It is not yet possible to provide financial managers

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Unformatted text preview: tructure. Nevertheless, financial theory does offer help in understanding how a firm’s chosen financing mix affects the firm’s value. In 1958, Franco Modigliani and Merton H. Miller14 (commonly known as “M and M”) demonstrated algebraically that, assuming perfect markets,15 the capital structure that a firm chooses does not affect its value. Many researchers, including M and M, have examined the effects of less restrictive assumptions on the relationship between capital structure and the firm’s value. The result is a theoretical optimal capital structure based on balancing the benefits and costs of debt financing. The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income. The cost of debt financing results from (1) the increased probability of bankruptcy caused by debt obligations, (2) the agency costs of the lender’s monitoring the firm’s actions, and (3) the costs associated with managers having more information about the firm’s prospects than do investors. Tax Benefits Allowing firms to deduct interest payments on debt when calculating taxable income reduces th...
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