Capital Structure Theories

Capital structure theories explore how a company finances its operations through debt and equity. The Modigliani-Miller theorem suggests that, in perfect markets, a company’s value is unaffected by its mix of debt and equity. The trade-off theory proposes businesses balance tax benefits of debt against costs like bankruptcy risk. The Pecking Order Theory indicates firms prefer internal funds, then debt, and lastly external equity, based on perceived risk. Lastly, the Market Timing Theory suggests companies choose financing based on current market conditions, aiming to maximize value by issuing or repurchasing securities at optimal times.