Capital Structure Theory

Capital Structure Theory explores how a company finances its operations and growth through different sources, mainly debt (loans) and equity (stocks). The theory examines the impact of these choices on the company's cost of capital and overall value. In essence, it seeks to find the optimal balance where the company minimizes its costs and maximizes value, considering risks like increased debt leading to higher bankruptcy risk. Various theories, such as Modigliani-Miller, suggest that under certain conditions, a firm's value is unaffected by its mix of debt and equity, while others emphasize the importance of trade-offs between tax benefits and financial risk.