The irrelevance of capital structure as discussed above rests on the absence of market imperfections. However, with introduction of imperfections, it is possible for the value of the firm and its cost of capital to change with changes in its capital structure. These imperfections are:

(a) Corporate Income Taxes

In a world with corporate taxes, where interest payments are tax deductible, it was recognized by MM that the issuance of debt can enhance the value of the firm. This is because the levered firm will pay less corporate taxes than the unlevered firm since the dividend payments are not tax deductible. 

The value of the firm will be:

Value of the firm = Value of Unlevered Firm + Value of the Tax Shield

From this formulae it can be seen that the greater the amount of debt, the greater the tax shield and thus the greater the value of the firm, other things remaining constant.

MM therefore concluded that the optimal capital structure is one with maximum amount of leverage.

(b) Personal Taxes

The above arguments may not hold in the presence of personal taxes as well.

It was shown by Merton Miller (M) in 1977 that when personal taxes are present, the present value of the tax shield is given by:

Miller argued that where tpd = tps the present value of the tax shield remains as before (tcB) and under this condition the levered firm has a higher value than the unlevered firm. However, the overall tax advantages associated with corporate debt is reduced by the fact that overall stock income is taxed at a lower personal rate than is debt income. This is so because stock income is divided into capital gain and dividend (capital gains tax has been suspended in Kenya).

Note that in a case where tc = tpd and tps = 0 then the tax shield will be equal to zero.

(c) Financial Distress and Agency Costs

Use of debt in the capital structure has a limit after which it becomes very hard to acquire more debt. Furthermore, the probability of the firm failing increases with increase in the use of debt. If such a situation would occur, then the firm would incur extra cost in the form of lawyers's fee, accountants and other court fees which would absorb part of the firm's value. The process of liquidation usually involves a lot of legal processes which result in the firm's loss of value. In some cases managers in a bid to guard against losing their jobs may make poor decisions so as to delay the process of bankruptcy. Such decisions may dilute the future value of the assets. Therefore, the levered firm should consider the cost of bankruptcy and financial distress.

Agency cost is the cost incurred by one party to monitor the activities of another. Protective covenants can be thought of as a way for the creditors to monitor the actions of stockholders, to preclude the erosion in value of their interest and this reduces the value of the firm to its shareholders. The value of the levered firm will therefore be:

VL = Vu + TcB – COD - AC

Where COD is the present value of expected financial distress costs and AC is the expected value of agency costs.