What are the main practical considerations which are likely to Essay

What are the main practical considerations which are likely to influence a firm's capital structure - Essay Example Their study was based upon the assumption that perfect capital markets existed, i.e, there was an absence of taxes, bankruptcy costs and other market friction. Under such a condition, their conclusion was one of capital structure irrelevance, which means that the kind of capital structure chosen by a firm will not impact upon its value and hence there is no advantage to be gained through the creation of debt. The value of the firm will be totally dependent upon its assets and their expected value, as well as the risk of cash flow generated from those assets. However, these same authors later took taxation into consideration and their conclusion then was that one of the features that would promote an optimal capital structure for the firm was the employment of as much debt capital as possible. (Modigliani and Miller, 1963). Once corporate earnings taxes are introduced, then there is an advantage to the firm to be gained by the firm, because the tax shield that can be provided by debt results in a gain from leverage. In this context, Miller (1977) also introduced personal taxes into the equation and he discerns three distinct tax rates in the United States that determine the total value of the firm, which are (a) corporate tax rate (b) tax rate imposed on income of dividends and (c) tax rates imposed on the inflows of interest. Miller stated that the capital structure of a firm will depend upon the relative height of each of the tax rates as compared to the other two. When tax rates on income from stocks and bonds are equal, then the advantage from leverage is zero, hence capital structure of the firm becomes irrelevant. However, for example when the tax rates on the income from the stock is lower than the tax rate on incomes from the debt, then leverage will negatively affect the value of the untaxed firm. With non trivial bankruptcy costs, the introduction of leverage creates a negative effect of debt financing