The Modigliani and Miller financing irrelevance theorem says that the amount of debt in a firm’s capital structure has no effect on shareholder value. That is an implication of the principle that issuing or repurchasing debt or equity securities at fair market value adds no value. Capital structure, the amount of financing debt to equity, varies considerably across firms. So, given it is irrelevant to value, what explains the differences?
The Modigliani and Miller theorem assumes debt and equity can be traded costlessly in so-called perfect capital markets, so explanations for capital structure are often based on relative costs associated with debt and equity. For example, interest on debt is tax deductible whereas dividends are not, favoring debt. Or debt incurs bankruptcy costs, favoring equities. Or debt financing is not available for start-ups, so they must be all equity financed.
However, there is a value investing view of capital structure. The value investor buys equities when they are cheap and sells them when they are deemed overpriced. Similarly, he or she buys bonds when they are underpriced and sells them when they are overpriced. Following the principle that trading in mispriced securities adds value for shareholders, the CFO or Treasurer of a firm can be a value investor when financing the firm: If debt is overpriced, issue debt rather than equity; if the firm’s shares are overpriced, issue equity rather than debt. That determines the capital structure. The capital structure is also affected if the CFO repurchases underpriced shares or underpriced debt. The CFO, of course, has privy to information about the pricing of the firm’s debt and equity (although must be aware of laws on trading on private information).