(capital stock) in the capital structure. Thus as the amount of equity capital
increases in a particular firm’s capital structure, the debt-equity ratio and
the degree of financial risk decrease. The conventional rate of return on the
equity is depicted on the vertical axis. Because of the pro forma profitability
of leverage, the rate of return on the equity falls as the proportional amount
of share financing increases, although volatility and financial risk decrease.
The transformation curve D gives the average rate of return for shares
and degree of risk for a financial structure containing varying amounts of
ownership capital. Superimposed in the figure are investors’ indifference
curves showing the investors’ substitution rate between earnings and the
degree of risk for a firm of this type. Each indifference curve represents a
given constant stock price. The tangency point E indicates the financial
structure, the trade-off between risk and return that will fetch the highest
price for the shares on the market. It is the point where the earnings and
the risk-adjusted discount rate yield the highest amount.
The tangency point E indicates the optimum amount of equity capital
and rate of return on equity capital for the firm. In brief, the optimum con-
ditions are:
Marginal Sacrifice in Earnings Marginal Decrease in Earnings
Marginal decrease in risk = Marginal increase in ownership
(investor’s choice) (decrease risk) (in the financial
structure of the firm)The letter R indicates the rate of earnings on equity investment and OC the
optimum amount of equity capital for the firm, setting up the market capi-
talization rate and expected earnings that maximize the value of the shares.
The optimum capital structure varies for firms in different industries
because the typical asset structures and the stability of earnings that deter-
mine inherent risks vary for different types of production. The theoretical
solution of the optimum capital structure is made in a very formal manner,
since it must give consideration to many variables—increasing lender’s
risk, increasing borrower’s risk, the interest rate structure, the forecasted
earnings function, and the possibility of discriminating against the market
supply of outside capital.
Modigliani and Miller—Constant Capital Costs
Professors Franco Modigliani and Merton Miller (M&M) in their 1958
study posited a model where in a nontax world, for a firm of a given risk
class, capital costs are constant regardless of the financial risk. There is no
optimum financial structure.