Key Elements of Capital Structure Theory

Capital structure theories include net income theory, net operating income theory, MM theory, agency theory and hierarchical funding theory.

(i) Net Return Theory

This theory suggests that the use of debt reduces a firm's overall cost of capital. Since the cost of debt is generally low, the higher the degree of indebtedness, the lower the comprehensive cost of funds and the greater the value of the enterprise. The value of the firm will be maximized when the debt ratio reaches 100%.

(ii) Net Operating Income Theory

This theory suggests that capital structure has nothing to do with the value of the firm, and that the key element in determining the value of the firm is the net operating income of the firm. Despite the increase in lower-cost debt capital, it also increases the risk of the enterprise, leading to an increase in the cost of equity capital, and the enterprise's consolidated cost of capital remains unchanged.

Regardless of the degree of financial leverage, the overall cost of capital remains the same, and the value of the firm is not affected by the capital structure, thus there is no optimal capital structure.

(iii) MM Theory

MM theory states that in the absence of corporate and personal income taxes, the value of any firm, whether it has debt or not, is equal to the operating profit divided by the rate of return that applies to its risk class.

The value of a firm with the same risk is unaffected by the presence or absence of debt and the degree of indebtedness; however, when income tax is taken into account, the value of the firm increases with the degree of indebtedness due to the presence of tax shelter benefits, and shareholders receive more benefits. Thus, the more indebtedness there is, the greater the value of the firm will be.

(iv) Agency Theory

Agency theory suggests that the capital structure of a firm affects the level of work and other behavioral choices made by managers, which in turn affects the firm's future cash receipts and the firm's market value. The theory suggests that debt financing has a strong incentive effect and views debt as a security mechanism. This mechanism can motivate managers to work harder for less personal enjoyment and to make better investment decisions, thus reducing agency costs due to the separation of powers;

However, debt financing may lead to another type of agency cost, namely, the cost incurred by the firm as a result of being subjected to creditor scrutiny. A balanced corporate ownership structure is determined by the equilibrium relationship between equity agency costs and debt agency costs.

(5) Hierarchical Financing Theory

(1) The cost of external financing includes not only the cost of management and underwriting, but also the cost of "underinvestment effect" caused by asymmetric information.

(2) Debt financing is better than equity financing. Because of the tax benefits of corporate income tax, debt financing can increase the value of the enterprise, that is, the more debt, the more the value of the enterprise increases.

Expanded:

Theoretical Development

Capital Structure Theory is one of the most important parts of the financial theory in western countries. Capital structure theory has gone through two stages: the old capital structure theory and the new capital structure theory. The old capital structure theory includes traditional theory, MM theory and trade-off theory. The main research results include:

1. Under ideal conditions, MM theory concludes that capital structure is not related to firm value.

2. Under the condition of the existence of corporate income tax, MM theory concludes that the value of the firm increases with the increase of liabilities.

3. Under the condition of the existence of bankruptcy costs, the trade-off theory concludes that maximizing the value of the firm involves a trade-off between the benefits of tax avoidance and the costs of bankruptcy.

The new capital structure theory is based on asymmetric information for research, including agency theory, control theory, signaling theory and pecking order theory. The main research result is to analyze the governance effect of capital structure under the condition of asymmetric information and the impact on company value.

Baidu Encyclopedia-Capital Structure