This paper aims to provide an investigation into the relationship that exists between the capital structure of a firm and its market value. For many years, companies have tried hard to discover a rule of thumb that would help them reduce their cost of capital, improve investment decisions and ultimately increase firm value. How a firm chooses a capital structure that is optimal and ideal is one of the most important issues in corporate finance – and one of the most complex. The aim of corporate finance has always been to work towards the maximisation of shareholder wealth and therefore increasing the value of the assets with the help of optimal financing decisions. To understand this better, various theoretical literatures will be used in order to unearth the underlying issues which impact the value of a firm.

The Miller and Modigliani's (MM) Irrelevance theorem of 1958 was one of the first noteworthy steps to understanding the complex nature of a firm's capital structure. Although this theory contains many assumptions which may sound unrealistic, this approach has proved to be a good start in order to understand some of the basic underlying principles at work. Before evaluating the MM approach it is important to understand the assumptions underlying the propositions of this theorem.

MM assumed that there were perfect capital markets, implying that there are no brokerage costs; perfect information is available to all economic agents; individuals and corporations borrow at the same rate and that there are no costs of financial distress(bankruptcy costs) and liquidation, therefore debt is risk free. The theorem was also based on; no taxation, the ability to categorise firms into distinct risk classes and that the firm's manager is selfless and always acting in the investors' interests.

MM's propositions of the Irrelevance theorem can be simply stated with the help of an algebraic equation: VL = VU = EBIT = EBIT WACC KsU Under the given assumptions, this theory convinces that a firm cannot change the total value of the outstanding securities just by altering the proportions of its debt and equity mix in the capital structure. No new change in the capital structure can be any more beneficial to the shareholders than the previous one, as an investor's initial investment would remain same in order to get a specific return from either a levered or an unlevered firm. This is illustrated by the three pies in figure 1, no matter what the mix is (debt or equity), the size of the pie remains constant. (total value of the firm remains same).

Proposition two of the MM theorem states that levered equity is more risky than unlevered equity as debtholders have the first right on the firm's cashflows. This causes equity holders to face the increasing financial risk besides just that business risk of the firm. An increase in leverage causes volatility of the cashflows to all equity holders and hence the cost of levered equity exceeds the cost of unlevered equity. MM also speak of the importance of the use of WACC as the discount rate in the calculation of firm value as the cost of capital should be considered on an overall basis and not by cost of debt or cost of equity separately. Since the WACC is unaffected by leverage the value of the firm should be calculated as; V = X / WACC Graphs 1.1 and 1.2 explain the proposition two in detail.

In 1961, MM incorporated the implications of tax into their theorem. This important step in capital structure analysis provided a new stance for companies looking at debt financing. Since the tax laws allowed debt interest to be paid before tax, this gave firms a considerable tax break if they used debt financing instead of equity as lesser tax had to be paid. Looking at figure 1.2, we can see that two pies are equal in value; however, the levered pie will have a higher value after paying to the taxman owing to the smaller size of the tax amount when compared to the unlevered pie. This can be proved with the help of an example in Appendix A.

Graphs 1.3 and 1.4 show how the firm benefits by taking on more debt as stated by MM's theory of 1961. This advocates that a company should amass as much debt as possible in order to reap benefits from the tax shield provided. In reality, this is not possible as too much of anything is usually never beneficial. The traditional view combines debt capacity with tax relief. This view states that once a firm reaches a dangerous level of debt (debt capacity) it can no longer benefit by taking on more debt as that would come with a price. Debt beyond the debt capacity is no longer risk free and also results in the downgrading of the firms credit ratings.

This would in turn increase the rate of borrowing and hence debt becoming more expensive. To gain a more clear understanding with the help of graph 1.5, it is clearly noticeable that after a certain point of debt financing, cost of debt goes up and the WACC increases with leverage. There is a clear trade off between the savings due to the tax shield and cost of debt after reaching debt capacity. This suggests that there may be an optimal capital structure that maximises firm value and reduces WACC.

The MM (1958) Irrelevance theorem contains a lot of implicit assumptions which do not apply in reality. The theorem assumes that; 1) managers are always selfless in their act and purely favour value maximisation for the shareholders; the contradicting reality being; managers are motivated to work for their own benefits owing to the existence of the principal-agent relationship. 2) The prospective information about the firm is symmetrically distributed between the firm's managers and the investors; the reality being managers of firms have extra information about the firm which they can use to benefit themselves. These issues can have a major impact on firm value by affecting not only the managerial incentives (agency costs) but also by the signalling characteristic of management decisions.