Theories of Capital Structure

By SmallStocks on Feb 24, 2009 in Investment

I thought it would be useful to look at some of theories of capital structure and what their purpose is, how they apply to companies and whether we really need to know about them as investors. Evidently, the later part of this statement is true all parts of finance are indeed useful and capital structure is no less important. There are three main theories of capital structure Trade-off Theory, Pecking Order Theory and Free Cash Flow and today I am only going to focus on the first two. Please keep in mind that entire books have been written on these two theories and I intend on only covering the basics. A brief introduction to each are outlined below:

Trade-off Theory The Trade-off Theory is a theory which suggests that companies have an optimal capital structure based on a trade-off between the benefits and the costs of using debt. Pecking Order Theory The Pecking Order Theory or the Capital Shuffle as I call it suggests that companies always follow a hierarchical pattern in financing sources such that internal funds are always preferred to external ones and borrowing is preferred to issuing risky securities. This theory is based on information asymmetry whereby all relevant information is not known by all parties interested in knowing it. Information asymmetry is the battle ground for most fundamental investors as it is involves the discrepancy between what insiders of a company know (managers) versus what those external to the company do (such as shareholders and lenders).

Trade-off Theory The trade-off theory really emphasis the effects of taxes and the costs of financial distress in engaging in high leverage finance. This theory suggests that companies should borrow until the marginal tax advantage of additional debt is offset by the increase in present value of the expect costs of financial distress. Many opponents to the tradeoff theory question how the theory actually explains capital structure decisions because there are many cases where corporate leveraging is much lower than what the trade-off theory suggests. Such opponents argue that many multinational companies with high profit margins have operated for an extended period of time with low debt ratios and achieved solid credit ratings. Trade-off theory would suggest that these same companies could achieve significant interest tax savings by increasing their debt ratios without any remote possibility of financial distress becoming an issue. Evidently, there are large bodies of evidence to suggest the opposite is also true and that trade-off theory is entirely useful. Trade-off theory can explain most of the differences in capital structure that exist between competing industries in stances where leveraging is low when business risk is high and when most of companies assets are intangible in nature. However, while trade-off theory does really take a common sense approach to capital structure there are many things it cannot explain. Some of these include:

the conservative nature of companies when utilising debt finance why leverage is negatively related to profitability why leverage is so consistent across most countries despite huge variances in their taxation systems

Pecking Order Theory The Pecking Order Theory is a popular capital structure theory which usually explains why internal finance is much more popular than external finance and why debt is classified as the most attractive external finance option. The theory basically suggests that companies with high profitability may use less debt than other companies because they have less need to raise funds externally and because debt is the cheapest and most attractive external option when compared to other methods of capital raising. Pecking order theory is really based on information asmmetry and when such information differences exist between mangers and investors issuing high risk securities involves large information costs. These costs are typically seen in the dilution of existing shareholders interests in a company if new shares are issued when they are undervalued.

The pecking order theory infers that because of the high information cost correlated to the new high risk securities, companies will generally only issue equity as an absolute last resort. Conclusion Both of these methods have there advantages and their disadvantages when examining the structures of capital financing. There are an abundant number of issues which must be explored and there are numerous texts available on this branch of finance. The most important aspect is to understand the different structures of capital financing so that it is possible to estimate the future profitability of a company and also the managements strategies in raising differing forms of finance. Information asymmetry does imply that insiders will always have a greater knowledge bucket in comparison to external investors of a company, and therefore examining the different methods of capital structure does help to strike a balance in the vicinity of par towards those external to a company.