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Modigliani–Miller Proposition and Trade-off Theory

In: Capital Structure in the Modern World

Author

Listed:
  • Anton Miglo

    (Toronto School of Finance)

Abstract

The Modigliani–Miller theorem (1958) is the foundation of modern capital structure theory. It states that when markets are perfect, the capital structure of a company does not matter. This chapter provides a review of this proposition and explains that capital structure choice is important when taxes are considered. By increasing the amount of debt in its capital structure, the firm creates a “debt tax shield” that can decrease the amount of taxes and increase the firm’s value. Increasing debt in a firm’s capital structure increases its probability of bankruptcy. Since bankruptcy is costly, the incentive to increase debt should depend on potential bankruptcy costs. The Trade-off theory of capital structure, which combines the debt tax shield and the expected bankruptcy cost ideas, is explained, and a review of recent literature is provided.

Suggested Citation

  • Anton Miglo, 2025. "Modigliani–Miller Proposition and Trade-off Theory," Springer Books, in: Capital Structure in the Modern World, edition 0, chapter 0, pages 21-42, Springer.
    • Handle: RePEc:spr:sprchp:978-3-031-85459-0_2
    DOI: 10.1007/978-3-031-85459-0_2
    as

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