A monitoring role, and a hypothesis tested across countries

The problem of corporate governance, the essay begins, is basically a problem of deciding an efficient way of controlling a firm, and also a problem of ownership and control. Control, it says, is proportional to the type and the size of the supply of capital, so the link between control and corporate finance arises naturally in the problem of governance. The role of corporate finance, in this reading, is an effective monitoring and control of the firm. From a macro point of view, that role also offers an important clue to the role of finance in economic development. Finance, by selecting investment opportunities and by monitoring users, strengthens an efficient allocation of resources and so promotes growth. That Schumpeterian hypothesis, the page says, has in recent years been tested through cross-country macroeconomic data, though research results on the relation between a particular financial structure and growth are not very many.

In practice, corporate finance is supplied by a collection of financial institutions, markets, and products, so the monitoring role of corporate finance means the monitoring role of that financial structure. Miller and Modigliani, the essay then says, treated a firm’s operating profit in relation to a market capitalisation rate that is independent of the capital structure — the starting point of the propositions that follow.

A value that does not depend on the mix, until tax is named

Without corporation tax, the first proposition of MM theory, restated on the page, is that a firm’s value is determined independently of its capital structure. If expected operating profit and business risk are the same, firm value is the same regardless of the mix of capital. In another wording given on the page, the total market value V of the firm is obtained by discounting expected operating profit at the weighted average cost of capital, and these are independent of capital structure. The firm’s value, in this reading, is obtained by discounting the expected cash flow it will earn at a discount rate appropriate to the risk class to which the firm belongs — a rate that reflects only business risk. Under proposition I, the weighted average cost of capital is determined without relation to the capital structure, and proposition III, the page says, follows easily from that.

When corporation tax exists, the first proposition of the revised MM theory is stated as follows: the value of a levered firm equals the value of an unlevered firm plus the present value of the tax savings from using debt. Therefore, as the use of debt increases, the firm’s value increases. In other words, the value of a firm that uses both other people’s capital and its own equity equals the value of a firm that uses only equity, plus the present value of the tax saving. Interest paid on the use of debt is recognised as an expense on the income statement, so a tax-saving effect can be obtained. A firm that uses both debt and equity is therefore larger, by the present value of the tax saving, than a firm that uses only equity, and in this model the more debt is used, the larger the firm’s value continues to become.

A perfect market, and the costs that a real market still has

A firm’s capital structure, the implications section says, is a quite important idea for the valuation of the firm and for setting the direction of management. Scholars have, on the basis of the cost of capital, put forward theories that try to identify or to explain an optimal capital structure, in which the firm’s value is maximised and the cost of capital is reduced as far as possible. These are called, together, capital-structure theory, or optimal-capital-structure theory. The theories reach different conclusions according to differences in their assumptions, and according to how they look at equity and at debt.

Among these theories, a quite important part is played by MM theory, that is, the Modigliani–Miller theorem. It can be spoken of as an early MM theory and, after criticism of the assumption of a perfect capital market, as a revised MM theory that accepts the incompleteness of the capital market. The criterion is whether, by relaxing the assumption of a perfect market, corporation tax is brought into the basic assumptions, or is not. In reality, factors of an imperfect market, such as bankruptcy costs, transaction costs, and the cost of obtaining information, are always present, so the revised theory that considers tax may, the writer thinks, be the more pertinent of the two.

Financial management, and the financial theory that governs it, the close says, may fairly be called among the most important elements in the management of a firm. The field of capital-structure theory itself can be divided, around MM, into a traditional theory and theories after MM, so large was the influence. The propositions should be understood clearly, and a firm’s financial activity should be carried on in that light. The references named on the page include Park Sung-yong, on capital-structure theory and valuation, in Monthly Accounting 22, no. 9 (2014); Jeong Ki-woong, a consideration of capital-structure theory, in Business and Economics 43, no. 1 (2010); and Kim Jeong-gyo and Kim Hye-ri, on the effect of a firm’s retained earnings on firm value, centred on capital-structure theory (2017).

Why a tax shield and a monitoring role are kept together

A proposition on a page is only a proposition, until a real market names its bankruptcy costs. The same Korean essay, at fuller length, is on CampusDown.

Sources

1. Essay on capital-structure theory and corporate governance, with a restatement of the Modigliani–Miller propositions with and without corporation tax (Korean source page).
2. The monitoring role of corporate finance; the Schumpeterian hypothesis as tested, the page says, through cross-country macroeconomic data; early MM and a revised MM that brings in corporation tax.
3. Park Sung-yong, Monthly Accounting 22, no. 9 (2014); Jeong Ki-woong, Business and Economics 43, no. 1 (2010); Kim Jeong-gyo and Kim Hye-ri (2017), as cited on the Korean page.

Last updated: 14 November 2026