Capital Structure Theories and Empirical Evidence

This assignment delves into various theories explaining corporate capital structure decisions, including Modigliani-Miller propositions, Trade-Off theory, and Pecking Order theory. It requires students to critically evaluate these theories and analyze empirical research examining the relationship between capital structure, firm characteristics, and financial performance. Students are expected to synthesize their understanding of both theoretical frameworks and empirical findings to provide insightful commentary on optimal capital structure for different types of firms.

Running head: ADVANCED CORPORATE FINANCE
Advanced Corporate Finance
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Table of Contents
Introduction......................................................................................................................................2
Contribution of “Modigliani and Miller to the theory of capital structure”....................................2
The limitations of the models developed by Modigliani and Miller...............................................3
Theories which try to explain why in practice capital structure is determined differently.............4
Connection between capital structure decision making and corporate governance........................6
Conclusion.......................................................................................................................................8
References........................................................................................................................................9

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Introduction
The “capital structure” of a company is considered as the means by which an
organization can finance its assets. A “company” is able to “finance its processes either with
equity or debt or with combination of both. The “capital structure” may compose of majority of
the “debt or majority of equity or mixture of both”. In the 1950s two instructors “Modigliani and
Miller”, analysed a “capital-structure theory” profoundly. The theory advocates capital structure
irrelevancy which suggest that a firm which is “highly leveraged” or bears “lower debt”
constituent has no impact on the “market value”. It also advocates that the firm valuation has no
relevance with the “capital structure of the company”. The main rationale of the value of market
of the firm is discerned to be reliant on the operating profits. The learnings of the study aim to
show the contribution of “Modigliani and Miller” to the theory of “capital structure”. The
learnings of the study have also suggested it’s limitations and theories which try to explain why
in practice capital structure is determined differently and draw a Connection between capital
structure decision making and corporate governance (Ahmeti & Prenaj, 2015).
Contribution of “Modigliani and Miller to the theory of capital structure”
The main aspects of the analysis developed by “Modigliani and Miller” conjectured that
the determination of “market value” is done by the earning power and “risk of underlying assets”
along with the self-determining way it indicates to finance the investment and “distribute
dividends”. The key assumptions of M&M proposition are considered with factors such as “No
taxes, No transaction costs, No bankruptcy costs, Equivalence in borrowing costs for both
companies and investors”. Along with the information, it also considers “symmetry of market
information, investors who have the same information, and there is no effect of debt on a
company's earnings before interest and taxes” (Kennedy et al., 2015).
“Modigliani and Miller's Capital-Structure Irrelevance Proposition”
The assumptions of the “M&M capital structure” show that there is irrelevance
proposition and assumption of no taxes or bankruptcy costs. In simplified terms it shows that the
WACC will continue to be persistent with the changes pertaining to “capital structure” of the
company. No matter, the way firm borrow, there won’t be any “tax benefit” because of payment

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of interest and no variations or assistances in terms of WACC. Moreover, as there are no
assistances from the increasing debt amount, the “capital structure” may not influence the “stock
price”. The “MM 1” theory considers MM capital-structure insignificance proposal assumption
with no taxes and “MM 2” theory is characterised with no bankruptcy costs (Abeywardhana,
2017).
Henceforth, it may be assumed that “MM I theory” (without the consideration of
corporate taxes) considers that firm's relative sizes of “debt and equity” don't matter. However,
as per the MM 1 the firm with greater proportion of debt is more valuable due to the presence of
interest tax shield. MMII considers the WACC. This is seen with the percentage of the debt in
the “capital structure” which increases with its “return on equity” to the “shareholders” on a
constant basis. The consideration of higher debt level makes the investment company more risk
prone to the shareholder’s demand and increased risk premium on stock of the company.
However, the changes pertaining to the “company's capital structure” is irrelevant and any
deviations in the “debt-equity ratio do not affect WACC”. Moreover, MM II theory recognizes
the “corporate tax” savings from the interest tax deductions and the disparities in the debt equity
ratio, as they do not make an impact on WACC. Henceforth, a greater proportion of the debt
reduces the WACC of the company (K. Ardalan, 2017).
The limitations of the models developed by “Modigliani and Miller”
The theory suggested by “Modigliani and Miller” does not consider the “taxes,
transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries
along with significant effects of the debt on earnings”. However, in real world such assumptions
are not possible. The model is seen to be further criticised as perfect capital market do not exist
and there is always provision needed to be made for the taxes existing in the capital market. As
per the theory suggested by MM there does not exist any difference in the internal and external
financing. However, this will be false in case there is any incidence in the flotation costs
involved with the new issues of stocks. This theory is further seen to assume that the
shareholders wealth is not affected with the dividends, while there may be a situation where the
transaction costs are related to the selling of shares to make cash inflows, this calls for the

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preference over dividends for the investors. The different types of the assumptions made by
Modigliani and Miller is based on a situation of uncertainty and unrealism. It needs to be
understood that the dividends are also relevant under certain conditions. The limitations of the
hypothesis have argued that there does not exist any difference among the investors of the firm
and the firm retains earnings or declares the dividend (Kavous Ardalan, 2016).
The retained earnings and the external financing are regarded as balancing value to each
other. The assumptions made by them is unrealistic in nature and unpractical. Despite of several
appealing theoretical evidences. The main problem associated to the “MM approach”, exists due
to the “imperfect markets, transaction costs, floatation costs and uncertainty of future capital
gains and the preference for current dividends”. The model accepts that there are perfectly
“capital markets”, whereas such marketplaces does not exist. The MM model further accepts that
there are no flotation costs or time gap necessary for raising the “equity capital”. While, in the
practical world the initiation cost must take place in accordance to the legal formalities (Dierkes
& Schäfer, 2017).
There is no assumption made for transaction costs, while there is significant expenditure
associated to the “commission and brokerage to sell shares”. The shareholders also prefer the
current dividend which is overlooked. The “MM model” considers that the company has the
scope to issue equity shares. However, this model cannot be regarded as valid when there is any
case of under-pricing based on the sale of the shares which is lesser than the present market
price. This signifies that a firm will have to sell more number of shares if it does not want to give
dividends. In this situation, the firm needs to retain the profits and not pay any dividends
(Sofiane Aboura & Lépinette, 2015).
Theories which try to explain why in practice capital structure is determined differently
The determination of practice of capital structure is discerned with significant impact
with the tax and bankruptcy assumptions. Due to this, the “capital structure” is inappropriate and
have no effect on the stock price. This calls for the need of “trade-off theory of capital structure”.
This hypothesis is considered with the use of Kraus and Litzenberger for determining a “trade-
off dead-weight costs of bankruptcy and the tax saving benefits of debt” (O’Brien, David,
Yoshikawa, & Delios, 2014).

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“Tradeoff Theory of Leverage”
The “trade-off theory of capital structure” is discerned as the main idea in which the
company chooses for the determining the amount of “debt finance and equity finance to use by
balancing the costs and benefits”. This theory mainly deals with “cost of financial distress and
agency costs”. The important reason for the “trade-off” in the “capital structure” is to clarify the
fact that the corporation are “financed partly with debt and partly with equity”. There has been
significant advantage associated to “financing with debt, the tax benefits of debt and there is a
cost of financing with debt”, “the costs of financial distress including bankruptcy costs of debt
and non-bankruptcy costs” are also included in this theory (Ippolito, Steri, & Tebaldi, 2017).
The assumptions made in this theory is able to state on the benefits to the leverage in the
“capital structure” until the desired capital structure is attained. This is able to recognize the
benefits of taxes from the payments made in interest. The interest paid on the debt is deductible
from tax and effective issue of bond effectively decreases the tax liability while “paying
dividends on equity does not”. In general, the real rate of interest which the “companies pay on
the bonds they issue is depicted to be less than nominal interest rate due to the tax savings
considerations. Several studies suggest that most companies have lesser leverage than suggested
by the optimal theory” (Brusov et al., 2014).
The comparison of the theories shows that the possible benefit in the debt in a “capital
structure comes from tax benefit of the interest payments”. This is due to the fact debt is tax
deductible, thereby issuing bonds in an effective manner to reduce the tax liability. The “MM
capital irrelevance theory assumes no taxes”; therefore, this advantage is not documented like
“tradeoff theory of leverage” in which “taxes, and tax benefit of interest payments”, are taken
into consideration (Allen, Carletti & Marquez, 2015). This theory is further able to consider the
agency costs with the cost debt obligations and explain why the companies are not having 100%
debt. Most of the empirical evidences are able to propose that there is significant conflict
between the shareholders and debt holders. This is considered to be important for explaining the
“Trade-off theory in relation with the capital structure”. Despite of criticisms from Fama and
French, “the trade-off theory” remains central consideration in case of corporate capital structure.

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The dynamic version of the usage of this model is able to explain enough flexibility in terms of
matching the data with the verbal argument along with “dynamic trade-off models” which are
very difficult to cast-off empirically (S. Aboura & Lepinette, 2017).
Connection between capital structure decision making and corporate governance
In general, “corporate governance and capital structure” has a significant role in
extension of shareholders wealth and value of the firm. Adherence to sound corporate
governance helps in assuring that investors would get their capital back and obtain an acceptable
return on their respective investment. Henceforth, developed financial system is able to provide a
market for corporate control whereas, a strong legal system is able to ensure that investors
contractual rights are protected by “minimizing the risk of loss arising from managerial
opportunism” (DeAngelo & Stulz, 2015). Corporate governance is acknowledged as a system in
which business corporations are controlled and directed to encompass the rules and framework
of relationships process to ensure the directors act in the interest of the company. Maintenance of
an optimized structure for capital is able to minimize the cost of financing thereby reducing any
instance of bankruptcy (Graham, Harvey & Puri, 2015).
There is large evidence to support that corporate governance and capital structure are
interrelated to each other. The evidence depicts that corporate governance particularly the part of
ownership structure plays a pivotal role in determining incentives of insiders to expropriate
minority shareholders. The review of literature has depicted that the role of ownership structure
has an impact on the firm value. The empirical work suggests that the corporate financial
decision and performance of firms are affected with issues such as agency conflicts between the
shareholders and the managers (Mouton & Smith, 2016). In several situations corporate
governance activities enhances the effectiveness and efficiency of the companies with the
implementation of proper control and supervision. CG also acts as an important framework for
aligning the interest of shareholders and management to reduce agency conflicts. Sound
corporate governance structure for the organization makes it is easier to obtain loans from
investors and predicting the interest of shareholders thereby increasing overall transparency
(Cline, 2015). It is further discerned that firms bearing poor governance practices are more likely

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to face agency problem as managers, than those who can easily make use of private benefits due
to slick corporate governance structure (Kakilli Acaravci, 2015).
As per the conduction of empirical studies to evaluate the relation between CG and CS, it
is realized that there is a noteworthy relation between “board size and capital structure”. This
shows that larger is the size of board membership, lower is the “debt ratio or leverage”. This also
accepts that larger board size is able to translate itself into strong pressure from corporate board
to make managers pursuant to lower leverage. It is seen that larger boards exert pressure on the
manager for following lower gearing levels to increase firm performance (Gersbach, Haller, &
Müller, 2015).
The statements given by Modigliani and Miller clearly proposed that financial system is
of prime importance to both the managers and providers of the fund. Optimal capital structure
may be attained in case there is tax sheltering benefit design with increasing “debt level equal to
bankruptcy costs”. This model suggested that managers should be able to spot the optimal
“capital structure” and try to sustain the same (Jaros & Bartosova, 2015).
However, Jensen and Ruback argued that managers are not always responsible to
maximize the return to the shareholder. In several situations, managers may decide to adopt
nonprofitable investment which will likely bring loss to the shareholders. These shareholders
tend to utilize free cash flow available instead of investing in positive NPV projects which would
have benefitted them. As per this model, the agency cost is likely to exacerbate the inclusion of
free cash flow in the firm. The mitigation of agency conflict argues that capital structure may be
used with increasing level of debt and agency costs (Serrasqueiro & Caetano, 2014).

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Conclusion
The depictions as per contribution of “Modigliani and Miller” to the philosophy of
“capital structure” have shown that there is irrelevance proposition and assumption of no taxes or
bankruptcy costs. In simplified terms it shows that the WACC will continued to be constant with
the changes pertaining to capital structure of the company. No matter, the way firm borrow, there
will be “no tax benefit” because of the “interest payments” and no variations or benefits in terms
of “WACC”. Moreover, as there are no assistances from the increasing debt amount, the capital
structure may not impact the stock price or the “capital structure”. The “MM 1” theory considers
“MM capital-structure irrelevance” proposition assumption with no taxes and “MM 2” theory is
discerned with no bankruptcy costs. It is further understood that the theory suggested by
“Modigliani and Miller” does not reflect the effect of “taxes, transaction costs, bankruptcy costs,
differences in borrowing costs, information asymmetries along with significant effects of the
debt on earnings”. However, in real world such assumption is not possible. The model is seen to
be criticised, as perfect capital market does not exist and there is always provision needed to be
made for the taxes present in the capital market. As per the theory suggested by MM, there does
not exist any difference in the internal and external financing. In addition to this, the link
between “capital structure” decision making and “corporate governance” portrays that corporate
governance particularly the part of ownership structure plays a pivotal role in determining
incentives of insiders to expropriate minority shareholders. Several empirical works suggest that
the corporate financial decision and performance of firms are affected with issues such as agency
conflicts between the shareholders and the managers.

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References
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Aboura, S., & Lepinette, E. (2017). New Developments on the Modigliani--Miller Theorem.
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Aboura, S., & Lépinette, E. (2015). Do banks satisfy the Modigliani-Miller theorem? Economics
Bulletin, 35(2), 924–935.
Ahmeti, F., & Prenaj, B. (2015). A Critical Review of MM Theorem of Capital Structure.
International Journal of Economics, Commerce and Management, III(6), 914–924.
Allen, F., Carletti, E., & Marquez, R. (2015). Deposits and bank capital structure. Journal of
Financial Economics, 118(3), 601-619.
Ardalan, K. (2016). Capital structure theory: Reconsidered. Research in International Business
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Brusov, P., Filatova, T., Orekhova, N., & Cook, S. (2014). Mechanism of formation of the
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banks.
DeAngelo, H., & Stulz, R. M. (2015). Liquid-claim production, risk management, and bank
capital structure: Why high leverage is optimal for banks. Journal of Financial
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