use of one class of financing has rebound effects on the costs of the rest of
the financial structure. In the optimal model, the overall cost of capital at
any given time is constant within the range of the optimal capital struc-
ture. Debt or equity financing or some combination may be used for any
particular project, as long as the financial mix is kept within an optimal
range. Nevertheless, because every type of financing has interactions with
the other sources of financing, the return on a project is not to be com-
pared to the direct cost of its mode of financing but to the overall cost of
the financial mix.
In the M&M model, the interaction between different types of financ-
ing is complete so there is no optimal financial structure. Thus the firm’s
overall cost of capital at any point of time is constant at the proper finan-
cial mix, or it is constant regardless of the mix. Quite importantly, both of
these views are in opposition to the sequential cost models, in which the
cost of capital depends on the financing that is being used currently, so that
the cost is lowest when the firm uses retained earnings, rises for outside
borrowing, and becomes still higher when borrowing capacity is strained
and additional funds depend on the flotation of new shares.
Empirical Factors Influencing Financial Structures
The two main external factors influencing the financial structure of a firm
are the composition of its assets and the stability of its cash flow. Financial
firms, such as banks and insurance companies, are prime examples of en-
terprises where the liquidity and marketability of their assets enable them
to carry a high proportion of liabilities. Of course, in this instance, the
firm’s selection of assets for safety, marketability, and liquidity may be pre-
determined by the heavy volume of the firm’s contingent or short-term lia-
bilities, rather than the other way around. Nevertheless, a firm with safe
marketable or short-term assets can finance these assets with a high pro-
portion of debt with relatively matching maturities. Thus, marketing firms
carry short-term inventories and creditable short-term accounts receivable
can safely carry a relatively high proportion of short-term debt.
The stability of cash flow is influential in shaping the financial struc-
ture. The cash flow is the amount of free funds the firm can utilize over a
short-run period. Cash flow and accounting profits or earnings may differ
considerably. Cash flow is less than earnings, for example, by any increases
in costs incurred on work in process; cash flow exceeds reported earnings
by the extent of depreciation, depletion, and other book or noncash
changes (i.e., noncash charges representing the using up of assets acquired
in the past). Although for internal control and budgeting purposes detailed
analyses are made of the components of the cash flow, the rough rule of