This lesson examines capital structure theory, which addresses the optimal mix of debt and equity financing. It covers the key theories, including the Modigliani-Miller theorem, the trade-off theory, and the pecking order theory, and explores the practical considerations in capital structure decisions, as detailed in university curricula at the University of Peradeniya and IIS University .

• The Capital Structure Decision: Capital structure refers to the mix of debt and equity used by a company to finance its operations and growth. The capital structure decision is one of the most critical in financial management because it directly influences a company’s risk profile, its cost of capital, and its overall market valuation. The University of Peradeniya syllabus identifies capital structure as a core topic, covering meaning, significance, optimal capital structure, determinants, and theories of capital structure .

• Modigliani-Miller (MM) Theorem: The MM theorem is a foundational theory of capital structure:

  • Proposition I (without taxes): In a perfect capital market, the value of a firm is independent of its capital structure. The market value of a firm is determined by its earning power and risk, not by how it chooses to finance itself.

  • Proposition II (without taxes): The cost of equity of a levered firm increases in direct proportion to its debt-to-equity ratio. This increase perfectly offsets the benefit of using cheaper debt, leaving the WACC constant.

  • With taxes: When corporate taxes are introduced, interest payments are tax-deductible, creating a tax shield that makes debt financing more attractive. The value of a levered firm becomes the value of an unlevered firm plus the present value of the interest tax shield. The IIS University syllabus explicitly covers MM Theory as part of modern capital structure theories .

• Trade-Off Theory: The static trade-off theory states that firms determine their optimal debt-equity ratio by balancing the benefits of debt (tax shield) against the costs (financial distress and bankruptcy). The optimal capital structure is the point at which the marginal benefit from the tax shield of an additional dollar of debt is precisely equal to the marginal cost of increased financial distress.

• Pecking Order Theory: This theory, popularised by Stewart C. Myers, states that firms prioritise their sources of financing based on the cost of financing and information asymmetry. The hierarchy is:

  1. Internal Funds (Retained Earnings): Preferred first, as they are the cheapest.

  2. Debt: If external financing is required, firms will issue debt first.

  3. New Equity: Equity is the least preferred method, considered a last resort.

• Determinants of Capital Structure: Practical factors influencing capital structure decisions include taxation, business risk, financial flexibility, control considerations, and industry norms. The University of Peradeniya syllabus identifies “Factors affecting capital structure” as a key topic .