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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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