Optimal Financial Policy in Imperfect Markets

Most textbooks in finance are apparently embarrassed by the Modigliani-Miller (MM) theorem on capital structure. The intense controversy it has provoked in academic circles over the past sixteen years makes it hard to ignore, and yet many textbook writers seem to be unable to distill anything from it that might be of interest to their readers. A typical example might begin by laying out the economist's conventional perfect market assumptions and showing that the theorem may be derived deductively from these assumptions. It is then observed that markets are not perfect and it is implied that perfect market theorems, while perhaps interesting to ivory-tower academics, are of no use to a businessman who has to act in imperfect real-world markets. (For example, Weston and Brigham [16], in their appendix to Chapter 11, on p. 339 state: “Given their assumptions, their theoretical arguments were quite correct. However, their assumptions have been questioned extensively, and very few authorities today accept the MM position.”) We are then returned rather uneasily to the traditional world of U-shaped cost of capital curves, in which managers are required to examine such holy relics as financial break-even charts (Van Home [15, p. 231]) or to exercise judgment about the stockholders' utility preferences (Weston and Brigham [16, p. 258]) in order to make their debt/equity decision.