In 1958, Franco Modigliani and Merton Miller flawlessly argued that in a perfect capital market, the capital structure was irrelevant. The apparent benefits of financing with debt were nullified when shareholders demanded a higher yield to compensate for the greater risk derived from the debt. In a perfect capital market, debt does not add value to the company, there is simply an exchange between risk and required return; Sooner or later the arbitration will correct the difference.

In response to MM, a “traditional position” emerged that upheld the existence of an optimal capital structure. This assertion is based on the imperfection of the capital markets: a “moderate” in debt would allow managers in debt to achieve an increase in the value of the company.

The difference between the traditional position and MM is based on the functioning of the capital market: the traditionalists seem to say “divide and conquer”, even though this seems a difficult argument to sustain if one thinks that the whole is the sum of the parts.

In 1963, MM corrected their theory by modifying the valuation of tax savings, which made it possible to understand how the corporate tax devalued the capital structure, which was one of the most important findings in financial theory. The whole is guided by being the sum of the parts, the difference is that when using debt in the capital structure, the State takes a smaller bite of the pie that is the operating result, and this passes to the shareholders eoria. Finally, although a High indebtedness can generate tax savings, it can also generate financial difficulties, which would reduce the value of the firm. This suggests that there is an optimal level of indebtedness, in which the fiscal advantages of debt are offset by the costs imposed by financial difficulties.

1. Explain what type of debts are included in the capital structure and what is the reason for working with market values rather than book values/

2. Mark true or false:

• Shareholders always benefit from an increase in the value of the firm.
• The return demanded by the shareholders increases with the debt because the probability of bankruptcy increases.
• If the companies did not have limited liability, the risk of their assets would increase.
• If the companies did not have limited liability, the risk of their actions would increase.
• If a firm has no debts, does not pay taxes, and does not grow, then EBIT = EBT = net profit = dividends
• MM Proposition I imply that a debt issue increases the expected earnings per share and causes an equivalent decrease in the price-earnings ratio.

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