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Capital Structure Theories^293

servicing is high so the interest rates charged by the creditors increase to reflect the

changing risk profile of the company.

Sometimes promoters having management capability and experience in high growth

potential areas are lacking in financial strength. These companies, if they have to raise

funds in the market will have to financially leverage their meagre capital contribution by

a high incidence of debt. Here, the need to retain management control limits the amount

of equity that can be raised and subsequently the debt that can be raised, too.

Taxation and capital structure

In 1963, MM added corporate taxes to their model. With corporate taxes considered, a

firm's stock price was shown to be directly related to its use of debt financing -- higher

the percentage of debt financing, the higher the stock price. Under the MM with tax

theory, firms should use virtually 100% debt financing. The reason for this result is the

corporate tax structure - returns to stockholders come from after-tax earnings, but

returns to creditors are paid before tax. The effect of this tax treatment is that more of

a company's operating income is left for investors when more debt financing is used.

Modigliani and Miller basic propositions with corporate taxes are as follows:

Proposition I

The total market value of a leveraged firm is equal to (1) the value of an unleveraged

firm in the same risk class plus (2) the gain from leverage, which is the value of the tax

savings due to debt financing and which equals the corporate tax rate times the amount

debt the firm uses.

VL = VU + TD

With zero debt the value of the unleveraged firm is equal to the value of its equity

E = VU =

ko,L

EBIT ( 1 - T)

Proposition II

The cost of equity of a leveraged firm is equal to (1) the cost of equity of an unleveraged

firm in the same risk class plus (2) a risk premium, whose size depends on the differential

between the costs of equity and debt to an unleveraged firm, the amount of financial

leverage and the corporate tax rate.



=^

E

D

ke,L ke,U + Risk Premium= ke,U + (ke,U - kd)(1-T)

This means that as the firm's use of debt increases, its cost of equity also rises but at a

slower rate now because of the effect of (1-T) which is less than 1.

Empirical Evidence Against MM Hypothesis

In spite of the MM arguments, firms do not usually use anywhere close to 100% debt