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. ...Show more