Theory of Capital Structure

Topics: Corporate finance, Capital structure, Finance Pages: 45 (14261 words) Published: April 13, 2013
Theory of Capital Structure - A Review
Stein Frydenberg£ April 29, 2004

ABSTRACT This paper is a review of the central theoretical literature. The most important arguments for what could determine capital structure is the pecking order theory and the static trade off theory. These two theories are reviewed, but neither of them provides a complete description of the situation and why some firms prefer equity and others debt under different circumstances. The paper is ended by a summary where the option price paradigm is proposed as a comprehensible model that can augment most partial arguments. The capital structure and corporate finance literature is filled with different models, but few, if any give a complete picture.

JEL classification: G32

University College, Department of business administration, Jonsvannsvn. 82, 7004 Trondheim, Norway. E-mail:

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The view that capital structure is literally irrelevant or that ”nothing matters” in corporate finance, though still sometimes attributed to us, far from what we ever actually said about the real-world applications of our theoretical propositions. Miller (1988)

I. Introduction
The paper introduces the reader to two main theories of capital structure, which is the static trade-off theory, and the pecking-order theory. Underlying these theories are the assumptions of the irrelevance theorem of Miller and Modigliani. Since the irrelevance theorem is indeed a theorem, the assumptions of the theorem, has to be broken before capital structure can have any bearing on the value of the firm. If the assumptions of the irrelevance theorem are justified, the theorem follows as a necessary consequence.

II. The Irrelevance Proposition
In complete and perfect capital markets, research has shown that total firm value is independent of its capital structure. An optimal capital structure does not exist when capital markets are perfect. Taxes and other market imperfections are essential to building or proving a positive theory of capital structure. Changes in capital structure benefit only stockholders and then if and only if the value of the firm increases. An expropriation of wealth from the bondholders would in a rational expectations equilibrium be expected by the bondholders, and the stockholders would ultimately carry the costs of the expropriation. Miller and Modigliani (1958b) wrote the seminal article in this field of research, using an arbitrage argument. If a firm can change its market value by a pure financial operation, the investors in the firm can take actions that replicate the resulting debt position of the firm. These transactions would merely change the weights of a portfolio and should, in a perfect capital market, give zero profit. If the market were efficient enough to eliminate the profits for the investors, any profit for the firm would be


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eliminated too. Modigliani and Miller in their original articles Miller and Modigliani (1958b) and Miller and Modigliani (1958a) assume several strict constraints.

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First, capital markets are assumed to be without transaction costs and there are no bankruptcy costs. All firms are in the same risk class. Corporate taxes are the only government burden. No growth is allowed since all cash flows are perpetuities. Firms issue only two types of claims, risk free debt and risky equity. All bonds (including any debts issued by households for the purpose of carrying stocks) are assumed to yield a constant income per unit of time, and the income is regarded as certain by all traders regardless of the issuer” Miller and Modigliani (1958b)

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Information is symmetric across insider and outsider investors. Managers are loyal stewards of owners and always maximize stockholders’ wealth. Copeland and Weston (1988)

Later, others such as...

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