Summarize the Modigliani and Miller contribution to the debate on the optimal capital structure

What will be an ideal response?

Answer: In their earliest model, M&M showed that under very restrictive assumptions—particularly with no taxes and no bankruptcy—it made no difference what mixture of debt and equity a company used: the cost of capital remained the same, and the firm value remained the same. This occurred because using more debt lowered capital costs, but it was exactly offset by rising equity costs due to the increased risk. However, in a later model, allowing for taxes, their conclusion totally changed since the tax write-off of more debt more than offset the increased equity risk. Therefore, it was now optimal to use all debt. Finally, allowing for the potential cost of bankruptcy, the modern viewpoint shows that there is an optimal amount of debt; low debt levels give the firm a tax break, but debt levels that are too high make the firm too risky and offset the tax advantages.