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According to many research of corporate finance, the capital structure decision is one of the most

fundamental issues facing to the executives and management level. The capital structure of a

company refers to a combination of debt and equity of finance that it uses to fund its long-term

financing. Equity and debt capital are the two major sources of long-term funds for a firm. The

theory of capital structure is closely related to cost of capital of firms. As the enterprises to obtain

funds need to pay some costs, the cost of capital in the investment activities is also the main

consideration of rate of return. The weighted average cost of capital !A""# is the expected rate

of return on the mar$et value of all of the firm%s securities. The decision regarding the capital

structure is based on the objective of achieving the maximi&ation of shareholders wealth and

irrelevant to the firm's investment decision.

(n )*+, iller and odigliani published the theory stated that in perfect capital mar$et the

value of a company does not depend on its financing structure. The value of assets does not

increase if the firms raise the weight of debt in its financing structure, as the !A"" of company

stays constant independent of the weights of debt and equity in its financing structure. iller and

odigliani made up two proposition are the overall cost of capital and the value of the firm are

independent of capital structure and the financial ris$ increase with more debt content in the

capital structure.

The first view of capital structure assumptions in a perfect marketis that no existence of taxes

either at a personal or a corporate level, no transaction costs, no asymmetric information and no

agency cost. /irms and investors can borrow or lend at the same rate. The costs of capital and the

value of the firm are not affected by the changed in capital structure. The proposition is that the

firm use gearing is equal to ungearing firm. 0rdinary shareholders are relatively indifferent to the

addition of small amounts of debt in terms of increasing financial ris$ and so the !A"" falls as

a company gears up. As gearing up continues, the cost of equity increase to include a financialris$ premium and the !A"" reaches a minimum value. 1eyond this minimum point, the !A""

increases due to the effect of increasing financial ris$ on the cost of equity and at higher levels of

gearing due to the effect of increasing ban$ruptcy ris$ on both the cost of equity and cost of debt.

"ontinuing to ignore taxation but assuming a perfect capital mar$et, miller demonstrated that the

!A"" remained constant as a company geared up, with the increase in the cost of equity due to

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financial ris$ exactly balancing the decrease in the !A"" caused by the lower before tax cost of

debt. 2ince a perfect capital mar$et the possibility of ban$ruptcy ris$ does not arise, the !A""

is constant at all gearing levels and the mar$et value of the company is also constant, therefore

the mar$et value of a company depends on its business ris$ alone and not on its financial ris$.

Therefore, the firm cannot reduce its !A"" to a minimum

The shortcoming of this argument is still has some drawbac$s mainly to the unrealistic nature of

their assumptions. /irst, the assumption that individuals can borrow at the same rate as

companies can be challenged. The costs of personal debt and corporate debt cannot the same,

because companies have higher credit ratings than the majority of individuals. 3ersonal

borrowing is seen as ris$ier, and therefore more costly than corporate borrowing. 2econdly, their

assumption that there are no transaction costs associated with the buying and selling of shares is

clearly untrue. 4igh personal borrowing rates and transaction cost both undermine the ability of

investors to ma$e ris$-free profit from arbitrage, therefore creating the possibility of identical

companies overvalued and undervalued.

(n the second paper on capital structure, miller later modified their earlier model to ta$e account

of corporate tax and argued that companies should gear up in order to ta$e advantage of the tax

shield of debt. !hen corporate tax was admitted into the analysis of miller in imperfect mar$et,

the interest payments on debt reduce by tax liability, which meant that the !A"" fell as gearing

increased due to the tax shield given to profits. 0n this view, firm could reduce its !A"" to a

minimum by ta$ing on as much debt as possible. A perfect capital mar$et is not available in the

real world and at high levels of gearing the tax shield offered by interest payment is more than

offset by the effects of ban$ruptcy ris$ and other costs associated with the need to service large

amounts of debt. The firm can see an optimal capital structure emerging. At the high levels of

gearing, additionally to ban$ruptcy costs, there are costs associated with the problems of agency.

(f gearing levels are high, shareholders have a lower sta$e in a company and have fewer funds at

ris$ if the company fails. Another reason why the firms fail to adopt higher levels of gearing is

that many companies have insufficient profits from which to derive all available tax benefits as

they increase their gearing level as tax exhaustion.

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The effect of miller model considers the relationship between gearing levels, corporate taxation,

the rate of personal taxation on debt and equity return, and the amount of debt and equity

available for investors to invest in.