Financial Management

Educational subject: E381054 - Management and Economics of the Enterprise

Management and Economics of the Enterprise Department
Mechanical Engineering Faculty, CTU in Prague

Assignment topic: Main Theories of Capital Structure

2020, Summer Term Gabriel Bruno Parreira

Introduction:

In businesses we know that there are basically 2 sources of external capital that a company can

have: Share capitals, which is basically individual investor giving some money to a company with the

expectation of some return in the future based on the increased value of a company, and loan capitals

which a company can get from a bank or credit provider which expects to receive the loaned valued

back with a fixed amount of interest on top of it. Now it is known that those 2 kinds of capital have a

different cost, with the loan capital being generally cheaper than share capital. Based on this fact

business throughout the years have asked the question of how to get the optimal financing structure

from these 2 sources such that the business value is maximized. Since Modigliani and Miller’s

“irrelevance theory of capital structure” (1958), which was based on the idea of a

perfect market in which the capital structure becomes irrelevant, 3 main theories

of capital structures based on real world markets have emerged: Trade-Off

theory, the Pecking Order theory, and lastly the Market Timing theory. The goal

of this text is to briefly explain my understanding of each of these theories and

its importance for business financing.

Capital structure theories:

For many years there was a vision that there is an optimal capital structure

that maximizes the value of a business, thus financial managers should be

concerned about finding the optimal balance between the share capital and loan

capital of their companies. However, in 1958 Modigliani and Miller published a

paper arguing that the capital structure was largely irrelevant for the business

value. Unlike the previous view the new model (called MM) proposed by them

was based on modern economics theory, but it also had the flaw of assuming that

the real world operated in a perfect market and it did not take into account,

taxes, cost of bankruptcy, etc. After taking into account taxes, the MM model

suggested that rather than being indifferent to capital structures, business

actually do have an optimal structure which would be 100% loan capital

financing. However, that is hardly what we see in the real-world market. Based on

that new review new theories were proposed to explain the capital structure that we actually observe in

the real world and why they differ so much from the MM model.

The first such theory which we will now discuss was the Trade-Off theory. After initial critics

of the MM model it was readily shown that there were a number of factors that ended up contributing

for the failure of the model when applied to the real world. The Trade-Off theory is especially

concerned with taking into account the effects that taxes have in the optimal

capital structure of companies. Since loans are tax deductible, that adds another

advantage to making use of loan capitals rather than share capital; the initial

review of the MM model taking that into account resulted in an optimal structure

which would be 100% made up of loan capital. Obviously, that is far from the

actual behavior of companies, so new refinements had to be made. One of the

main problems with the tax-corrected MM model was that it oversimplified the

real tax system, which then caused some of the distortions observed in it, further

review of the trade-off theory tried to explain the discrepancy by taking into

account the risk that loan capital brings with it, which many times is riskier than

share capital since the company is making “a promise” to pay back the loan with

the required interest. The resulting effect is that the cost of bankruptcy increases

linearly as the loan capital level increases, and eventually those costs outnumber

the tax benefits and the advantage of cheaper loan capital when compared to

share capital. Thus, an optimal point for capital structure would have less than

100% loan capital in it. This new version of the trade-off theory brough

substantial improvements but even it is still incomplete in the sense of explaining

businesses behavior. Further improvements were proposed in later studies to

take in consideration the fact that the best structures depend on the future plans
of the company and if the business is planning to invest or to finance its

operations. Such improvements have been called the dynamic trade-off theory,

as it takes into account that the optimal capital structure may change according

to the current situation of a company and what are its plans for the future. Still

unsatisfied with the results economists looked to propose a more accurate model

which brings us to the second theory discussed in this work.

The Pecking Order Theory in basic terms affirms that companies are in

general averse to seeking external finance and will first seek to finance

themselves with internal resources, then, if necessary, they will issue debt, and

at last they will issue shares to finance their activities. There are many reasons

why it is thought that companies prefer internal sources of financing over using

external sources such as debt and share issuance. I will briefly explain a couple of

those reasons here in the following paragraph.

One reason why manager in business give preference to their internal

savings is the fact that these managers might have information that investor

from the outside do not possess. This asymmetry of information would make

shares fall in price, which in turn reduces wealth of current shareholders which is

undesirable. Therefore, to avoid an undervaluation of shares a company will

always seek to first use their internal savings followed by issuance of debt rather

than issuing shares. Another reason pointed by some researches is that the

attitude of the current owners of a company is of retaining the ownership of said

company. By avoiding issuing shares when it is not necessary those owners

retain their control over the company and how to manage it. One of the reasons

why the asymmetric information reduces the value of a company when the

company issues shares is because since investors do not posses the internal

information that a company has they see the issuance of shares as a sign that a
company is not in great shape since if they were they would rather issue riskless

debt instead of selling more shares. In that case investors end up requiring

higher compensation to make up for the supposed higher risk of investing in a

company that issues “too many” shares.

The last theory we will discuss here is the Market Timing Theory. The

Market Timing theory argues that companies shift their capital structure

according to the current conditions of the stock market. In that way instead of

having a static optimal capital structure, companies are dynamically shifting their

structure according to how they perceive the performance of the market, and

basing their decisions in past performance in times when the market was similar

to its current form. One way in which companies do that is by buying or issuing

shares. If the company perceive that their share is overvalued, they will issue

more shares to make the price per share go down, on the other hand if their

shares is undervalued, the company will buy back their own shares to make the

prices per share go up.

The Market timing theory has the advantage of not necessarily assuming

that the market is inefficient and does not require that managers try to project

future returns from the market. The only assumption made is that managers can

time the market according to their previous experiences and current perception

of the market. Thus, the market timing theory has a strong advantage in that it

can explain not only differences in multiple companies but it can also account for

dynamic changes in companies’ capital structure over time.

Conclusion:

As we were able to see, since the MM model appeared in the fifties, a

number of capital structure theories have appeared to try to explain the actual
structures that we see in the real market instead of what the original proposal of

the MM model have suggested. While some of those theories are more general

than the others it is important to note that none of them were intended to be

universal explanations of company’s capital structures.

Although the pecking order theory and the tradeoff theory have some

weaknesses in certain circumstances, in a way we can see them as almost

complementary with each one explaining certain behaviors according to the

market conditions. The newest theory proposed out of the 3 discussed, the

Market Timing theory, is maybe the one that comes closer to be an almost

universal theory for capital structure behavior, since its assumptions easily allow

for changes in behavioral changes of companies based on the current state of the

market. It also has the advantage of making simple assumptions without having

to consider the structure of the market itself, but rather only the behavior of

managers with respect to the market.

Even with all their strengths all these theories are still incomplete and

even in concert they are not fully able to explain market phenomena. Thus, more

research has to be made in all 3 of them to improve them or maybe even to

come up with a totally new theory that could be more efficient in explaining

capital structure of companies.

References:

1. Atrill, P. (2017). Financial management for decision makers . Retrieved

from https://ebookcentral.proquest.com;

2. Luigi, P., & Sorin, V. (n.d.). A REVIEW OF THE CAPITAL STRUCTURE THEORIES.

3. Jahanzeb, Agha & Khan, Saif-ur-Rehman & Bajuri, Norkhairul & Karami, Meisam &
Ahmadimousaabad, Aiyoub. (2013). Trade-Off Theory, Pecking Order Theory and Market
Timing Theory: A Comprehensive Review of Capital Structure Theories. International Journal
of Management and Commerce Innovations (IJMCI). 1. 11-18.