As companies grow and continue to operate, they must decide how to fund their various projects and operations as well as how to pay employees and keep the lights on. While sales revenues are key sources of income, most companies also seek capital from investors or lenders as well. But what is the right mix of equity stock sold to investors and bonds sold to creditors? Capital structure theory is the analysis of this key business question.

The net income approach, static trade-off theory, and the pecking order theory are three financial principles that help a company choose its capital structure. Each plays a role in the decision-making process depending on the type of capital structure the company wishes to achieve. The pecking order theory, however, has been empirically observed to be most used in determining a company's capital structure.

Key Takeaways

  • Capital structure refers to the mix of revenues, equity capital, and debt that a firm uses to fund its growth and operations.
  • Several economists have devised approaches to identify and optimize the ideal capital structure for a firm.
  • Here, we look at three popular methods: the net income approach, static trade-off theory, and pecking order theory.

The Net Income Approach

Economist David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change in capital costs. In other words, if there's an increase in the debt ratio, capital structure increases, and the weighted average cost of capital (WACC) decreases, which results in higher firm value.

The Net Operating Income Approach, also proposed by Durand, is the opposite of the Net Income Approach, in the absence of taxes. In this approach, WACC remains constant. It postulates that the market analyzes a whole firm, and any discount has no relation to the debt-to-equity ratio. If tax information is provided, it states that WACC reduces with an increase in debt financing, and the value of a firm will increase.

In this approach to Capital Structure Theory, the cost of capital is a function of the capital structure. It's important to remember, however, that this approach assumes an optimal capital structure. Optimal capital structure implies that at a certain ratio of debt and equity, the cost of capital is at a minimum, and the value of the firm is at a maximum.

Static Trade-off Theory

The static trade-off theory is a financial theory based on the work of economists Modigliani and Miller in the 1950s, two professors who studied capital structure theory and collaborated to develop the capital-structure irrelevance proposition. This proposition states that in perfect markets, the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets.

According to Modigliani and Miller, value is independent of the method of financing used and a company's investments. The M&M theorem made two propositions:

  • Proposition I: This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not be affected by the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.
  • Proposition II: This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.

With a static trade-off theory, since a company's debt payments are tax-deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital through a capital structure with debt over equity.

However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.

Pecking Order Theory

The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity.

This pecking order is important because it signals to the public how the company is performing. If a company finances itself internally, that means it is strong. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.

The Bottom Line

There are several ways that firms can decide what the ideal capital structure is between cash coming in from sales, stock sold to investors, and debt sold to bondholders. Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability.