## Theories of Capital Structure
### 1. Trade-off Theory
A firm chooses between debt and equity by balancing the costs and benefits of debt.
Benefits of Debt:
- Interest is tax-deductible → Tax shield
Costs of Debt:
- Financial distress (when the firm cannot meet debt obligations)
- Agency costs (conflicts of interest)
#### Financial Distress Costs
| Type | Examples |
|---|---|
| Direct | Administrative costs, legal fees, distress asset sales |
| Indirect | Damage to relationships with employees, customers, suppliers, investors |
#### Agency Costs Arise From Conflicts Between:
- Shareholders vs. Managers
- Shareholders vs. Debt holders
Key Mechanics:
- As debt increases → marginal tax benefit declines
- As debt increases → marginal bankruptcy cost rises
- Optimum = where these two marginal values balance
> Modigliani & Miller (1963): Attractiveness of debt decreases with personal tax on interest income.
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### 2. Pecking Order Theory
Based on Asymmetric Information — managers know more about the firm than outside investors.
Core Logic:
- Managers choose the source that reveals the least information to the market.
- Equity issuance signals bad news (managers issue equity when they think it is overpriced).
Order of Preference for Raising Funds:
1. Internal Financing (retained earnings) — first choice
2. Debt (secured → unsecured → hybrid)
3. Equity — last resort
Why internal equity beats external equity:
- No transaction/issue costs
- No tax on internal equity
Why no fixed target D/E ratio:
The theory says there is no ideal target — firms just follow the pecking order.
### Comparison Table
| Theory | Preferred Order | Has D/E Target? |
|---|---|---|
| Pecking Order | Internal → Debt → Equity | No |
| Trade-off | Debt preferred (up to optimal point), then Equity | Yes |