Theory of Capital Structure

Theory of Capital Structure - A Review
Stein Frydenberg£ April 29, 2004

ABSTRACT This paper is a review of the central theoretical literature. The most important arguments for what could determine capital structure is the pecking order theory and the static trade off theory. These two theories are reviewed, but neither of them provides a complete description of the situation and why some firms prefer equity and others debt under different circumstances. The paper is ended by a summary where the option price paradigm is proposed as a comprehensible model that can augment most partial arguments. The capital structure and corporate finance literature is filled with different models, but few, if any give a complete picture.

JEL classification: G32

University College, Department of business administration, Jonsvannsvn. 82, 7004 Trondheim, Norway. E-mail: [e-mail].

£ Sør-Trøndelag

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Electronic copy available at: http://ssrn.com/abstract=556631

The view that capital structure is literally irrelevant or that ”nothing matters” in corporate finance, though still sometimes attributed to us,...is far from what we ever actually said about the real-world applications of our theoretical propositions. Miller (1988)

I. Introduction
The paper introduces the reader to two main theories of capital structure, which is the static trade-off theory, and the pecking-order theory. Underlying these theories are the assumptions of the irrelevance theorem of Miller and Modigliani. Since the irrelevance theorem is indeed a theorem, the assumptions of the theorem, has to be broken before capital structure can have any bearing on the value of the firm. If the assumptions of the irrelevance theorem are justified, the theorem follows as a necessary consequence.

II. The Irrelevance Proposition
In complete and perfect capital markets, research has shown that total firm value is independent of its capital structure. An optimal capital structure does not exist

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