Capital structure: Modigliani-Miller, and what it assumes

Chapter 9 ended on a question. If debt is cheaper after tax, why not use more?

The famous answer is that it makes no difference at all — and the value of that answer lies entirely in the assumptions it needs.

The irrelevance proposition

In a world with no taxes, no bankruptcy costs, no transaction costs and symmetric information, the value of a firm is independent of how it is financed.

The argument is simple and worth following, because it is the thing that makes the result useful rather than merely surprising.

A firm's value comes from its assets — the cash flows its operations generate. Debt and equity are claims on those cash flows. Changing the proportions changes how the pie is sliced, not how large it is.

The arbitrage argument closes it: if a levered firm were priced above an identical unlevered one, an investor could replicate the leverage personally by borrowing on their own account and buying the unlevered firm. Since individuals can lever themselves, they will not pay a premium for a company doing it for them. The prices must converge.

So the cheapness of debt is an illusion in this world. Adding debt raises the risk borne by equity, so the cost of equity rises exactly enough to offset the cheaper debt, and WACC is unchanged.

That last sentence is the real content, and it is why the proposition matters even though its world does not exist: debt is not free money; its cost partly shows up somewhere other than the interest line.

Adding taxes

Relax one assumption. Interest is deductible and dividends are not, so the government subsidises debt.

Now the levered firm is worth more — by the present value of the tax shield — and the logic points to as much debt as possible. Which no company does, so at least one more assumption must matter.

What actually limits it

The problem asks for three reasons.

Financial distress costs. As leverage rises, the probability of being unable to meet obligations rises, and distress is expensive well before insolvency: suppliers tighten terms, customers hesitate over long contracts, good staff leave, and management time goes to lenders rather than the business. These costs are borne by the firm and they grow faster than linearly. Chapter 11 is this in detail.

Debt capacity and lender behaviour. Lenders stop lending, or price the next rupee punitively, long before the theoretical optimum. This is the most immediately binding constraint for a mid-sized Indian manufacturer: the ceiling is set by what banks will extend against available security and cash flows, not by a computed optimum. Add the regulatory layer — SEBI's buyback regulations require debt after a buyback to be no more than twice paid-up capital and free reserves — and the structure is partly chosen by others.

Agency and flexibility. Heavy debt constrains future choices. A firm at its borrowing limit cannot fund an opportunity that arrives unexpectedly, and the value of the projects it is forced to decline does not appear anywhere in a WACC calculation.

Ranking for a mid-sized Indian manufacturer: debt capacity first, because it binds before anything else; distress costs second; flexibility third.

The trade-off view

Put the tax shield against distress costs and there is an interior optimum: borrow until the marginal tax benefit equals the marginal expected cost of distress.

It predicts, correctly, that stable firms with tangible assets and reliable cash flows carry more debt than volatile ones with intangible assets. A steel producer can borrow in ways a software company cannot, and both are behaving sensibly.

It does not predict everything — many profitable firms carry far less debt than the trade-off implies.

The pecking order view

An alternative, built on information asymmetry. Managers know more than investors, so issuing equity signals that managers think the shares are expensive, and the price falls on announcement. Firms therefore prefer, in order:

1. Internal funds — no signal, no issue cost
2. Debt — a weaker signal, since lenders are repaid regardless
3. Equity — last resort

This explains the observed behaviour the trade-off theory misses: profitable firms use less debt not because they want less leverage but because they have retained earnings and never needed to raise anything.

The honest conclusion

There is no formula for the right capital structure. What there is:

• Leverage increases expected returns to equity and the variance of them — chapter 5 of the Quantitative methods subject's $a^2$ on variance
• The tax shield is real but requires taxable profit
• Distress is costly before it is terminal
• Flexibility has value that no model prices well
• In practice the lender and the regulator set the ceiling before the theory does

The point

In a frictionless world, capital structure is irrelevant: the firm's value comes from its assets, and cheaper debt is exactly offset by a rising cost of equity, so WACC does not move. That result matters because it identifies what does make leverage worthwhile — the tax shield — and what limits it: distress costs, what lenders and regulators permit, and the value of retaining flexibility. The pecking order explains why profitable firms often borrow least.