Security Interests, Misbehavior, and Common Pools

The Modigliani-Miller Theorem on the irrelevance of corporate capital structure is perhaps the best-known result in modern finance. Simply put, the theorem states that, under certain assumptions, the market value of a firm is independent of its capital structure. Under the stylized assumptions of the theorem, substituting equity for debt or adding layers of debt to the capital structure of a firm, as occurred during much of the 1980s, has no affect on the firm's value.1 The theorem applies not only to the mix of debt and equity, but also to the mix of debt itself, such as between secured and unsecured or senior and subordinated debt. Understanding existing patterns of debt and equity therefore begins with the Modigliani-Miller Theorem. One must identify which of the theorem's assumptions do not hold and explain why relaxing them leads to the patterns of debt and equity that currently exist. Much scholarship has examined the assumption that changes in capital structure do not affect the way in which a firm uses its assets.3 There is little reason to think that this assumption is true. It is now well-understood that equityholders may choose different projects if debt is present than they would otherwise: equityholders enjoy all of the benefits of successful projects but share the losses from unsuccessful ventures with creditors.