Capital Structure Theory: a Current Perspective

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Summary This paper (by Susan Chaplinsky, Robert S. Harris, 2008) provides an overview on how the capital-structure theory evolves. The classical theory (Modigliani and Miller (MM)) states a firm’s value is independent of capital structure in perfect capital markets, which has four critical properties: (1) No taxes; (2) No transactions/distress costs; (3) Common objectives among decision-makers; (4) Perfect information to all. The evolution is based on relaxing these four properties: the modern “traditional” theory (revised MM) based on relaxing (1), (2) assumptions; while the recent agency theory focuses on the (3), (4) assumptions. Key Findings By pulling up all elements together, CFO’s choice on capital-structure is posing trade-offs among five considerations: (1) the tax benefits of financing, (2) the explicit costs of financial distress, (3) the agency costs of debt, (4) the agency costs of equity, and (5) the signaling effect of security issuance. The first two considerations 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 last one recognizes that the action of issuing a security can convey different (good and bad) information to investors. The evolving theories provide a rich array of insights into aspects of financial policy beyond slicing on the debt-equity pie. However, there still no overarching synthesis of these theories. Therefore, practical application requires careful identification of how these particular theories are relevant to the business, the markets, and the situation facing, and it is a major duty and decision of every CFO. My Thoughts The evolving capital structure theories implicates the world is filled with potential conflicts of interest as different decision-makers interact;

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