The document discusses several theories of capital structure: 1) The traditional approach finds that a firm's value and cost of capital initially decrease with more debt but then increase after a certain point as debt rises. 2) Modigliani and Miller's approach suggests capital structure does not affect firm value in the absence of taxes. 3) Pecking order theory proposes firms prefer internal funds, then debt, and finally equity when raising capital, due to costs and information asymmetries. 4) Static trade-off theory finds an optimal capital structure where the marginal benefit of debt's tax shield equals the marginal costs of bankruptcy.

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Amity Business School
Capital Structure

2. Amity Business School
The Traditional Approach
• Intermediate Approach
• According to this: the value of firm can be increased
initially or the cost of capital can be decreased by
using more debt as the debt is a cheaper source of
funds than equity. Beyond a particular point, the cost
of equity increases because increased debt increases
the financial risk of the equity shareholders.

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• The advantage of cheaper debt at this point is offset by
increased cost of equity.
• After this there comes a stage, when the increased cost
of equity cannot by offset by the advantage of low cost
debt.
• Thus overall cost of capital, decreases up to a certain
point, remains more or less unchanged for moderate
increase in debt thereafter; and increases beyond a
certain point.

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Modigliani and Miller Approach
• In the absence of taxes
• Arbitrage Process

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6. Amity Business School
Pecking Order Theory
• The pecking order theory suggests that there is
an order of preference for the firm of capital
sources when funding is needed.
• The firm will seek to satisfy funding needs in the
following order:
– Internal funds
– External funds
• Debt
• Equity

7. Amity Business School
Pecking Order Theory
• There are three factors that the pecking order
theory is based on and that must be
considered by firms when raising capital.
1. Internal funds are cheapest to use (no issuance
costs) and require no private information release.
2. Debt financing is cheaper than equity financing.

8. Amity Business School
Pecking Order Theory
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmetric information, investors
may make inferences about the value of the firm
based on the external source of capital the firm
chooses to raise.
• Equity financing inference – firm is currently overvalued
• Debt financing inference – firm is correctly or undervalued

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Pecking Order Theory
• The pecking order theory suggests that the firm will first
use internal funds. More profitable companies will
therefore have less use of external sources of capital
and may have lower debt-equity ratios.
• If internal funds are exhausted, then the firm will issue
debt until it has reached its debt capacity .
• Only at this point will firms issue new equity.
• This theory also suggests that there is no target debt-
equity mix for a firm.

10. Amity Business School
Static theory of Finance
 However, as the firm assumes more debt, it becomes
more risky, i.e., will have a higher chance of
defaulting on its debt and investors will therefore
demand a higher return.
 When the possibility of bankruptcy and its associated
costs are considered, the optimal capital structure
(optimal debt-equity ratio ) is at the point where the
additional tax-shield benefit of taking on one more
dollar of debt (marginal benefit) is equal to the cost of
bankruptcy (marginal cost).