MM Proposition I (No Tax) states that in a perfect market, how a firm finances its operations (Debt vs Equity) is irrelevant to its total value. Value is determined by its earning power and risk of assets, not funding mix.

If ROI > Cost of Debt, using debt magnifies the Earnings Per Share (EPS) for shareholders (Trading on Equity). If ROI < Cost of Debt, leverage destroys value.

At the indifference point, the firm is indifferent between choosing Debt plan or Equity plan because the EPS remains identical. Below this EBIT level, equity is better; above it, debt is better.

Firms prefer internal funds (Retained Earnings) first because they are cheapest and safest. Next is Debt. External Equity is the last resort due to high costs and dilution.

The goal is to find the cheapest mix of funds. Lower WACC means higher Net Present Value of future cash flows, thus maximizing firm value.

NOI theory suggests that the benefits of cheaper debt are exactly offset by the increasing cost of equity (higher risk), leaving the overall WACC (Ko) and Firm Value unchanged.

Firms take on debt to get tax shields (benefit), but only up to a point where the risk of bankruptcy (financial distress cost) starts outweighing the tax benefit.

These costs offset the tax benefits of debt in the Trade-off Theory, suggesting an optimal level of debt exists.

As a firm takes on more debt (higher D/E ratio), the financial risk to shareholders increases. Shareholders demand a higher return (Ke) to compensate for this added risk.

Excessive debt increases the probability of bankruptcy. Lenders compensate for this increased credit risk by charging higher interest rates.

Cheaper debt reduces WACC, but increased financial risk raises Ke. MM II argues these exactly cancel out, keeping overall WACC constant.

Unlike MM theory, the Traditional View argues that judicious use of debt initially lowers the WACC (Ko) up to a point. Beyond this point, rising financial risk causes Ke and Kd to rise, increasing WACC. The lowest point of the U-shaped WACC curve is the optimal structure.

Managers might pursue personal goals (like expensive jets) over shareholder wealth (Agency cost of equity). Shareholders might take high risks to shift loss to debt-holders (Agency cost of debt).

With taxes, debt provides a tax shield. The value of the firm increases by the Present Value of the Tax Shield, which is Debt * Tax Rate (Dt). So Vl = Vu + Dt.

Over-capitalization doesn't mean too much money. It means the capital base is too large relative to the earnings, leading to low dividend rates and falling share prices.