11.1 Capital Structure Theories

Capital structure theories explore how companies finance their operations through debt and equity. These theories aim to explain why firms choose certain mixes of financing and how it affects their value and performance.

The Modigliani-Miller theorem kicks things off, proposing that capital structure doesn't matter in perfect markets. Other theories, like trade-off and pecking order, consider real-world factors like taxes, bankruptcy costs, and information asymmetry to explain firms' financing decisions.

Modigliani-Miller and Trade-off Theories

Modigliani-Miller Theorem and Capital Structure Irrelevance

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• Modigliani-Miller (MM) theorem proposes that in a perfect capital market, a firm's value is unaffected by its capital structure
• Assumes no taxes, no transaction costs, no bankruptcy costs, and efficient markets
• Under these conditions, the market value of a firm is determined by its earning power and risk of underlying assets, not by how it is financed
• Implies that a firm's debt-equity ratio does not affect its weighted average cost of capital (WACC)
• In reality, capital structure does matter because perfect market assumptions do not hold

Trade-off Theory and Tax Shield

• Trade-off theory suggests that firms balance the benefits and costs of debt financing to arrive at an optimal capital structure
• Main benefit of debt is the tax shield it provides since interest payments are tax-deductible ($Tax Shield = Corporate Tax Rate * Interest Paid$)
• Higher debt levels lead to greater tax savings, increasing the firm's value
• However, higher debt also increases the probability of financial distress (bankruptcy costs, legal fees, loss of customers and suppliers)
• Optimal debt level is reached when the marginal benefit of the tax shield equals the marginal cost of financial distress
• Firms with stable cash flows and tangible assets can support more debt than firms with volatile cash flows and intangible assets (tech companies)

Pecking Order and Agency Cost Theories

Pecking Order Theory

• Pecking order theory states that firms prefer internal financing over external financing
• If external financing is required, firms prefer debt over equity due to information asymmetry between managers and outside investors
• Managers know more about the firm's prospects, risks, and value than outside investors
• Issuing equity may signal that managers believe the stock is overvalued, leading to a drop in share price
• Hierarchy of financing preferences: retained earnings > debt > equity
• Predicts a negative relationship between profitability and leverage (profitable firms have more internal funds available)

Agency Cost Theory

• Agency cost theory focuses on the conflicts of interest between shareholders (principals) and managers (agents)
• Managers may pursue actions that benefit themselves at the expense of shareholders (empire building, perks, risk aversion)
• Debt can be used as a disciplining device to reduce agency costs
• Debt reduces free cash flow available for managers to spend on non-value-maximizing activities
• Threat of bankruptcy and job loss incentivizes managers to be more efficient
• However, too much debt can lead to asset substitution problem (managers take on riskier projects to benefit shareholders at the expense of bondholders)
• Optimal capital structure balances the agency costs of equity and debt

Market Timing Theory

• Market timing theory suggests that firms issue equity when market valuations are high and repurchase shares when valuations are low
• Managers exploit temporary mispricing in the market to time financing decisions
• Firms are more likely to issue equity when their market-to-book ratios are high (overvalued) and switch to debt when ratios are low (undervalued)
• Implies that capital structure is the cumulative outcome of past attempts to time the market
• Explains why firms tend to issue equity after periods of high stock returns and why stock prices often decline after equity issuances
• Challenges the notion of an optimal capital structure and suggests that market conditions play a significant role in financing decisions