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 In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In the capital structure decision. The theorem states that, in a perfect market, the value of a firm is unaffected by how that firm is financed. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy costs, agency costs and asymmetric information. This analysis can then be extended to look at whether there is in fact an 'optimal' capital structure the one which maximizes the value of the firm. Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. That is, you cannot change the size of a cake by cutting it into different sized pieces. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created.
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