Stewart C. Myers
The Journal of Economic Perspectives, Vol. 15, No. 2. (Spring, 2001), pp. 81-102. Stable URL:
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Sun Oct 21 09:10:16 2007
Journal of Economic Perspectives-Volume 15, Number 2-Spring 2001-Pages 81-1 02 Capital Structure
Stewart C. Myers
he study of capital structure attempts to explain the mix of securities and financing sources used by corporations to finance real investment. Most of the research on capital structure has focused on the proportions of debt vs. equity observed on the right-hand sides of corporations' balance sheets. This paper is an introduction to that research.
There is no universal theory of the debt-equity choice, and no reason to expect one. There are several useful conditional theories, however. For example, the tradeoff theoly says that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. The tradeoff theory predicts moderate borrowing by tax-paying firms. 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 cashpow theory says that dangerously high debt levels will increase value, despite the threat of financial distress, when a firm's operating cash flow significantly exceeds its profitable investment opportunities. The free cash flow theory is designed for mature firms that are prone to overinvest.
There is another possibility:perhaps financing doesn't matter. Modigliani and Miller (1958) proved that the choice between debt and equity financing has no material effects on the value of the firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which financial innovation would quickly extinguish any deviation from their predicted equilibrium. The logic of the Modigliani and Miller (1958) results is now widely accepted. Nevertheless, financing clearly can matter. The chief reasons why it matters include Stewart C. Myers is the Gordon Y Billard Professor of Finance, Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts. 82 Journal of Economic Perspectives
taxes, differences in information and agency costs. Theories of optimal capital structure differ in their relative emphases on, or interpretations of, these factors. The tradeoff theory emphasizes taxes, the pecking order theory emphasizes differences in information, and...