In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. Competing capital structure theories explore the relationship between debt financing, equity financing and the market value of the firm.
Traditional Approach
According to the traditional theory, a company should aim to minimize its weighted average cost of capital (WACC) and maximize the value of its marketable assets. This approach suggests that the use of debt financing has a clear and identifiable limit. Any debt capital beyond this point will create company devaluation and unnecessary leverage.
Managers and financial analysts are required to make certain assumptions under the traditional approach. For example, the interest rate on debt remains constant during any one period and increases with additional leverage over time. The expected rate of return from equity also remains constant before increasing gradually with leverage. This creates an optimal point at which WACC is smallest before rising again.
Other Approaches
One popular alternative to traditional capital structure theory is the Modigliani and Miller approach. The MM approach has two central propositions. The first says that capital structure and company value have no direct correlation; instead, the firm’s value is dependent on expected future earnings. The second proposition then asserts that financial leverage increases expected future earnings but not the value of the firm. This is because leverage-based future earnings are offset by corresponding increases in the required rate of return.
The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.