Modigliani–Miller Proposition and Trade-off Theory

Anton Miglo ()
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Anton Miglo: Toronto School of Finance

Chapter Chapter 2 in Capital Structure in the Modern World, 2025, pp 21-42 from Springer

Abstract: Abstract The Modigliani–Miller theorem (1958) is the foundation of modern capital structure theory. It states that when markets are perfect, the capital structure of a company does not matter. This chapter provides a review of this proposition and explains that capital structure choice is important when taxes are considered. By increasing the amount of debt in its capital structure, the firm creates a “debt tax shield” that can decrease the amount of taxes and increase the firm’s value. Increasing debt in a firm’s capital structure increases its probability of bankruptcy. Since bankruptcy is costly, the incentive to increase debt should depend on potential bankruptcy costs. The Trade-off theory of capital structure, which combines the debt tax shield and the expected bankruptcy cost ideas, is explained, and a review of recent literature is provided.

Keywords: Perfect market vs. imperfect market; Capital structure irrelevance; Trade-off theory; Debt tax shield; Bankruptcy cost (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:spr:sprchp:978-3-031-85459-0_2

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DOI: 10.1007/978-3-031-85459-0_2

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