Another eminent book, titled as “Applicability of financial theories of capital structure to

the Chinese cultural context: A study of privately owned SMEs” talks about pecking order theory

as being prominent in determining the capital structure decision for firms. It specifically talks in

context of the Chinese firms and goes about explaining the importance of the profitability and

firm size as being correlated to the leverage.

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