The Changing Nature of Debt and Equity: A Financial Perspective

Historically, corporations have mainly financed their activities with two securities, debt and equity. The stockholders have responsibility for the operation of the firm through the election of the board of directors; the dividends they receive in return for their subscription of capital are not guaranteed and are paid at the discretion of the board of directors. In contrast, debtholders are promised a particular rate of return; they have no rights of control unless payments by the firm are omitted, in which case they have the right to foreclose on assets or, in some cases, force bankruptcy. Dewing (1934, pp. 236-37) ascribes these differences in rights between debtholders and equityholders to the historical distinction in Anglo-Saxon law between debtors and creditors. As a result of the importance of debt and equity, the focus of inquiry into firms’ choice of capital structure has traditionally been "What is the optimal debt-equity ratio?" Modigliani and Miller (1958) and subsequent authors1 showed that if capital markets are perfect and complete and no taxes are in effect, a firm’s debt-equity ratio has no effect on its value because investors’ opportunity sets are not affected by its capital structure. If a corporate income tax is in effect, with interest deductibility, Modigliani and Miller (1963) used the same logic to show firms should use entirely debt finance since this allows corporate taxes to be avoided.