Capital Structure: What leverage
level should firms hold?
JOAN TAPIA BOIL
Table of Contents
1. Introduction (I and II)
2. Pillars of Capital Structure
3. Trade-off Theory
4. Pecking Order Theory
5. Agency Costs Theory
“the mix of securities and financial resources used by
corporations to finance real investment” (Myers,
2001, p. 81)
The way to finance assets (investments)
Resarch by Modigliani and Miller in 1958
Two forms of capital:
Debt (long and short term)
Capital (retained profits, contributed capital)
How much should firms
Three main pillars: Interest
tax shield, asymmetric
information and agency
Pillars of Capital Structure
• Interest Tax is deductible.
• Debt can reduce firm taxes and
increase firm cash flows
• Adverse Selection
• Moral Hazzard
• Relationship between shareholders,
creditors and managers
• Conflicts of Interest
Trade-off Theory (I)
Trade-off between the tax benefits on
the interest of debt and the costs of
Trade-off determines optimal capital
Value of the leveraged firm L
VL = VU (firm without debts)+PV(tax shield) - PV (cost of
With higher profits, higher leverage ratios to reduce the
Pecking Order Theory
No optimal capital structure
Based on the asymmetric information
Hierarchal sort of financial sources to fund new
1. Retained profits
3. Hybrid Securities such as convertible bonds
Applied for Small and Medium Enterprises (SME)
Agency Costs Theory
Manager and Shareholders Relationship
Agency equity costs
Usage of the Cash Flow
Debt holders and Shareholders relationships
Agency debts costs
Optimal Capital Structure:
Overall costs are at the lowest level
There is no a magical formula for the optimal debt
No one theory can capture everything that drives
that lead to the debt vs. equity choices
Helpful theories depending on the firms characteristics.
“It doesn't matter whether a company is big or
small. Capital structure matters. It always has and
always will” Mr. Milken (2009)
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