FREE online courses on Capital Structure of Firms - Capital Structure Theory - Capital Structure Theory

 

Once we have understood that the financial risk of a firm plays an important role in determining its capital structure, it will be easier for us to understand some of the theories that try to explain how a firm determines its optimal capital structure. The pioneers in the capital structure theory are Modigliani and Miller. Their theories embodied some very simplify assumptions that might not represent the real world, but they are very important in helping you understand how a firm determines the correct mixture of debt and equity financing.

 

The Modigliani and Miller (MM) original capital structure model has the following assumptions:

 

• Investors have homogenous expectations.
• Perfect capital market, i.e. no transaction cost and individuals and corporations can borrow at the same rate.
• The cost of debt is constant and it is represented by the risk-free rate.
• All firms are zero-growth firms, i.e. earnings are assumed to be constant and perpetual, and all earnings are paid out as dividends.