The relevance and irrelevance theory of capital structure was first proposed by American economist and Nobel laureate, Franco Modigliani and his colleague, Merton Miller. The theory suggests that a company’s capital structure does not affect its overall value or cost of capital in a perfect market.

According to the irrelevance theory, the value of a company is determined solely by its cash flows, regardless of how it is financed. In other words, a company’s total value is independent of its capital structure, as long as the company’s investments are financed by the optimal mix of debt and equity. The theory also assumes that all investors have access to the same information and have similar preferences, and that there are no taxes, transaction costs, or other market imperfections.

In contrast, the relevance theory proposes that capital structure can affect a company’s value in certain situations, such as when there are taxes, bankruptcy costs, or other market imperfections. For example, if a company has a high level of debt, it may face higher bankruptcy costs and a higher cost of capital, which can reduce its overall value. Additionally, if a company’s tax rate is high, it may be more advantageous to finance its investments with debt rather than equity, as interest payments on debt are tax-deductible.

Overall, while the irrelevance theory suggests that a company’s capital structure has no effect on its overall value in a perfect market, the relevance theory suggests that there are certain market imperfections that can make a company’s capital structure relevant to its overall value and cost of capital.