Their conclusion at that time was that value of the firm increased as debt was added to the capital structure because of the tax deductibility of interest payments on debt. In 1977, Miller further updated this research to include the personal taxes of investors on proceeds from equity and debt. If the value of a firm can be changed simply by changing the capital structure, then it is very important to understand all the dynamics so that a financial manager can find the optimal capital structure, i.e., maximum the value of the firm. Chapter 15 explores the research of MM 1958, MM 1963, and Miller 1977 in more detail so that some of the complexities in optimizing the capital structure can be understood. These 3 slides indicate the concept of financial leverage.
Financial leverage occurs when a corporation adds debt to the capital structure.
You can think of such a change conceptually by imagining that the V.P. Finance decides to sell some bonds and use the proceeds to simultaneously buy back common stock. But the financial performance might change significantly depending on the future level of earnings. The third slide shows the EPS under the proposed capital structure for these same three scenarios. Now, since there is debt, the corporation must subtract interest on the debt from EBIT to calculate Net Income. Even though Net Income is less than before, because there are fewer shares outstanding, the EPS is larger when the company performs well but smaller when the company does not perform well.