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Financing Best Practice

Issuing Corporate Debt

by Steven Lowe

Executive Summary

  • The Nobel Prize-winning Modigliani and Miller theorem that capital structure does not matter does not reflect the inefficiencies of the real world.

  • Taxes, default costs, agency costs, equity dilution issues, credit rationing, and stockholder/debtholder tensions all impact the economists’ perfect market.

  • Divergent goals between debt and equity holders lead to a number of behaviors, such as decision risk shifting, underinvestment, and asset stripping, which can skew the financing decision. Debt covenants exist to even out the risk/reward structures between debt and equity holders.

  • Current economic theory suggests that an optimal capital structure that balances the risk of bankruptcy with the tax savings of debt does exist, although it can be a struggle for individual corporations to hit this target amid the constantly changing influences of the modern operating environment.


The existence and determination of optimal capital structure is an ongoing topic of research in corporate finance. In a perfect market setting, with no frictions, Modigliani and Miller’s seminal research in 1958 suggested that the market value of a firm is independent of its capital structure. In other words, capital structure does not matter.

Miller (1991) explained the intuition for this with a simple analogy: “Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring.” He continued: “The Modigliani–Miller proposition says that if there were no costs of separation (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk.” The essence of the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk)—selling off safe cash flows to debtholders leaves the firm with more lower-valued equity, keeping the total value of the firm unchanged. Put differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two.

Of course, corporations do not operate in a perfect world, and few if any companies are 100% debt financed. Since Modigliani and Miller’s Nobel Prize-winning paper, a host of possible explanations for the relevance of particular financial structures has emerged, centering around the impact of taxes, the costs of default, agency costs, equity dilution, and credit rationing, as well as the differing goals of management and sponsors. Modigliani and Miller have also suggested that firms maintain a reserve borrowing capacity to allow for economic uncertainty. We will look at each of these potential inefficiencies in turn.

Impact of Taxes

Of the most obvious violations of Modigliani and Miller’s assumptions are corporate taxes and the tax deductibility of interest payments. Usually, interest payments made to debtholders are deducted from corporate profits before they are taxed. Consequently, the corporate tax saved acts as a subsidy on interest payments. For example, if the tax rate is 34%, then for every dollar paid in interest payments 34 cents of corporate taxes are avoided by the company (although those receiving the interest must pay tax on their interest income). In contrast, if income is paid out as dividends to stockholders, that income is taxed twice, once at the corporate level via corporate taxes, and again as an income tax on the equity holder. Hence, any corporation seeking to minimize its taxes and maximize the revenues available to investors should finance itself entirely with debt.

In a 1977 article, “Determinants of corporate borrowing,” Myers showed that considering corporate taxes in isolation does not reflect real world economic interactions. Transferring interest payments to individual bondholders to avoid corporate taxes does not make investors any better off if they then have to pay higher personal taxes on that interest income than the corporation and investors would have owed had the corporation not used debt. Miller argued that because tax rates on capital gains have often been lower than tax rates on individuals’ dividend and interest income, the firm might lower the total tax bill paid by the corporation and investor combined by not issuing debt at all. Moreover, taxes owed on capital gains can be deferred until the realization of those gains, further lowering the effective tax rate on capital gains. Because of this interaction, there is an optimal level of debt (less than the 100% suggested above) for corporations as a whole.

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Further reading


  • Chew, Donald H., Jr. The New Corporate Finance: Where Theory Meets Practice. 3rd ed. New York: McGraw-Hill, 2001.
  • Jaffee, D. M. Credit Rationing and the Credit Loan Market. New York: Wiley, 1971.


  • Allen, Franklin, and Douglas Gale. “Optimal security design.” Review of Financial Studies 1:3 (Fall 1988): 229–263. Online at:
  • Donaldson, Gordon. “Financial goals: Management vs stakeholders.” Harvard Business Review (May–June 1963): 116–129.
  • Hackbarth, Dirk. “Determinants of corporate borrowing: A behavioral perspective.” Paper presented at 14th Annual Utah Winter Finance Conference, February 5–7, 2004.
  • Harris, Milton, and Artur Raviv. “The theory of capital structure.” Journal of Finance 46:1 (March 1991): 297–355. Online at:
  • Jensen, Michael C., and William H. Meckling. “Theory of the firm: Managerial behavior, agency costs and ownership structure.” Journal of Financial Economics 3:4 (October 1976): 305–360. Online at:
  • Miller, Merton H. “Debt and taxes.” Journal of Finance 32:2 (May 1977): 261–275. Online at:
  • Miller, Merton H. “Leverage.” Journal of Finance 46:2 (June 1991): 479–488. Online at:
  • Modigliani, Franco, and Merton H. Miller. “The cost of capital, corporation finance and the theory of investment.” American Economic Review 48:3 (June 1958): 261–297. Online at:
  • Myers, Stewart C. “Determinants of corporate borrowing.” Journal of Financial Economics 5:2 (November 1977): 147–175. Online at:
  • Myers, Stewart C. “The capital structure puzzle.” Journal of Finance 39:3 (July 1984): 575–592. Online at:
  • Myers, Stewart C., and Nicholas S. Majluf. “Corporate financing and investment decisions when firms have information that investors do not have.” Journal of Financial Economics 13:2 (June 1984): 187–221. Online at:
  • Simerly, Roy L., and Mingfang Li. “Re-thinking the capital structure decision: Translating research into practical solutions.” B>Quest (2002). Online at:
  • Stiglitz, Joseph E. ”On the irrelevance of corporate financial policy.” American Economic Review 64:6 (December 1974): 851–866. Online at:
  • Stiglitz, Joseph E, and Andrew Weiss. “Credit rationing in markets with imperfect information.” American Economic Review 71:3 (June 1981): 393–410. Online at:


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