Finance Reading: Capital Structure Theory

By: Timothy A. Luehrman

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Synopsis: This reading introduces students to the theory of capital structure. It explores the determinants of an optimal capital structure-first in the context of Modigliani and Miller's (M&M's) perfect market conditions, and then as M&M conditions are selectively relaxed. The reading begins with an overview and comparison of the distinctive characteristics of debt and equity securities and why the choice between them is relevant. The effects of leverage on measures of company financial performance and on the allocation of risk between debt and equity holders follows, laying the groundwork for a discussion of capital structure choice that is initially cast in terms of selecting a target leverage ratio. Next, the M&M propositions are introduced and readers learn why, under perfect market conditions, financing decisions are irrelevant to firm value. Numerical examples and an interactive illustration are used to illustrate the propositions. The M&M conditions are then relaxed to include taxes, financial distress, agency costs, asymmetric information, etc. Alternative theories of optimal capital structure-including the static tradeoff model and pecking order theory-are developed and compared. The Supplemental Reading covers the difficulties of resetting capital structure once firms are overleveraged and also provides some real-world context for how corporate managers make capital structure decisions.