9.1 Capital Structure Theories

Capital structure theories explore how firms choose between debt and equity financing. The Modigliani-Miller theorem suggests a firm's value is unaffected by its financing mix under perfect market conditions. This challenges traditional views on the importance of debt-equity ratios.

Other theories consider real-world factors. The trade-off theory balances tax benefits of debt against bankruptcy costs. The pecking order theory proposes firms prefer internal funds, then debt, and lastly equity due to information asymmetry concerns.

Modigliani-Miller Theorem and Trade-Off Theory

Modigliani-Miller theorem implications

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• Modigliani-Miller (MM) theorem asserts a firm's value is unaffected by its capital structure choice between debt and equity financing
  • Assumes idealized conditions of perfect capital markets, absence of taxes, transaction costs, and bankruptcy costs
  • Implies the weighted average cost of capital (WACC) stays constant irrespective of the debt-to-equity ratio (leverage)
• MM Proposition I: The market value of a levered firm equals the market value of an unlevered firm with identical assets and cash flows
  • $V_L = V_U$, where $V_L$ represents the value of a levered firm and $V_U$ represents the value of an unlevered firm (no debt)
• MM Proposition II: The cost of equity rises linearly with the debt-to-equity ratio due to increased financial risk for equity holders
  • $r_E = r_0 + (r_0 - r_D) \times (D/E)$, where $r_E$ denotes the cost of equity, $r_0$ denotes the cost of equity for an unlevered firm, $r_D$ denotes the cost of debt, and $D/E$ represents the debt-to-equity ratio
• Implications suggest capital structure decisions are irrelevant in perfect markets, challenging traditional views on the importance of debt and equity mix

Trade-off theory of capital structure

• Trade-off theory posits firms balance the tax benefits of debt financing against the costs of potential financial distress to arrive at an optimal capital structure
  • Benefits of debt include tax deductibility of interest payments, creating a tax shield that increases cash flow
  • Costs of debt encompass financial distress costs, such as direct bankruptcy costs (legal and administrative fees) and indirect costs (loss of customers, suppliers, and employees)
• Firms should take on additional debt until the marginal tax benefit equals the marginal cost of financial distress at the optimal point
• Key assumptions of the trade-off theory:
  • Presence of corporate taxes and potential bankruptcy costs in imperfect markets
  • Firms have a target debt-to-equity ratio they aim to maintain
  • Firms adjust their capital structure over time to converge towards the target ratio (dynamic trade-off)
• Implies a moderate level of debt is optimal, as excessive debt increases the likelihood of financial distress and reduces firm value

Pecking Order Theory and Comparison of Capital Structure Theories

Pecking order theory in financing

• Pecking order theory argues firms follow a hierarchy of financing preferences based on the principle of least effort or resistance
  • Hierarchy of financing sources: internal funds (retained earnings) > debt financing > equity financing
• Firms prioritize internal financing and only resort to external financing when necessary, issuing debt before considering equity
• Equity issuance is the last resort due to the perceived information asymmetry between managers and outside investors
  • Managers possess inside information about the firm's prospects and may time equity issues when shares are overvalued
  • Investors interpret equity issues as a signal of overvaluation, leading to a decline in share price (negative signaling effect)
• Implications of the pecking order theory:
  • Firms do not have a specific target debt-to-equity ratio, as financing decisions are driven by the availability of internal funds and the need for external financing
  • Profitable firms with ample retained earnings tend to have lower debt ratios, as they can finance investments internally
  • High-growth firms may have higher debt ratios, as their investment needs exceed internally generated funds, requiring debt financing

Comparison of capital structure theories

• Modigliani-Miller theorem:
  • Based on perfect capital market assumptions, including no taxes or bankruptcy costs
  • Argues capital structure is irrelevant to firm value, as investors can replicate any capital structure through personal borrowing or lending
• Trade-off theory:
  • Incorporates taxes and bankruptcy costs, recognizing the tax benefits and financial distress costs of debt
  • Suggests an optimal capital structure that maximizes firm value by balancing the marginal tax benefits and marginal bankruptcy costs
• Pecking order theory:
  • Focuses on information asymmetry between managers and investors and the resulting signaling effects of financing decisions
  • Proposes a financing hierarchy based on the principle of least effort, with a preference for internal funds and debt over equity
• Key differences among the theories:
  • MM theorem assumes perfect markets, while trade-off and pecking order theories acknowledge market imperfections (taxes, bankruptcy costs, information asymmetry)
  • Trade-off theory implies a target debt-to-equity ratio, while pecking order theory suggests financing decisions are driven by the availability of internal funds and the need for external financing
  • Pecking order theory emphasizes the role of information asymmetry and signaling effects in financing decisions, while trade-off theory focuses on the tax benefits and financial distress costs of debt