Capital structure
Lecture for Corporate Finance
Ing. Tomáš Heryán, Ph.D.
Corporate Finance
FIU/BAFIK
Outline of the lecture
• Definition the capital structure
• The theories of capital structure
• Classification of theories
• Model M & M
• Trade off theory
• Pecking order theory
• Factors affecting capital structure in enterprises
Capital structure – definition
Equity
Long-term
external
internal
Debt
Long-term
internal
Short-term
Capital structure
The optimal capital structure can be considered as a capital distribution that is associated
with the minimization of the cost of capital acquisition and is in line with the development of
the company's revenue, profits and structure.
Capital structure – definition
• The capital structure is often defined as a structure of long-term capital, from which longterm
assets are financed, in various sources of financial theories.
• The capital structure deals primarily with the internal structure, which is further influenced
by the technical conditionality of the property structure according to the branch or field of
business of the company.
• Funding rules mean the management of the interconnections of assets, sources of financing
and also links between the company's equity and capital structure.
• The capital structure is essential for a company's high-quality business development and also
underpins its sound financial development.
Theories of capital structure
Theories of capital structure
MM model
Trade off
theories
Static trade off
theories
Dynamical
trade off
theories
Pecking order
theories
Theory with
information
asymmetry
The theory with
conflict of
interest
M&M model
The M & M model was created in 1958 and its authors are Franco Modigliani and Merton
Miller (M & M). Before them, no general theory of capital structure has been formulated.
At the time, it was a theory that was based on very restrictive assumptions that were the basis
for the proper functioning of the relationship between leverage and the value of the company's
stocks. To date, however, this model is one of the most important theories in optimizing the
capital structure.
Miller and Modigliani are based on the assertion that each enterprise has a set of expected cash
flows. If an enterprise chooses for a certain level of debt financing, it must realize that the
effects of business activity must be such as to not limit the effects that are being realized for the
shareholders (the investors).
According to them, the leverage effect is measurable only at the enterprise level and has no
effect on the market value of the business.
Miller and Modigliani Model
Theory Main features Imperfection Main studies
MillerandModiglianimodel
MM I. In a world without taxes, debt does not
bring benefits
The unreality of the world
without taxes
Miller a
Modigliani (1958)
MM II. With the growth of debt, the expected
profit is growing. Introduction of
taxation.
Unlimited debt growth. With
rising debt, there is a growing
risk.
Miller a
Modigliani (1958)
MM III. It introduces the cost of financial
distress. The profitability rate must
exceed the expected earnings per share
rate - the investment is then acceptable
Used costs are associated
with the impossibility of
regulating the capital
structure - absorbing the
effect of the interest rate tax.
Miller a
Modigliani (1963)
Miller and Modigliani Model
re
WACC
Cost of
debt
D/E
Cost of capital
Cost of debt
re
WACC
Cost of capital
D/E
Version I. Version II. Version III.
cost of debt-free
companies
re
WACC
Cost of debt
after taxes
D/E
Cost of capital
Trade off theories
Traditional view and trade off theories are a reaction to the M & M model. For the first time,
indications of these theories are already in the M & M version III model (Miller and
Modigliani, 1963).
They are very similar to this model, but they reject the assumption of perfection of capital
markets while preserving other assumptions, and derive from it the existence of an optimal
capital structure in terms of its impact on the value of the business.
Attention is focused on minimizing the average cost of capital. In essence, it is an attempt to
describe the real behavior of financial managers based on empirical research.
The term trade off theory summarizes a group of theories based on the cost-benefit analysis of
the leverage effect. They also often assume that the choice of sources of funding should be
optimal to offset marginal costs and marginal returns.
Trade off theories
The basis for exploring these theories is that companies are continually assessing the
trade-off between the costs and returns that result from the leverage effect.
The choice of source of funding is usually conditioned by offsetting the marginal cost
of acquiring a foreign source of financing (these bonds are considered only bonds) and
the marginal benefits of using debt financing.
They are divided into static and dynamic depending on whether the time factor enters
their models.
The basic features and shortcomings of trade off theories are summarized in the
following table.
Trade off theories
Theories Main features Imperfections Main studies
Statictradeoff
theories
Compromise between interest rate,
tax and cost of financial distress.
Real profitability is influenced by
debt control within the capital
structure.
It does not use dynamics.
Difficult quantifiability of debt,
equity and average costs, depending
on the debt ratio.
Theory is tested on bonds as the
only form of debt. Unreality of
theory when using a bank loan.
Stiglitz (1973)
Kraus a Litzeberger
(1973)
Hangen a Senbet
(1978)
Bradley et al. (1984)
Myers (1984)
Graham (2000, 2006)
Dynamicaltradeoff
theories
Capital Structure Optimization
Using Continuous Decisions:
• Tax advantage of debt versus
cost of financial distress.
• Investment decisions versus
restructuring costs.
• The optimal capital structure is
replaced by an optimal range.
Difficult quantifiability of debt,
equity and average costs, depending
on the debt ratio.
Fisher et al. (1989)
DeAngelo (2011)
Strabulaev a Whited
(2012)
The core of trade off theories
The core of the trade off theory is the discussion of four basic topics:
• Firstly, the target distribution of funding sources is not clearly defined. This in essence means
that there is a large amount of variants in how to achieve the optima in different businesses in
different forms of used funding sources.
• Secondly, the impact of taxes is highly problematic and is very much dependent on the
conditions flowing from tax laws in the country concerned. Graham (2003) was the most
prominent of this issue in the US.
• Third, the costs of financial distress are perceived as deadweight rather than as transfers
between different forms of funding sources. In this context, many questions arise, e.g. whether it
is a fixed cost, whether it grows with company size and financial problems, whether costs are
disposable or permanently associated with damage to company reputation, etc. The first study on
this issue is the Hangen and Senbet study (1978).
• The last major issue is transaction costs. It is assumed here that the adjustment of the capital
structure must be gradual rather than sudden, and marginal costs are rising with increasing use of
debt financing.
Static trade off theories
re
WACC
Cost of debt
DER
Cost of capital
Traditional viewers see the link between the real profitability of ordinary shares and the share of debt
capital in total company resources. It claims that the real profitability of a common stock is only slightly
influenced by debt control within the capital structure.
Brealey and Myers (2000) further point out that minimizing average weighted capital costs is not the
same as maximizing company value.
Static trade off theories
Static trade off theory, as has been said, is based on a compromise between the interest tax shield and
the cost of financial distress. It seeks to find an optimal distribution of capital when another crown of
debt brings tax support that offsets the cost of deadweight. All interpretations of static trade off theories
tend to be that marginal costs and marginal benefits of using the debt have to be balanced.
Theory works with the idea that an enterprise should borrow until the marginal value of the tax benefit
of another debt is offset by an increase in the present value of the cost of financial distress. (Myers,
1984)
Market value of
company
Debt
value of the enterprise without debt
PV cost of financial distress
PV tax shield
indebted enterprise value
Dynamic trade off theories
DER
time
DER upper limit
DER lower limit
The dynamic trade off theory is based on the fact that companies optimize their capital structure
through continuous decisions not only about balancing the tax benefit of the debt and the potential cost of
financial distress, but also balancing investment decisions and restructuring costs.
Fisher et al. (1989) developed a model in which, instead of optimal capital structure, they introduce an
optimal range of capital structure within which the firm can move.
The cost of financial distress and bankruptcy
as the cost of adjusting the capital structure
Unused tax benefits of using the debt as a cost
Adjustment of the capital structure
Pecking order theory
Pecking order theories are another group of theories. They have a common character
with dynamic trade off theories, as they also work with the ability to finance themselves.
The chief representative of the theories is Stewart Myers with his pecking order theory,
or asymmetric information theory based on empirical research by Gorgon Donaldson
(1961).
The starting point of this theory is that the optimal capital structure of the company in
general, and more specifically in the individual sectors, basically does not exist and that
efforts to over-generalize can be very misleading. Every company is so specific that its
optimization efforts can not be transferred to other companies. Each company continually
optimizes its financial decisions due to the constantly changing specific conditions of its
development.
Pecking order theory
Pecking order theory is based on the fact that, due to the existence of an unfavorable
selection, the company primarily uses the retained earnings for its financing, then debt
financing, and is then focusing on obtaining additional own sources of financing.
Myers (1984) argues that undistributed profits are better than debt, debt is better than core
capital. Almost all the theories belonging to this group deal with the interpretation of the
relative use of internal and external sources of financing and the preference of debt before
issuing equity securities.
Internal sources
Debt financing
Issue of share
Pecking order theory - information asymmetry and adverse selection
• The most profitable companies borrow the least.
• Businesses are not trying to make the best financial decisions, they are the least
resistance.
• The two-way flow of capital is conditional on the existence of free cash flow.
• It is based on an incorrect valuation of equity on the basis of insufficient
information.
• Information asymmetry concerns only the value of the new project, the problem
of over-investment may arise. The question of the right timing.
Main studies: Myers (1977, 2001), Harris a Raviv (1991), Myers a Majluf (1984),
Korajczyk et al. (1990), Frank a Goyal (2003), Taggart (1977), Baskin (1989), Allen (1993),
Adediji (1998), Rashiah a Peong (2011), Jensen (1986)
Determinants of the financial structure and their relation to the use of debt sources
of financing
Linking the use of debt sources and the relevant
factor in individual theories
Trade off theory Pecking order theory
Profitability + Liquidity
+ Fixed
assets + effective
tax rate + Firm‘s
size + Growth
of investment opportunities - +
Influence of banking + -
Determinants of the financial structure - profitability
In terms of enterprise profitability, the trade off theory says that profitable businesses tend to use other
foreign sources of funding because of the existence and functionality of the tax shield. If businesses are
profitable, their free cash is growing under otherwise unchanged conditions, the risk of availability of
funds in general is decreasing and, at the same time, the availability of debt financing on favorable
terms in terms of debt costs is increasing. It also means that with the growth of profitability the
probability of bankruptcy and the cost of financial distress are decreasing. This leads to the essence of
the trade off theory of the positive relationship between return on equity and used debt financing.
On the other hand, the pecking order theory states that if there are internal sources of funding, they
will be preferred because of the absence of additional transaction costs. Foreign resources will be used
only in the absence of retained earnings. With increasing profitability, efforts to keep profits are
increasing and excess of retained earnings leads to a lower debt value. In terms of this theory, debt is
perceived rather as a signal of insufficiency in terms of profitability. As a result, a negative relationship
between profitability and the growth of use of foreign funding sources is expected.
Determinants of the financial structure – growth of investment opportunities
Growth of investment opportunities by trade off theories in significantly profitable
companies will cause a fall in the volume of free cash flows. With the growth of investment
opportunities, also according to the theory of compromise, there is a growing conflict
between shareholders and bondholders as shareholders tend to take advantage of investment
opportunities at the expense of increased risk, and by using debt sources of finance to shake
that risk on the lender as well. The opportunity for investment is falling with the increase in
costs of financial distress and the risk associated with an inefficient firm. This also reduces
the availability of debt financing. Realized studies (eg Jung et al., 1996, Jensen 1986, Stulz
1990) predict the negative relationship between investment opportunities and the current state
of debt financing.
By contrast, the pecking order theory assumes a positive relationship between investment
opportunities and debt financing, as the need for financial resources is increasing with
investment. The use of debt financing is preferred because of less disclosure of internal
information.
Determinants of the financial structure – fixed assets
The examination of the impact of the volume of fixed assets in the ownership of enterprises
on the extent of the use of foreign sources of financing is based on two fundamental aspects.
The first aspect is the stability and image of the company, which assumes that a wellestablished
long-term tangible capital is presumed to have an established company looking
after its development.
The second aspect is a guarantee. Long-term assets are perceived within the banking-oriented
financial system as a guarantee for the problems that may arise during the term of the
creditor's relationship.
Determinants of the financial structure – size of firm
Another significant determinant of the capital structure was the size of a firm that, in trade
off theories, assumes that the company's size is positively linked to the leverage effect, as
larger companies are considered more stable and less risky. Therefore, the acquisition of debt
sources of financing by large firms may be cheaper under the same conditions than with
smaller firms. In this context, fixed assets are also considered, as they can provide debt relief.
The pecking order theory is oriented in this direction to a negative correlation between the
size of the company and the size of the use of foreign sources of financing. This negative
correlation is due to the fact that large companies are associated with higher profitability and
hence the existence of a larger number of internal sources of financing.
Factors affecting the capital structure
Business risk
Linked to the existence of a business
Affected by competition in the industry
Corporate Tax Position
Possibility to deduct interest costs
Reducing the effective cost of capital
Financial flexibility
Availability of sources of funding
Using foreign resources not only for investments
Managerial conservatism and aggression
Manager skills, manager behavior
Factors affecting the capital
structure
Factors affecting the capital structure
Business risk is associated with the company's own existence if it does not use debt
financing (higher business risk means a lower debt ratio).
The corporate tax position is related to the fact that the main reason for using the
debt is to deduct the interest burden from the tax base of income tax, which
ultimately reduces the effective cost of foreign capital.
Financial flexibility testifies to the ability to raise capital in "reasonable" time
under unfavorable conditions. The supply of capital is absolutely necessary for
stable operation.
Managerial conservatism and aggression are linked to managers' ability to
leverage debt capital in an effort to increase profits.
Sources:
1) ROSS, S. A., R. W. WESTERFIELD, J. JAFFE & B. D. JORDAN, 2019. Capital
structure. In: Corporate Finance, Chap. 16-17, pp. 487-550. ISBN 978-1-260-
09187-8.
2) BERK, J. & P. DeMARZO, 2017. Capital structure. In: Corporate Finance, PART
5, pp. 520-550. ISBN 978-1-292-16016-0.
Thank you for
your attention!
