CAPITAL STRUCTURE - THEORIES

Theory Year Brief Description Assumptions Advantages Limitations

Propounders
1 Net Income David Suggests that the value of the - Cost of debt is lower Encourages higher use of debt to Unrealistic assumptions:
(NI) Approach 1952 Durand firm increases as the proportion than cost of equity. - maximize firm value, lowering constant cost of debt and
of debt in the capital structure Cost of debt and equity overall cost of capital. equity, ignoring the financial
increases due to cheaper debt. remain constant distress and bankruptcy risks.
regardless of leverage.
2 Net David States that capital structure is - Cost of equity Simple approach focusing on Ignores the tax benefits of
Operating 1952 Durand irrelevant to the value of the firm. increases as debt operations rather than financial debt, assuming market
Income (NOI) The firm’s value depends only on increases. - WACC structuring. efficiency and no risk of
Approach operating income and the overall remains constant at all default.
WACC. levels of debt.
3 Traditional Ezra Advocates that there is an - At low levels of debt, Recognizes both debt and equity Difficult to estimate the exact
Approach 1958 Solomon optimal capital structure, with a WACC decreases due to impacts and suggests an optimal point at which the firm's
mix of debt and equity that the lower cost of debt. capital structure exists. capital structure becomes
minimizes WACC and maximizes - Beyond a certain "optimal."
the firm’s value. point, WACC rises as
risk increases.
4 Modigliani Franco Argues that in a perfect market, - No taxes, transaction Simple, foundational theory for Ignores real-world factors
and Miller 1958 Modigliani & the capital structure is irrelevant costs, or bankruptcy understanding capital structure. like taxes, bankruptcy costs,
(M&M) Merton to the value of the firm. The firm's costs. - Investors can and market imperfections.
Proposition I Miller value depends only on its earning borrow at the same
(Without power and risk of its underlying rate as firms.
Taxes) assets.
5 Modigliani Franco Incorporates corporate taxes and - Same as Proposition I, Highlights the tax advantage of Ignores financial distress and
and Miller 1963 Modigliani & concludes that the value of the but includes tax debt and explains the benefits of agency costs, focusing solely
(M&M) Merton firm increases with debt due to benefits. - No leveraging. on tax benefits of debt.
Proposition II Miller the tax shield on interest bankruptcy or agency
(With Taxes) payments. costs considered.
6 Trade-off Kraus and Argues that firms aim to balance - Firms make a trade- More realistic by accounting for Difficult to quantify the point
Theory 1977 Litzenberger the tax benefits of debt (interest off between tax savings both tax benefits and financial where the costs of distress
tax shield) with the costs of and bankruptcy costs. - distress risks. outweigh the benefits of
debt.
 potential financial distress and Optimal debt level
bankruptcy. varies by firm.
7 Pecking Order Stewart C. Firms prefer internal financing, - Internal financing Explains why profitable firms tend No clear optimal capital
Theory 1984 Myers & followed by debt, and issue equity preferred over debt to use less debt and how financing structure, assumes firms do
Nicholas as a last resort due to asymmetric and equity. - Managers decisions reflect information not target a specific debt-to-
Majluf information and signaling effects. have better information asymmetry. equity ratio.
about firm value than
investors.
8 Agency Cost Jensen and Suggests that the capital - Agency costs exist Addresses real-world challenges of Difficult to measure agency
Theory 1976 Meckling structure is influenced by agency due to conflicts of conflicts in financial decisions costs and their influence on
costs arising from conflicts interest between between management and capital structure decisions.
between shareholders, debt different stakeholders. investors.
holders, and managers. - Firms aim to minimize
these costs.

DIVIDEND THEORY

Theory Year Propounders Brief Description Assumptions Advantages Limitations

Irrelevance 1961 Modigliani & Suggests that dividend No taxes, perfect Simplifies the valuation model, Unrealistic assumptions; ignores
Theory Miller policy has no effect on a capital markets, stressing that internal investment taxes and real-world frictions.
firm’s value or stock price; no transaction or decisions drive value.
the value is determined by flotation costs.
earning power.
Bird-in-the- 1963 Myron Gordon States that investors prefer Investors are Addresses investor preferences for Ignores tax implications and
Hand Theory & John Lintner dividends now over risk-averse, certainty and dividend payouts. assumes investors are universally
uncertain future capital preferring certain risk-averse.
gains. dividends over
uncertain
growth.
Tax Preference 1977 Litzenberger & Proposes that investors Differential Explains investor behavior based on Assumes all investors have the
Theory Ramaswamy prefer capital gains over taxation between tax advantages, favoring retained same tax profile and ignores non-
dividends because capital dividends and earnings. tax factors.
gains are taxed at a lower capital gains.
rate than dividends.
Clientele Effect Various Suggests that different Investors sort Explains why firms may attract Assumes that investors can
Theory 1970s Economists investors prefer different themselves into different groups of investors based seamlessly switch firms without
dividend policies based on firms based on on payout strategies. transaction costs.
their individual tax or income preferred
preferences. dividend policies.
Signaling Stephen Ross Posits that dividend changes Managers use Explains why firms may increase Can lead to misinterpretations or
Theory 1980s convey information to the dividend policy dividends to signal strength to excessive focus on dividends for
market about the firm’s to signal private investors. signaling purposes.
future earnings and financial information
health. about the firm.
Residual 1956 Donaldson Firms should only pay Firms have Prioritizes investment opportunities Inconsistent dividends; can make
Dividend dividends from residual access to over dividends, potentially investors uncertain about income
Theory earnings after all profitable profitable maximizing growth. reliability.
investments have been investment
financed. opportunities
and aim to
maximize
shareholder
value through
reinvestment.
Agency Cost Michael Jensen Dividend payments reduce Managers may Aligns managerial actions with Could limit firm’s flexibility for
Theory 1980s the agency costs between waste excess shareholder interests by reducing investment and create financial
shareholders and managers cash; paying free cash flow. strain.
by limiting the cash available dividends forces
to managers. better capital
discipline.