This document discusses capital structure and the different theories around the optimal leverage level for firms. It covers the trade-off theory, which balances the tax benefits of debt against the costs of financial distress, and the pecking order theory, which states firms fund investments first through retained earnings, then debt, and finally equity. It also discusses agency costs theory and how the relationships between shareholders, creditors, and managers influence capital structure. The conclusion is that no single theory can fully explain capital structure choices and the optimal leverage level depends on firm-specific characteristics.

1. Capital Structure: What leverage
level should firms hold?
JOAN TAPIA BOIL

2. 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
6. Conclusion
7. Bibliography

3. Introduction (I)
 “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)

4. Introduction (II)
 Questions:
 How much should firms
borrow?
 Understanding Balance
Sheet
 Overcoming recessions
 Three main pillars: Interest
tax shield, asymmetric
information and agency
costs

5. Pillars of Capital Structure
• Interest Tax is deductible.
• Debt can reduce firm taxes and
increase firm cash flows
Corporate
taxes
• Adverse Selection
• Moral Hazzard
Asymmetric
Information
• Relationship between shareholders,
creditors and managers
• Conflicts of Interest
Agency
Relationships

6. Trade-off Theory (I)
Trade-off between the tax benefits on
the interest of debt and the costs of
financial distress
Trade-off determines optimal capital
structure
 Value of the leveraged firm L
 VL = VU (firm without debts)+PV(tax shield) - PV (cost of
distress)
 With higher profits, higher leverage ratios to reduce the
taxable income.

7. Pecking Order Theory
 No optimal capital structure
 Based on the asymmetric information
 Hierarchal sort of financial sources to fund new
investments:
1. Retained profits
2. Debt
3. Hybrid Securities such as convertible bonds
4. Equity
 Applied for Small and Medium Enterprises (SME)

8. Agency Costs Theory
 Agency Relationships:
 Manager and Shareholders Relationship
 Agency equity costs
 Usage of the Cash Flow
 Debt holders and Shareholders relationships
 Agency debts costs
 Risky Investments
 Optimal Capital Structure:
 Overall costs are at the lowest level

9. Conclusion
 There is no a magical formula for the optimal debt
ratio
 No one theory can capture everything that drives
that lead to the debt vs. equity choices
 Helpful theories depending on the firms characteristics.
 SME
 Pharmaceutical firms
 “It doesn't matter whether a company is big or
small. Capital structure matters. It always has and
always will” Mr. Milken (2009)

10. Bibliography
 Aybar Arias, C. A. Casino Martínez and J. López Gracia, 2001, “Jerarquía de preferencias y
estrategia empresarial en la determinación de la estructura de capital de la pyme: un
enfoque con datos de panel”. WP–EC 2001–06, Instituto Valenciano de Investigaciones
Económicas.
 Binks, M. R., Ennew, C. and Reed, G., 1988. “Small Business and Banks: A Two Nation
Perspective”. The Forum of Private Business, UK and the National Federation of Independent
Businesses, USA.
 Brealey, R.A., Myers, S.C., Partington, G. and Robinson, D. (2011), “Principles of Corporate
Finance”. 7th edition, Irwin McGraw-Hill.
 Ferrer, M. A. and Tresierra, A, 2009. “Las PYMES y las teorías modernas sobre
estructura de capital” Compendium, 22, pp. 65- 83.
 Frank M.Z., and Goyal V.K., 2003. “Testing the Pecking Order Theory of Capital Structure”.
Journal of Financial Economics, 67, 217-48.
 Harris, M. and A. Raviv, 1991. “The theory of capital structure”. The Journal of Finance 46, pp.
297–355.
 Jensen M. C. and Meckling W.H., 1976. “Theory of the Firm: Managerial Behavior, Agency Cost
and Ownership Structure”. Journal of Financial Economics, 3 (4), 305-60.
 Modigliani, F. and M.H. Miller, 1958. “The Costs of Capital, Corporate Finance, and the Theory
of Investment”. American Economic Review 48 (June): 261-297.

11. Bibliography
 Modigliani, F. and M.H. Miller, 1963. “Corporate Income Taxes and the Cost of Capital: A
Correction”. American Economic Review 53 (June): 433-443.
 Myers, S.C., 1977. “Determinants of Corporate Borrowing”. Journal of Financial
Economics 5, 147-175.
 Myers, S.C., 1984. “The Capital Structure Puzzle”. Journal of Finance 39, 575-592. Myers,
S. C., 2001. “Capital structure”. The Journal of Economic Perspectives, 15, 81-102.
 Scott, J. H., 1977. “Bankruptcy, secured debt, and optimal capital structure”. The Journal
of Finance, 32, 1-19
 Sogorb, M. F., 2005. “How SME uniqueness affects capital structure: Evidence from a
1994–1998 Spanish data panel”. Small Business Economics, 25, 447–457.
 Stiglitz, J. E. and A. Weiss, 1981. “Credit Rationing in Markets with Imperfect
Information”. American Economic Review 71(3), 393–410.
 Wald, J. K., 1999. “How firm characteristic affect capital structure: an international
comparison”. Journal Financial Research, 22(2), 161 – 88.
 Zambrano, S. M. and Acuña, G. A. (2011). “Estructura de capital. Evolución teórica”.
Criterio Libre 15(9), 81-102.
 Zoppa, A. and McMahon, R., 2002. “Pecking Order Theory and the Financial Structure of
Manufacturing SMEs from Australia‟s Business Longitudinal Survey”. School of
Commerce, The Flinders University of South Australia. Research Paper Series 02-1.
Australia.

12. The End.