Capital structure theories explore how firms choose between different sources of financing, particularly the mix of debt and equity. These theories help understand the impact of capital structure decisions on a company’s value, cost of capital, and financial risk. The main capital structure theories are:
1. Net Income (NI) Theory
- Proposed by: David Durand
- Concept: The theory suggests that an increase in debt in the
capital structure decreases the overall cost of capital (due to the tax
deductibility of interest), leading to an increase in the firm's value.
- Key Point: Higher debt proportion results in a lower weighted
average cost of capital (WACC), thus increasing the firm's value.
2. Net Operating Income (NOI) Theory
- Proposed by: David Durand
- Concept: The theory assumes that the cost of equity increases
as debt increases, leaving the overall cost of capital unchanged. As a
result, capital structure decisions do not affect the value of the firm.
- Key Point: Capital structure is irrelevant to the firm’s
valuation; only operating income matters.
3. Traditional Theory
- Concept: This theory is a compromise between the NI and NOI
theories. It argues that there is an optimal capital structure where the
WACC is minimized, and the firm's value is maximized. Beyond this point,
increasing debt will raise the cost of equity significantly, leading to an
increase in WACC.
- Key Point: The firm should use some debt, but too much debt will
eventually increase the firm's risk and cost of capital.
4. Modigliani and Miller (M&M) Theory
- Developed by: Franco Modigliani and Merton Miller (1958)
- Concept:
- Proposition I (Without Taxes): In a world with no taxes, the value of a firm is
independent of its capital structure. The firm’s value is determined by
its earning power and the risk of its underlying assets.
- Proposition II (With Taxes): When taxes are considered, the use of debt creates a
tax shield (since interest is tax-deductible), which increases the value
of the firm. Hence, in the presence of corporate taxes, the firm should
finance entirely through debt to maximize its value.
- Key Point: Debt increases firm value because of tax benefits,
but other factors like bankruptcy costs should be considered.
5. Pecking Order Theory
- Proposed by: Stewart Myers and Nicholas Majluf (1984)
- Concept: Firms prefer internal financing (retained earnings)
over external financing. If external financing is necessary, firms prefer
to issue debt over equity. This preference is due to information
asymmetry, as issuing equity can signal to investors that managers believe
the firm is overvalued.
- Key Point: Firms follow a financing hierarchy: internal funds →
debt → equity.
6. Trade-Off Theory
- Concept: This theory acknowledges the tax advantages of debt
(interest tax shield) but also considers the costs of financial distress
and bankruptcy. Firms aim to balance these costs and benefits to find an
optimal capital structure.
- Key Point: There is a trade-off between the tax benefits of debt
and the potential bankruptcy costs.
7. Agency Theory
- Developed by: Jensen and Meckling (1976)
- Concept: This theory focuses on conflicts of interest between
managers (agents) and shareholders (principals). High levels of debt can
reduce agency problems by limiting the free cash flow available for
managers to misuse. However, excessive debt can also lead to risk-shifting
behavior, where managers take on high-risk projects at the expense of debt
holders.
- Key Point: Capital structure choices are influenced by the need
to mitigate agency conflicts.
8. Market Timing Theory
- Concept: This theory suggests that firms time their financing
decisions based on market conditions. Firms issue equity when stock prices
are high (overvalued) and issue debt when interest rates are low.
- Key Point: Firms adjust their capital structure to take
advantage of favorable market conditions.
9. Signaling Theory
- Concept: According to this theory, capital structure decisions
send signals to the market. Issuing debt can be a positive signal that the
firm is confident in its ability to generate cash flows to service the
debt, while issuing equity may signal that the firm's stock is overvalued.
- Key Point: The choice between debt and equity conveys
information to investors.
Summary of Key Theories:
Each of these theories provides a different perspective on how firms make decisions about their capital structure and the trade-offs involved.
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