3.3 Capital structure theories: nature of capital structure; factors influencing the firm’s capital structure; traditional theories of capital structure – assumptions of the theories, Net income theory and Net operating income theory; Franco Modigliani and Merton Miller’s propositions – MM without taxes, MM with corporation taxes, MM with corporation and personal tax rates and MM with taxes and financial distress costs; other theories of capital structure; the pecking order theory; Static Trade-off theory and Agency effects, determination of the firm’s optimal capital structure using the Hamada model, CAPM and WACC

There are several capital structure theories that attempt to explain the relationship between a company’s capital structure and its value. The main capital structure theories include:

1. Modigliani-Miller (M&M) Theorem: The M&M theorem states that, under certain assumptions, the value of a firm is independent of its capital structure. It suggests that in the absence of taxes, bankruptcy costs, and information asymmetry, the market value of a firm is determined solely by its underlying assets and the cash flows generated by those assets. This theory implies that changes in capital structure, such as the proportion of debt and equity, do not affect the overall value of the firm.
2. Trade-off Theory: The trade-off theory suggests that companies have an optimal capital structure that balances the benefits and costs of debt financing. According to this theory, there is a trade-off between the tax advantages of debt (interest tax shield) and the costs associated with financial distress and agency conflicts. As a result, companies may choose to have a mix of debt and equity to maximize their overall value.
3. Pecking Order Theory: The pecking order theory proposes that companies have a preferred order of financing sources based on their costs and availability. According to this theory, companies prefer internal financing (retained earnings) over debt, and debt financing over equity. This preference is driven by the information asymmetry between managers and investors, where managers have better information about the firm’s prospects than outside investors. As a result, companies tend to rely more on internal funds and debt financing to maintain financial flexibility and minimize adverse selection costs associated with equity issuance.
4. Agency Costs Theory: The agency costs theory emphasizes the role of conflicts of interest between shareholders and managers. It suggests that the capital structure choices of a firm are influenced by the need to align the interests of shareholders and managers. Debt financing can act as a disciplinary mechanism, as it imposes financial constraints on managers and reduces their discretion. By having a higher proportion of debt in the capital structure, shareholders can mitigate agency costs and align the incentives of managers with their own.
5. Market Timing Theory: The market timing theory argues that companies consider market conditions and timing when making capital structure decisions. This theory suggests that companies may issue debt or equity when they believe market conditions are favorable to optimize their cost of capital. Market timing theory implies that capital structure decisions are influenced by external factors, such as market conditions and investor sentiment.