Theories of Capital Structure

In the past, several significant theories of capital structure in financial management have emerged. But before we discuss these theories you should know what is capital structure. A firm’s Capital structure is the relative proportions of debt, equity, and other securities in the total financing of its assets.

A business needs to plan its capital structure to optimize the application of the funds and also to be able to adjust easily to the changing environments.

Theories of Capital Structure in Financial Management

• Modigliani-Miller
• Trade-Off
• Pecking Order
• Market Timing
• Net Income
• Net Operating Income

Modigliani And Miller’s Theory

Decisions related to an optimal capital structure has irritated theoreticians for many years.  The early work made quite a few assumptions in an effort to simplify the problem and assumed that both the cost of debt as well as the cost of equity were separate from capital structure and that the appropriate figure for consideration was the net income of the firm. Using these suppositions, the average cost of capital reduced by using leverage and the value of the firm (the value of the debt and equity combined) improved while the value of the equity remained the same. Modigliani and Miller revealed that this could not be the truth.  Their argument was that 2 similar businesses, varying only in their capital structure, should have identical total values.  If they didn’t, individuals would engage in arbitrage and create the market forces which would make the 2 values equal.

This theory starts by assuming that the business has a certain set of predicted cash flows. When a business prefers a certain percentage of financial debt and equity, it simply divides the cash flows between investors. Investors and corporations are assumed to have similar access to financial markets. According to this theory, the market value of a business is based on its earning power and by the potential risk of its main assets. Moreover, the value of the business is not dependent on the way it selects to finance its investments or distribute dividends.

Figure 1: What are the Theories of Capital Structure?

Trade-Off Theory

The term trade-off theory is commonly used to describe a group of associated theories. In all these theories, a decision maker examines the different costs and advantages of alternative leverage plans. The tradeoff theory assumes that you can get benefits to leverage within a capital structure until the optimum capital structure is achieved. The theory acknowledges the tax advantage from interest payments. This theory mainly refers to the two concepts – cost of financial distress and agency costs. A major objective of the trade-off theory is to explain the fact that businesses generally are funded partially with debt and partially with equity.

Pecking Order Theory

According to pecking order theory (pecking order model), companies show a distinct preference for utilizing internal finance (as retained earnings or excess liquid assets) over external finance. If internal funds are insufficient to finance investment opportunities, a company might obtain external financing but it will choose among the various external finance sources in a manner as to minimize additional costs. This theory regards the market-to-book ratio as a way of measuring investment opportunities. This theory is made popular by Myers and Majluf as he claims that equity is a significantly less favored way to raise capital because when managers issue fresh equity, investors feel that managers think that the company is overvalued and managers are taking advantage of this over-valuation. Because of this, investors will place a reduced value to the new equity issuance.

Market Timing Theory

This theory of capital structure states that companies time their equity issues in a way that they issue fresh stock when the stock prices are overvalued, and buy back shares when they are undervalued. As a result, variations in stock prices influence firms capital structures. Companies don’t usually care whether they finance with debt or equity, they simply pick the type of financing which, at that point in time, appears to be more valued by financial markets.

Watch a Video on Different Types of Capital Structure Theories

Net Income Theory

According to this theory, the cost of debt is recognized as cheaper source of financing than equity capital. The more use of debt in the capital structure lowers the total cost of capital. Debt is less expensive source of financing due to the fact that its interest is deductible from net profit before taxes. Following deduction of interest, a business has to pay reduced tax and therefore, it will reduce the weighted average cost of capital. The value of the business is higher in the case of lower overall cost of capital because of more use of leverage in the capital structure.

Net Operating income Theory

According to this theory, the value of a company isn’t impacted by the alteration of debt in the capital structure. It assumes that the gain which a company gets by infusion of debt is negated by the rise in the required rate of return by the stockholders.

With rise in debt, the bankruptcy risk also increases and such a risk perception increases the expectations of the equity holders.