Analyse the Development of Capital Structuring Theory

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Introduction

The essay intends to cover the development of capital structuring theory over the course of the 20th Century. It will highlight the different theories put forth by researchers, primarily Franco Modigliani and Merton Miller and their work during the 1950’s and 1960’s, and describe the differences in the theories and their implications and impact in the world of business and finance.

Background of Theory

In 1952, David Durand produced an article titled “Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement” (Durand, 1952), for the National Bureau of Economic Research. Within this publication he created what is now known as a ‘Traditional View’ of capital structuring which “according to this view, the value of the firm can be increased or the cost of capital can be reduced by the judicious mix of debt and equity capital” (Chand, 2015). This implies that the market valuation of a corporation can be altered depending on the capital structure used to finance the organisation. The ‘Traditional View’ assumes that as debt capital increases the overall cost of capital decreases and thus the market valuation of a company can be increased through the benefit of a “Tax-shield of Debt” that is apparent when a company decides to finance through debt (FT Lexicon, 2015). This is due to the fact that interest payments on debt capital are treated as tax-deductable therefore a company will obtain more profit and shareholders are more inclined to accept a certain amount of debt finance. However, as leverage begins to increase beyond a certain amount – an optimal point – then shareholders are aware of bankruptcy risks, resulting in an increased cost of capital to compensate an increase in risk, lowering company market valuation. Furthermore, as you increase debt capital you are at the whim of some macro-economic factors, such as the setting of interest base-rates by the country’s central bank which of course would increase debt payments, perhaps beyond an efficient level, again increasing risk. However, in 1958 Franco Modigliani and Merton Miller published a conflicting article in The American Economic Review titled “The Cost of Capital, Corporation Finance and the Theory of Investment” (Modigliani and Miller, 1958). Within this article they put forth different propositions in relation to how capital structuring affects the market value of a corporation and they criticised David Durand’s “assumption that the cost of equity remains unaffected by leverage up to some reasonable limit” as in their view the cost of equity is an increasing function of debt capital (Chand, 2015). This is likely to be because as bankruptcy risks are increasing shareholders are more inclined to request an increasing amount of returns to compensate, therefore the cost of equity will increase. Within the 1958 article Modigliani and Miller had the view that an organisation’s weighted average cost of capital is not affected by changes in its capital structure. Modigliani and Miller also published an article in 1963 titled “Corporate Income Taxes and the Cost of Capital: A Correction”

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