Theories of Capital Structure

Theories of capital structure explore how a company chooses the best mix of debt (loans) and equity (owners' money) to finance its operations. Key ideas include the Modigliani-Miller theorem, suggesting that in perfect markets, a company's value isn’t affected by its debt-equity mix. The Trade-Off Theory suggests balancing the benefits of debt (like tax advantages) with its risks (like bankruptcy). The Pecking Order Theory indicates companies prefer internal funds first, then debt, and finally issuing new equity, to minimize costs and maintain control. These theories help explain why firms select specific financing strategies.