There was not any accepted theory on capital structure before 1958. Miller
and Mongolian (1958) explained that firm’s value didn’t vary by any change
occurred in the capital structure. The contemporary theory of capital structure
was specified by Miller and Mongolian (1958) who proved that there was not any
effect of financing on firm’s value.
Total cash flows Firms build for investors unaffected despite the consequences
of capital structure. In other words, shifting the capital structure didn’t
bring any change in the total cash flows of firms. As a result, the overall
assets’ value presented possession of such cash flows which didn’t change.
Myers (2001) described that weighted average cost of capital (WACC) depending on
cost of equity and cost of debt and also market value ratios of equity and debt
to firm value. Miller and Mongolian (1963) recognized the effect of taxes by
using assumption of none corporate tax and in this way corporations were
permitted to deduct interest in the form of expense.
Modigliani and Miller (1963) recognized that net of tax approach encouraged the
firms to utilize 100 percent debt in capital structure but Modigliani and Miller
(1963) discouraged 100 percent debt policy. Some other sources were also there
to generate the funds at lower costs like retained earnings. In some conditions,
retained earnings may be cheaper even tax status of shareholders under the
personal income tax also considered.
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