Determinants from the Theory of Finance

Abstract

The determinants of the firm’s optimal capital structure have been a contentious issue in the theory of finance for three decades now and the debate, that was started by the publication of Modigliani and Miller’s (1958, 1963) seminal papers, is still far from being concluded. As Modigliani and Miller’s initial conclusions of capital structure irrelevance and, subsequently, of optimal capital structure at a 100% debt financing are clearly incompatible with observed capital structures, their findings initiated a considerable research effort to identify costs of debt financing that would offset its corporate tax advantage. Robichek and Myers (1965) and Baxter (1967) were among the first to suggest that the dead-weight losses associated with bankruptcy and reorganization might represent the major missing element. Since then, Kraus and Litzenberger (1973), Scott (1976), Kim (1978) and other authors, using a variety of approaches, have shown that the combination of leverage related costs and a corporate tax advantage of debt produces an optimal capital structure at less than a 100% debt financing, as the tax advantage is traded off against the likelihood of incurring the costs. However, both major elements in this “tax savings-bankruptcy costs” model became subject to criticism. This criticism is mainly of empirical nature and directed to the quantitative result of the model (i. e. the locus of optimal capital structure). Authors like Haugen and Senbet (1978) have argued that bankruptcy costs may be too small to have substantial influence on optimal leverage. Miller (1977) questioned the tax savings side of models of optimal capital structure, arguing that, under certain conditions, the corporate tax advantage of debt may be offset by tax disadvantages at the personal level, making leverage again irrelevant.