A REVIEW OF THE CAPITAL STRUCTURE THEORIES

Since the publication of the Modigliani and Miller’s (1958) “irrelevance theory of capital
structure”, the theory of corporate capital structure has been a study of interest to finance
economists.

Following are the major theories of capital structure

1. The Modigliani-Miller Theorem

The theory of business finance in a modern sense starts with the Modigliani and Miller (1958)
capital structure irrelevance proposition. Before them, there was no generally accepted theory of
capital structure. Modigliani and Miller start by assuming that the firm has a particular set
of expected cash flows. When the firm chooses a certain proportion of debt and equity to finance
its assets, all that it does is to divide up the cash flows among investors. There is no effect of
debt and dividend on firms value.

Their well-known theory is based on several assumptions as followings:

 Perfect and frictionless markets

 No transaction costs
 No bankruptcy cost
 No taxation
 No agency cost
 Both firms and investors can borrow at the same interest rate.

2. Trade-Off Theory

Jensen and Mackling (1976) suggest that the firm's optimal capital structure will involve the
tradeoff among the effects of corporate and personal taxes, bankruptcy costs and agency costs,
etc. Trade-Off theory suggests that corporate should consider a reasonable debt ratio and tries to
achieve this goal in a long term. Through this way, a firm can benefit greatly by using of debt as
a cheap source of financing. Tax saving is one of the advantages that results from using of debt
and consequently, the cost of potential financial distress is considered as a disadvantage of using
debt, especially when the firm relies on too much debt. This theory suggests a trade-off between
the tax benefit and the disadvantage of higher risk of financial distress.

3. Pecking Order Theory of Financing Choice

Pecking order theory is the consequence of Asymmetric information (Myers, 1984). The pecking
order theory does not take an optimal capital structure as a starting point, but instead asserts
that firms prefer to use internal finance (as retained earnings or excess liquid assets) over
external finance. If internal funds are not enough to finance investment opportunities, firms may
or may not acquire external financing, and if they do, they will choose among the different
external finance sources in such a way as to minimize additional costs of asymmetric
information. In order to minimize external cost of financing, firms prefer to use debt leverage at
first, then issuance of preferred stock and finally issuance of common stock. The results of
pecking order theory follow as: internally generated funds first, followed by respectively low-
risk debt financing and share financing.

4. Agency Cost Theory

It proposes that the optimal capital structure is determined by agency cost, which results from
conflict of interest among different beneficiaries (Jensen and Mackling, 1976).

 Conflict of interests between managers and stakeholders.

 Conflict of interests between stakeholders and holders of corporate debt securities.

We may think of management as agents of the owners of the company, the

shareholders. These shareholders, hoping that the agents will act in the shareholders’ best
interests, delegate decision-making authority to them. For management to make optimal
decisions on the shareholders’ behalf, it is important that management not only have the
correct incentives (salary, bonuses, stock options, and “perks”) but that they be monitored
as well. Monitoring can be done through such methods as bonding the agents, auditing
financial statements, and explicitly restricting management decisions. Creditors monitor the
behavior of management and shareholders by imposing protective covenants in loan
agreements between the borrower and lenders.
The monitoring activities mentioned necessarily involve costs. The greater the probable
monitoring costs, the higher the interest rate, and the lower the value of the firm to its
 shareholders, all other things staying the same. The presence of monitoring costs acts as a
disincentive to the issuance of debt, particularly beyond a prudent amount. It is likely that the
amount of monitoring required by debt holders increases with the amount of debt
outstanding. When there is little or no debt, lenders may engage in only limited monitoring,
whereas with a great deal of debt, they may insist on extensive monitoring.
5. Signaling Theory

The theory that investors regard dividend changes as signals of management’s earnings
forecasts.

Financial decisions are signals sent to investors by managers in order to compensate information
asymmetry. These signals are regarded as the main core of financial relationships.

A financing action by management that is believed to reflect its view of the firm’s stock value;
generally, debt financing is viewed as a positive signal that management believes the stock is
“undervalued, “and a stock issue is viewed as a negative signal that management believes the
stock is “overvalued.”

6. Market Timing Theory (Baker and Wurgler (2002)

The market-timing theory of capital structure argues that firms time their equity issues as
follows: They issue new stock when the stock price is perceived to be overvalued, and buy back
own shares when there is undervaluation. Consequently, fluctuations in stock prices affect firm's
capital structures.