Research in International Business and Finance 39 (2017) 696–710

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Research in International Business

and Finance
j o u r n a l h o me p a g e : w w w . e l s e v i e r . c o m / l o c a t e / r i b a f

Capital structure theory: Reconsidered

Kavous Ardalan
School of Management, Marist College, Poughkeepsie, New York 12601-1387, USA

a r t i c l e i n f o a b s t r a c t

Article history: In the mainstream of the academic field of finance, the Modigliani and Miller’s (1958) proof
Received 14 April 2015 of capital structure irrelevance theory, has been praised as the cornerstone of modern
Received in revised form 26 October 2015 scientific finance. However, the capital structure irrelevance theory is based on a set of
Accepted 27 November 2015
assumptions, which are both unrealistic and contradictory to the main assumption of the
Available online 2 January 2016
mainstream academic finance. This paper shows that by making more appropriate assump-
tions, capital structure becomes relevant. The paper, on a foundational ground, argues that
JEL classification:
since the results of sophisticated mathematical models change as soon as their underlying
B40
assumptions are changed, the claim about the scientific nature of the mainstream academic
B50
G32 finance becomes questionable.
© 2016 Elsevier B.V. All rights reserved.
Keywords:
Capital structure
Firm value maximization
Share price maximization
Risky debt
Assumptions
Paradigms

1. Introduction

In the mainstream of the academic field of finance, the Modigliani and Miller’s (1958) proof of capital structure irrelevance
theory, has been praised as the cornerstone of modern scientific finance. However, the capital structure irrelevance theory
is based on a set of assumptions, which are both unrealistic and contradictory to the main assumption of the mainstream
academic finance. This paper shows that by making more appropriate assumptions, capital structure becomes relevant.
More specifically, this paper shows that based on the joint assumption that debt is risky and that the goal of the firm is share
price maximization (rather than Modigliani and Miller’s (1958) firm value maximization assumption, which is contradictory
to the main assumption of the mainstream finance), then capital structure becomes relevant. The paper, therefore, starts
with share price maximization as the goal of the firm, and analyzes the change in the share price as a result of the increase
in the proportion of risky debt in the capital structure of the firm. It shows that after the initial rise in share price, at some
point, the share price starts to fall. This illustrates that there exists an optimal capital structure for the firm.
This paper arrives at the same conclusion as does the long-winded trade-off theory, which also follows Modigliani and
Miller’s (1958) assumption of firm value maximization. But this paper does so without introducing extensive, remote, and
questionable assumptions that does the trade-off theory. It is important to note that this paper shows that capital structure
becomes relevant with only a minimal set of assumptions, whereas the extant literature (i.e., the trade-off theory) shows
that capital structure becomes relevant with a much extensive and much stronger set of assumptions.

E-mail address: [email protected]

http://dx.doi.org/10.1016/j.ribaf.2015.11.010
0275-5319/© 2016 Elsevier B.V. All rights reserved.
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 697

The paper, on a foundational ground, argues that since the results of sophisticated mathematical models change as soon
as their underlying assumptions are changed, the claim about the scientific nature of the mainstream academic finance
becomes questionable.
The paper is organized as follows. Section 2 provides a brief literature review of contributions which have been made to
the capital structure theory in mainstream finance. It emphasizes that such long-winded development in the capital structure
theory is also based on the firm value maximization assumption of Modigliani and Miller (1958). Section 3 discusses four broad
worldviews or paradigms: functionalist, interpretive, radical humanist, and radical structuralist, each of which is based on its
own set of assumptions and generates its own theories and analytical tools. This section notes that the mainstream finance
is limited to the functionalist paradigm. The discussion of paradigms, by its very nature, emphasizes the attention which
needs to be paid to the underlying assumptions, and therefore, knowledge of paradigms would have warned mainstream
finance scholars about the contradictory assumption made in Modigliani and Miller (1958). Section 4 starts the discussion
by noting that the consensus in mainstream finance is that: share price maximization is the goal of the firm, rather than
firm value maximization. This section also notes that share price is determined via the dividend discount model. Section 5
discusses the effect of increasing the proportion of debt in the capital structure of the firm on the cash flows which accrue
to the shareholders. Section 6 discusses the effect of increasing the proportion of debt in the capital structure of the firm
on the riskiness of the cash flows which accrue to the shareholders. Section 7 illustrates the existence of an optimal capital
structure. Section 8 discusses the net effect of increasing the proportion of debt in the capital structure of the firm on the
share price. Section 9 is the conclusion.

2. Literature review

In mainstream finance, the extant capital structure literature1 has recognized that Modigliani and Miller’s (1958) proof
of the irrelevancy of capital structure has been based on the following set of assumptions:

1. Capital markets are frictionless.

2. Individuals can borrow and lend at the risk-free rate.
3. There are no costs to bankruptcy or business disruption.
4. Firms issue only two types of claims: risk-free debt and equity.
5. All firms are assumed to be in the same risk class.
6. Corporate taxes are the only form of government levy.
7. All cash flow streams are perpetuities.
8. There are no signaling opportunities.
9. There are no agency costs.
10. Operating cash flows are completely unaffected by changes in capital structure.

Since the publication of the Modigliani and Miller’s (1958), a great deal of efforts have been devoted to finding alternative
sets of assumptions based on which the firm’s value, after some point, would start to decrease as a result of financing with
more debt.2
Modigliani and Miller (1958) also incorporated corporate taxes in their analysis and proved that the levered firm’s value
is greater than the unlevered firm’s value by the amount of debt tax shield, i.e., gain in the firm’s value from leverage.
Miller (1977) considered both personal taxes and corporate taxes, and showed that the gain in the firm’s value from
leverage might be much smaller than when only corporate taxes are considered.
DeAngelo and Masulis (1980) examined the effect of tax shields generated by factors other than interest payments on
debt. That is, tax shield generated by non-cash charges such as depreciation, oil depletion allowances, and investment tax
credits. They demonstrated that there exists a non-zero corporate use of debt that maximizes the firm’s value, without
assuming bankruptcy costs or agency costs.
Stiglitz (1969) and Rubinstein (1973) incorporated risky debt in their model and proved that capital structure does not
affect the firm’s value. That is, they confirmed Modigliani and Miller’s (1958) fundamental theorem that, in complete and
perfect capital markets, the way that the stream of operating cash flows of the firm is split up does not affect the firm’s value.
The percentages of debt and equity in the capital structure of the firm do not affect the firm’s value, i.e., the total value of
the cash flow streams provided by the productive investments of the firm. Therefore – in the absence of bankruptcy cost
payments to third parties, such as trustees and law firms – it does not make any difference whether debt is risk-free or risky.
The firm’s value is obtained by discounting expected cash flows from firm’s investments. The way that these cash flows are
partitioned and divided into risky debt and risky equity has no impact on the firm’s value.

1
See, for example, Copeland et al. (2005).
2
Because this paper’s purpose is very foundational, it focuses only on the major contributions made in mainstream finance to the capital structure
theory. For reviews of capital structure theory and practice see: Barnea et al. (1981), Bradley et al. (1984), Copeland et al. (2005), Gifford (1998), Graham
and Harvey (2002), Harris and Raviv (1991), Kamath (1997), Klein et al. (2002), Masulis (1988), Miller (1988), Myers (1984, 1993, 2003), Norton (1991),
Pinegar and Wilbricht (1989), Rajan and Zingales (1995), Ravid (1988), Riley (2001), Smith (1986), and Tagart (1985).
698 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710

Leland (1994) and Leland and Toft (1996) examined the firm’s value under the assumption that the present value of
business disruption costs and the present value of lost interest tax shields are affected by the firm’s choice of capital structure.
They concluded that there is an optimal capital structure – defined as a capital structure at which the firm’s value is maximized
– such that the value created by the present value of interest tax shield trades off with both the value lost from the present
value of business disruption costs and the present value of lost interest tax shields.
Jensen and Meckling (1976) based their model on agency costs and showed that there is an optimal capital structure,
which maximizes firm’s value. They noted that the probability distribution of the cash flows of the firm depends on its
ownership structure. This is because there are agency costs of debt as well as agency costs of external equity. The agency
costs of debt increase with the increased use of debt. The agency costs of external equity increase with the increased use of
external equity. Therefore, there is an optimum combination of debt and equity that minimizes agency costs and maximizes
firm’s value, i.e., firm’s optimal capital structure. In this way, they showed the existence of the firm’s optimal capital structure
without assuming taxes and bankruptcy costs.
Ross (1977) considered the effect of signaling on capital structure. Ross noted that the Modigliani and Miller (1958)
irrelevancy proposition is based on the assumption that the market knows the expected future cash flow stream of the firm
and that the market values the cash flow stream in order to determine the firm’s value. Ross argues that in fact the market
values the “perceived” stream of future cash flows of the firm. Therefore, changes in the capital structure may change the
market’s perception. That is, changes in the firm’s capital structure may change the market’s perceived risk class of the firm,
even though the actual risk class of the firm remains unchanged. Firm’s managers have inside information about the firm’s
expected future cash flows, which outside investors do not have access to. Managers can send them unambiguous signals
about the firm’s future via their choice of financial leverage. More specifically, managers by their choice of higher financial
leverage can signal an optimistic future for the firm, which then increases the firm’s value in the market.
The purpose of this paper is to replace Modigliani and Miller’s (1958) assumption that “Firm value maximization is the goal
of the firm” with the assumption that “Share price maximization is the goal of the firm” and, together with the assumption
of risky debt, the paper shows that capital structure becomes relevant, i.e., there is an optimal capital structure for the firm.
It should be emphasized that, this paper shows that with a minimal set of assumptions capital structure becomes relevant.
This is in contrast to the trade-off theory that bases its analysis on an extensive set of remote and questionable assumptions.
The optimal capital structure is that capital structure at which the firm’s share price is maximized, as opposed to the
firm’s value being maximized. The firm’s share price maximization is clearly emphasized in the first chapter of mainstream
finance textbooks.3 Indeed, the first chapter in mainstream finance textbooks sets the theme for the rest of the chapters in
the textbooks by setting firm’s share price maximization as the goal of the firm. It should be emphasized here that none of the
finance textbooks, in their first chapter, states that firm value maximization is the goal of the firm. It is important to note that,
according to Kuhn (1962), textbooks reflect the prevailing consensus in the mainstream of a given field of study. Therefore,
the current finance textbooks show that the consensus in the mainstream finance is that share price maximization is the
goal of the firm, not the firm value maximization. Modigliani and Miller (1958) and the extant capital structure theories in
mainstream finance contradictorily base their analysis on the assumption that firm value maximization is the goal of the
firm. Indeed, Ardalan (2002) has reviewed mainstream finance textbooks and has made it clear that finance textbooks, which
reflect the consensus in academic finance, in their chapter on capital structure theory, contradictorily consider firm value
maximization as the goal of the firm. In this way, both extant mainstream capital structure theories, and their reflections in
the capital structure chapters of finance textbooks, embody the contradictory assumption of firm value maximization.
It is important to recall from the earlier discussion that Stiglitz (1969) and Rubinstein (1973) have shown that under the
two assumptions: (1) that firm value maximization is the goal of the firm; and (2) that debt is risky, the capital structure is
irrelevant. In comparison, this paper shows that under the two assumptions: (1) that share price maximization is the goal of
the firm; and (2) that debt is risky, the capital structure is relevant.

3. Paradigms

This paper argues that since the results of sophisticated mathematical models change as soon as their underlying assump-
tions are changed, the claim about the scientific nature of the mainstream academic finance becomes questionable. This
section elaborates on this issue by discussing four most diverse broad worldviews or paradigms: functionalist, interpretive,
radical humanist, and radical structuralist.4
The mainstream academic finance is based on the functionalist paradigm, and, for the most part, mainstream scholars
are not always entirely aware of the traditions to which they belong. Their understanding of different paradigms leads to a
better understanding of the multifaceted nature of their academic field of study. Although a financial researcher may decide
to conduct research from the point of view of the functionalist paradigm, an understanding of the nature of other paradigms
leads to a better understanding of what one is doing, as well as what one is not doing.

3
See, for example, Brealey et al. (2013), Brealey et al. (2011), Brigham and Ehrhardt (2014), Brigham and Houston (2016), Keown et al. (2013), Ross et al.
(2012), and Ross et al. (2015).
4
This section is mostly based on Burrell and Morgan (1979).
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 699

The discussion of paradigms, by its very nature, emphasizes the attention which needs to be paid to the underlying
assumptions, and therefore, knowledge of paradigms would have warned mainstream finance scholars about the contradic-
tory assumption made in Modigliani and Miller (1958), and the trade-off theory, which followed thereafter and has continued
until now.
Social theory can usefully be conceived in terms of four key paradigms: functionalist, interpretive, radical humanist, and
radical structuralist. The four paradigms are founded upon different assumptions about the nature of social science and the
nature of society. Each generates theories, concepts, and analytical tools which are different from those of other paradigms.
Each theory can be related to one of the four broad worldviews.
The functionalist paradigm has provided the framework for current mainstream academic finance, and accounts for the
largest proportion of theory and research in this academic field.
Before discussing each paradigm, it is useful to look at the notion of “paradigm.” Burrell and Morgan (1979) 5 regard the:
... four paradigms as being defined by very basic meta-theoretical assumptions which underwrite the frame of refer-
ence, mode of theorizing and modus operandi of the social theorists who operate within them. It is a term which is
intended to emphasize the commonality of perspective which binds the work of a group of theorists together in such
a way that they can be usefully regarded as approaching social theory within the bounds of the same problematic.
The paradigm does... have an underlying unity in terms of its basic and often “taken for granted” assumptions, which
separate a group of theorists in a very fundamental way from theorists located in other paradigms. The “unity” of the
paradigm thus derives from reference to alternative views of reality which lie outside its boundaries and which may
not necessarily even be recognized as existing. (pages 23–24)

3.1. Functionalist paradigm

The functionalist paradigm assumes that society has a concrete existence and follows certain order. These assumptions
lead to the existence of an objective and value-free social science which can produce true explanatory and predictive knowl-
edge of the reality “out there.” It assumes scientific theories can be assessed objectively by reference to empirical evidence.
Scientists do not see any roles for themselves, within the phenomenon which they analyze, through the rigor and technique
of the scientific method. It attributes independence to the observer from the observed. That is, an ability to observe “what
is” without affecting it. It assumes there are universal standards of science, which determine what constitutes an adequate
explanation of what is observed. It assumes there are external rules and regulations governing the external world. The goal
of scientists is to find the orders that prevail within that phenomenon.
The functionalist paradigm seeks to provide rational explanations of social affairs and generate regulative sociology. It
assumes a continuing order, pattern, and coherence and tries to explain what is. It emphasizes the importance of under-
standing order, equilibrium and stability in society and the way in which these can be maintained. It is concerned with the
regulation and control of social affairs. It believes in social engineering as a basis for social reform.
The rationality which underlies functionalist science is used to explain the rationality of society. Science provides the
basis for structuring and ordering the social world, similar to the structure and order in the natural world. The methods of
natural science are used to generate explanations of the social world. The use of mechanical and biological analogies for
modeling and understanding the social phenomena are particularly favored.
Functionalists are individualists. That is, the properties of the aggregate are determined by the properties of its units.
Their approach to social science is rooted in the tradition of positivism. It assumes that the social world is concrete, meaning
it can be identified, studied and measured through approaches derived from the natural sciences.
Functionalists believe that the positivist methods which have triumphed in natural sciences should prevail in social
sciences, as well. In addition, the functionalist paradigm has become dominant in academic sociology and mainstream
academic economics. The world of economics is treated as a place of concrete reality, characterized by uniformities and
regularities which can be understood and explained in terms of causes and effects. Given these assumptions, the individuals
are regarded as taking on a passive role; their behavior is being determined by the economic environment.
Functionalists are pragmatic in orientation and are concerned to understand society so that the knowledge thus generated
can be used in society. It is problem orientated in approach as it is concerned to provide practical solutions to practical
problems.

3.2. Interpretive paradigm

The interpretive paradigm assumes that social reality is the result of the subjective interpretations of individuals. It sees
the social world as a process which is created by individuals. Social reality, insofar as it exists outside the consciousness of
any individual, is regarded as being a network of assumptions and intersubjectively shared meanings. This assumption leads
to the belief there are shared multiple realities which are sustained and changed. Researchers recognize their role within
the phenomenon under investigation. Their frame of reference is one of participant, as opposed to observer. The goal of the

5
This paper borrows heavily from the ideas and insights of Burrell and Morgan (1979) and applies them to finance.
700 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710

interpretive researchers is to find the orders that prevail within the phenomenon under consideration; however, they are
not objective.
The interpretive paradigm is concerned with understanding the world as it is, at the level of subjective experience. It seeks
explanations within the realm of individual consciousness and subjectivity. Its analysis of the social world produces sociology
of regulation. Its views are underwritten by the assumptions that the social world is cohesive, ordered, and integrated.
Interpretive sociologists seek to understand the source of social reality. They often delve into the depth of human con-
sciousness and subjectivity in their quest for the meanings in social life. They reject the use of mathematics and biological
analogies in learning about the society and their approach places emphasis on understanding the social world from the
vantage point of the individuals who are actually engaged in social activities.
The interpretive paradigm views the functionalist position as unsatisfactory for two reasons. First, human values affect
the process of scientific enquiry. That is, scientific method is not value-free, since the frame of reference of the scientific
observer determines the way in which scientific knowledge is obtained. Second, in cultural sciences the subject matter is
spiritual in nature. That is, human beings cannot be studied by the methods of the natural sciences, which aim to establish
general laws. In the cultural sphere human beings are perceived as free. An understanding of their lives and actions can be
obtained by the intuition of the total wholes, which is bound to break down by atomistic analysis of functionalist paradigm.
Cultural phenomena are seen as the external manifestations of inner experience. The cultural sciences, therefore, need
to apply analytical methods based on “understanding;” through which the scientist can seek to understand human beings,
their minds, and their feelings, and the way these are expressed in their outward actions. The notion of “understanding” is
a defining characteristic of all theories located within this paradigm.
The interpretive paradigm believes that science is based on “taken for granted” assumptions; and, like any other social
practice, must be understood within a specific context. Therefore, it cannot generate objective and value-free knowledge.
Scientific knowledge is socially constructed and socially sustained; its significance and meaning can only be understood
within its immediate social context.
The interpretive paradigm regards mainstream economic theorists as belonging to a small and self-sustaining community,
who believe that corporations and financial markets exist in a concrete world. They theorize about concepts which have little
significance to people outside the community, who practice economic theory, and the limited community whom economic
theorists may attempt to serve.
Mainstream academic economic theorists tend to treat their subject of study as a hard, concrete and tangible empirical
phenomenon which exists “out there” in the “real world.” Interpretive researchers are opposed to such structural absolution.
They emphasize that the social world is no more than the subjective construction of individual human beings who create
and sustain a social world of intersubjectively shared meaning, which is in a continuous process of reaffirmation or change.
Therefore, there are no universally valid rules of economics. Interpretive economic research enables scientists to examine
aggregate market behavior together with ethical, cultural, political, and social issues.

3.3. Radical humanist paradigm

The radical humanist paradigm provides critiques of the status quo and is concerned to articulate, from a subjective
standpoint, the sociology of radical change, modes of domination, emancipation, deprivation, and potentiality. Based on its
subjectivist approach, it places great emphasis on human consciousness. It tends to view society as anti-human. It views
the process of reality creation as feeding back on itself; such that individuals and society are prevented from reaching their
highest possible potential. That is, the consciousness of human beings is dominated by the ideological superstructures of
the social system, which results in their alienation or false consciousness. This, in turn, prevents true human fulfillment. The
social theorist regards the orders that prevail in the society as instruments of ideological domination.
The major concern for theorists is with the way this occurs and finding ways in which human beings can release themselves
from constraints which existing social arrangements place upon realization of their full potential. They seek to change the
social world through a change in consciousness.
Radical humanists believe that everything must be grasped as a whole, because the whole dominates the parts in an
all-embracing sense. Moreover, truth is historically specific, relative to a given set of circumstances, so that one should not
search for generalizations for the laws of motion of societies.
The radical humanists believe the functionalist paradigm accepts purposive rationality, logic of science, positive functions
of technology, and neutrality of language, and uses them in the construction of “value-free” social theories. The radical
humanist theorists intend to demolish this structure, emphasizing the political and repressive nature of it. They aim to
show the role that science, ideology, technology, language, and other aspects of the superstructure play in sustaining and
developing the system of power and domination, within the totality of the social formation. Their function is to influence
the consciousness of human beings for eventual emancipation and formation of alternative social formations.
The radical humanists note that functionalist sociologists create and sustain a view of social reality which maintains the
status quo and which forms one aspect of the network of ideological domination of the society.
The focus of the radical humanists upon the “superstructural” aspects of society reflects their attempt to move away from
the economism of orthodox Marxism and emphasize the Hegelian dialectics. It is through the dialectic that the objective
and subjective aspects of social life interact. The superstructure of society is believed to be the medium through which the
consciousness of human beings is controlled and molded to fit the requirements of the social formation as a whole. The
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 701

concepts of structural conflict, contradiction, and crisis do not play a major role in this paradigm, because these are more
objectivist view of social reality, that is, the ones which fall in the radical structuralist paradigm. In the radical humanist
paradigm, the concepts of consciousness, alienation, and critique form their concerns.

3.4. Radical structuralist paradigm

The radical structuralist paradigm assumes that reality is objective and concrete, as it is rooted in the materialist view
of natural and social world. The social world, similar to the natural world, has an independent existence, that is, it exists
outside the minds of human beings. Sociologists aim at discovering and understanding the patterns and regularities which
characterize the social world. Scientists do not see any roles for themselves in the phenomenon under investigation. They
use scientific methods to find the order that prevails in the phenomenon. This paradigm views society as a potentially domi-
nating force. Sociologists working within this paradigm have an objectivist standpoint and are committed to radical change,
emancipation, and potentiality. In their analysis they emphasize structural conflict, modes of domination, contradiction, and
deprivation. They analyze the basic interrelationships within the total social formation and emphasize the fact that radical
change is inherent in the structure of society and the radical change takes place though political and economic crises. This
radical change necessarily disrupts the status quo and replaces it by a radically different social formation. It is through this
radical change that the emancipation of human beings from the social structure is materialized.
For radical structuralists, an understanding of classes in society is essential for understanding the nature of knowledge.
They argue that all knowledge is class specific. That is, it is determined by the place one occupies in the productive process.
Knowledge is more than a reflection of the material world in thought. It is determined by one’s relation to that reality. Since
different classes occupy different positions in the process of material transformation, there are different kinds of knowledge.
Hence class knowledge is produced by and for classes, and exists in a struggle for domination. Knowledge is thus ideological.
That is, it formulates views of reality and solves problems from class points of view.
Radical structuralists reject the idea that it is possible to verify knowledge in an absolute sense through comparison with
socially neutral theories or data. But, emphasize that there is the possibility of producing a “correct” knowledge from a class
standpoint. They argue that the dominated class is uniquely positioned to obtain an objectively “correct” knowledge of social
reality and its contradictions. It is the class with the most direct and widest access to the process of material transformation
that ultimately produces and reproduces that reality.
Radical structuralists’ analysis indicates that the social scientist, as a producer of class-based knowledge, is a part of the
class struggle.
Radical structuralists believe truth is the whole, and emphasize the need to understand the social order as a totality rather
than as a collection of small truths about various parts and aspects of society. The economic empiricists are seen as relying
almost exclusively upon a number of seemingly disparate, data-packed, problem-centered studies. Such studies, therefore,
are irrelevant exercises in mathematical methods.
This paradigm is based on four central notions. First, there is the notion of totality. All theories address the total social
formation. This notion emphasizes that the parts reflect the totality, not the totality the parts.
Second, there is the notion of structure. The focus is upon the configurations of social relationships, called structures,
which are treated as persistent and enduring concrete facilities.
The third notion is that of contradiction. Structures, or social formations, contain contradictory and antagonistic relation-
ships within them which act as seeds of their own decay.
The fourth notion is that of crisis. Contradictions within a given totality reach a point at which they can no longer be
contained. The resulting political, economic crises indicate the point of transformation from one totality to another, in which
one set of structures is replaced by another of a fundamentally different kind.

3.5. Summary

This section briefly discussed social theory, its complexity, and diversity. It indicated that finance theorists are not always
entirely aware of the traditions to which they belong. While each paradigm advocates a research strategy, these vary from
paradigm to paradigm. The phenomenon to be researched is conceptualized and studied in many different ways, each
generating distinctive kinds of insight and understanding. There are many different ways of studying the same financial
phenomenon, and given that the insights generated by any one approach are at best partial and incomplete, the financial
researcher can gain much by reflecting on the nature and merits of different approaches before engaging in a particular mode
of research practice. A knowledge of paradigms would have warned finance scholars about the contradictory assumption
which was made in Modigliani and Miller (1958) and its following long-winded trade-off theory of capital structure.
Knowledge of finance is ultimately a product of the researcher’s paradigmatic approach to this multifaceted phenomenon.
Viewed from this angle, the pursuit of financial knowledge is seen as much an ethical, moral, ideological, and political
activity, as a technical one. Finance scholars and professionals can gain much by exploiting the new insights coming from
other paradigms.
702 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710

Exhibit 1. The share price is determined via the dividend discount model, where dividends are perpetual.

4. Capital structure and share price maximization

Firms finance their assets with a mix of debt and equity. This mix is called the capital structure. The optimal capital
structure is that capital structure at which the firm’s share price is maximized, as opposed to the firm’s value being maximized.
The share price is determined via the dividend discount model, which is shown in Exhibit 1. As per Modigliani and Miller
(1958) dividends are perpetual:
D
P=
rs
where D = dividend per share, rs = cost of equity.
The effect of increasing debt in the capital structure of the firm on the share price takes place through changes in both the
cash flows accruing to the shareholders – i.e., the dividend which appears in the numerator in the dividend discount model
– and the riskiness of these cash flows – i.e., the cost of equity which appears in the denominator in the dividend discount
model.
The use of fixed-cost debt in the capital structure of the firm leads, on the one hand, to a higher rate of return (ROR) – a
higher earnings per share (EPS) and a higher dividend per share (D) – which leads to a higher share price. On the other hand,
it leads to a higher risk borne by equity holders, a higher required rate of return by the equity holders (rs ), and a lower share
price. These effects are shown is Exhibit 2, where it is emphasized that, in general, the net effect on the share price, i.e., the
direction of share price movement, is not known with certainty.

5. Capital structure and shareholders’ cash flows

The use of debt has the advantage that it is less costly than equity and, therefore, it increases the rate of return (ROR) –
the earnings per share (EPS) and the dividend per share (D) – to the equity holders compared to the case where there is no
debt in the capital structure of the firm. This tends to increase the share price. However, as will be shown below, this is not
always the case when the percentage of debt in the capital structure of the firm is increased.
An intuitive numerical example of the benefit of the use of debt in the capital structure of the firm is provided in Exhibit
3. In this Exhibit, all dollar values are expressed in hundreds of dollars. Here, the firm is financed in two different ways, i.e.,
two different capital structures. The firm’s investment in real assets is $1000 and generates a rate of return of 15% per year,
i.e., $150 per year. When this firm is financed with all equity, then all the $150 belong to the equity holders of the firm and
therefore they receive a rate of return of 15%. However, when the firm is financed with $800 of equity and $200 debt – which
is obtained at the rate of 8% per year – then from the $150 which is generated by the firm’s real assets, $16 would have to
be paid to the debt holders and the remainder, which is $134, would be paid to the equity holders, which implies a rate of
return of 16.75% to the equity holders.

Exhibit 2. The use of fixed-cost debt in the capital structure of the firm leads, on the one hand, to a higher dividend per share (D) and a higher share price.
On the other hand, it leads to a higher required rate of return by the equity holders (rs ) and a lower share price. In general, the net effect on the share price
is not known with certainty.
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 703

Exhibit 3. Equity holders benefit from the use of debt in the capital structure of the firm. Consider the firm under two different capital structures. The
firm’s investment in real assets is $1000 and generates a rate of return of 15% per year, i.e., $150 per year. When this firm is financed with all equity, then
all the $150 belong to the equity holders of the firm and therefore they receive a rate of return of 15%. However, when the firm is financed with $800 of
equity and $200 debt – which is obtained at the rate of 8% per year – then from the $150 which is generated by the firm’s real assets, $16 would have to
be paid to the debt holders and the remainder, which is $134, would be paid to the equity holders, which implies a rate of return of 16.75% to the equity
holders. The rate of return to equity holders with debt financing is higher. This happens because the $200 borrowed money when invested in the firm’s real
assets generates a rate of return of 15%, but only a rate of return of 8% is paid to the debt holders and the remaining 7% is retained and paid to the equity
holders that increases the total rate of return to the equity holders.

When the rates of return to equity holders under the two capital structures are compared, it is noted that the rate of
return in the case with debt financing, i.e., 16.75%, is higher than the rate of return in the case with no debt financing, i.e.,
15%. This happens because any dollar which is invested in the firm’s real assets generates a rate of return of 15%, therefore
the $200 borrowed money when invested in the firm’s real assets generates a rate of return of 15%, but only a rate of return
of 8% is paid to the debt holders and the remaining 7% is retained and paid to the equity holders that increases the total
rate of return to the equity holders. This shows that as long as the firm borrows at a lower rate, e.g., 8%, and invests it in the
firm’s real assets that generate a greater rate of return, e.g., 15%, then the total rate of return to equity holders of the firm
increases. This example shows that the use of debt in the capital structure of the firm is beneficial to the equity holders of
the firm compared to the case where there is no debt used in the capital structure of the firm.
The logic behind this numerical example can be used to mathematically express the rate of return to the equity holders
in terms of the rate of return on the real assets of the firm, the cost of debt, and the capital structure. Let:

A = the amount of the value of the investment in the real assets of the firm
E = the amount of the value of the equity of the firm
D = the amount of the value of the debt of the firm
ra = the rate of return on the investment in the real assets of the firm
re = the rate of return to the equity holders of the firm
rd = the rate of return to the debt holders of the firm = the cost of debt to the firm

Then:

(ra )(A) = the amount of cash flow generated by the real assets of the firm
(rd )(D) = the amount of cash flow paid to the debt holders of the firm
(ra )(A) – (rd )(D) = the amount of cash flow remaining for the equity holders of the firm
[(ra )(A) – (rd )(D)]/(E) = the rate of return to the equity holders of the firm = re

That is:

re = [(ra )(A) − (rd )(D)]/(E)

This can be rearranged as follows:

re = [(ra )(D + E) − (rd )(D)]/(E)

re = [(ra )(D) + (ra )(E) − (rd )(D)]/(E)

re = [(ra )(E)]/(E) + [(ra )(D) − (rd )(D)]/(E)

re = (ra ) + [(ra − rd )(D)]/(E)

704 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710

Exhibit 4. Consider the firm with the total assets of $100,000 under two financing alternatives: the unlevered and the levered. In the unlevered alternative,
the firm is financed with 20,000 shares. In the levered alternative, the firm is fifty per cent financed with debt – i.e., $50,000 debt at the interest rate of
20% – and it is fifty per cent financed with equity – i.e., 10,000 shares. This Exhibit consists of three sets of rows. The first set of rows shows the common
top half of the income statement, which reflects the business aspect of the firm. The second set of rows shows the bottom half of the income statement
when the firm is all-equity financed. The third set of rows shows the bottom half of the income statement when the firm is financed with fifty per cent
debt and fifty per cent equity. Therefore, there are two income statements that share the same top half. For each income statement there is one net income.
However, the net incomes of the two financing alternatives are not directly comparable because whereas the net income under the all-equity-financed
case should be distributed among 20,000 shares, the net income under fifty-per-cent-debt-and-fifty-per-cent-equity-financed case should be distributed
among 10,000 shares. Therefore, at the bottom of each income statement the corresponding EPSs are calculated for the sake of comparisons. When sales
change by 10%, then the EPS for the unlevered case changes by 20%, but the EPS for the levered case changes by 40%. Financial leverage results in a much
wider EPS swings because of fixed interest charges. Financial leverage widens the probability distribution of EPS and increases the probability of a very low
EPS, thus increasing the risk borne by the equity holders of the firm.

This can be expressed as:6

re = ra + (ra − rd )(D/E) (1)

This equation will be used in the discussion of Sections 5 and 6.

6. Capital structure and shareholders’ risk exposure

The use of debt has the disadvantage that it makes the firm more risky. If the firm falls on hard times and operating
income is not sufficient to cover interest charges, its equity holders will have to make up the shortfall, and if they cannot,
bankruptcy will result. Therefore, the debt holders and the equity holders of the firm require higher rates of return and,
consequently, the cost of debt (rd ) and the cost of equity (rs ) rise. This tends to decrease the share price.
When debt is increased in the capital structure of the firm, the equity holders are exposed to a wider variation in the
ROR – and earnings per share and dividend per share. Financial Leverage is the use of debt in financing a firm. Financial
risk is the additional risk placed on the equity holders as a result of the decision to finance with debt. If a firm uses debt,
this concentrates the business risk on equity holders. This concentration of business risk occurs because debt holders, who
receive fixed interest payments, bear smaller business risk relative to the equity holders of the firm.
The following intuitive numerical example shows how the use of debt in the capital structure of the firm increases
the risk to which the equity holders are exposed. Consider the firm with the total assets of $100,000 under two financing
alternatives: the unlevered and the levered. In the unlevered alternative, the firm has no debt and it is all-equity financed
with 20,000 shares. In the levered alternative, the firm is fifty per cent financed with debt – i.e., $50,000 debt at the interest
rate of 20% – and it is fifty per cent financed with equity – i.e., 10,000 shares. Exhibit 4 shows the firm under the two capital
structures. This Exhibit consists of three sets of rows. Since a change in the capital structure affects the bottom half of the
income statement, the first set of rows in Exhibit 4 shows the common top half of the income statement, which reflects
the business aspect of the firm. The second set of rows in Exhibit 4 shows the bottom half of the income statement when
the firm is all-equity financed. The third set of rows in Exhibit 4 shows the bottom half of the income statement when the
firm is financed with fifty per cent debt and fifty per cent equity. That is, in Exhibit 4, the top half of the income statement
is complemented with two bottom halves, each showing a different financing alternative. Therefore, in Exhibit 4, there
are two income statements that share the same top half. For each income statement there is one net income. However,
the net incomes of the two financing alternatives are not directly comparable because whereas the net income under the
all-equity-financed case should be distributed among 20,000 shares, the net income under fifty-per-cent-debt-and-fifty-per-
cent-equity-financed case should be distributed among 10,000 shares. Therefore, at the bottom of each income statement
the corresponding EPSs are calculated for the sake of comparisons.

6
This equation is one of the upshots of Modigliani and Miller (1958).
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 705

Exhibit 5. When the firm uses more debt in its capital structure, both the debt holders and equity holders are exposed to a higher level of risk and,
consequently, require a higher rate of return. This translates into a higher cost of debt and a higher cost of equity to the firm. The cost of equity is higher
than the cost of debt. This is because the equity holders receive their cash flows from the firm after debt holders have received their cash flows from the
firm. Therefore, the equity holders are exposed to a higher level of risk than the debt holders. Consequently, equity holders require a higher rate of return
than debt holders, which means a higher cost of equity than cost of debt to the firm.

Next, the two financing alternatives are compared when the economy and the sales of the firm change by 10%. As is noted
in Exhibit 4, when sales change by 10% then7 the EPS for the unlevered case changes by 20%, but the EPS for the levered case
changes by 40%. Financial leverage results in a much wider EPS swings because of fixed interest charges. Financial leverage
widens the probability distribution of EPS and increases the probability of a very low EPS, thus increasing the risk borne by
the equity holders of the firm.
To sum up, when the firm uses more debt in its capital structure, both the debt holders and equity holders are exposed
to a higher level of risk and, consequently, require a higher rate of return. This translates into a higher cost of debt and a
higher cost of equity to the firm. This is depicted in Exhibit 5. It should be emphasized that, as the firm uses more debt in its
capital structure the cost of debt increases.
Note that the cost of equity is higher than the cost of debt. This is because the equity holders receive their cash flows from
the firm after debt holders have received their cash flows from the firm. This holds true whether the firm is in operation or
is in the state of bankruptcy. When the firm is in operation, equity holders receive their dividends after debt holders have
received their interest from the firm. When the firm is in the state of bankruptcy and the assets of the firm are liquidated,
the equity holders receive any of their equity after debt holders have received most of their principal amount they had lent.
So, whether the firm is a going concern or is bankrupt, the equity holders receive their cash flows from the firm after debt
holders have received their cash flows from the firm. Therefore, the equity holders are exposed to a higher level of risk than
the debt holders. Consequently, equity holders require a higher rate of return than debt holders, which means a higher cost
of equity than cost of debt to the firm. This is shown in Exhibit 5.

7. The existence of optimal capital structure

An optimal capital structure exists because the ROR reaches its maximum and then declines, which is shown in Exhibit
6. This can be shown by starting with:

re = ra + (ra − rd )(D/E) (1)

and noting that the cost of debt (rd ) depends on the extent of the use of debt in the capital structure (D/E) and that at very
low levels of debt the cost of debt is relatively flat and as the use of debt in the capital structure is increased the cost of debt
increases at an increasing rate, as shown in Exhibit 5. That is, in Eq. (1), rd is a function of D/E:

rd = f (D/E) where : f  = rd > 0 and f  = rd > 0 (2)

The ROR reaches its maximum when the first derivative of Eq. (1) with respect to D/E is equal to zero:

ra − rd (D/E) − rd = 0

which can be solved for D/E to obtain8 the capital structure at which the ROR reaches its maximum:

D/E = (ra − rd )/rd

7
The operating income, i.e., EBIT, changes by 20% because the firm has some operating leverage.
8
This equation is not in reduced form. But, it can be expressed in reduced form when the specific function for rd is known.
706 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710

Exhibit 6. The share price is maximized at a capital structure for which the slope of the rate of return on equity investment (re ) becomes equal to the slope
of the cost of equity raised (rs ).

The value on the right-hand side is positive and, therefore, defines a proper D/E. More specifically, the numerator of the
above ratio is positive because firms rationally borrow only when the rate at which they borrow is less than the rate of return
which they earn from the real assets in which the funds are invested, as per the logic discussed with respect to Exhibit 3.
The denominator of the above ratio is also positive, as was noted in Eq. (2). Since both the numerator and the denominator
in the above ratio are positive their quotient is also positive. In this way, the quotient on the right-hand side of the above
equation is positive and, therefore, defines a proper D/E, i.e., capital structure.
Before this specific level of D/E is reached the ROR increases and after this specific level of D/E the ROR decreases. This is
because the second derivative of Eq. (1) is negative:

−rd (D/E) − rd − rd = −rd (D/E) − 2rd = −[rd (D/E) + 2rd ] < 0

This is negative because the term inside square brackets is positive, and the native of a positive value is negative. The term
inside square brackets is positive because it is the sum of two positive values. The first term is positive because it is the
product of two positive values, because rd is positive, as was noted in Eq. (2), and D/E is also positive. The second term inside
the square bracket, rd , is also positive, as was noted in Eq. (2). Therefore, the second derivative of Eq. (1) is negative. In sum,
since the second derivative of Eq. (1) is negative, the ROR increases, reaches a maximum, and falls as the use of debt in the
capital structure increases.
The share price is maximized at a capital structure for which the slope of the rate of return on equity investment (re )
becomes equal to the slope of the cost of equity raised (rs ), i.e., re = rs . This is because the share price increases when at the
margin the rate of return equity holders earn on their invested equity, i.e., re , is greater than their required rate of return, rs ,
which is risk-adjusted. That is, the share price increases when the marginal benefit to the equity holders is greater than the
marginal cost to the equity holders. Therefore, the share price is maximized when the marginal benefit is equal to marginal
cost, i.e., re = rs . More formally:

Net Benefit to Equity Holders = Total Benefit − Total Cost

Net Benefit to Equity Holder = (re )(E) − (rs )(E)

To maximize the “Net Benefit to Equity Holders,” it is necessary to set its first derivative equal to zero and solve for the
solution:

re = rs

Both re and rs depend on D/E. The former, it was shown, first increases, reaches a maximum, and decreases as D/E increases,
i.e., its slope is correspondingly positive, zero, and negative. The latter increases as D/E rises, i.e. its slope is always positive
as per Eq. (2). Therefore, the slopes of these two curves can be equal only where their slopes are positive, i.e. at a D/E before
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 707

Exhibit 7. The cash flow benefit to the equity holders of the firm as a result of the initial financing with some debt more than offsets the slight risk to the
equity holders that comes with the initial use of some debt. So, with reference to the dividend discount model, initially the share price will rise. When
debt is increased still further, then the firm becomes still more risky and accordingly the debt becomes much more expensive because the debt holders are
exposed to a much higher level of risk and therefore require a much higher rate of return. Consequently, the ROR to the equity holders of the firm starts to
go down. This is because the money is borrowed at a rather higher rate and is used to earn the fixed rate of return on the real assets of the firm, and the
small difference between the two is paid to the equity holders. Note that the closing of the gap between the rate at which the money is borrowed from the
debt holders and the rate at which money is generated by the real assets of the firm results in a smaller ROR to the equity holders of the firm. There reaches
a point at which the cash flow benefit to the equity holders of the firm as a result of the substantial amount of financing with debt is more than offset by
the increased risk to the equity holders that comes with the further use of debt. So, with reference to the dividend discount model, finally the share price
goes down.

re reaches a maximum.9 This D/E is the optimal capital structure for the firm. Before this capital structure is reached the
share price increases and after this capital structure is reached the share price decreases, as shown in the lower diagram in
Exhibit 6.

8. Some discussion of capital structure and share price

When the use of debt in the capital structure of the firm is increased, on the one hand, the resultant higher cash flows
to the equity holders of the firm tends to increase the share price, and, on the other hand, the resultant higher level of risk
to which the equity holders are exposed tends to lower the share price. The net effect of these two opposing tendencies on
the share price depends on which tendency is stronger, as per dividend discount model shown in Exhibits 1 and 2. It will
be noted that the relative strength and direction of these two tendencies vary with the increased use of debt in the capital
structure of the firm, as shown in Exhibit 7. More specifically, it will be noted that as the firm uses more debt, always the
cost of equity goes up – as per Eq. (2) and as shown in Exhibit 5 – and as a result it always puts downward pressure on the
share price. After some point, the further use of debt also causes the ROR – earnings per share and dividend per share – to
the equity holders to go down. This reinforces the downward pressure on the share price – caused by the higher cost of
equity – and therefore the share price goes down.
The middle diagram in Exhibit 7 depicts the variations in share price corresponding to the variations in the capital
structure, as represented by the debt to equity ratio, D/E. Initially, when debt is increased then the firm is relatively low in
risk and accordingly the debt is relatively cheap because the debt holders are exposed to a relatively lower risk and therefore
require a relatively lower rate of return. This constitutes the initial relatively flat portion of the cost of debt shown in Exhibit
5. Consequently, the cash flow and ROR to the equity holders of the firm are relatively high. This is because according to the
logic discussed in Exhibit 3, the money is borrowed at a relatively lower rate and is used to earn a relatively higher rate, and
the difference is paid to the equity holders. Note that the wider the gap between the rate at which the money is borrowed
from the debt holders and the rate at which the money is generated by the real assets of the firm then the higher will be the
ROR and the dividends paid to the equity holders of the firm. This is shown in Exhibit 8, which is based on the same logic as
was used in Exhibit 3. In Eq. (1):

re = ra + (ra − rd )(D/E) (1)

9
Therefore, the existence of the optimal capital structure depends only on the rising segment of the re curve.
708 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710

Exhibit 8. Initially, when debt is increased then the firm is relatively low in risk and accordingly the debt is relatively cheap because the debt holders are
exposed to a relatively lower risk and therefore require a relatively lower rate of return. This constitutes the initial relatively flat portion of the cost of
debt shown in Exhibit 5. Consequently, the cash flow and ROR to the equity holders of the firm are relatively high. This is because according to the logic
discussed in Exhibit 3, the money is borrowed at a relatively lower rate and is used to earn a relatively higher rate, and the difference is paid to the equity
holders. Note that the wider the gap between the rate at which the money is borrowed from the debt holders and the fixed rate at which the money is
generated by the real assets of the firm then the higher will be the ROR and the dividends paid to the equity holders of the firm.

ra is fixed and rd increases by a very small amount, so the larger D/E results in higher re . Overall, the cash flow benefit to the
equity holders of the firm as a result of the initial financing with some debt is expected to more than offset the slight risk to
the equity holders that comes with the initial use of some debt. So, with reference to the dividend discount model, initially
the share price is expected to rise.
After the initial phase of borrowing, when debt is further increased, then the firm becomes relatively risky and accordingly
the debt becomes relatively more expensive because the debt holders are exposed to a relatively higher risk and therefore
require a relatively higher rate of return. This constitutes the slightly faster rising portion of the cost of debt in Exhibit 5.
Consequently, the cash flow and ROR to the equity holders of the firm start to become sensitive to the rising cost of debt.
This is because according to the logic discussed in Exhibit 3, the money is now borrowed at a relatively higher rate and is
used to earn the fixed rate of return on the real assets of the firm, and the difference is paid to the equity holders. Note that as
the gap between the rate at which the money is borrowed from the debt holders and the rate at which money is generated
by the real assets of the firm narrows then the possibility starts to arise that the ROR paid to the equity holders of the firm
might go down. Exhibit 9 is based on the same logic as was used in Exhibit 3. In Eq. (1):

re = ra + (ra − rd )(D/E) (1)

ra is fixed and rd has started to rise such that the gap between the two is narrowing, i.e., (ra – rd ) is getting smaller, but the
positive change in D/E more than offsets the negative change in (ra – rd ) such that re becomes larger. Overall, the cash flow
benefit to the equity holders of the firm as a result of further financing with debt is still more than offsetting the risk that
comes with the use of more debt. So, with reference to the dividend discount model, in this second range of financing with
debt the share price is still expected to rise.
In the last phase of borrowing, when debt is increased still further, then the firm becomes still riskier and accordingly
the debt becomes much more expensive because the debt holders are exposed to a much higher level of risk and therefore
require a much higher rate of return. This constitutes the final portion of the cost of debt in Exhibit 5, where the increasing
use of debt results in higher cost of debt. Consequently, the ROR to the equity holders of the firm starts to go down. This is

Exhibit 9. After the initial phase of borrowing, when debt is further increased, then the firm becomes relatively riskier and accordingly the debt becomes
relatively more expensive because the debt holders are exposed to a relatively higher risk and therefore require a relatively higher rate of return. This
constitutes the slightly faster rising portion of the cost of debt in Exhibit 5. Consequently, the cash flow and ROR to the equity holders of the firm start to
become sensitive to the rising cost of debt. This is because according to the logic discussed in Exhibit 3, the money is now borrowed at a relatively higher
rate and is used to earn the fixed rate of return on the real assets of the firm, and the difference is paid to the equity holders. Note that as the gap between
the rate at which the money is borrowed from the debt holders and the rate at which money is generated by the real assets of the firm narrows then the
possibility starts to arise that the ROR paid to the equity holders of the firm might go down. Overall, in the above case, the cash flow benefit to the equity
holders of the firm as a result of further financing with debt is still more than offsetting the risk that comes with the use of more debt. So, with reference
to the dividend discount model, in this second range of financing with debt the share price will still rise.
 K. Ardalan / Research in International Business and Finance 39 (2017) 696–710 709

Exhibit 10. In the last phase of borrowing, when debt is increased still further, then the firm becomes still riskier and accordingly the debt becomes much
more expensive because the debt holders are exposed to a much higher level of risk and therefore require a much higher rate of return. This constitutes
the final portion of the cost of debt in Exhibit 5, where the increasing use of debt results in higher cost of debt. Consequently, the ROR to the equity holders
of the firm starts to go down. This is because according to the logic discussed in Exhibit 3, the money is borrowed at a rather higher rate and is used to earn
the fixed rate of return on the real assets of the firm, and the small difference between the two is paid to the equity holders. Note that the closing of the
gap between the rate at which the money is borrowed from the debt holders and the fixed rate at which money is generated by the real assets of the firm
results in a smaller ROR to the equity holders of the firm. Overall, in the above case, the cash flow benefit to the equity holders of the firm as a result of the
substantial amount of financing with debt is more than offset by the increased risk to the equity holders that comes with the further use of debt. So, with
reference to the dividend discount model, finally the share price goes down.

because according to the logic discussed in Exhibit 3, the money is borrowed at a rather higher rate and is used to earn the
fixed rate of return on the real assets of the firm, and the small difference between the two is paid to the equity holders.
Note that the closing of the gap between the rate at which the money is borrowed from the debt holders and the fixed rate
at which money is generated by the real assets of the firm results in a smaller ROR to the equity holders of the firm. This is
shown in Exhibit 10, which is based on the same logic as was used in Exhibit 3. In Eq. (1):

re = ra + (ra − rd )(D/E) (1)

ra is fixed and rd has increased further such that the gap between the two is closing, i.e., (ra – rd ) is reduced still further, so
the positive change in D/E is more than offset by the negative change in (ra – rd ) resulting in a lower re . Overall, the cash flow
benefit to the equity holders of the firm as a result of the substantial amount of financing with debt is more than offset by
the increased risk to the equity holders that comes with the further use of debt. So, with reference to the dividend discount
model, finally the share price goes down.
At the optimal capital structure – shown as “optimal” in Exhibit 7 – the share price is maximized. At the optimal capital
structure, with reference to the dividend discount model, the higher risk to the equity holders as a result of the additional
debt is equally offset by the ROR benefit to the equity holders as a result of the additional debt.

9. Conclusion

The Modigliani and Miller’s (1958) proof of the capital structure irrelevance theory is based on a set of assumptions
which are unrealistic and contradictory to the main assumption of mainstream finance. This paper showed that based on
the joint assumption that the goal of the firm is share price maximization (rather than firm value maximization) and that
debt is risky, then capital structure becomes relevant, and therefore, there is an optimal capital structure for the firm. The
paper, therefore, started with share price maximization as the goal of the firm, and analyzed the effect on the share price as a
result of the increase in the proportion of risky debt in the capital structure of the firm. It showed that after an initial rise in
share price, at some point, the share price starts to fall. This illustrated that there exists an optimal capital structure for the
firm.
The paper argues that since the results of sophisticated mathematical models change as soon as their underlying
assumptions are changed, the claim about the scientific nature of the mainstream academic finance becomes questionable.
Knowledge of finance, as in any other phenomenon, is ultimately a product of the researcher’s paradigmatic approach to
that multifaceted phenomenon. Viewed from this angle, the pursuit of the knowledge of finance is as much an ethical, moral,
ideological, and political activity, as a technical one. Ardalan (2008, 2014, 2016) shows how a variety of phenomena (includ-
ing financial phenomena) can be approached and analyzed from four most diverse paradigmatic viewpoints. This approach
can be used to analyze any other phenomena, and therefore, it is useful for this approach to be used to analyze other financial
phenomena, because this approach provides a clearer and more balanced view of the financial phenomenon under consid-
eration. Indeed, a knowledge of paradigms would have warned finance scholars about the contradictory assumption which
was made in both Modigliani and Miller (1958) and its following long-winded trade-off theory of capital structure.

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