Modgliani and Miller’s work on capital structure theory concludes that in a world with no taxes and no bankruptcy costs, capital structure is irrelevant. However, in a subsequent study, they updated their work to include the effect of taxes. Since corporations can deduct interest payments when determining taxable income, the stockholders will benefit from the use of debt. According to their theory, the optimal capital structure in a world with taxes is 100% debt – Statement 1 is correct. However, if bankruptcy costs are factored into their results, debt is useful initially for its tax savings to lower the cost of capital, but only up to the point where it increases risk and the cost of debt and equity starts to rise. In a world with taxes and bankruptcy costs, the optimal capital structure is the one that minimizes the weighted average cost of overall capital - not simply the cost of debt |
