Capital Structure
- (pp. 81-102)
(Complimentary)
Abstract
Research on capital structure attempts to explain how corporations finance real investment, with particular emphasis on the proportions of debt vs. equity financing. There is no universal theory of the debt-equity choice, and no reason to expect one. But three useful conditional theories are reviewed in this paper. The tradeoff theory says that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. Thus, the amount of debt will reflect the firm's cumulative need for external funds. The free cash flow theory says that dangerously high debt levels will increase value, despite the threat of financial distress. Each of these theories "works" for some firms in some circumstances. More general theories will require a deeper understanding of the financial objectives of corporate managers.Citation
Myers, Stewart, C. 2001. "Capital Structure." Journal of Economic Perspectives, 15 (2): 81-102. DOI: 10.1257/jep.15.2.81JEL Classification
- G32 Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
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