TheopeningsalvointhisdebatewasfiredbyMertonMiller
and Franco Modigliani intheir seminal paperpublishedin
1958,
13 wheretheyshowedthatinaworldwithouttaxes,default
risk,andagencyproblems,thevalueofafirmisdetermined
bythequalityofitsinvestmentsandnotbythemixofdebt
andequityusedtofundthem.Theargumenttheyusedwas
simpleandpowerful.Theyconcededthatdebtischeaperthan
equitybutnotedthatborrowingmoneymakesequityearnings
morevolatileandriskier.Theresultingincreaseinthecostof
equityexactlyoffsetsanycostsavingsthatwillbegenerated
bysubstitutingdebtforequity,thuskeepingcost ofcapital
constant.
Intheyearssince,theframeworkthatMillerandModigliani
developed has been probed and expanded to examine the
questionofwhetherfinancialleverageaffectsvalue.Infact,
Miller and Modigliani showed in a subsequent paper that
introducing taxes into their default-free, agency-costless
world wouldcreatea scenario where firmvalue wouldbe
maximizedat 100 percentdebt.Introducingbankruptcyrisk
and taxes into the model does createa trade-off on debt,
where additional debt creates benefits (in theform of tax
savings)and costs(inadditionalbankruptcycosts)and can
affect value.
Theempiricalevidenceonwhethercapitalstructure affects
valueismixed.SupportingtheMiller-Modiglianiviewofthe
worldisevidencethatthereislittlecorrelationbetweendebt
ratiosand valuations acrosspublicly traded firms.In other
words,thereislittletoindicatethatfirmswithhigherorlower
debtratiostradeathighervaluations(measuredasmultiples
ofearningsorbookvalue).However,thereisevidencethat