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2025 R25 Module 25.2

The document discusses various capital structure theories, primarily focusing on the Modigliani-Miller (MM) propositions, which state that a firm's value is unaffected by its capital structure under certain assumptions. It also introduces the Static Trade-Off Theory, which suggests an optimal capital structure where the tax shield from debt balances the costs of financial distress. Additionally, it covers Agency Costs and the Pecking Order Theory, highlighting how managers prefer retained earnings over debt and equity to minimize negative signaling.

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Ĺuke Shah
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6 views4 pages

2025 R25 Module 25.2

The document discusses various capital structure theories, primarily focusing on the Modigliani-Miller (MM) propositions, which state that a firm's value is unaffected by its capital structure under certain assumptions. It also introduces the Static Trade-Off Theory, which suggests an optimal capital structure where the tax shield from debt balances the costs of financial distress. Additionally, it covers Agency Costs and the Pecking Order Theory, highlighting how managers prefer retained earnings over debt and equity to minimize negative signaling.

Uploaded by

Ĺuke Shah
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Corporate Issuers

Capital Structure Theories

Capital Structure Theories

Modigliani-Miller (MM) Propositions


MM I: value of a firm is unaffected by its capital structure
 Levered and unlevered firm have same value
Assumptions
 No taxes, transaction costs, bankruptcy costs
 Homogeneous expectations
 Borrowing and lending at risk-free rate
 No agency costs
 Investment decisions unaffected by financing decisions

© Kaplan, Inc. 1

1
Capital Structure Theories

Modigliani-Miller (MM) Propositions


MM II: WACC is unaffected by capital structure
 rd < re because cash

Cost of capital
flows to debtholders are
less risky D
re = r0 + (r0 – rd )  
 re increases as E
proportion of debt
increases WACC
r0
Same assumptions as
Cost of debt
MM I, including no taxes

© Kaplan, Inc. Debt/equity 2

Capital Structure Theories

Modigliani-Miller (MM) Propositions


 MM with taxes: debt financing creates a tax shield that
increases company value
Cost of capital

 Cost of capital minimized D


re = r0 +   (r0 – rd ) 1 – TC 
and value of the firm E
maximized at 100% debt
WACC
rd After-tax
cost of debt

% of debt in
3
© Kaplan, Inc.
capital structure

2
Capital Structure Theories

Modigliani-Miller (MM) Propositions


 In practice, firms do not use 100% debt due to costs of
financial distress:
 Legal and administrative fees from bankruptcy
 Loss of trust, foregone investment opportunities
 Agency costs of debt: managers represent equity owners

© Kaplan, Inc. 4

Capital Structure Theories

Static Trade-Off Theory


Cost of capital

Cost of equity A firm’s optimal capital


structure is the proportion
of debt at which the value of
WACC
the tax shield from additional
borrowing just offsets the
increase in costs of financial
After-tax cost of debt distress.
with financial distress

Optimal % of debt in
capital structure capital structure
© Kaplan, Inc. 5

3
Capital Structure Theories

Agency Cost and Asymmetric Information


 Firm insiders have a better quality of information.
 Outsiders look for signals from managers.

Agency cost (of separation of ownership and control)


 Monitoring cost
 Bonding cost
 Residual losses

© Kaplan, Inc. 6

Capital Structure Theories

Pecking Order Theory


 Managers want to send the least amount of negative signal.
Accordingly, their preferred sources of capital (highest to
lowest) are as follows:
 Retained earnings
 Debt
 New equity

 The pecking order theory states that the observed capital


structure is the result of the manager’s choices over time.

© Kaplan, Inc. 7

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