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: email@example.com.
Electronic copy available at: http://ssrn.com/abstract=556631
The view that capital structure is literally irrelevant or that ”nothing matters” in corporate ﬁnance, though still sometimes attributed to us,...is far from what we ever actually said about the real-world applications of our theoretical propositions. Miller (1988)
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
Electronic copy available at: http://ssrn.com/abstract=556631
eliminated too. Modigliani and Miller in their original articles Miller and Modigliani (1958b) and Miller and Modigliani (1958a) assume several strict constraints.
¯ ¯ ¯ ¯ ¯
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)
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...
References: Aghion, Philippe and Bolton, Patrick. An Incomplete Contracts Approach to Financial Contracting. Review of Economic Studies, 59:473–494, 1988. Akerlof, Georg. The Market for ”lemons”: Qualitative Uncertainty and the Market Mechanism. Quarterly Journal of Economics, 89 Aug. 70:488–500, 1970. Allen, Franklin and Winton, Andrew. Corporate Financial Structure, Incentives and Optimal Contracting. Handbooks in Operations Reserch and Management Science, Vol 9, Finance, R. A. Jarrow, V. Maksimovic and W. T. Ziemba(eds.). North-Holland, 1995. Bøhren, Øyvind and Michalsen, Dag. Finansiell Økonomi, Teori og prakis. Skarvet Forlag, 2001. Brealey, Richard A. and Myers, Stewart C. Principles of corporate ﬁnance. McGraw-Hill, 2000. Chiang, Alpha C. Fundamentals of Mathematical Economics, Third Edition. McGraw-Hill, 1984.
Chirinko, Robert S. and Anuja R. Singha. Testing Static Tradeoff against Pecking Order models of capital structure: a critical comment. December, 58:417–425, 2000. Coase, Ronald H. The Nature of the Firm. Economica, 2:386–405, 1937. Copeland, Thomas. F. and Weston, Fred. Financial theory and Corporate policy. AddisonWesley, Third edition, 1988. Diamond, Douglas W. Reputation acquisition in debt markets. Journal of Political Economy, 97:828–862, 1989. Fama, D. E. and Jensen, M. C. Agency Problems and Residual Claims. Journal of Law and Economics, June 1983, 1983. Frydenberg, Stein. Capital Structure Function with a Stratiﬁed Sample. Working Paper, Trondheim Business School, pages 1–25, 2001. Garvey, Gerald T. and Gordon Hanka. The Management of Corporate Capital Structure: Theory and Evidence. Working Paper, University of British Columbia, 1997:1–32, 1997. (January 1997). http://ssrn.com/abstract=1501. Green, R. C. Investment Incentives, Debt , and Warrants,. Journal of Financial Economics, 13, 1984. Green, R. C. and Talmor, E. Asset Substitution and the Agency Cost of debt Financing. Journal of Banking and Finance, 10:391– 399, 1986. Harris, M. and Raviv, A. The Theory of Capital Structure. Journal of Finance, XLVI:297–355, 1991. Harris, Milton and Raviv, Arthur. Capital Structure and the Informational Role of Debt. Journal of Finance, 45:321–350, 1990. Haugen, Robert A. and Senbet, Lemma W. Bankruptcy and agency costs: Their Signiﬁcance to the theory of Optimal capital Structure. Journal of Financial and Quantitative Analysis, 23:27–38, 1988. 38
Hirshleifer, J. Investment Decisions under Uncertainty: Applications of the State-preference Approach. Quarterly Journal of Economics, 237-277, 1966. Hull, John C. Options, Futures and Other Derivatives. Prentice Hall Inc., 2003. Jensen, Michael C. Agency Cost of Free Cash Flow, Corporate Finance, and takeovers. American Economic Review, 76,:323–329, 1986. Jensen, Michael C. and Meckling, William H. Theory of the Firm: Managerial Behavior, Agency Costs and the Ownership Structure. Journal of Financial Economics, 3:305–360, 1976. Kraus, Alan and Litzenberger, Robert. A State Preference Model of Optimal ﬁnancial Leverage. Journal of Finance, 28:911–922., 1973. Leland, Hayne and Pyle, David. Informational Asymmetries, Financial Structure and ﬁnancial Intermediation. Journal of Finance, XXXII:371–387, 1977. Lewellen, W. G. and Mauer, D. C. Tax Options and Corporate Capital Structures. Journal of ﬁnancial and quantitative analysis, pages 387–400, 1988. Merton, R. C. Continous-time ﬁnance. Basil Blackwell, 1990. Miller, Merton. Debt and taxes. Journal of Finance, 32:261–275., 1977. Miller, Merton. The Modigliani-miller propositions after thirty years. Journal of Economic Perspectives, 2:99–120, 1988. Miller, Merton and Modigliani, Franco. Corporate Income Taxes and the Cost of Capital: A correction. American Economic Review, 48:261–297, 1958a. Miller, Merton and Modigliani, Franco. The Cost of Capital, Corporation Finance, and the Theory of Investment. American Economic Review, 48:261–297, 1958b. Myers, Stewart C. Determinants of Corporate Borrowing. The Journal of Financial Economics, 9:147–176, 1977. 39
Myers, Stewart C. The Capital Structure Puzzle. The Journal of Finance, XXXIX:575–592, 1984. Myers, Stewart C. Still Searching for optimal Capital Structure. Journal of Applied Corporate Finance, 6:4–14, 1993. Myers, Stewart C. and Majluf, N. S. Corporate Financing and Investment Decisions when Firms have Information that Investors do not have. 13:187–221, 1984. Nassim Taleb. Dynamic Hedging, Managing Vanilla and Exotic Options. Wiley Series in Financial Engineering. John Wiley & Sons, Inc, 1997. Ross, Steven A. The Determination of Financial Structure: The Incentive-signalling Approach,. The Bell Journal of Economics, 8:23–40, 1977. Rothscild, M. and Stiglitz, Joseph E. Equilibrium in Competetive Insurance Markets: An essay on the economics of imperfect information,. Quarterly Journal of Economics, 90:629 – 649, 1970. Sjo, Hege. Aktuelle Børstall nr. 4 1996. Relevant statistics from the Oslo Stock Exchange,, Accounting Figures 1995:Oslo Stock Exchange, Oslo, 1996. Smith, Clifford W. and Warner, J. B. Investment Banking and the Capital Acquisition Process. Journal of Financial Economics, 15:3–29, 1979. Stein Frydenberg. The Importance of Being Indebted. Working Paper, Trondheim Business School, pages 1–29, 2001. Stiglitz, Joseph E. A Re-examination of the Modigliani-miller theorem. The American Economic Review, 59:784–793, 1969. Stiglitz, Joseph. E. On the irrelevance of corporate ﬁnancial policy. The American Economic Review, December 1974:851–866, 1974. Journal of Financial Economics,
Stulz, Rene M. Merton Miller and Modern Finance. Keynote adress, Financial Managment Association Meetings, Seattle, October 2000, pages 3–25, 1990. Thakor, A. V. Competetive Equilibrium with type convergence in an asymmetrically informed market. Review of Financial Studies, 2:49–71, 1989. Titman, Sheridan. The Effect of capital Structure on a Firm¼ s Liquidation decision. Journal of Financial Economics, 13:137–151., 1984. Warner, J. B. Bankruptcy Costs: Some Evidence,. Journal of Finance, XXXII, No. 2., 1977. Williams, J. T. Financial and Industrial Structure with Agency. Review of Financial Studies, 8:431 – 475, 1988. Williamson, Oliver E. The Modern Corporation: Origins, Evolution and Attributes. Journal of Economic Literature, 19:1537–68., 1981. Zender, J. F. Optimal Financial Instruments,. Journal of Finance, XLVI:1645 –1663., 1991.
Please join StudyMode to read the full document