M & M Capital Structure Theory

A literature review is the backbone of research and connected to the research topic and the appropriate research methodology. It is essential for researchers, as a reader, and for us, as authors, to have a concrete frame of reference in mind before continuing their search journey.
Most of all, a solid framework represents the coherence of the theories chosen. This chapter discusses Modigliani-Miller theorem, theory of capital structure, (trade-off theory, pecking order theory & agency cost theory), capital structure and corporate performance, determinants of capital structure, review of empirical studies, and over view of Ethiopian insurance industry.

2.1 THEORETICAL FRAMEWORK.
How can the capital structure be determined that maximizes the firm’s value? This puzzle is introduced by Modigliani and Millers (1958). Whether the costs and

Theories of capital structure
Capital structure theory, as known today, originates from the work of Modigliani and Miller, hereafter named M&M, who published their famous article in 1958. Many, if not all business and finance academics have heard and know about M&M‘s capital structure irrelevance proposition and several textbooks within corporate finance begin their explanations of capital structure and cost of capital with the work of

Trade-off theory states that there are benefits of financing with debt i.e. tax shield benefit, agency benefit and there are also costs of funding with debt e.g. costs of financial distress, agency costs. Therefore the firm that is maximizing its value will focus on offsetting costs against benefits of debt when making decision about how much debt and equity to use for financing its business. Ross et al (2008) argue that firm can optimize its value at a point where marginal costs of debt and marginal benefits of debt are