In this chapter we went beyond the simplified structure of perfect markets, and looked at a number of different factors (tax, bankruptcy costs, information asymmetry, conflicts of interest) which make analysis more complex, but also more relevant.

Modigliani and Miller demonstrated how, when corporate tax is included in the equation (financial expenses are tax-deductible whereas dividends are not), debt financing becomes an attractive option. The value of a levered company is equal to what it would be without the debt, plus the present value of savings generated by the tax shield.

There are, however, two major drawbacks to this approach. Firstly, the higher a company’s debts, the greater the probability of bankruptcy costs, whether direct or indirect. Secondly, if the personal tax situation of the investor is taken into account, this offsets the tax shield that debt enjoys at a corporate level. For individual taxpayers, the tax breaks on income on equity are better than they are for debt.

All in all, recent research shows that the costs of bankruptcy and personal taxation offset the tax advantage of debt at the corporate level. Taxation therefore does not explain capital structure.

Agency theory analyses debt as an internal means of controlling management, which has to work hard to ensure that debt repayments are met. For a mature company making healthy profits but without major growth prospects, incurring large debts is a way of discouraging managers from spending cash on risky diversification projects or rash expansion projects, which both destroy value. The LBO, an innovation of the 1980s, is what has come out of this theory. LBOs create value, not on the basis of the accounting illusion of the leverage effect, but thanks to the high motivation of managers who are under pressure to repay debts, and who have a financial incentive to work harder as a result of the potentially very lucrative profit-sharing schemes that have been set up.

Problems stemming from information asymmetry between shareholders and investors have an obvious impact on the choice of capital structure. Managers believing that their companies are undervalued would prefer to increase debt levels rather than to issue new shares at a low price, and possibly carry out a capital increase once the share price has gone up. Similarly, a decision to use debt finance for a project is a sign of management’s confidence in its ability to service the debt and an indirect sign that the project is likely to be profitable.

Pushing the information asymmetry problem to the limit brings us to the pecking order theory, which holds that managers choose sources of financing on the basis of the amount of intermediation costs and agency costs: cash flow, debt and only then a capital increase.

This takes us a long way from the simplistic assumptions made in the first models designed by Modigliani and Miller!