Capital Structure Theories: Critical Assessment


The modern theories about capital structure have gained momentum since the groundbreaking 1958 article written by Modigliani and Miller (hereafter, MM). Before the issue of the article, there was only a vague knowledge of the real consequences of debts and equity problems for the capital structure without any analytical or systematic framework on the topic. The MM works led to the emergence of new theories on capital structure. Between the 1960s and 1970s, an array of economists developed a couple of theories on this subject, including the trade-off theory, agency theory, corporate control theory, and others (Baker & Martin, 2011).

An optimal capital structure is one with a financing mix that is able to add value to the firm. However, there are mixed opinions about the existence of an optimal capital structure. Some say that the value of the firm is not influenced by the financial mix, and thus, the optimal capital structure does not exist. According to the primary capital structure theory proposed by Modigliani and Miller, the value of a firm does not rely on its capital structure, even in the most competitive capital markets.

Another viewpoint is that managers can in theory figure out the optimal capital structure of a firm. In the last five decades, economists have reconsidered the strict assumptions on the capital structure and included the capital structure frictions into the model. By the means of introducing the capital market frictions such as bankruptcy costs, taxes, and asymmetric information, financial economists were able to justify some factors that contribute to the decision-making process in terms of capital structure. Thus, there were outlined several capital structure theories that included the trade-off theory, the pecking order theory, the signaling, and the market timing theory that explained the importance of capital structure. When taken into consideration separately, the theories do not explain particular facts about the notion of capital structure. Thus, despite the existing research on capital structure, the determination of a particular financial mix that helps with the market value maximization of a firm remains unresolved.

Capital Structure Seen Commonly

A firm that deals with a deviation between an optimal and the actual ratio of debt can choose from several solutions to the issue. For a start, a firm should come up with an answer to a question: Is it better to pursue the optimal ratio or remain at the point the firm is at now? Then, once this question is out of the way, it is important to decide whether to move swiftly toward a goal or to implement a step-by-step approach. The external pressure from stockholders guides this decision. Lastly, if the firm decides to implement a step-by-step approach, it is important to figure out whether put new investments into innovative projects or put the investments into the already existing ones (Damodaran, n.d., p. 1).

It is implicitly assumed that if a firm deals with a deviation between an optimal and the actual ratio of debt, it will definitely want to move towards the optimal ratio. In reality, it rarely happens like that. Some firms tend to stay under leverage and do not use their debt capacity. Moreover, there are firms that are in so much debt that they choose to ignore it and not pay down. Thus, the main question for a firm is to change or not to change.

To answer the question adequately, it is crucial to consider the under-levered firms first. The main reason for the firm not to move towards the optimal value is the firm’s view that this objective will not contribute to the value. If the firm’s primary objective is the maintenance of a relatively high bond rating, having more is viewed less desirable than having less debt. The firm’s stockholders should thoroughly discuss the issue with managers that avoid debts because of an availability of an alternative objective and encourage them to justify this objective (Damodaran, n.d., p. 3).

MM Capital Structure Theory

The MM capital structure theory is considered a cornerstone for the sphere of corporate finance. The theory starts with a question “what is the cost of capital to a firm?” Modigliani and Miller speculate that this question causes some issues for three classes of economists. For example, economists that deal with finances are concerned with the techniques and strategies of a firm to make sure that it continues to exist. Economists-managers are focused on the capital budgeting strategies and decisions, and the economic theorists deal with the investment behavior on both micro and macro levels (Baker & Martin, 2011).

MM argue that the most important issue to consider is the risk preferences of the company’s owners. Otherwise, managers will have difficulties when deciding on which projects are best suitable for the company. Thus, the decision-making criteria that guide managers are either accepting the project increases for the firm’s value or not. The use of such criteria suggests the adoption of the market value approach.

The first proposition of the MM theory states that the firm’s market value is independent in its financing decisions. Thus, MM have created their own model that is grounded on the following assumptions:

  1. The opportunities on firm’s investment are fixed.
  2. The company’s investors have similar expectations about the future earnings as well as their volatility.
  3. There are no transaction costs and taxes to be borrowed from the capital market.
  4. There are no reorganization costs or bankruptcy.
  5. The debt and the debt interest rate are risk-free.
  6. The standard earning deviation can measure the firm’s business risk.

The second propositions states the rate of return on common stock of companies whose capital structure includes some debt is equal to the appropriate capitalization rate for a pure equity stream plus a premium related to financial risk that is equal to the debt-to-equity ratio times the spread between the capitalization and risk-free rates (Baker & Martin, 2011).

Jensen, Meckling and Myers’s Theory

The theories of Jensen, Meckling, and Myers can be summed up under the name of the pecking order theory. This theory assumes that the target capital structure does not exist. Companies are able to choose their capitals in accordance with a preference order that includes the internal finance, debt, and equity. Pecking order theory argues the existence of the “information symmetry” that is existent between the company’s investors and managers. It is suggested that the firm’s management has more insight information about the company that the investors that rarely are interested in the details of the business process.

Thus, the theories of Jensen, Meckling, and Myers identify the conflict of interest between managers of the firm and its shareholders, and between shareholders and the debt-holders. These conflicts lead to the costs of equity and costs of debt respectively. In the majority of situations, the firm’s managers are interested in accomplishing their set goals that may go across the values of the company. The firm’s owners can monitor the behavior of their managers; however, such control can lead to the costs of equity. On the other hand, because the lender offers money to the company, the interest rate relies on the firm’s risk (Chen & Chen, n.d., p. 2).

The pecking theory models may be based on the adverse selection consideration, the consideration of the agency as well as other factors. There are several features that ground the pecking order theories. The first feature of the theory is the fact that the firm objective function is linear. The second feature of the theory is the fact that the model is simple. The structure of the pecking order is relatively simple because if the model is complex then it is likely to have a complex solution (Frank & Goyal, 2005, p. 19).

Trade-Off Theory

The trade-off theory was initially introduced by Kraus and Litzenberger (1973) and then followed by Ritter and Huang (2009). According to the theory, a company balances the tax benefits of debt against the deadweight costs of financial distress and bankruptcy. Because companies are allowed to reduce their interest paid on debt from their tax liability, they favor debt over equity. The present value of the resulting gains from choosing debt over equity, the so-called tax shield, increases firm value. Without any additional and offsetting cost of debt, this tax advantage would imply full debt financing (Baker & Martin, 2011).

In general, a firm that follows the static trade-off theory is the one in which the leverage is based on the trade-off period. Such period is characterized by the bankruptcy and agency costs of equity and debt. A firm that keeps up with the trade-off theory usually determines a particular ratio of debt-to-value and then step by step moves in the direction of the set ratio. This ratio is found by the balance of bankruptcy costs against the debt tax shields. However, the static model of the trade-off theory is only focused on a single-period decision and does not include the target adjustment. To be more specific, a static model offers an answer to the issue of leverage, but the company does not have any other option to be at any other point apart from the leverage.

In a dynamic trade-off model, the ratio of debt for the majority of companies is more likely to be different from the optimal ratio. For instance, Welch and Bessler were able to document the fact that the leverage of the firm does not correspond to the fluctuations on a short-run equity when being measured in terms of the market perspective (Baker & Martin, 2011).

Capital Structure Theories Assumptions Comparison

The first assumption of the Modigliani-Miller theory is that there is no cost for the financial transactions. A firm that wants to sell its stock in order to finance a new project is able to do so without compulsory payments to an intermediary body, for example, an investment bank. However, in reality, transaction costs do exist. Apart from the firm being compelled to pay fees when it comes to stock, warrant, or bond issue, a firm is forced to wait some time. In some cases of planning, the firm’s top management has to spend months, which distracts the focus form other tasks. The second assumption of the MM theory is the investors’ ability to borrow funds at the same cost. This assumption is a crucial component of the theory, as its authors argue that the result of the actions of a firm or an investor borrowing money remains the same. In any case, the investor is being leveraged, thus, he has to consider the risks that go hand-in-hand with the borrowed funds. The third assumption of the MM theory is that in case the firm acquires extra funds, it will not waste it. Despite the large amounts of funds that remain in a bank, a firm will invest in case of a promising opportunity; however, if there are no extra funds, the firm will return the money to shareholders. However, in real world of corporate finance, this assumption rarely works out. In reality, firms tend to waste extra funds, often finding risky projects.

The assumption of the trade-off theory is that there are existing benefits of leverage in a capital structure until the reach of an optimal capital structure. This theory underlines the benefit of taxes from the interest payments. However, the majority of studies prove that companies usually far less leverage than the theory deems optimal. When comparing the assumptions of the theories, the major difference between the two is the potential profit from debt in the capital structure. This profit appears from the tax benefit of the interest fees. Because the MM theory has an assumption of no taxes, the interest benefit is not taken into account; however, in the trade-off theory, the taxes and consequently tax benefits are taken into account.

Unlike the trade-off theory, the pecking order theory assumes that a firm prefers to fund itself through the use of retained earning. However, when the source of retained earnings is unavailable, the firm issues debt and only in the case of emergency it issues equity. This is connected with the types of messages sent to the market. For example, the debt signalizes that the firm’s management are sure that they can pay the debt, equity signalized that the management can face a downfall in its share price. In such terms, the pecking order theory looks at the capital structure from a viewpoint that has roots in the agency theory. However, empirical research has concluded that there is very little evidence that these theories explain how firms implement their decisions in financing.

The trade-off theory assumption helps firms figure out their capacity of debt while the pecking order theory is able to describe the preference of a firm to choose between various financing methods. Pecking order satisfactorily gives the explanation to the behavior of bigger firms, but not smaller. The distinction between the larger and smaller firms is a sensible remark because the size of a firm is a variable that is crucial for the firm’s access to capital markets (Capital Structure: Trade-Off Theory VS. Pecking Order Theory, 2012, para. 6).

Overall, the discussion over capital structure is not likely to be concluded in terms of dominance of one theory over another because of a large number of components that should be taken into consideration. While it is crucial for the capital structure to minimize the cost of capital, such ability has to be based on the flexibility that is an issue for the modern market environment. Thus, the existence of several theories on capital structure in comparison to one is quite beneficial.

Capital Structure Trends

In the process of analyzing various measures in the realms of corporate financing patterns, one can observe common trends. First, in the postwar period, the use of debt financing has skyrocketed to considerable rates. Despite the widespread availability of inflationary distortions in some data types, the mentioned trend appears irrespective of the used method of measurement. Nevertheless, there is significantly more doubt as to the matter of whether some levels of debt are unexplainably high compared to the levels documented in the prewar period. Second, there has been changes within the parts of corporate finance when it comes to debt and equity. Despite the fact that the changes in corporate finance are only detectable the sources and uses of data funds, there appears very little deviations about the increase of long-term liability importance. However, this trend is directional. Within the component of equity, there is no ambiguity in terms of preferred and common stock’s decrease in relative importance. On the other hand, the equity that is generated internally is now quite low in comparison to previous decade; however, it is far less clear whether the equity will be as unusually low when the long-run view is taken into account (Taggart, 1985, p. 28).

Market Efficiency, Availability of Information and Market-Financial Structure Interactions

According to Fama, market efficiency is defined as “A market in which prices always ‘fully reflect’ available information is called ‘efficient’.” (as cited in Jarrow & Larsson, 2011, p. 1). When discussing efficient markets, there are three sets of information considered. The sets are the following: historical prices, information available publicly, and information available only privately. To each set of information, a particular market can be efficient or inefficient. There are three outlined forms of market efficiency:

  1. Weak-form efficiency. In this form of market efficiency, an investor cannot earn excess returns by the means of creating trading rules on the basis of return information or historical prices. To simplify, to dominate the market, a technical analysis or chart reading is useless. Thus, the weak-form efficiency makes an implication that the actual asset price reflects the historical information (Gregoriou, n.d., p. 4).
  2. Semistrong-form efficiency. In this form of market efficiency, an investor cannot earn excess returns with the use of information available publicly. Thus, the semistrong-form efficiency makes an implication that the actual asset price reflects the information available publicly.
  3. Strong-form efficiency. In this form of market efficiency, an investor cannot earn excess returns with the use of any available information, private or public. Thus, the strong-form efficiency makes an implication that the actual asset price reflects all information. Moreover, this type of market efficiency implies that private information will not help in acquiring any profit by the market insiders. Furthermore, according to the strong-form efficiency, before even having a chance to trade upon the news, the prices would have already been adjusted (Gregoriou, n.d., p. 7).

The reliance on the availability of informational efficiency as a primary attribute of allocational efficiency can be suitable in cases if particular market components exist. These components include the flow of financial information that is not interrupted, the possibility of investors to process and analyze the available information, and the availability of a exchange mechanism that is developed both legally and technically. These conditions are available in the majority of US markets with available information on finances, information disseminators, an abundance of services on financial advisory, and the trading mechanism.

The majority of financial market-product interactions with a focus on the capital structure were originally demonstrated by Jensen (1986), Myers (1977), and Meckling (1979) in terms of a single-firm environment. First, when it comes to the risky debt outstanding, the generated from investment cash flows fall into the hands of debt holders. Second, because equity reminds of the firm’s total cost, the management has a stimulus to choose specifically risky projects of investment. Third, the capital structure can influence the decision-making process of the management in terms of dissipative projects of investment that can result in various perks (Zechner, 1996, p. 884).

The majority of interaction models between financial and product markets rely on the relationships between bondholders, the investors, and firm’s management. However, the information that is being revealed in the financial market is a crucial channel through which markets cooperate. To allow firms trade in the area of financial markets, make better production and investment decisions, and make a profit from trading, it is important to utilize available information. Therefore, the aggressive trading can not only affect the prices within particular market, but also shed light on the information about competitors.

The basic framework of the market-financial structure model can be also used within the area of the fiirm’s bonds or stocks. The amount of generated information can rely on the decisions of the firm when it comes to the capital structure. Moreover, in this context, the firm’s decision to go public when it comes to information availability can be considered. By the means of listing stock in terms of stock exchange, a firm also generates market information. Thus, there could be an industry equilibrium in which some firms go public while others don’t. Lastly, the market-financial structure model can be extended in such a way that it can allow the optimal firm to choose its size (Zechner, 1996, p. 894).


Despite the in-depth research, financial economists still consider capital structure a “puzzle in which all the pieces do not fit perfectly into place” (Baker & Martin, 2011). The main goal of the capital structure decision is connected with the determination of a financial leverage that is able to give or take the value of a firm. In the theory developed by Miller and Modigliani that was developed without taxes, the notion of capital structure has no relevant effect on the value of a firm.

From the development of capital structure theories over the last twenty years, several crucial conclusions can be made. Financial economists have majorly tested the pecking order and trade-off theories. When considered separately, these theories have no ground when it comes to the explanation of capital structure. However, in the future research, economists should keep developing alternative versions of these theories for the development of new ideas.


Baker, K., & Martin, G. (2011). Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. Hoboken, NJ: John Wiley & Sons.

Capital Structure: Trade-Off Theory VS. Pecking Order Theory. (2012).

Chen, L-J., & Chen, S-Y. (n.d.). How the Pecking Order Theory Explain Capital Structure.

Damodaran, A. (n.d.). Chapter 9. Capital Structure: The Financing Details.

Frank, M., & Goyal, V. (2005). Trade-Off and Pecking Order Theories of Debt. Web.

Gregoriou, A. (n.d.). Money Banking and Finance Efficient Markets Hypothesis: Theory and Evidence.

Jarrow, R., & Larsson, M. (2011). The Meaning of Market Efficiency.

Taggart, R. (1985). Secular Patterns in the Financing of U.S. Corporations. In B. Friedman (Ed.), Corporate Capital Structures in the United States (pp. 1-11). Chicago, IL: The University of Chicago Press.

Zechner, J. (1996). Financial market-product market interactions in industry equilibrium: Implications for information acquisition decisions. European Economic Review, 40(1), 883-896.

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