Theories Of Capital Structure

Question 1

Capital Strucutre Irrelevance

Answer 1

MM1 and 2 implies
- CF do not change with leverage
- CF comes from the asset
- ER does not change with leverage
- WACC is constant
- There is no optimal capital structure

Question 2

Pecking Order Theory

Answer 2

• Information asymmetry exists
• Managers know their firms investment prospects better
• Investors therefore require a higher return
• External financing is more expensive
• Firms prefer 1 internal funding 2 new debt 3 issuing new equity
  Implication
  No target capital structure
  Firms with large profits borrow less
  Firms build financial slack

Question 3

Signalling Theory

Answer 3

• Information asymmetry exists
  
  • Overvalued - issue equity
  • Undervalued - issue debt
    Implication
    Firms that are overvalued borrow less

Question 4

Agency Theory

Answer 4

• Firms agents (CEO) and shareholders have different interest
  
  • CEO would like to empire build and fund ‘pet projects’
  • debt would restrict this
    Implication
    Powerful CEO’s borrow less
  • to avoid the monitoring role of debt

Question 5

Trade Off Theory

Answer 5

• Leverage is decided by the cost vs benefit of debt
  
  • Debt is cheaper and provides a tax shield
  • more debt = more financial distress
    Implication
    Firms have their own target debt ratio
    Large firms with tangible assets borrow more