Capital Structure Theory

Capital structure theory is a science that studies how companies configure the proportional relationship between liabilities and equity through different financing methods, such as bonds, stocks, hybrid bonds, etc., in order to maximize corporate value. Capital structure theory involves many factors such as enterprise costs, risks, taxes, information asymmetry, agency problems, etc., and is one of the important components of financial theory in Western countries.

Capital structure theory is of great significance to enterprises because it can help enterprises make reasonable financing decisions, reduce capital costs, improve capital efficiency, and enhance competitiveness and risk resistance. Different capital structures will have different impacts on an enterprise's operating performance, market value, credit rating, etc. Therefore, enterprises need to choose the capital structure that best suits them based on their own characteristics and the external environment.

What are the main schools of capital structure theory? What are their characteristics and contributions?

There are many schools of capital structure theory, which can be mainly divided into two stages: old capital structure theory and new capital structure theory. The old capital structure theory is based on a series of strict assumptions, including traditional theory, MM theory and trade-off theory. The new capital structure theory is based on asymmetric information, including agency theory, control rights theory, signaling theory and pecking order theory

Traditional theory believes that there is an optimal capital structure that maximizes corporate value. This optimal capital structure is the result of striking a balance between using financial leverage to reduce the average cost of capital and controlling financial risks.

MM theory was proposed by Modigliani and Miller and is a groundbreaking and revolutionary theory. Under the assumption of perfect markets, it concluded that capital structure has nothing to do with corporate value; under the conditions of corporate income tax, it concluded that corporate value increases with the increase in liabilities. It emphasizes the irrelevance of capital structure and the tax shield effect, providing an important basis for subsequent research.

The trade-off theory is based on the MM theory, relaxes the perfect market assumption, introduces bankruptcy costs, agency costs, information asymmetry and other factors, and believes that when enterprises choose capital structures, they must weigh the tax shield effect brought by debt financing and other factors. Financing costs increase, thereby maximizing corporate value. This theory explains why most real-world companies prefer debt financing rather than equity financing.

Agency theory is a theory that studies capital structure from the additional financing costs brought about by asymmetric information. It believes that there are three agency costs in enterprises: asset substitution effect, underinvestment phenomenon and free cash flow. These agency costs will affect the company's investment decisions and value creation, so companies need to reduce agency costs through appropriate capital structures.

Control rights theory is a theory that analyzes capital structure from the perspective of conflicts of interest and competition for control rights among equity owners. It believes that when enterprises choose capital structures, they should take into account the impact of equity dispersion and centralization on corporate governance efficiency and value. balance. This theory explains why some companies choose a capital structure with high debt or high equity to prevent control from being diluted or taken away.

Signaling theory is a theory that explores capital structure from the perspective of companies sending and receiving messages. It believes that companies can convey their internal messages to the market through different financing methods, thus affecting the market's assessment of the value of the company. This theory explains why some companies choose to issue stocks or bonds as a signal that they are confident or conservative about their future prospects.

The pecking order theory is a capital structure theory based on asymmetric information proposed by Myers. It believes that companies will determine the company's financing order based on the difficulty of obtaining information and the level of agency costs.

What are the practical applications of capital structure theory? How do they help companies improve their competitiveness and value?

Capital structure theory has many practical applications, mainly including the following aspects:

Capital structure design: Enterprises can choose the capital structure that best suits them based on their own characteristics and the external environment to achieve the goals of lowest cost, lowest risk, and highest value. Enterprises can refer to different capital structure theories, such as trade-off theory, pecking order theory, etc., to formulate their own financing strategies and plans.

Capital structure adjustment: Enterprises can adjust their capital structure in a timely manner according to market changes and their own development to adapt to new situations and needs. Enterprises can adjust their capital structure in different ways, such as issuing or recycling stocks, bonds, etc., or carrying out equity restructuring, debt restructuring, etc.

Capital structure evaluation: Enterprises can evaluate their competitiveness and value by analyzing the capital structure of themselves and their competitors. Enterprises can use different methods to evaluate their capital structure, such as the weighted average cost of capital method, financial leverage method, asset pricing model, etc.

Capital structure communication: Companies can convey their messages to the market by displaying their capital structure, thus affecting the market's evaluation and trust of themselves. Enterprises can use different capital structure theories, such as signaling theory, control rights theory, etc., to send different signals, such as indicating their confidence or conservatism in future prospects.

In short, capital structure theory is a highly practical knowledge that can help companies make reasonable financing decisions under different circumstances, reduce costs, improve efficiency, and enhance competitiveness and value. Enterprises need to flexibly use different capital structure theories according to changes in themselves and the market to achieve the best capital structure.