Construct · 4 names · 6 citations
Different names. Different fields. One construct. One map.
● jangle · one leverage choice, rival theories Nearest construct by meaningModigliani-Miller theoremcompare the meaningsEvery construct on the map is compared with every other by the meaning of its definitions, and the closest one is surfaced here. The nearest construct to capital structure is Modigliani-Miller theorem.
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The Modigliani and Miller proposition that, in a market with no taxes, no bankruptcy costs, and no information gaps, the total value of a firm does not depend on how it splits its financing between debt and equity. Their 1958 paper The Cost of Capital, Corporation Finance and the Theory of Investment argued that an investor can undo or reproduce any leverage a firm chooses by borrowing or lending on their own account, so the mix cannot move what the firm is worth. Their 1963 correction added corporate taxes and showed that, because interest is deductible, debt carries a tax shield that does raise value, which turns strict irrelevance into a benchmark rather than a description of the real world. The referent is the total market value of one firm and whether its debt-to-equity mix changes that value. This is the origin of the whole debate: every later theory is a story about which of these frictionless assumptions fails.[1][2]
The theory that a firm chooses its debt-equity mix by balancing the tax shield from deducting interest against the expected costs of financial distress and bankruptcy that more debt brings. Kraus and Litzenberger's 1973 A State-Preference Model of Optimal Financial Leverage set out this balance formally, giving a firm an interior optimum where the marginal tax benefit of one more dollar of debt just meets the marginal cost of possible default. On this view there is a target leverage ratio, and firms are expected to move back toward it over time. The referent is the same value-maximizing leverage choice that Modigliani and Miller studied, now read as a point of balance reached because bankruptcy is costly. What differs from the pecking order is the claim itself: here firms aim at an optimal ratio, not at a fixed financing order.[3][4]
The theory that firms do not aim at a target ratio at all, but finance in a fixed order set by information gaps: internal funds first, then debt, and new equity only as a last resort. Myers and Majluf's 1984 Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have showed that when managers know more than outside investors, issuing equity signals that the stock may be overpriced, so the market marks it down and firms learn to avoid it. Myers's 1984 The Capital Structure Puzzle gave this order its name and set it against the trade-off view. The referent is again the one leverage decision, but here the observed debt ratio is a running total of past deficits and surpluses, not a chosen goal. A firm with high profits ends up with low debt under this story, the opposite of what the trade-off theory predicts.[5][4]
The theory that a firm's debt-equity mix is mostly the built-up outcome of past attempts to time the market, issuing equity when its shares look expensive and leaning on debt when they look cheap. Baker and Wurgler's 2002 Market Timing and Capital Structure found that a firm's leverage today is strongly related to a weighted history of the market-to-book ratios at which it once raised money, and that these effects persist for a decade or more. On this view there is no target ratio and no strict order; leverage is a residue of timing decisions that were never reversed. The referent is once more the same observed leverage, now explained by neither taxes nor a financing order but by managers acting on perceived mispricing. It stands as a third rival account of one number, and part of the puzzle is that these stories can each fit the data in different samples.[6]
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