The two most significant theories dealing with this subject, as explained by Brealey and Myers, are that of Miller and Modigliani (MM), and the traditionalist view. According to the theory proposed by MM, the capital structure of the firm has no relevance to determining the value of the firm. So, they opine that there is no difference in the value of stock between geared and ungeared firms. Gearing does not affect the value of a firm, whether positively or negatively. The payment of dividend also is not necessarily required to be done on a regular basis, since it does not have any effect on the value of the share price. MM have proved that capital structure can be irrelevant even when debt is risky. (Brealey and Myers 469) Thus, MM propose that financial leverage or gearing does not affect shareholders wealth. And secondly, that the rate of return on shares increases as the firm's debt-equity ratio increases (pp. 473). But, this increase is exactly offset by increased risk and hence, the required rate of return, which nullifies the increase in returns.
A "traditionalist" view has emerged in response to MM's proposals regarding geared equity. The traditionalists believe that personal borrowing is more expensive, risky and inconvenient to investors, so they are willing to pay a premium for shares in moderately geared firms. Consequently, they believe that firms should borrow to "realise" this premium. (Brealey and Myers 782) According to this view, up to a certain point of gearing, the Weighted Average Cost of Capital (WACC) decreases, and after this point WACC increases. The point where WACC is minimum is the optimal point of gearing, where shareholders' wealth is maximised or price per share is highest. (McLaney 231)
MM rejected this view and opined that WACC is impervious to level of gearing. Wacc and the value of a firm only depend on (1) the cash flows generated by the investments of the firm, and (2) their business risk. (pp 234) They see a world without taxes or bankruptcy costs. McLaney observed that a large proportion of firms do go for some level of capital gearing, while very high levels of gearing are very rare. Thus, managers do believe that gearing lowers WACC, but not at very high gearing levels.
Empirical evidence shows that "firms with safe, tangible assets and plenty of taxable income have higher debt to equity ratios than an unprofitable business with intangible assets." (Warner 1976, and Altman 1984 qtd. in Soderlund and Ostermark) The pecking orders theory by Myers (1987) gives a conflicting view. It explains that some profitable firms borrow less as they have less requirement of outside money. Kjellman and Hansen (1993) have found that Finnish financial managers seek to maintain a constant debt to equity ratio. (qtd. in Soderlund and Ostermark) Soderlund and Ostermark have found that there are less dividend payouts when interest payments are high, since funds are channeled more towards creditors. There is a tradeoff between dividends and investments also. A tradeoff is also seen between dividends and net income. "When maximising net income, the model minimises dividends and prefers investments." (Soderlund and Oste