Capital Structure Theories/Capital Structure Irrelevancy Theory (Modigliani – Miller Theorem)
In the 1950s, two financial economists, Franco Modigliani and Merton Miller, made significant contribution to the corporate finance and were rewarded decades later with a Noble Prize in economics. They came up with the new propositions to explain the capital structure theory and here starts the birth of modern capital structure theory. Their contribution was to show that, under certain assumptions (known as the MM assumptions and MM theory), the capital structure, or mix of debt and equity, does not have an impact on the overall value of the firm. Theory of irrelevancy was presented in an era when research was dominated by assumption that there is no interaction between a firm’s investment and financial decisions of the firm.
Capital Structure Static Trade-off Theory
The Static trade-off theory (STT) came as a reaction on the Miller and Modigliani theory, presenting the benefits of debt financing via debt related tax shields. Doubts were raised over the fact that there was no offsetting cost to debt. Therefore, a discussion followed saying that the optimal leverage should be found where a trade-off between tax shield benefits of debt and costs of financial distress was found
Pecking Order Theory
Firm managers or insiders are assumed to possess private information about the characteristics of firm’s returns and the investment opportunities available to them . Various theories have been developed that have attempted to explicitly model this private information which has consequently given rise to theories other than the Trade-off Theory. The Pecking Order Theory (POT) is one such theory that attempts to explain capital structure decisions by formally taking into account the inherent information asymmetry that exists between different parties.
The next important theory mentioned in the literature is the agency cost theory. This theory was developed by Jensen and Meckling in their 1976 publications. This theory considered debt to be a necessary factor that creates conflict between equity holders and managers. Both scholars used this theory to argue that the probability distribution of cash flows provided by the firm is not independent of its ownership structure and that this fact may be used to explain optimal capital structure. Jensen and Meckling recommended that, given increasing agency costs with both the equity-holders and debt-holders, there would be an optimum combination of outside debt and equity to reduce total agency costs.
