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Capital Structure Theory: a Current Perspective

14 Pages Posted: 21 Oct 2008  

Robert S. Harris

University of Virginia - Darden School of Business

Susan Chaplinsky

University of Virginia - Darden School of Business

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Abstract

Finance scholars' approach to capital-structure issues reflects a progression of thought over time. This note provides an overview of the current state of capital-structure theory. One perspective on capital-structure choice is to view it as posing trade-offs among five elements: (1) the tax benefits of financing, (2) the explicit costs of financial distress, (3) the agency costs of debt (including an array of indirect costs linked to financial distress), (4) the agency costs of equity, and (5) the signaling effect of security issuance. The first two elements reflect the "modern, traditional" balancing theory of capital structure. The third and fourth build on agency theory and imperfect information and emphasize the individual incentives of decision makers. The fifth element recognizes that the very act of issuing a security can convey new information to investors when there is imperfect information. While newer theories provide a rich array of insights into aspects of financial policy beyond how much debt the firm should undertake, the downside is that at present there is no overarching synthesis of these theories. As a result, practical application requires careful identification of how these particular theories are relevant to the business, the markets, and the situation at hand. This note is well suited to an advanced corporate-finance course after students have been exposed to the basic theory.

Excerpt

UVA-F-1165

CAPITAL STRUCTURE THEORY: A CURRENT PERSPECTIVE

A complex set of decisions creates a firm's capital structure. Capital structure dictates the funding sources tapped by the company and allocates risks and control rights to various parties. Pursued wisely, capital structure decisions should enhance value in financial markets. Key decisions include the overall mix of debt and equity, the forms, terms, and maturity structure of debt, the allocation of voting control among equity classes, the timing of security issuance, and a host of issues about particular types of financial claims (including hybrids such as convertibles and debt substitutes such as leasing).

The approach of finance scholars to capital structure issues reflects a progression of thought over time. The result is an eclectic set of sometimes competing, theories dealing with many forces that shape financial decisions. This note provides an overview of the current state of capital structure theory.

Classical Theory—Perfect Capital Markets

Early theory focused on capital structure as a way to carve up a fixed amount of operating cash flow. In this “fixed pie” view, the key choice was the best split between debt and equity to allocate those operating results. This view originated with the classic contribution of Modigliani and Miller (1958). They showed that in perfect capital markets, a firm's value is independent of capital structure: That is, any number of different mixes of debt and equity can result in the same firm value. While Modigliani and Miller's policy conclusion is not particularly appealing, their work laid an important foundation. In particular, by spelling out the assumptions of perfect capital markets, Modigliani and Miller (MM) pointed the way to factors (relaxed assumptions) that helped to explain financial structure. The critical properties of perfect capital markets are:

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Keywords: capital structure

Suggested Citation

Harris, Robert S. and Chaplinsky, Susan, Capital Structure Theory: a Current Perspective. Darden Case No. UVA-F-1165. Available at SSRN: https://ssrn.com/abstract=909392

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Susan J. Chaplinsky

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4810 (Phone)
434-243-7676 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/chaplinsky.htm

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