Optimal capital structure debt and equity

Literature Review

The capital construction of the house is made of two things, one is the degree of debt and the other is the proportion of equity. The direction of the house has to make up one’s mind an appropriate mix of both the support beginnings for the smooth running of the house and the maximization of the stockholders wealth. Traditional position was that to increase pitching degree to acquire leaden mean cost of capital ( WACC ) depression which will accordingly give a higher present value of future hard currency flows and enhance stockholders wealth. However the higher degree of debt will necessitate a higher payment of involvements before dividends which in bend leads the house to go financially hard-pressed and in utmost fortunes to be liquidised. Therefore, acquiring an optimum capital construction is indispensable. In this survey I will discourse the two theories, ‘optimal capital construction theory ‘ and the ‘pecking order theory ‘ with the aid of literature.

Literature Review of Optimal Capital Structure Theory

Franco Modigliani and Merton Miller ( 1958 ) developed a theory for optimum capital construction. At first they assumed that there is a perfect capital market which means that there are no income revenue enhancements and dealing costs. If the market is ideal so the house ‘s capital construction is inappropriate to its value as the investors are prudent, the needed return of equity is straight relative to increase in pitching. There is therefore a additive association between cost of equity and geartrain. The encouragement in cost of equity exactly offsets the benefits of the cheaper debt finance and hence the WAAC remains unaffected.

A figure of practical unfavorable judgments were made at the premises of perfect market specifically at the guess of no revenue enhancements which seemed unrealistic because the debt involvement is revenue enhancement deductible the consequence of revenue enhancement could non be neglected. However when corporation income revenue enhancements and dealing costs came into drama Miller and Modigliani ( 1963 ) changed their position of holding a perfect market and rephrased their theory stating that because debt involvement is revenue enhancement deductible the optimum capital construction can be complete debt finance as replacing debt alternatively of equity generates excess revenue enhancement nest eggs which can non be achieved otherwise. Firms can so go through on this excess economy to portion holders and other investors in the signifier of higher returns. Arnold. G ( 2004 ) further explains this modified position as a house financed with 99 % of debt and 1 % of equity serves its stockholders better so one funded by 50 % debt and 50 % equity. This in bend agencies that debt finance is cheaper so equity and utilizing every bit much debt as possible in a house ‘s capital construction will do the public presentation and result outstanding in footings of returns to its investors.

This raised a farther inquiry that if the debt reduces the revenue enhancement payments and consequences in the higher dividends to portion holders so does this mean that the houses financed mostly by equity are paying unneeded corporation revenue enhancement on the portion holders financess?

Miller ( 1977 ) discussed this job as by increasing the debt finance in capital construction of the company we can salvage money on revenue enhancement payouts but this will non alter the value of the entity because the money saved by increasing the debt finance is paid back to the portion holders in the signifier of dividends. In other words if the involvement payments of debt is greater than the equity returns so it removes the advantage of debt finance. ( Anne P. Villamil )

The job with Miller and Modigliani ‘s theories is that if the company is financed by 99 % debt it will set the company in the utter most grade of hazard because debt is riskier than equity every bit good as cheaper. What is meant by hazard here is that loaners will desire their return before company can make anything else with its net incomes and if company have to pay big sums of its gross towards the loaners so other duties such as payments to providers, dividends, rewards and wages and other concern disbursals will non be met by the company. This can besides ensue in hapless evaluation by bureaus and will halt investors to put in the company in future and there will be no other manner so to liquefy the company.

Pecking Order Theory

This theory is managerial type in which Myer ( 1984, p581 ) gives the thought that there is no such thing as optimum capital construction alternatively he argues that houses should raise finance in three different ways in order to salvage costs. First they should bring forth financess internally secondly the debt finance should be used and thirdly there should some new portion issues as good if needed. The ranking of fund elevation in this peculiar manner is wholly based upon the issue costs of the three different types. Because internally generated financess have the lowest issue costs so publishing debt has moderate issue costs and publish new equity has the highest costs. Therefore houses when of all time they need financess for what of all time ground should first bring forth financess internally and so travel on to the following class if they need to.

The picking order theory is best explained by position of asymmetric information and the being of dealing costs. Asymmetric or uneven information costs exist when houses produce funding for them internally to convey an investing ‘s net present value ( NPV ) to be positive. The outside investors, when the market monetary value of the equity is greater than the existent value can under or over estimate the monetary value of equity because normally they have really limited information about the company every bit compared to the directors and this gives opportunity to the directors to publish securities at a higher monetary value ( Myers and Majluf 1984 ) . Some elegant investors are cognizant of the inducements behind the issue of new equity when the market overvalues the bing equity therefore they will set the monetary value consequently and as a consequence of this the new securities will be under priced in the market. The impact of under priced new equity issue will be a loss to bing portion holders because new investors detain more of the NPV of the new undertaking. The directors moving in the favor of bing portion holder in such fortunes will reject the undertaking even if the NPV is positive. This under investing can be avoided by financing the new undertaking internally. ( Mayer and Majluf 1984 ) .

The picking order theory can besides be explained by manner of dealing costs. The costs linked with external fund elevation are the key to choose the beginning of finance. The beginnings can be ranked in order of the dealing costs associated with them as explained in the start of the picking order theory subdivision. There is another ground for the directors to give internal funding penchant over external funding that is the directors or proprietor do non desire to lose control over the entity by giving opportunity to the new portion holders to come in in the company and exercising control ( Holmes and Kent, 1991 ; Hamilton and Fox, 1998 ) therefore directors will try to finance their activities every bit much as possible with internally generated financess. However if there are no sufficient financess available to back up the activities so the following option director will take for funding will be the one which gives the investor no or really less control over the entity such as short term and long term debt and the concluding pick if there is no other manner to raise finance will be issue of new equity.

The job with the picking order theory is that it presses the point of giving penchant to internal financess. If this is the instance so the house would hold pitching ratio equal to nothing. However, for being able to hold adequate internally generated financess and to get by with growing or to finance the activities the house should be good established and mature. In world this is non possible for most of the turning houses which do non hold that degree of internal financess hence they have no other pick but to trust on debt finance which means the pitching ratio tends to travel off from nothing.


There is no any optimal capital construction which a house can follow and get down running its concerns. A house can acquire the point of pitching where it can maximise the stockholders wealth but happening that point is the job in the existent universe. The point of optimal degree of geartrain is different for different type of industries like some of them have little degree of adoptions,


  • Modigliani F. and Miller M. , 1958. The Cost of Capital, Corporation Finance, and The Theory of Investment. American Economic Review 48, 261-297.
  • Myers S.C. , 1984. The capital construction mystifier. Journal of Finance 34 ( 3 ) , 575-592.
  • Myers S.C. and Majluf N. , 1984. Corporate Financing and Investment Decisions when Firms have Information Investors do non hold. Journal of Financial Economics 13, 187-221.
  • Hamilton R.T. and Fox M.A. , 1998. The funding penchants of little house proprietors. International Journal of Entrepreneurial Behaviour & A ; Research 4 ( 3 ) , 239-248.
  • Holmes S. and Kent P. , 1991. An Empirical Analysis of the Financial Structure of Small and Large Australian Manufacturing Enterprises. Journal of Small Business Finance 1 ( 2 ) , 141-154.