July 2025

Academic perspectives on optimal debt structure and bankruptcy costs

July 21, 2025 by Snehasish CHINARA

In this article, Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025) explores the academic evolution of capital structure theory, focusing on the delicate balance between debt and equity financing. Starting from the foundational Modigliani and Miller propositions, this post delves into how the introduction of real-world frictions—particularly bankruptcy costs and financial distress—gave rise to the Trade-Off Theory.

Introduction to Capital Structure

Capital structure refers to the mix of debt and equity financing that a company uses to fund its operations and growth. It is a critical component of corporate finance, as it directly impacts a firm’s cost of capital, financial risk, and overall valuation.

Capital structure is reflected in a company’s balance sheet, which provides a snapshot of its financial position at a given point in time. Specifically, it is composed of two primary financing sources:

1. Debt (Liabilities) – Found under the Liabilities section, debt includes short-term borrowings, long-term loans, bonds payable, and lease obligations. Debt financing requires periodic interest payments and repayment of principal, increasing financial obligations but also benefiting from potential tax shields.

2.Equity (Shareholders’ Equity) – Located under the Shareholders’ Equity section, equity includes common stock, preferred stock, retained earnings, and additional paid-in capital. Equity financing does not require fixed interest payments but dilutes ownership among shareholders.

Table 1 below gives a simplified version of a balance sheet.

Table 1 – Simplified Balance Sheet Example

Table 1 shows that the firm finances its $350M in assets with $140M in debt (40%) and $210M in equity (60%), demonstrating a debt-to-equity ratio of 0.67 (=140/210). Additionally, the debt ratio, D/(D+E), measures the proportion of total financing that comes from debt 40% (=140/(140+210)). This indicates that a significant portion of capital is funded through borrowed money, allowing the company to take advantage of the use of debt, but also exposing it to higher financial risk if it faces difficulties in meeting debt obligations. These ratios are a few key indicators used to assess a company’s financial leverage and risk exposure.

Beyond Taxes — The Real-World Cost of Debt

Capital structure theory begins with Modigliani and Miller (1958), who argued that in a perfect market—with no taxes or distress costs—a firm’s value is unaffected by its mix of debt and equity. This implies that financing decisions are irrelevant: the firm’s cost of capital remains unchanged regardless of leverage.

Their later work in 1963 introduced corporate taxes, shifting the narrative. Since interest is tax-deductible, debt creates a tax shield that reduces taxable income, lowering the firm’s WACC and increasing its value. In theory, this would mean the more debt a firm uses, the better.

However, this doesn’t match real-world behaviour. Firms rarely use excessive debt. To explain this, Miller (1977) brought personal taxes into the picture. While firms benefit from interest deductibility, investors may face higher taxes on interest income compared to equity income. This reduces the net benefit of debt. At the market level, an equilibrium emerges where additional debt offers no further advantage—explaining why firms stop before 100% leverage.

Together, M&M and Miller show why debt can be attractive due to tax savings—but they don’t account for the costs of debt, which are crucial in practice. This article now turns to academic perspectives that build on these theories by introducing bankruptcy costs, financial distress, and agency issues, offering a more complete view of how firms decide on an optimal capital structure.

The Trade-Off Theory: Balancing Tax Shields and Bankruptcy Costs

While M&M (1963) and Miller (1977) emphasize the tax advantages of debt, real-world firms don’t pursue unlimited leverage. Why? Because with higher debt comes higher financial risk. This leads to the Trade-Off Theory—a more realistic and widely taught framework in modern corporate finance.

At the heart of this theory lies a simple question: How much debt is too much?

The Trade-Off Theory proposes that firms weigh the benefits of debt (primarily the interest tax shield) against the costs of debt (most notably bankruptcy risk and financial distress costs). The optimal capital structure is achieved when the marginal benefit of taking on more debt equals its marginal cost. Therefore, firms pick capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress (including agency costs of debt).

This framework leads to a simple but powerful relationship:

where:

V_L is the value of a levered firm using debt.

V_U is the value of a unlevered firm not using debt but only equity

Tax shield benefits: arising from the tax deductibility of interest payments

Expected bankruptcy cost: a function of both the probability of distress and the magnitude of associated losses (probability of distress x cost if distress occurs)

The Trade-Off Theory argues that the value of a firm initially increases with debt due to tax savings from interest deductibility, but only up to a point. Beyond that, the probability of bankruptcy and the costs associated with financial distress begin to outweigh the benefits of the tax shield. Due to this, there exists an optimal capital structure where the marginal benefit of debt exactly equals its marginal cost.

Tax shield benefit: This term represents the annual tax saving due to deductible interest.

where:

T_C: Corporate tax rate

r_D: Interest rate on debt

D is the amount of debt of the firm

Expected Bankruptcy Cost:

This cost includes:

Direct costs (legal, administrative): typically 2–5% of firm value

Indirect costs (reputation, supplier reactions, customer attrition): potentially far higher

How Firm Value Changes with Debt

According to the Trade-off Theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the expected tax savings from debt, less the present value of the expected financial distress costs.

It is represented as follows:

where:

V_L is the value of a levered firm using debt.

V_U is the value of a unlevered firm not using debt but only equity

Firms should increase leverage until they reach the optimal level where the firm value (and the net benefit of debt) is maximized. At the optimal leverage, the marginal benefits of interest tax shields that result from increasing leverage are perfectly offset by the marginal costs of financial distress.

Figure 1 – Trade-Off Theory Optimal Leverage

Source: “The Static Theory of Capital Structure” Brealey, Myers, & Allen

Figure 1 above illustrates the Trade-Off Theory of capital structure, which posits that a firm’s value is influenced by two opposing forces: the benefits of debt and the costs of financial distress.

The upward-sloping blue line represents the firm’s value if we consider only the corporate tax advantage of debt, where each additional unit of debt increases firm value by the present value of the tax shield (Tc×D). However, this idealized trajectory (as per M&M 1963) does not account for real-world frictions.

As leverage rises, so too does the probability of financial distress, bringing with it both direct costs (legal and administrative expenses) and indirect costs (reputation damage, lost sales, supplier concerns). These rising costs are reflected by the gap between the blue and pink curves.

The pink curve represents the actual value of a levered firm after subtracting distress costs. It shows the actual value of the firm once these financial distress costs are taken into account. Initially, this curve rises along with the tax shield benefits. But after a certain point, the marginal cost of debt begins to exceed its marginal benefit, causing the curve to flatten and then decline.

The pink curve peaks at the point marked D∗—the firm’s optimal capital structure. The point D∗ is the optimal amount of debt where the marginal benefit of the tax shield is exactly offset by the marginal expected cost of financial distress.

To the left of D∗, adding more debt increases firm value; to the right of it, further leverage diminishes value. The curve therefore reflects a concave relationship between debt and firm value, with the maximum point corresponding to the firm’s optimal capital structure.

Figure 1 delivers three core insights:

Leverage is a double-edged sword—it creates value through tax savings but erodes it through risk.

The optimal debt level is not universal—it depends on a firm’s industry, asset type, cash flow stability, and access to capital markets.

Real-world capital structure decisions are about finding a balance, not maximizing one benefit in isolation.

Static vs. Dynamic Trade-Off Models: From Simplified Theory to Real-World Complexity

The traditional Trade-Off Theory provides a powerful intuition: firms balance the benefits of debt (tax shields) against its costs (financial distress). However, how firms actually make capital structure decisions over time is more complex than the simple static view. This brings us to an important academic distinction: static vs. dynamic trade-off models.

Static Trade-Off Models: A Snapshot of Capital Structure

A static trade-off model is a one-period, one-time optimization framework. It assumes that a firm evaluates all its financing options at a single point in time and selects the capital structure that maximizes firm value. The firm is thought to instantly move to its optimal leverage ratio and maintain it indefinitely.

This model gives us a clean formula for firm value:

While this is helpful in teaching and early analysis, it oversimplifies real-world decision-making. Firms don’t reset their debt every day based on a formula. Instead, they must plan, adjust, and adapt—which is where dynamic models offer deeper insight.

Dynamic Trade-Off Models: Capturing Real-World Decision-Making

Dynamic trade-off models build on the static framework by recognizing that:

Capital structure is adjusted over time, not all at once. Firms face adjustment costs when issuing new debt or equity (e.g., flotation costs, signaling effects).

Business conditions, tax environments, interest rates, and risk evolve. Managers are forward-looking—they consider not only current benefits and costs but also future risks, taxes, and financing needs.

In these models, the optimal debt level is not a fixed point. Instead, firms operate within a target range of leverage and make gradual adjustments toward it when the benefits outweigh the costs of doing so.

For example:

A firm may not issue new debt today even if it’s slightly under-leveraged, because issuing comes with costs. It might instead wait for a better interest rate, a tax law change, or an internal cash flow event.

Dynamic models are particularly well-captured in the work of:

Fischer, Heinkel, and Zechner (1989) – who modelled how firms behave in a stochastic environment where recapitalization is costly.

Leland (1994) – who showed that default thresholds and optimal leverage depend on firm value and volatility over time.

Types of Bankruptcy Costs: The Hidden Burden of Excessive Leverage

While tax benefits of debt are quantifiable and immediate, the costs of financial distress—especially bankruptcy—are more nuanced, less visible, and often underestimated. These costs are central to the Trade-Off Theory, and understanding their components is essential for evaluating real-world capital structures.

Bankruptcy costs can be broadly classified into three types:

1. Direct Bankruptcy Costs

These are the explicit, out-of-pocket expenses incurred during legal bankruptcy proceedings.

Legal fees, court costs, bankruptcy consultants

Administrative expenses, such as auditing and trustee services

Empirical studies suggest that direct costs range from 2–5% of firm value, though they may be higher in complex bankruptcies. While these are easier to measure, they are not necessarily the largest component.

Example: A manufacturing firm with a $500 million valuation that enters Chapter 11 could incur $10–25 million in legal and court-related costs alone.

2. Indirect Bankruptcy Costs

These are opportunity costs or value losses incurred even if bankruptcy does not occur—simply being in distress can harm the business.

Loss of customers: Buyers lose trust in a distressed brand.

Supplier tightening: Suppliers demand advance payments or withdraw credit.

Employee turnover: Top talent exits due to job insecurity.

Delayed investments: Management focuses on liquidity over strategy.

Indirect costs are often much larger than direct ones—estimated at 10–20% of firm value in some studies.

Example: A hotel chain facing debt pressure may see a fall in bookings, reduced vendor support, and higher staff attrition—impacting operations even before legal proceedings begin.

3. Agency Costs of Debt

As financial distress increases, so do agency conflicts between debt holders and equity holders.

Two prominent issues are:

Asset Substitution Problem – Shareholders may prefer riskier projects with higher upside (but higher default risk) because they capture the gains, while losses are partially borne by creditors.

Underinvestment Problem – Highly leveraged firms might pass on positive NPV projects because the gains would go to debt holders, not shareholders. Thus, debt discourages investment when it is most needed.

These agency costs distort management incentives, especially when firms are close to violating debt covenants or already under pressure.

Academic Contributions on Bankruptcy and Alternative Views on Capital Structure

Pecking Order Theory and Information Asymmetry

Contrasting the Trade-Off Theory, Myers and Majluf (1984) introduced the Pecking Order Theory, which prioritizes financing sources based on information asymmetry. Firms prefer internal financing (retained earnings) first, then debt, and issue equity only as a last resort. This hierarchy arises because managers possess more information about the firm’s value than external investors, leading to adverse selection concerns when issuing new equity.

Dynamic Models of Capital Structure

Recognizing that capital structure decisions are not static, researchers have developed dynamic models to reflect real-world complexities. Leland (1994) incorporated factors such as agency costs, taxes, and bankruptcy costs into a continuous-time framework, providing insights into how firms adjust their leverage over time in response to changing conditions.

Human Capital and Bankruptcy Risk

Recent studies have explored the interplay between human capital and capital structure. For instance, research by Berk, Stanton, and Zechner (2010) examines how firms with significant human capital considerations may adopt lower leverage to mitigate the adverse effects of financial distress on their workforce and overall operations.

Empirical Evidence and Contemporary Reviews

Empirical studies have tested these theories across various contexts. For example, research published in the Journal of Finance investigates how bankruptcy risk influences firms’ capital structure choices, revealing an inverse relationship between bankruptcy risk and leverage. Comprehensive literature reviews, such as those by Cerkovskis et al. (2022) and Visinescu and Micuda (2023), provide critical analyses of the evolution and empirical validation of capital structure theories, offering valuable insights for both scholars and practitioners.

Practical Considerations in Capital Structure Decisions

While theories like Modigliani-Miller (M&M), the Trade-Off Theory, and Agency Cost Theory provide useful frameworks for understanding capital structure, real-world evidence shows that firms consider multiple factors beyond theory when making financing decisions. Empirical studies highlight how industries, economic conditions, credit ratings, and market perceptions influence a company’s choice between debt and equity.

Real-World Capital Structure Choices

Empirical research supports the idea that firms do not strictly follow any single capital structure theory but instead balance tax advantages, financial flexibility, and risk. Some key observations from real-world studies include:

Myers (1984) found that firms follow a “Pecking Order” when raising funds, preferring internal financing (retained earnings) first, followed by debt, and issuing equity as a last resort due to information asymmetry.

Graham (2000) estimated that firms use only about 60% of the potential tax benefits of debt, indicating that firms hesitate to take on excessive leverage due to bankruptcy risks.

Frank & Goyal (2009) confirmed that larger, more profitable firms tend to have higher leverage, while smaller, riskier firms avoid debt due to financial distress concerns.

These studies suggest that firms do not maximize leverage, but rather choose a debt level that balances benefits and risks based on firm size, profitability, and market conditions.

Why Should I Be Interested in This Post?

Understanding a firm’s optimal debt structure is essential for anyone involved in finance, strategy, or investment analysis. Whether you’re an investor evaluating risk, a finance professional shaping capital decisions, or a student building foundational knowledge, the trade-off between debt and equity lies at the core of corporate financial strategy. This post offers a deep dive into the academic perspectives on capital structure, highlighting how bankruptcy costs, financial distress, and tax considerations influence real-world financing decisions. By mastering these concepts, you’ll be better equipped to assess firm value, understand risk-return dynamics, and make more informed financial judgments in a world where leverage can both create and destroy value.

Useful resources

US Courts Data – Bankruptcy

S&P Global – Bankruptcy Stats

Statista – Bankruptcy data

About the author

The article was written in July 2025 by Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025).

Optimal capital structure with corporate and personal taxes: Miller 1977

July 21, 2025July 20, 2025 by Snehasish CHINARA

In this article, Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025) explores the optimal capital structure for firms, which refers to the balance between debt and equity financing. This post focuses on how the impact of personal taxes on the firm capital structure. The author unpacks Miller’s 1977 proposition, which presents a formula for calculating the right tax advantage of debt, and explains how it helps reconcile theory with what we actually observe in practice.

Introduction

When Modigliani and Miller introduced their capital structure theory in 1958, they shook the foundations of corporate finance. They argued that, in a perfect market with no taxes, no bankruptcy costs, and no frictions, a firm’s value is completely independent of how it is financed. In other words, it doesn’t matter whether a firm uses debt, equity, or a combination of both—the total firm value remains the same.

In 1963, Modigliani and Miller revised their theory to incorporate corporate taxes. With this adjustment, interest payments on debt are tax-deductible, and then provide firms with a “tax shield” that effectively reduces the cost of debt. This made debt financing more attractive than equity, leading to the conclusion that firms should increase their leverage to maximize their value (ideally reaching a 100 debt ratio). In the extreme, this version of the theory suggested that firms should be financed entirely with debt to benefit from the maximum tax advantage.

However, the real world tells a different story. Very few firms rely solely on debt. In fact, most maintain a balanced mix of debt and equity. If debt is supposedly so advantageous under corporate tax rules, why don’t we see more of it being used? This is where Merton Miller’s 1977 work offers a crucial refinement to the theory.

Miller introduced a critical yet often overlooked component into the capital structure discussion: personal taxes. While interest payments are tax-deductible at the corporate level, the income received by investors—whether as interest or dividends—is also subject to personal taxation. Importantly, interest income is often taxed at a higher rate than equity income (like capital gains or dividends). This means the supposed advantage of debt at the corporate level may be offset—or even completely nullified—by the higher tax burden borne by investors.

Modigliani-Miller 1963 Theorem (M&M 1963)

Let us first remind you about the main findings of Modigliani and Miller (1963). In their revision of their first article published a few years earlier (1958), their theory about the firm capital structure introduced corporate taxes, which has a crucial impact on their earlier conclusions which found that the capital structure was irrelevant. They recognized that, in most economies, governments impose corporate income tax, but companies can deduct interest payments on debt from their taxable income. This interest tax-shield increases the after-tax profits of a firm and thereby raises its overall value.

The tax shield refers to the reduction in taxable income that results from interest payments on debt. Since interest expenses are tax-deductible, they effectively reduce the amount of taxes a company owes. This provides a direct financial benefit to firms that use debt financing, making it a valuable tool for optimizing capital structure.

The formula for the tax shield is:

This means that, under the M&M (1963) proposition, the value of a leveraged firm is given by:

where:

V_L is the value of a levered firm using debt.

V_U is the value of a unlevered firm not using debt but only equity

T_c is the Corporate tax rate

D is the amount of debt of the firm

This formula shows that the value of a firm increases by the amount of tax shield (Tc⋅D) when debt is introduced into the capital structure. The more debt a company takes on, the greater the tax benefit, making debt financing more attractive than equity financing.

Miller (1977): The Role of Personal Taxes in Capital Structure

Modigliani and Miller’s 1963 revision made a powerful case for debt: because interest payments are tax-deductible, firms enjoy a tax shield that reduces their cost of capital. The logical (but extreme) implication of this idea was that firms should maximize debt in their capital structure. However, the theory still fell short of explaining reality—most firms do not load up on debt. Why?

This is where Merton Miller’s 1977 paper brought a major refinement. While M&M (1963) focused on corporate taxes, Miller highlighted the crucial role of personal taxes paid by investors. Specifically, he noted that:

Interest income (from bonds or loans) is typically taxed at a higher personal rate (T_Pi),

While equity income (via dividends or capital gains) is often taxed at a lower rate (T_Pe).

Thus, although the firm saves taxes through debt, the investor receiving interest income may lose part of that advantage due to higher personal taxes. Miller argued that the tax benefit of debt is not universal—it depends on the relative tax positions of the firm and its investors.

Miller quantified the net tax advantage of debt with the following formula:

where:

T_Pi is the personal tax rate on interest income

T_Pe is the personal tax rate on equity income (dividends/capital gains)

T_c is the corporate tax rate

This expression compares the after-tax returns from debt and equity financing, from both the firm’s and investor’s perspectives.

Value of a Levered Firm according to Miller (1977)

In Miller (1977), the value of the firm incorporates both:

1. The corporate tax shield (from M&M 1963), and

2. The personal tax disadvantage from investor taxation on interest income.

Unlike M&M 1963 (which assumed value keeps increasing with leverage due to tax shields), Miller showed that the firm’s value plateaus at an equilibrium level, reflecting the offsetting effect of personal taxes.

There isn’t a single formula as elegant as in M&M 1963 because Miller focuses on market equilibrium, not firm-level maximization. But we can express the adjusted value of a levered firm relative to the unlevered firm as:

that is,

where:

V_L is the value of a levered firm using debt.

V_U is the value of a unlevered firm not using debt but only equity

T_c is the Corporate tax rate

T_Pi is the personal tax rate on interest income

T_Pe is the personal tax rate on equity income (dividends/capital gains)

D is the amount of debt of the firm

Figure 1. Firm Value vs Debt according to Miller 1977 Theorem

where:

T_c is the Corporate tax rate

T_Pi is the personal tax rate on interest income

T_Pe is the personal tax rate on equity income (dividends/capital gains)

The Equilibrium Capital Structure Across Firms

One of the most insightful—and often misunderstood—contributions of Miller (1977) is that there is no single “optimal” capital structure for all firms. Instead of recommending that every company should maximize debt (as M&M 1963 might suggest), Miller argued that the optimal mix of debt and equity depends on the broader market, not just individual firm decisions. His approach introduced a market-level equilibrium perspective, which helps us understand the diverse financing strategies we observe in the real world.

Miller recognized that not all investors are taxed equally. Some investors—like pension funds, endowments, or individuals in low tax brackets—are less affected by taxes on interest income. These investors prefer debt because they can earn stable interest income without facing significant tax penalties. On the other hand, investors in higher tax brackets might favour equity, particularly because capital gains and dividends are often taxed at lower rates than interest income.

This diversity in investor preferences (from different personal tax rates) creates a kind of natural balance in the financial markets. Some firms will issue more debt to attract income-focused investors, while others will rely more on equity to appeal to investors who value capital gains. Over time, this leads to a market equilibrium in which different firms adopt different capital structures based on the preferences of the investors they attract.

In reality, we do not see all firms aggressively using debt to lower their tax bills. Instead, we see some firms—like utilities or financial institutions—using higher levels of debt, while others—like tech startups or growth firms—rely more on equity. This variation observed in practice aligns perfectly with Miller’s theory. The aggregate tax advantage of debt is “used up” across the economy, so not every firm needs to (or should) leverage itself heavily.

Firms essentially compete for investor types, and their capital structure decisions reflect the marginal investor’s personal tax situation. In this way, the equilibrium is not found at the level of a single firm, but across the entire set of firms.

How Miller (1977) Redefined the Cost of Equity and WACC from Modigliani-Miller (1963)

In M&M (1963), the introduction of corporate taxes led to a crucial insight: because interest payments are tax-deductible, debt financing creates a tax shield that reduces the firm’s Weighted Average Cost of Capital (WACC). The model predicted that, as leverage increases, WACC decreases, and firm value rises—implying that a firm should use as much debt as possible to minimize its cost of capital.

This had a direct impact on the cost of equity as well. In M&M (1963), the cost of equity (rE) increases with leverage to compensate for the rising risk faced by shareholders:

where:

r_E is the cost of equity for a levered firm

r_U is the cost of equity for an unlevered firm

r_D is the cost of debt

D/E is the debt to equity ratio measuring leverage

Here, while the cost of equity increases due to higher financial risk, the overall WACC falls, thanks to the tax shield:

Where: V is the Value of the firm (V= D + E)

Miller (1977) introduced personal taxes into the equation—something that M&M (1963) completely ignored. He observed that investors are not only taxed at the corporate level but also at the personal level:

Interest income is taxed at the personal level (personal tax rate on interest income: T_Pi)
Equity dividends and capital gains are taxed at the personal level (personal tax rate on equity: T_Pe)

Crucially, interest income is taxed more heavily than equity dividends and capital gains: T_Pi > T_Pe. This is the case in the United States and most developed countries.

This alters the perceived tax advantage of debt as the benefit of corporate tax deductibility may be neutralized—or even outweighed—by the higher taxes on interest income.

While Miller (1977) didn’t give a neatly adjusted cost of equity formula like Modigliani and Miller (1963), he did show that the tax advantage of debt financing is not universal—it depends on both corporate and personal tax rates. This led to a redefinition of the net tax advantage of debt, which in turn affects WACC:

And so, the adjusted value of the tax shield, and by extension the impact of debt on WACC, becomes:

Using this expression, the WACC becomes:

where,

T_c is the Corporate tax rate

T_Pi is the personal tax rate on interest income

T_Pe is the personal tax rate on equity income (dividends/capital gains)

D/V is the proportion of debt in the capital structure

E/V is the Proportion of equity in the capital structure

r_E is the cost of equity for a levered firm

r_D is the cost of debt

This means that the WACC no longer declines indefinitely with debt. Instead, as the tax burden on interest income increases (via Ti ), the marginal benefit of debt diminishes. At market equilibrium, the advantage of debt disappears, and WACC flattens—explaining why we observe moderate, not extreme, debt usage in practice.

If Ti > Te and corporate tax Tc is high, debt still offers a net tax advantage, though smaller than in M&M (1963).

If the term in brackets equals zero, there is no net tax advantage—WACC remains flat regardless of leverage.

If the term becomes negative, equity becomes more tax-efficient, and adding debt raises the WACC.

Why Should I Be Interested in This Post?

In corporate finance, the debate around how much debt a firm should take on is far from settled. While traditional models like Modigliani-Miller (1963) emphasize the tax benefits of debt, they ignore the taxes investors pay. This post introduces the groundbreaking Miller (1977) framework, which shows how personal taxes can offset corporate tax advantages, reshaping our understanding of optimal capital structure. If you’re a finance student, investor, or aspiring professional, understanding this equilibrium-based view will give you a more realistic—and nuanced—perspective on how real-world firms decide between debt and equity.

Useful resources

US Courts Data – Bankruptcy

S&P Global – Bankruptcy Stats

Statista – Bankruptcy data

About the author

The article was written in July 2025 by Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025).

Optimal capital structure with taxes: Modigliani and Miller 1963

July 20, 2025 by Snehasish CHINARA

In this article, Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025) explores the optimal capital structure for firms, which refers to the balance between debt and equity financing. This post dives into the article written by Modigliani and Miller (1963) which explores the case of corporate tax and a frictionless market (no bankruptcy costs).

Introduction to Modigliani and Miller Propositions

In 1958, Franco Modigliani and Merton Miller introduced a groundbreaking theory on capital structure, famously known as the M&M Proposition. Their research concluded that, under certain ideal conditions, the way a company finances itself—whether through debt or equity—does not affect its overall value. This result, known as the Capital Structure Irrelevance Principle, was based on assumptions such as no corporate taxes, no bankruptcy costs, and perfect capital markets. The intuition behind this idea is simple: if investors can create their own leverage by borrowing personally at the same rate as firms, then a company’s financing mix should not matter for its value.

According to M&M Proposition I (1958), in a frictionless world:

where:

V_L is the value of a levered firm using debt.

V_U is the value of a unlevered firm not using debt but only equity

Key Assumptions:

No taxes (in reality, firms pay corporate taxes).

No bankruptcy costs (in reality, firms pay costs if they go bankrupt).

No financial distress (in reality, too much debt can make investors nervous).

However, this initial model had a major limitation: it ignored the effect of corporate taxes. In reality, most governments tax corporate profits, but they allow firms to deduct interest expenses on debt from taxable income. This means that using debt provides a tax advantage, which was missing from the 1958 model. Recognizing this, Modigliani and Miller revised their original work in 1963, introducing the impact of corporate taxes. Their new findings dramatically changed the conclusion: debt financing increases firm value because interest payments reduce taxable income, creating a tax shield. This update laid the foundation for modern corporate finance by showing that, with corporate taxes, firms should prefer debt over equity.

Modigliani-Miller 1963 Theorem (M&M 1963)

Modigliani and Miller’s 1963 revision to their capital structure theory introduced the concept of corporate taxes, which has a crucial impact on their earlier conclusions. They recognized that, in most economies, governments impose corporate income tax, but companies can deduct interest payments on debt from their taxable income. This interest tax-shield increases the after-tax profits of a firm and thereby raises its overall value.

The formula for the tax shield is:

Since interest expense is calculated as:

Therefore, the tax shield for a single year becomes:

The Modigliani-Miller (1963) model assumes perpetual debt primarily for simplification and mathematical clarity. The use of perpetual debt helps in calculating the present value of the tax shield without the need for complex discounting over a finite period.

If the firm has perpetual debt, meaning it never repays the principal and continues paying interest forever, the total value of the tax shield is found by calculating the present value of all future tax shield benefits. Since the tax shield is received every year indefinitely, its present value is:

Using the cost of debt (rd) as the discount rate, we get:

The (rd) cancels out, simplifying to:

This means that, under the M&M (1963) proposition, the value of a leveraged firm is given by:

where:

V_L is the value of a levered firm using debt.

V_U is the value of a unlevered firm not using debt but only equity

T_c is the Corporate tax rate

D is the amount of debt of the firm

Figure 1. Firm Value vs Debt according to M&M 1963 Theorem

In simple terms, taxes make debt financing more beneficial because firms pay interest on debt before paying taxes, reducing their taxable income. On the other hand, dividends paid to equity shareholders are not tax-deductible, meaning that firms must pay taxes on their entire profit before distributing dividends.

Implication for Capital Structure Decisions:

Firms benefit from using debt due to the tax shield, leading to a preference for more leverage.

The Modigliani-Miller (1963) model with taxes suggests that because of the tax shield on debt, a firm’s value increases as it takes on more debt. The formula for value of a levered firm according to M&M(1963) shows that every additional unit of debt directly increases firm value by the tax savings it provides. In theory, this means that a firm should finance itself entirely with debt (100% debt financing) to maximize its value. This is a significant departure from M&M (1958), where capital structure had no effect on firm value.

Limitations

However, in real-world scenarios, firms do not rely solely on debt. This is because excessive debt increases the risk of financial distress and bankruptcy costs, which M&M (1963) did not initially consider.

Case Study: Implications of M&M 1963 (Optimal Capital Structure with corporate taxes)

Alpha Corp operates in an imperfect capital market (with taxes only). It has two financing options for the capital structure:

Option 1: equity only (100% equity, 0% debt)

Option 2: debt and equity (60% equity, 40% debt)

Each option funds a $100 million investment that generates an annual operating income of $10 million. The risk-free interest rate is 5%, and the corporate tax rate is 30%.

Figure 2. Simplified Balance Sheet of Alpha Corp

Table 1. M&M 1963: an Example

Based on Table 1, the key takeaways are as follows:

1.Debt Creates a Tax Shield:

Under Option 2 (40% debt, 60% equity), Alpha Corp pays €2 million in interest expense, reducing taxable income from €10 million to €8 million.

This results in a lower corporate tax payment (€2.4 million instead of €3 million), leading to a €600,000 tax shield benefit.

2.Net Income is Lower with Debt, But Firm Value Increases:

Despite reducing tax liability, net income under Option 2 (€5.6 million) is lower than Option 1 (€7 million) because of interest expenses.

However, the firm’s total value increases due to the tax shield, meaning equity holders still benefit from debt financing.

How Modigliani-Miller (1963) Redefined the Cost of Equity and WACC from Modigliani-Miller (1958)

In Modigliani-Miller (1958), the firm’s capital structure—the mix of debt and equity—was considered irrelevant to its overall cost of capital (WACC) and, by extension, its firm value. This proposition, based on ideal market conditions (no taxes, no bankruptcy costs), argued that whether a firm is financed by debt or equity, the overall cost of capital remains unchanged. The cost of equity increases with leverage because equity holders demand higher returns to compensate for the additional financial risk, but this increase in cost of equity was offset by the lower cost of debt. Therefore, WACC stayed constant regardless of a firm’s capital structure.

However, when Modigliani and Miller (1963) introduced corporate taxes into their model, they demonstrated a significant change in the cost of capital (WACC) and cost of equity dynamics. With the tax deductibility of interest payments on debt, the cost of debt is effectively reduced, which leads to a reduction in WACC. This creates a clear benefit for firms that use more debt in their capital structure, making debt financing a value-enhancing tool. Let’s explore these key differences in detail.

Impact on the Cost of Equity (r_E)

MM (1958) – Cost of Equity Increases with Leverage

Under the Modigliani-Miller (1958) framework, the cost of equity (rE) increases as a firm takes on more debt because equity holders demand higher returns for taking on additional risk due to leverage. The relationship between cost of equity and leverage is described by the following formula:

where:

r_E is the cost of equity for a levered firm

r_U is the cost of equity for an unlevered firm

r_D is the cost of debt

D/E is the debt to equity ratio measuring leverage

This formula shows that as a firm increases its debt, its cost of equity increases to compensate for the increased financial risk borne by equity holders. However, since debt is cheaper than equity, the overall WACC remains unchanged.

MM (1963) – Tax Shield Reduces the Impact on Cost of Equity In MM (1963), the introduction of corporate taxes changes the scenario. Since interest expenses on debt are tax-deductible, the effective cost of debt (r_D) becomes lower. This reduces the overall risk for the firm and, therefore, the increase in the cost of equity (r_E) is less severe than in MM (1958). The new formula for cost of equity becomes:

where Tc is the corporate tax rate. The (1 – Tc) term reduces the increase in cost of equity (r_E), because the firm’s debt is now partially subsidized by the tax shield. This shows that while leverage still increases the cost of equity (r_E), the effect is less pronounced in the presence of tax deductibility of interest payments.

Impact on the Weighted Average Cost of Capital (WACC)

M&M (1958) – WACC Remains Constant Regardless of Leverage

In MM (1958), because the increase in the cost of equity (rE) offsets the benefit of cheaper cost of debt (rD), the WACC remains constant no matter the debt-to-equity ratio. The formula for WACC in this model is:

where:

V=D+E is the total firm value

r_E is the cost of equity for a levered firm

r_D is the cost of debt

D is the total debt

E is the total equity

According to MM (1958), since debt and equity are in perfect balance (i.e., the increase in the cost of equity (r_E) is offset by the lower cost of debt (r_D)), the WACC stays constant. The capital structure—how much debt or equity a firm uses—has no effect on the overall cost of capital or the firm’s value in a world without taxes.

MM (1963) – WACC Declines as Debt Increases

With the introduction of taxes, MM (1963) shows that WACC decreases as a firm increases its debt. The tax shield created by the deductibility of interest payments lowers the effective cost of debt (rD), making debt financing more attractive.

The formula for after-tax WACC in MM (1963) is:

In this scenario, debt financing becomes more advantageous because the firm can lower its overall WACC by utilizing debt, which reduces the tax burden. The WACC decreases as a firm increases its leverage (debt) because the cost of debt (r_D) is reduced due to the tax shield, and the cost of equity (r_E) increases at a slower rate due to the reduced impact of debt on financial risk.

Figure 3. Modigliani-Miller View Of Gearing And WACC: With Taxation (MM 1963)

Case Study: Implications of M&M 1963 (Optimal Capital Structure with corporate taxes)

Alpha Corp operates in a capital market (no bankruptcy costs, and no market imperfections). It has two financing options:

Option 1: Fully equity-financed (No debt with Corporate Taxes of 30%)

Option 2: 40% Debt, 60% Equity (without Corporate Taxes)

Option 3: 40% Debt, 60% Equity (with Corporate Taxes of 30% )

Each option funds a $100 million investment that generates an annual operating income of $10 million. The risk-free interest rate is 5%, and the required return on equity is 10%.

Figure 4. Modigliani-Miller View Of Gearing And WACC: With Taxation (MM 1963)

Table 2. M&M 1963: an Example

Key takeaways from this example are as follows :

1. Corporate Taxes Make Debt Financing More Attractive by Reducing the Effective Cost of Debt

In a no-tax world (M&M 1958, Option 2), firms are indifferent between debt and equity, as capital structure does not affect WACC.

However, M&M (1963) proves that in a taxed environment (Option 3), debt financing creates value because interest payments reduce taxable income, leading to lower corporate taxes.

This is called the “tax shield” effect, where firms pay less in taxes by using debt, increasing after-tax cash flows available to shareholders.

2. WACC Declines with Leverage When Corporate Taxes Exist, Unlike in M&M (1958)

In M&M (1958) (no taxes, Option 2), WACC remains constant at 10%, regardless of leverage.

M&M (1963) (Option 3) introduces taxes, causing WACC to drop to 8.80% due to the tax shield.

Strategic Takeaway: Firms can reduce their cost of capital and increase firm value by incorporating moderate levels of debt into their capital structure.

3. Cost of Equity Increases with Debt, But the Tax Shield Reduces the Rate of Increase

Higher leverage increases financial risk for shareholders, leading to a higher required return on equity (r_E).

In Option 2 (M&M 1958, No Taxes), introducing 40% debt raises the cost of equity to 13.33% due to added risk.

In Option 3 (M&M 1963, With Taxes), the cost of equity only increases to 12.33%, because the tax shield offsets part of the financial risk.

4. After-Tax Cost of Debt is Lower than the Cost of Equity, Making Debt a Cheaper Financing Option

The cost of debt before taxes is 5%.

Due to the corporate tax rate (30%), the effective cost of debt is reduced: r_D^after-tax= r_D ×(1−T_c)

Comparing Financing Costs in Option 3:
- Cost of Equity (r_E) = 12.33%
- After-Tax Cost of Debt (r_D) = 3.5%
Debt financing is significantly cheaper than equity financing after adjusting for the tax shield.

Firms should utilize debt strategically to lower overall financing costs.

5. The Trade-Off Between Tax Benefits and Financial Distress Risk Determines the Optimal Capital Structure

M&M (1963) suggests using more debt to reduce WACC, but in reality, excessive debt increases financial distress risks.

While debt reduces WACC through the tax shield, too much debt leads to higher bankruptcy risks, credit downgrades, and operational constraints.

Most firms balance debt and equity to optimize WACC, using debt to take advantage of tax savings without excessive financial risk.

Takeaways on Optimal Debt Structure and Bankruptcy Costs from M&M 1963 Theorem

The Modigliani-Miller (1963) proposition demonstrated that the presence of corporate taxes fundamentally changes the implications of capital structure on firm value. Unlike their earlier 1958 proposition, where capital structure was deemed irrelevant, the 1963 revision highlighted the benefits of debt financing due to the tax shield effect. Since interest expenses on debt are tax-deductible, firms can reduce their taxable income and, consequently, their tax obligations. This finding suggests that, in a world with corporate taxes and no other frictions, firms should finance themselves entirely with debt to maximize their value.

The M&M (1963) proposition remains a cornerstone in understanding capital structure decisions, demonstrating that debt financing enhances firm value through tax savings. However, in practice, firms must carefully balance leverage to avoid excessive financial distress. The optimal capital structure is not purely debt-driven but rather a carefully calibrated mix of debt and equity that maximizes firm value while maintaining financial stability.

Why Should I Be Interested in This Post?

This post explains a key concept in corporate finance—how debt financing affects firm value through corporate tax benefits and financial risks. If you’re a student, finance professional, or investor, understanding the Modigliani-Miller (1963) proposition will help you grasp why companies use debt. With clear explanations, real-world examples, and Excel-based analysis, this post provides practical insights into optimal capital structure decisions.

Useful resources

US Courts Data – Bankruptcy

S&P Global – Bankruptcy Stats

Statista – Bankruptcy data

About the author

The article was written in January 2025 by Snehasish CHINARA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022-2025).

Understanding organizations’ role in bargaining tariffs

July 12, 2025 by Annie YEUNG

In this article, Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025) explains about understanding tariff bargaining that involves international organizations, governments, and industries..

The World Trade Organization (WTO)

The WTO was established in 1995 and is the most influential international organization in managing and negotiating for global trade. The WTO includes 164 member countries, and its main goal includes facilitating trade negations and monitor trade policies, especially tariffs. There has been statistics showing that average global tariffs has decreased since the establishment of WTO. For example, average bound tariffs for decreased by nearly 3 percent from 1995 to 2023.

The WTO is also plays an important role in bargaining tariffs. For example, the Doha Development Round, launched in 2001 under the WTO has focused on improving trading for developing nations. This negotiation, initiated by the WTO, has aimed to make global trade equitable. Its missions include reducing agricultural subsidies, lowering tariffs, which all have effect in order to help developing nations improve access to trading in the global market. There has been negotiations created amongst developed and undeveloped countries, with these negotiations focusing on farm subsidies and market access, as well as lowering industrial tariffs to allow developed nations to better participate in global trading activities . however it is important to note that despite ongoing talks, this round of negotiation has not been successful in delivering an agreement. This failure could have been attributed to the challenges in different trading activity interests amongst different countries. For example, there has been different perspectives in trading such as agricultural subsidies, and tariffs on services, resulting in unresolved conflicts despite negotiation.

WTO negotiations reflect deeper global power imbalances, which are manifested in trading activities and tariffs imposed. The more influential and wealthier nations often hold more bargaining power and power in the global trading market landscapes. For example, these influential countries, particularly those in the G20, often set agenda in the trade negotiations and possess more negotiating capacity. As a result these countries often dominate in negotiations, setting a dynamic that advocate for their trade interests during the process of bargaining of tariffs.

The African Group, the Association of Southeast Asian Nations (ASEAM) are organizations that have become more active, which these countries have formed organizations in order to bargain for equity in the global trading landscape. These organizations that are forming alliances in order to bargain for equitable trading systems that are recognizing asymmetries between economies to push for stabilization for less developed countries. While developed nations are pushing for lower tariffs across all sectors. However, the countries with large economies often contend that decreased tariffs will destabilize economies. As a result, the WTO plays a crucial role to address this imbalance. For example, the “Special Differential Treatment” proposed by the WTO framework promotes more support for developing countries in implementing trade agreements and reducing tariffs. This could reduce unfair trade advantages and reconcile global trade liberalization amongst developed and undeveloped countries..

Trade Negotiation Teams – Representatives

Trade negotiations are often led by high-ranking officials representing their nations. For example, the U.S. Trade Representative (USTR) is a team of experts that are specializing in multiple fields in industries, including agriculture, technology, labor, environment etc. For example, the negotiation team participating in the 2024 Trade Policy Agenda which the USTR emphasized on commitments for their countries interests, negotiating for high-standard commitments in sustainable trade practice to bolster supply chain resilience. The USTR also participates in the World Trade Organization to unify positions with other organizations such as the African Group and the ASEAN to implement trade agreements with other developing countries.

For example, the United States imposes an average agricultural tariff of 5.1%. India has an average agriculture tariff of 38% to protect domestic producers. The European Union imposes 11% in agricultural tariffs. These disparities often lead complex negotiations, especially with agriculture which is crucial for food security .Hence, negotiation objectives often focus on reciprocity. This means to maximize benefits, which trading partners much seek for equivalent concessions, and negotiate on agreements to match others. For example, if one agrees to lower tariffs, the trading partner shall agree to provide benefits on a similar traded product. This ensures mutual benefit in policy making and reaching political goals. However, reciprocity could sometimes be challenging when two countries are under asymmetrical power dynamics, such as negotiating between developed and developing countries, Furthermore, during negotiation, while trade liberation is a long-term mission in tariff negotiations, each country approaches tariff negotiation seeking to protect strategic sectors, preserve jobs, and ensuring their own country’s interests. In negotiating for tariff cuts, some countries may insist on tariffs in protection for their own domestic producers, or in goal to safeguard their own strategic sectors.

Examples of governments’ Tariffs – a case study

Trump – the U.S. – China Trade War during 2018 to 2020

The U.S. China trade war during the 2018-2020 led to higher prices for American consumers. China responded with retaliatory tariffs on U.S. goods, and global trade dynamics were disrupted. The trade wars between U.S. and China also casted an effect on the economies globally, as the two countries have such large economies.

As a result from the trade war, both the U.S. and China have experienced profound effects in multiple perspectives of their economies. The U.S> economy were affected in their GDP and employment. According to a report from Bloomberg Economics, the trade war in 2019 has costed the US economy at $316 billion. The trade wars has also resulted U.S. in stock market losses, with research from the federal reserve Bank of New York finding U.S. firms losing at least $1.7 trillion in market value as a result from the tariffs imposed on imports from China. China has also experienced economic challenges as a result from the trade wars, with export decline and experiencing economic pressures. China has experienced an export growth slow-down, indicating deepened economic challenges.

Furthermore, the trade wars has casted a great effect to the global economic markets. With the two countries being two of the world’s largest economies, their trade tensions has led to significant shifts in market dynamics and economic growth on a global scale. According to data from Banque de France, 10 percent increase in tariffs could reduce global GDP by 3%. This decline as a result from the trade wars and increased tariffs is a result of increased prices that leads to decreased productivity, higher financing costs and reduced investment demand. According to data from The World Economic Forum, it is documented that the trade war has resulted a decrease of global GDP growth to 2.8% in 2019.

Useful resources

A Quick Review of 250 Years of Economic Theory About Tariffs

Tariff Negotiations and Renegotiations under the GATT and the WTO — Procedures and Practices

A quantitative analysis of multi-party tariff negotiations

About the author

This article was written in June 2025 by Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025).

Understanding the Evolution of Tariffs

July 12, 2025 by Annie YEUNG

In this article, Annie YEUNG discusses the historical development of tariffs and the evolution of tariffs over economic landscapes overtime.

Brief explanation of history of global tariffs

In the 19th century, tariffs were the main source of government revenue in aim for protectionism. Tariffs were widely used to protect domestic industries that were in their beginning stages. Many countries such as the United States and Europe has imposed high tariffs in order to ensure the development of their industrializing economies. For example, the U.S. implemented tariffs, such as the Tariff of Abominations in 1828 to protect its manufacturing industry. During the post World War II era, the General Agreement on Tariffs and Trade was established in 1947. In response to the post war devastation, countries lowered their tariffs in order to promote economic growth. Reciprocal lower tariffs were also implemented amongst countries and trading partners. Starting in near the beginning of the 21st center, the launch of the World Trade Organization in 1995 marked a significant evolution in global trade, where governance of trade tariffs were established through the launch of the WTO. The WTO emphasized on the trading of goods and introduced a governance structure for development considerations, granting special support for developing and less developed countries. The WTO also introduced an institutional structure for the dispute settlement procedures on global trading. Today, tariff reductions have continued due to negotiations and regional trade agreements, which deepened the harmonization of the global markets, facilitating increased global trade volumes. However, during the last decade, there has been an introduction of resurgence of tariffs amongst increased instability in the current geopolitical grounds. Tariffs has served as a political tool. For example, the U.S.- China trade war has seen tariffs as an economic tool under rising geopolitical tensions where billions of dollars of goods subject to tariffs. As two of biggest economies globally, this trade war has disrupted global supply chains. This has posed challenges as other countries have also employed tariffs for protectionism goals.

The Protectionism Approach

The United States has been maintaining high tariffs to nurture for its developing domestic industries during the 19th centuries. The United States has seen an increase in the average tariff rate over a century of time. During the beginning of the 19th century, the U.S.Average Tariff Rate was 35%, whereas by 1913, the U.S. Average Tariff Rate has increased to 40%. This historical evolution could be attributed to the need for domestic protection; early industrialization period during the early 19th century required protection, whereas in the beginning of the 20th century, tariffs needed to support the growing industry. European countries such as Germany and France also utilized tariffs to protect industrial growth during this period of time. However, developing countries struggled developing tariffs as threir internal markets were still in developing stages. However, beginning from the early 1900s, there has been a further rise in nationalism. Some tariffs rates exceeded 60%, and as a result, global trade decreased by 66% between 1929 to 1934. This was also during the period of the Great Depression, in which these tariff hikes and set-back in economy was a result of reduced international trade.

Trade Liberalization

After the establishment of the General Agreement on Tariffs and Trade in 1947 to reduce tariffs, there have been successful negotiation amongst nations to cut average tariffs worldwide in order to reduce protectionism and open up markets to global trading activity. This is seen from the data presented from the World Bank World Development Indicators, which there has been a gradual deduction in average global tariff rate from 15% to 6% from from the year 1950 to 2000. Since the beginning of tariff reductions and the start of post-war rehabilitation and rebuilding of the economy in 1950, continued multilateral negotiations has resulted in a historic low of tariffs in the year 2000. As a result, trade volumes increased and there was a global economic growth.

Complex Socio-economical landscapes

Despite the decreasing of average global tariff rate, trade policies in the 21st century, especially in the recent years, has grown to become more complex. For example, there has been targeted tariffs and trade conflicts, leading. To increased uncertainty in global trading markets. For example, U.S. has increased its tariffs from the year 2017 to 2020, with the average U.S. Tariff Rate of 1.6% in 2017 plummeting to 3.1% in the year 2020. This could have been attributed to the increased policies on tariffs on steel, aluminum, and the trade wars with China, resulting to much higher tariff rates compared to the beginning of the 2000s. For example, targeted tariffs has become a strategic target tariff, a tool with political goals. For example, the steel and aluminum tariff was to protective domestic industries, which the Trump administrated imposed a 25% tariff on steel and 10% on aluminum in March 2018. These tariffs were to uphold national security to maintain the U.S. domestic metals industry. However, this tariff led to price increases and resulted in retaliation of tariff policies from its trading partners.

< p> Increased tariffs from one country often results in retaliatory tariffs from its trading partners. Not just China, but there were also other countries that have responded to U.S.’s tariff hikes, including Canada, the European Union, and India. As a result, the increase in tariff has resulted in increased uncertainty to the global trade environment, affecting stock markets, companies, local businesses etc. Hence, the tariff can cast direct effects to each producer and consumer domestically, as investors raise concern over costs, and supply chains are rendered volatile, slowing businesses.

A Case Study: The European Union’s tariff on Chinese Electric Vehicles

In the year 2024, the European Union imposed tariffs of 38.1% on Chinese imported electrical vehicles. This is an example of the shifting grounds of global trading market environments. Today, tariffs have increased globally, and this tariff is an example that has marked a shift in the European Union trade policy and has great implications for the global automotive industry as well as the international trading landscapes. For example, the EU has imposed different tariffs targeting on specific different companies. The SAIC Motor has an 38.1% tariff, whereas Geely experiences a 20% tariff, while BYD has a 17.4% tariff for all goods imported into the European Union from China. These tariffs were imposed by the EU due to the low prices that Chinese manufacturers deliver to the European market, which may potentially undermine local producers through competition. In response to the tariff, China has filed a complaint with the World Trade Organization to contend for EU’s actions, appealing that the EU may have constituted to protectionism under fair competition. The tariff casts a large impact on the European EV market, which European consumers are facing higher prices. Market share also shifts, as the tariffs has changed the competitive landscape; Chinese manufactured EVs are facing higher costs, which may benefit domestic European manufacturers. Hence, the EU’s recent tariffs on Chinese manufactured electric vehicles marks today’s international trade policies amongst the historical evolution of global trade and tariffs, and has sparked debate and challenges.

Evolution of tariffs

Source: ACEA.

Why should I be interested in this post?

Evolution of tariffs is crucial as it reveals how economic policies shape international trade dynamics, and this affects to domestic industries, producers, consumers, and also has a wider effect to the global market. Studying the changes of tariffs throughout time can allow us to gain insights into historical trends, and stay informed upon future policy decisions.

Useful resources

A history of free trade — and the deep irony of ‘liberation day’

The Evolution of Tariffs

History of U.S. tariffs and why it matters today

The Problem of the Tariff in American Economic History, 1787–1934

Financial Times Transcript: Tariffs past, present and future. With Doug Irwin

About the author

The article was written in June 2025 by Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025).

Understanding the Economics of Tariffs

July 12, 2025 by Annie YEUNG

In this article, Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025) explains about understanding how tariffs are crucial for consumers, suppliers, and policymakers.

Introduction: What are tariffs?

Tariffs is a tax that is placed on imported and exported goods, essentially, a duty on goods when they cross international borders. Tariffs are taxes that is imposed by a government, and they are often utilized by governments to protect domestic industries, raise government revenue, and influent foreign policy. Tariffs are always impacting global economies on a large scale, as the effect they bring are always to large bodies of consumers and suppliers internationally, especially if the tariffs are imposed by a country with large export or import volumes. Trade tariffs make a direct effect by making imported goods more expensive, and they can often shift increased consumptions towards domestically produced goods. Tariffs take effect by rendering international imported goods more expensive, which consumers would, due to effect of demand, increase their quantity demanded towards domestic goods. Hence, tariffs take effect in protecting domestically produced goods, and may achieve political goals. However, as prices are increased, consumers often need to pay a higher price, which this may lead to inefficiencies and deadweight loss; this may lead to trade disputes.

Evolution of tariffs

Source: Average of World Tariffs, Adapted from Mitchell (1992) and Coatsworth and Williamson (2002).

Different types of tariffs

Ad Valorem Tariffs

An Ad Valorem Tariff is a tariff that is added onto the price of the imported good as a percentage. For example, an ad valorem tariff may be a 10 percent tax that is added onto the price of each good imported. Hence, an ad valorem tariff means that the more expensive a good is, the more tariff is added on. This may mean that higher valued imported goods are rendered much more expensive and takes greater effect as a result from the tariff.

Specific tariffs

Specific tariffs are tariffs that charges a fixed fee on the quantity or physical unit of the imported good. Hence, special tariffs are imposed on goods that are regardless of their price, and it would be a fixed fee that is imposed per physical unit of the imported good. For example, a specific tariff could be a $1 imposed on per kilogram of wheat that is imported wheat into the country. The economic impact are easier to administer and do not adjust with the market price of the good.

Compound tariffs

A compound tariff is a combination of both ad valorem and specific tariffs. Compound tariffs may include both an ad valorem tariff and a specific tariff combined to be imposed on an imported good.

Sliding Scale tariffs

Sliding scale tariffs are a variable tariff rate that are adjusted based on global commodity prices, domestic supply levels, inflation volatility etc. The tariff is dependent on when world prices of the good increases or rises. When world prices decrease, the sliding scale tariff increases, and when world prices increase, the tariff decreases. Hence, this tariff takes an economic effect by helping to maintain a minimum domestic price of a good, and helping to balance price stabilization. Hence, sliding scale tariffs may help stabilize domestic goods’ prices, and smooths the supply and demand for domestic goods, protecting domestic producers and reducing market volatility in face of global economic changes.

Protective tariffs

Protective tariffs take effect by protecting domestic industries from foreign competition. The goal of imposing a protective tariff is to encourage consumers to purchase more from domestic by raising the price of internationally imported goods. As a result, when demand for domestic goods increase as a result from protective tariffs, more domestic jobs can be created, and growth of local industries are secured, which exemplifies the protection for these domestic sectors.

Revenue tariffs

Revenue tariffs are tariffs to raise government revenue instead of protecting domestic producers. The purpose of imposing revenue tariffs is to generate an income for the government, especially when the country’s economic system heavily depends on imported goods and has a high volume of imported goods. However, revenue tariffs may be a great burden for domestic consumers as they bear the higher prices of goods, and may affect trade flows and consumption choices within the population, as consumers are the major price payers under a revenue tariff.

Economic Effects of Tariffs

Tariffs can create multidimensional impacts on the global economy both in short term and long term, and consumers, producers, governments, as well as international relations may all be affected. Hence, tariffs are a very important factor in influencing the international landscape and may cast a great effect on global economic markets.

The effect of tariffs on consumers

Tariffs firstly directly impacts consumers. When a government imposes tariffs, suppliers importing a good internationally will need to pay an extra cost to the government. As a result, this will raise prices of goods, reducing the purchasing power of consumers. Furthermore, as pries increase for imported goods, consumers may find more limited choices in the market, and this may lead to consumer dissatisfaction.

The effect of tariffs on domestic producers

Tariffs are generally casting a more beneficial effect for domestic producers as they often result in increased output and employment to domestic industries. With more demand turned to domestic producers, they may result in higher sales and revenue outputs, boosting the economic return for domestic producers. While tariffs may provide protection to domestic industries as they gain a price advantage over foreign producers, there may be reduced competition. Furthermore, domestic producers may also be harmed through tariffs if they rely on foreign inputs. For example, when domestic producers rely on imported raw materials, their input cost increases, and this may result in less profit earned.

The effect on governments and the international landscapes

Trade tariffs may generate positive impacts to governments, as trade tariffs may act as a channel for revenue generation. Governments also utilize trade tariffs for political goals, and may cast a strategic effect on trade negotiations and affect the economic diplomacy. Simultaneously, trade tariffs may manipulate trade flows, and cause dissatisfaction, as rising consumer prices may lead to domestic unrest and trade wars. When one country imposes a tariff, this may often provoke retaliation from other countries, leading to a spiral of protective tariffs, that rises global prices and slows global economies. Hence, tariffs can lead to trade wars and lead to geopolitical instability.

Why should I be interested in this post?

This post discusses how trade policies may affect all actors in the economy. Understanding tariffs help you understand global events, and this can influence your everyday life as well.

Useful resources

CEPR Trump’s China tariffs: Lessons from first principles of classic trade policy welfare analysis

Knowledge.deck Trade and Tariff Impact Analysis

Wall Street Journal Tariffs Are More Than Just Taxes. They Are a Tool of Geopolitics.

About the author

The article was written in July 2025 by Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025).

My internship experience at Partner plus Investments Limited

July 12, 2025 by Annie YEUNG

In this article, Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025) shares her summer internship experience at Partner Plus Investments Limited as the Junior Analyst.

About the company

Partner Plus Investments Limited is an asset management company particularly focusing on fund of funds company. Partner plus investments limited operates by intersecting finance and technology and leverages sophisticated financial data analysis and modeling. The company is high-tech, and the team retrieves and develops insights from big data in order to make analytical insights and help our clients make informed investment decision. The company also aims to create and share reports to make investment decisions and specializes in sophisticated financial big data for extract valuable information. Partner Plus Investments limited meticulously curate portfolios and is driven by the exceptional commitment to deliver investment outcomes and value to the company’s clients. With an expertise and financial analysis and strong understanding of market dynamics, the company utilizes cutting edge, tools and technology to extract insights from vast amounts of financial data, which enables the company to make investment decisions and suggestions for clients with confidence and precision by staying on top of market trend and continuously monitoring the funds performance, Partner plus investments, limited strives to adapt their strategies, proactively to capture opportunities and make the best outcomes for clients in face of market dynamics. Therefore, partner plus investments limited focuses on transparency, integrity approaches, and builds long-term relationships with their clients based on trust and efficient communication, whilst always putting their clients first. Therefore, partner plus investment Limited serves its clients as being a trusted partner in achieving its clients’ financial goals.

Partnerplus Investments logo.

Source: Partnerplus Investments.

My internship

As the summer intern, I took on the role of being the junior analyst, contributing to the team with asset management and portfolio monitoring through daily analysis of financial data. At partner plus investments, I went beyond traditional data analysis through the creation of interactive reports that help empower and engage clients to understand macroeconomic environments and how it is related to our own investment decisions.

During the internship, one of my main tasks included conducting macroeconomic research. One of my important tasks included updating macroeconomic indicators on our data base. Based on the conducted research, we compiled and analyzed the data to create reports that not only showcase our findings but also provide a comprehensive summary and overview of our teams’s collaborative decision making and making sure that our investment strategies are reasoned and aligned with our client’s financial goals.

My missions

Hence, during the internship, I was able to combine technological knowledge with financial expertise and contribute to our team. I learned to use softwares and navigate through sophisticated financial data bases, including Bloomberg terminal, to compile data in order to drive insights and conduct interactive reporting. For example, we used graphic model for visualization of the fund performance for our clients.

Required skills and knowledge

In partner plus investments I learned about the skills and knowledge to retrieve vast amounts of financial data in order to analyze them and transform them into our known own knowledge that allow us to make well informed investment choices.

The first skill I learned was portfolio management skills which I understood about how we strategically allocate assets in order to optimize returns and effectively manage risks in our asset allocation. I also learned about performance analysis as I kept track of our companies investment and evaluated the performance of our portfolios by performing benchmark analysis to assess our investment outcomes. I also gained knowledge about fund of funds. During our fun selection I understood how we identified and selected funds in order to construct our diversified portfolios. I also learned about fund monitoring by making informed decisions, and keeping ourselves informed under changing market conditions, and trying to identify market patterns and apply them into our investment strategies. another skill that I learned was client reporting. as part of our daily job, it was important for us to communicate clearly to our clients. For example, we developed and wrote clear client reports in order to communicate effectively our investment strategies and performances to our clients. I learned about presenting complex financial information and to clear and concise formats for our clients. This included visualization of our data through software such as Excel and simplifying our data in order to make it clear to our clients.

What I learned

Another skill that I learned was how to perform financial modeling and utilize problem solving skills to solve and project financial situations. Financial modeling comes in large variety, and one may create models in order to address situations for different financial issues. I understood the importance of employing an analytical mindset.

I learned about problem solving and financial modeling during my internship at partner plus investments for example in one of my financial modeling tasks I learned to identify and manipulate different variables in order to address different investment outcomes as a result of our investment choices this was crucial in understanding and applying investment strategies in order to optimize our portfolio performance. I also learned about understanding the significance of periodic investments. during one of my tasks, I utilized periodic investments as a dependent variable and I saw how they impact overall portfolio growth and how they also allowed us to mitigate risks. I also gained technical proficiency as I was able to hone my skills in using excel and I applied my prior knowledge that I gained in previous academic settings to professional settings. I also honed my analytical thinking, as I was able to understand relationship more skillfully between target returns and investment timelines; I was able to apply this in analyzing for our fun performance metrics. I also learned about outcome evaluation; in our client reporting stages, I learned about analyzing data and scrutinizing the credibility of source of information before we included it in our reports.

Financial concepts related to my internship

I present below three financial concepts related to my internship: efficient market hypothesis, client Relationship management, and Sharpe ratio.

Efficient market hypothesis

The first important financial concept that I learned from my internship was the efficient market hypothesis. This hypothesis explains that share price reflects all available information. Hence, in an efficient market, it would be impossible for invewstors to purchase undervalued stocks or sell stocks for inflated prices; it would be Impossible to outperform market through expert stock selections. Indeed, there are studies that find only 23% active managers were able to outperform their passive peers. With a stock market with such large amount of actors, some investors would outperform the market, and some investors would underperform the market. However, it is important to note that in our current world’s markets, it may be hard to have a completely efficient market. This means that due to other outside factors, some investors may have more information than others, which this leads to an inefficient market. Hence, in inefficient markets, asset prices don’t accurately reflect true value due to info asymmetries, lack of buyers and sellers, and high transaction costs.

Client Relationship management

Another important financial concept that was important to my internship was Client Relationship management. As I refine my skills in evaluating for our investment outcomes through client reporting, I understood the importance of client relationship management. this involved managing our interactions with clients and potential clients which was essential for our company by effectively building relationships we were able to tailor our investment strategies to meet our clients’ needs and help our clients better reach their financial goals. during our client relationship management, it was also important that we we’re able to generate accurate performance assessments in order to report our performance to our clients and provide frequent performance updates and investment recommendations effectively. hence only through ensuring reliable credible and transparent reporting could we provide our clients with detailed insights about our portfolios and enhance our partnership with them.

Sharpe ratio

The third financial concept that was incredibly important to my internship was the Sharpe ratio. The Sharpe ratio is a measure of risk-adjusted return, and it defines as the excess return of an investment compared to the risk free rate per unit of risk. during the internship by calculating and interpreting sharpie ratios we were able to better assess the performance of our investment portfolios, and this could effectively allow us to evaluate the returns generated by our portfolio. a higher ratio indicates better risk-adjusted returns; hence we could use the Sharpe ratio to compare the risk-adjusted performance and better understand how much risk we are taking to achieve a certain level of return.

Why should I be interested in this post?

This post should interest you if you are also looking for gaining valuable professional experience in a fund related company, as it introduces and discusses what it is like to work in one! You will be able to learn many hands-on knowledge about portfolio management and conducting financial research.

About the author

The article was written in July 2025 by Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025).

My internship experience at FTI Consulting

July 12, 2025 by Annie YEUNG

In this article, Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025) shares her experience as an Intern at FTI Consulting.

About the firm

FTI consulting Is a business consultancy firm and global management advisory company. It is one of the leading global expert firms to help organizations that are facing crisis or transformation. fti consulting is a global company with a great presence in 33 countries and it has become a market leading global consulting firm that has experts to serve and help their clients as the trusted advisor for their clients to cope with challenges and leverage opportunitIes. FTI Consulting Has been recognized globally for their comprehensive services to assist their clients businesses and make a global impact under dynamic business cycles and unexpected crises. Therefore fti consulting is a prominent firm in the financial consultancy and services landscape and the company is largely recognized for its expertise and professionalism offering its clients financial services that are tailored to meet to meet their diverse nfti consulting . Fti consulting advises on risk management as well as it assists organizations on navigating through complex financial challenges and restructuring processes.

FTI Consulting Logo.

Source: FTI Consulting.

FTI consulting operates across various departments and each are specializing in distinct areas of professionalism and expertise to help solve diverse and comprehensive solutions for their clients.

Corporate finance and restructuring focuses on providing financial advisory services to companies who are undergoing financial distress, restructuring processes. Services may include success, debt restructuring, turnaround strategies, financial analysis, which FTI consulting may help optimize their clients’ financial performance.
Forensic and litigation consulting includes investigating and litigation support services which FTI consulting assist their clients in addressing legal challenges, regulate increase, and fraud investigations. FTI consulting acts as the expert to provide analysis and support legal proceedings for their clients.
Economic consulting, help their clients to conduct economic analysis, and provides analysis and insights into complex economic issues. FTI, consulting, economic, and financial consulting, helps their clients to understand more about economic and financial regulatory opportunities, and challenges in order to better support their companies, legal and business decisions.
Technology helps clients to manage and leverage technology and enhance their IT infrastructure as well as security protocols and their businesses.
Strategic communication helps clients to navigate through crisis and manage their reputation through effective communication with stakeholders. Strategic communication helps clients to reduce risk, and specializes in multiple areas, including corporate reputation, crisis communications, financial communications, public and government affairs, transaction communications, communications and insights.
Risk and compliance focuses on helping organizations navigate through regulatory requirements as well as compliance procedures.
Transaction advisory services provides support and advisory services to clients and mergers and acquisitions and other strategic transactions. FTI consulting provides valuation financial advisory services to support their clients in making their informed business decisions.
Health solutions specializes in providing healthcare organizations and management support and helps them address challenges and seize opportunities

My internship

During my internship at FTI consulting as the corporate finance and restructuring summer intern, I was able to gain valuable experience in immersing in a dynamic environment that provided me with invaluable, hands-on experience in financial analysis as well as restructuring procedures. One of the many important rules, I undertook during my internship included conducting detailed company research and delving into various legal papers. I conducted detail company re-and also organized for the adjudication of debts. in conducting from our financial analysis I enjoyed researching through numerous financial data from our clients, reviewing searching, checking sorting and grouping for these data. By organizing transaction data, I was able to learn more about a company and also practice my attention to detail.

Required skills and knowledge

Through my involvement in various tasks during my internship, I understood more about the important skills and knowledge required during my work. For example, I realized it was important important to develop a keen eye for detail and hold a meticulous approach when scrutinizing financial data. The ability to gather interpret understand and organized complex financial data was important. I also realize the importance of effective communication in the field of corporate finance and restructuring while working in FTI consulting. For example, whether if it is engaging in internal discussions with my team or communicating with clients, I realize the importance of delivering clear and concise communication in order to better convey our financial analysis and concepts. It was also crucial in building relationship with our clients as well as facilitating teamwork within our department in order to ensure the process was smooth. Furthermore, for more technical skills I learned how important it was to understand how companies manage their finances to optimize value. my exposure to transaction analysis and financial analysis as well as understanding the transparency and financial reporting processes allowed me to understand How to during restructuring assessments. It is important to evaluate a companies financial health and implement strategic planning to improve its overall financial position.

What I learned

The internship experience was extremely rewarding to me. I learned how restructuring process works, restructuring involves assessing a company’s financial situation and making changes to its structure or capital structure in order to improve on the companies financial health. Incorporate financial and restructuring I learned about the transactional, valuation and advising procedures of FTI consulting. Through taking the role on advising for our clients, I learned how to advise companies in managing their finances in order to maximize their company value and minimize their risks. Furthermore, the internship experience not only gave me exposure to financial procedures scrutiny, but also honed my skills of being attentive to detail, ability gather and interpret complex information, which is a vital skill in financial analysis. I was able to hone my analytical skills, make informative decisions based on multifaceted data.

Financial concepts related to my internship

I present below three financial concepts related to my internship: debt restructuring, financial analysis, and valuation techniques.

Debt restructuring

The first financial concept I gained insight into during my intern internship was debt restructuring. Debt restructuring means modifying the terms of existing debt agreements to alleviate companies financial or improve its financial position. Debt restructuring processes may include various steps such as refinancing debt, extending maturity dates, negotiating interest rates etc. I learned about how companies may effectively manage their debt obligations in order to optimize their financial structure, and ensure their financial position’s health.

Financial analysis

The second financial concept I learned during my intern intern internship was financial analysis. By looking at bank statements and financial reports, I realize how critical financial analysis is to corporate finance and restructuring. I developed a deep understanding of this concept and skills in evaluating financial statements, understanding the meaning behind each number on the financial report as well as understood more about performance metrics in order to assess the companies financial health and performance. By reviewing detailed ledgers and analyzing and identifying significant transactions, I was better able to interpret complex financial data as part of the process in helping our client make better informed business decisions.

Valuation techniques

The third financial concept I learned was valuation techniques, as it is utilized to determine a companies asset or investment value. Not only did I learn more about cash flows, market trends and cash flow, I was also able to hone my skills in learning about valuation models in order to determine the fair value of assets, which was an important procedure in the restructuring process .

About the author

The article was written in June 2025 by Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025).

My Audit Summer Internship experience at KPMG

July 12, 2025 by Annie YEUNG

In this article, Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025) shares her experience as an Audit Summer Intern in KPMG, as well as the details of what working in audit may be like, and the necessary skills and goals if one wishes to develop a career in Auditing.

About the firm – KPMG

KPMG, as recognized as one of the big four auditing companies alongside Deloitte, PwC, and EY, is one of the world’s leading professional services firms. The company provides professional financial services, and has a wide range of different departments, including audit, tax, and advisory services, facing diverse clients, including large corporations, governments, and even non-profit organizations. KPMG has a strong global presence. First founded in 1987, KPMG came to what it is today as a leading company through the merger of Klynveld Main Goerdeler and Peat Marwick International, and KPMG has excelled in the field of accounting, building trust from its clients.

Logo of KPMG.

Source: KPMG.

KPMG’s audit practice is one of its core components in the firm and plays a critical role in delivering accountable financial reports, in order to support the transparency of global financial systems. In auditing, the team aims to deliver independent, high-quality financial statement audits that allow stakeholders to understand the company through information that is reliable. KPMG focuses on building a strong ethical foundation, and today it leverages advanced data analytics and data intelligence to build a stronger audit practice. For example, the KPMG Clara is a smart audit platform to provide greater insights into the financials of their clients, and is a great tool designed to support the auditing process. In KPMG auditing, teams also ensure that companies meet financial reporting standards, such as the IFRS and US GAAP, and auditors work closely with their clients to gain a thorough understanding of their financials, industry, risks, and operations, to approach the assurance with tailored auditing processes. Furthermore, KPMG has also been proactive in addressing sustainability. The firm focuses on Environmental, Social, and Governance (ESG) reporting to extend their non-financial reporting, ensuring that companies’ sustainability claims are verifiable.

Overall, KPMG is a major player in the global professional accounting services market, and strongly commits to innovation, ethical practices, in order to deliver value to their clients. In the audit sector, auditors in KPMG play a crucial role in safeguarding the transparency of financial reporting and safeguarding public trust.

My Internship Experience

During my internship, I had the opportunity to work as part of the audit team as an Audit Summer Intern. I engaged closely with our client, contributing to the financial reporting during that audit cycle. This experience provided me a comprehensive understanding of how theoretical knowledge that I have gained from my academic studies could be translated into the practical applications in the world of auditing, My internship experience was both very challenging and rewarding at the same time; as the intern, II gained hands-on experience in handling audit tasks and financial statement reviews.

One of my major responsibilities during my internship involved conducting company and market research for our client as part of the audit procedure. For example, when working with our client, I conducted auditing procedures such as comparing company sales prices to market benchmarks. I was able to hone my skill in attention to detail, as I researched industry standards with similar features to our clients to ensure that the values reported by our client were reasonable and consistent with market standards. Through this procedure, I gained the ability to assess the credibility of pricing through benchmarking techniques in auditing, and I gained a more thorough understanding of inconsistencies in valuation, which allowed my seniors to further review. Another key aspect of my work included journal entry testing, where I was tasked with reviewing and vouching the selected entries back to the original supporting documents provided by our clients. This supported the auditing procedure by identifying potential risks of misstatements or irregularities in the financial statements. I also worked on financial statement reviews for numerous subsidiaries of our clients, which included larger corporations. I prepared working papers and learned to maintain audit trails for every assertion tested. Through this analytical review and control testing, I gained a great exposure to the structure of the performance of an external audit.

What I learned during my internship

Apart from the technical skills that I have strengthened during my internship, such as my proficiency in Microsoft Excel and on-the-field communication and collaboration, I was also able to gain a much wider learning experience through my experience in practicing auditing. Auditing is a detailed and structured process that ensures a company’s financial statements are accurate, transparent, and in compliance with industry standards. Hence, it is important to build trust in financial information so stakeholders can take the information and make informed decisions.

For example, I developed a strong sense of professional skepticism and prudence, especially when working on auditing procedures that involved vouching and checking for reasonableness. By examining the details, I understood the importance of attention to detail, and I improved my ability to think critically, as it was an important skill required in auditing in order to protect stakeholders and support the transparency in financial reporting.

Important key takeaways from working in KPMG auditing

Compliance with accounting standards and regulations

One of the primary goal of auditing is to check whether clients’ financial statements are in compliance with accounting standards and regulations. For each financial item and the financial statements, whether if it’s revenue, inventory, or assets, it is important to understand how these items are treated by the company. Hence, during auditing procedures, it could help us better determine if the item is fairly and accurately represented in the financial reports.

Developing professional skepticism

During the auditing process, I also learned the importance of adopting the mindset for professional skepticism, which we learn to question, verify, and ensure the integrity of financial data. Only by adopting this mindset can auditors detect potential misstatements, errors, or even fraud.

Identifying different types of risks

One of the key aspect in auditing involves identifying different types of risks. Business risk is related to the risk that a company might not be able to achieve its objectives; legal risk is about the company’s potential risk in facing legal consequences due to not being able to comply with laws and regulations; financial risks involve the possibility of market volatility etc. Auditing is particularly playing an essential role in helping companies to minimize and avoid legal risks. Only through the auditing processes verifying financial information of a company can we help maintain the integrity and sustainability of the firm.

IFRS vs GAAP in auditing

There are two auditing frameworks that provide guidelines on how financial statements shall be prepared. The two accounting frameworks, IFRS (International Financial Reporting Standards and GAAP (Generally Accepted Accounting Principles) are the two frameworks that is most widely used and known in the world of accounting.

The International Financial Reporting Standards

The IFRS is an international accounting standard that is developed by the International Accounting Standards Board. The IFRS is used by over 140 countries, and it emphasizes on transparency, accountability, and efficiency. The IFRS provides a global framework and guides how public companies should prepare their financial statements to ensure it delivers efficient financial information about the company to investors.

The Generally Accepted Accounting Principles

The GAAP is a standardized accounting guideline that is mainly used in the U.S. for financial reporting. The GAAP is different with the IFRS on some parts. The IFRS may often require more judgement-based decisions from auditors, and often requires a higher level of professional scepticism and judgement. On the other hand, the GAAP has more rigid guidelines, and thus requires less judgement during the auditing process.

About the author

This article was written in July 2025 by Annie YEUNG (ESSEC Business School, Global Bachelor in Business Administration (GBBA) – Exchange Student, 2025).

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