The Lahore Journal of Business

1 : 2 (Spring 2013): pp. 117–124

A Note on Corporate Capital Structure Theories

Mawal Sara Saeed*

1. Introduction

Financial theory revolves around rational participants who want to

maximize their utility or wealth for a given level of risk. This
maximization, in the first place, calls for the optimality of available
resources, making capital financing decisions critical for corporations. Any
discussion on optimal capital structure leads back to Modigliani and
Miller’s classical capital structure irrelevance hypothesis (1958), according
to which, in an efficient market, the value of the firm is unaffected by its
choice of capital structure in the absence of taxes, bankruptcy costs, and
asymmetric information. This irrelevance makes the firm’s managers
indifferent to opting for debt or equity in the firm’s capital structure.

Modigliani and Miller’s proposition was criticized primarly for

ignoring the tax shield that would be available if a firm was financed by
debt. Later, Modigliani and Miller (1963) relaxed the assumption of zero
taxes and demonstrated that debt financing might contribute toward the
value of the firm, due to the available tax shield, but the impact was shown
to be lower. Moreover, the use of debt financing leveraged the capital
structure, consequently raising the cost of capital. The Modigliani and
Miller propositions have had important implications for the theory of
investment decisions. First, they demonstrate that such decisions can be
separated from the corresponding financial decisions. Second, the rational
criterion for investment decisions is a maximization of the market value of
the firm. Last, the rational concept of capital cost refers to total cost, and
should be measured as the rate of return on capital invested in shares of
firms in the same risk class.

Building on the foundations of the Modigliani and Miller capital

structure notion, an exhaustive body of literature on alternative theories of
capital structure has emerged, debating the existence of an optimal capital
structure and its impact on the cost of capital and, ultimately, on the value of
the firm. These theories have been widely tested but contradictory empirical
results raise questions about their validity. This note briefly discusses these
theories of capital structure, along with some empirical findings.

*
The author is a teaching associate at the Lahore School of Economics.
118 Mawal Sara Saeed

2. Static Tradeoff Theory

Myers (1984) divides contemporary thinking on capital structure

into two theoretical currents. The first is the static trade-off theory, which
presumes that firms set up a debt target ratio and move toward it.
According to this model, an optimal capital structure does exist and is
found as the optimal tradeoff between the tax benefits of debt and the
increase in the costs of financial distress associated with debt, i.e.,
bankruptcy costs against tax benefits.

3. Pecking Order Theory

Myers and Majluf (1984) posit that managers use private

information to issue risky securities when they are overpriced. Investors
are aware of this asymmetric information problem, and the prices of risky
securities fall when new issues are announced. Managers anticipate the
price declines and may forego profitable investment if they must be
financed with risky securities. To avoid this distortion of investment
decisions, managers follow what Myers (1984) calls the pecking order.
They finance projects first with retained earnings, which have no
asymmetric information problem; then with low-risk debt, for which the
problem is negligible; and then with risky debt. Equity is issued only in
distress or when investment exceeds earnings in a way that financing with
debt would produce excessive leverage. Myers (1984) also suggests that, in
the short term, dividends are (for unspecified reasons) sticky, leaving
variations in net cash flows to be absorbed mainly by debt.

Furthermore, share repurchases give rise to asymmetric

information problem. As Shyam-Sunder and Myers (1999) have pointed
out, a firm that announces a repurchase will tempt investors to assume that
managers have positive information not reflected in the stock price,
causing the price to rise. This can deter the repurchase if the price rises
above what managers consider to be the equilibrium level. Thus, when
firms use financing retention to retire securities, they first retire debt. They
retire equity only when leverage is low or when poor investment
opportunities (relative to earnings) lower the value of debt capacity. In
short, repurchases should be limited to firms with little or no leverage, few
investment opportunities, or both.

Two additional points about the pecking order are pertinent when
interpreting their empirical results. First, Myers (1984) emphasizes
asymmetric information problems, but recognizes that transaction costs
 A Note on Corporate Capital Structure Theories 119

alone can produce pecking order financing if they are higher for debt
than for retained earnings and higher yet for equity. In other words,
asymmetric information may be unnecessary. Transaction costs can give
rise to a pecking order.

Second, in Myers (1984) and Myers and Majluf (1984), the pecking
order arises through an implicit assumption that there is no way to issue
equity that avoids asymmetric information problems. If firms find ways to
issue equity without such problems, asymmetric information might not
constrain equity issues. As a result, pecking order financing can disappear,
i.e., financing with equity is not a last resort, the incentive to avoid
repurchases to maintain debt capacity is gone, and asymmetric information
problems do not drive capital structures. This does not mean that
asymmetric information is irrelevant, but its implications do become quite
limited. Firms avoid issuing risky securities in ways that involve
asymmetric information problems, but financing decisions do not follow
the pecking order.

4. Market Timing Hypothesis

Equity market timing refers to the practice of issuing equities at

high prices and repurchasing them at low prices to exploit temporary
fluctuations in the cost of equity relative to the cost of other fund-raising
measures. In the efficient and integrated capital markets assumed by the
Modigliani and Miller theorem, the costs of different forms of capital do
not vary independently and thus no gain can be obtained from
opportunistically switching between debt and equity.

Also, according to the tradeoff theory, when equity prices rise, the
market value of leverage ratios fall and firms try to raise leverage ratios by
increasing debt and/or repurchasing equity. Thus, the market timing
hypothesis predicts the opposite direction envisaged by the tradeoff
theory. In practice, many market participants point out that firms tend to
issue equities instead of debts when market value is high, relative to book
value and past market values, and tend to repurchase them when market
value is low.

5. Agency Theory and Capital Structure

There are three kinds of agency costs that bring in the importance
of capital structure when calculating the worth of a firm. The first factor is
the asset substitution effect, which states that, with increased levels of
leverage, the management is induced to take up even those projects with a
120 Mawal Sara Saeed

negative net present value (NPV). If the project becomes successful, then
shareholders are entitled ownership of all the gains and debt holders
receive their pre-fixed rate of return, whereas unsuccessful ventures result
in debt holders also sharing the loss. This could result in a transfer of
wealth from debt holders to shareholders.

Another problem is that of underinvestment. In situations where

debt is risky, the gains are passed on to the debt holders for taking that
risk. This results in the rejection of such projects that would yield positive
future cash flows and have a positive NPV, and would also result in an
increase in the value of the firm.

There is a significant body of literature that models the influence of

agency costs on capital structure stemming from conflicts of interest.
Jensen and Meckling (1976) argue that a conflict of interest can arise
between shareholders and managers since the latter hold less than 100
percent of the residual claims. Consequently, they do not capture the entire
gain from their profit-enhancing activities, but instead bear the entire cost
of these activities. For instance, managers can invest less effort in managing
firm resources and may be able to transfer firm resources for their personal
benefit by consuming “perquisites”. This inefficiency is reduced as the
fraction of the firm’s equity owned by managers’ increases—the larger the
shareholding ratio of large investors, the more effective their monitoring.
This leads to less chance of conflicts of interest.

Another conflict could be posed by the availability of free cash flows.

If the management’s tendency is that of an empire builder, it will undertake
high-risk projects—the underlying risk of which will be borne by the
shareholders. Therefore, increases in debt levels for firms with positive free
cash flows will reduce the agency problem because it will force the
management to pay out the excess cash. Thus debt acts as a monitor of firm
performance, it requires management to run the firm efficiently to avoid the
negative consequences of not being able to service the firm’s debt payments,
and it requires the management to disburse its free cash flow.

6. Some Empirical Evidence on Capital Structure Theories

As mentioned earlier, the alternative theories of capital structure

along with Modigliani and Miller’s basic irrelevance theorem has been
widely discussed in the financial literature. No single theory explains all
the time-series and cross-sectional patterns that have been documented.
The relative importance of these explanations has varied in different
studies. Shyam-Sunder and Myers (1999) test the pecking order theory by
 A Note on Corporate Capital Structure Theories 121

estimating a regression using a firm’s net debt issuance as the dependent

variable and its net financing deficit as the independent variable. They find
that the estimated coefficient on the financing deficit is close to 1 for their
sample and interpret the evidence as supporting the pecking order theory.

In general, the pecking order theory enjoyed increasing favor in the

1990s, but has recently fallen on hard times. Chirinko and Singha (2000) use
three examples to illustrate potential problems with using the Shyam-
Sunder and Myers test to evaluate the theory. Frank and Goyal (2003)
argue that none of its predictions hold when a broad sample of firms and a
longer time-series is used. Fama and French (2002) find that short-term
variations in earnings and investment are mostly absorbed by debt, as
predicted by the pecking order, but that it has other failings (namely
significant equity issues by small-growth firms). Baker and Wurgler (2002)
relate capital structure to historical market-to-book ratios. With their
findings, the market timing theory has increasingly challenged both the
static tradeoff and pecking order theories.

Fama and French (2004) reject the pecking order theory’s central
predictions about how often and under what circumstances firms issue and
repurchase equity. First, they report that equity issues were commonplace
during 1973–2002, and so pervasive that they could not have been limited to
firms in distress. Second, repurchases have turned out to be not that rare.
Further, they attribute the failure of pecking order breaks at least in part to
equity issue with low transaction costs and modest asymmetric information
problems. Three of the alternatives to traditional equity offering include
issues to employees, rights issues, and direct purchase plans, which have
both low transaction costs and minor asymmetric information problems. A
fourth, mergers financed by stock, could also fall into this category. They
argue that, if there are ways to issue equity that avoids the costs assumed by
the pecking order theory, transaction costs and asymmetric information
problems might not seriously constrain equity issuance. Therefore, equity
issuance is not the last option for raising finance and the asymmetric
information problem that is the focus of the pecking order theory is not the
sole or perhaps even an important determinant of capital structure.

Fama and French (2004) disagree with Shyam-Sunder and Myers

(1999) about the success of the pecking order model, but agree with their
conclusion that its main competitor, the tradeoff model, has serious
problems. Like asymmetric information, tradeoff considerations (for
example, the bankruptcy cost of debt) surely plays a role in financing
decisions. However, there are important aspects of the tradeoff model that
get little empirical support. They conclude that the tradeoff model and
122 Mawal Sara Saeed

pecking order model have serious problems, challenging their position as

stand-alone theories of capital structure. Perhaps it is best to regard the two
models as “stablemates, each with elements of truth that help explain some
aspects of financing decisions.”

Ismail and Eldomiaty (2004) compare the three capital structure

theories using the stochastic search variable selection procedure. They
observe that, with innovations in economic and business dynamics, no
single theory can explain capital structure choice. Their results support the
pecking order and static tradeoff propositions while they cannot deduce
any significance for the agency and free cash flow theories. They attribute
the transition of manager choices from the pecking order to tradeoff
theories and vice versa to factors such as market and financial risk, tax
shield, firm growth rate, and expected investment opportunities.

Dittmar and Thakor (2007) present an alternative theory of capital

structure and provide supporting empirical evidence. They find little or no
evidence for other known theories such as the pecking order, static tradeoff,
timing, and time-varying adverse selection theories. Although the agreement
theory appears to be an extension of the timing and time-varying adverse
selection theories, there is a major difference. In the timing theory, high stock
prices are a consequence of overvaluation while in the agreement model
they are the result of market agreement. In the time-varying adverse
selection theory, they are attributed to low information asymmetry. Apart
from this, the authors claim that, given the model and the empirical
evidence, their theory has incremental explanatory power over the timing
and time-varying adverse selection hypotheses concerning security issuance
decisions. The model’s variables provide insight into the firm’s capital
structure and investment decisions, and the statistics demonstrate that
manager-investor agreement is a determinant of corporate decisions.

7. Conclusion

Capital structure choice is one of the critical decisions that a firm’s

management must make. The empirical literature on the subject is
exhaustive, and focuses on the various determinants that drive this choice.
However, the empirical findings are not conclusive since the results
support and fail to support the capital structure theories that have been
proposed over the last 50 years. Even five decades after Modigliani and
Miller’s seminal paper, capital structure choice is still largely a puzzle and
warrants further research on the option of debt versus equity in a dynamic
business and economic environment.
 A Note on Corporate Capital Structure Theories 123

References

Baker, M., & Wurgler, J. (2002). Market timing and capital structure.
Journal of Finance, 57, 1–32.

Chirinko, R., & Singha, A. (2000). Testing static tradeoff against pecking
order models of capital atructure: A critical comment. Journal of
Financial Economics, 58, 417–425.

Dittmar, A., & Thakor, A. (2007). Why do firms issue equity? Journal of
Finance, 72, 1–54.

Fama, E. F., & French, K. R. (2002). Testing tradeoff and pecking order
predictions about dividends and debt. Review of Financial Studies,
15, 1–33.

Fama, E. F., & French, K. R. (2004). Financing decisions: Who issues stock?
Journal of Financial Economics, 76, 549–582.

Frank, M., & Goyal, V. (2003). Testing the pecking order theory of capital
structure. Journal of Financial Economics, 67, 217–248.

Jensen, M. C., & Meckling, W. (1976). Theory of the firm: Managerial

behavior, agency costs, and ownership structure. Journal of
Financial Economics, 3(4), 305–360.

Ismail, A. M., & Eldomiaty, I. T. (2004). Bayesian identification of the

predictors for capital structure in Egypt. Advances and Applications
in Statistics, 4(2), 15–35.

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation

investment, and the theory of investment. American Economic
Review, 48, 261–297.

Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the
cost of capital: A correction. American Economic Review, 53(3), 433–
443.

Myers, S. C. (1984). The capital structure puzzle. Journal of Finance, 39,

575–592.
124 Mawal Sara Saeed

Myers, S. C., & Majluf, N. (1984). Corporate finance and investment

decisions when firms have information that investors do not have.
Journal of Financial Economics, 13, 187–221.

Shyam-Sunder, L., & Myers, S. (1999). Testing static tradeoff against

pecking order models of capital structure. Journal of Financial
Economics, 51, 219–244.