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A Brief Review of Capital Structure Theories

Author Affiliations

  • 1B.N. Bahadur Institute of Management Sciences, University of Mysore, INDIA

Res. J. Recent Sci., Volume 3, Issue (10), Pages 113-118, October,2 (2014)


This paper surveys literatures on five theories of capital structure theories from Modigliani and Miller research paper at 1958 to Halov and heider at 2004. There are two main sources of firmsí financing: internal and external financing, internal financing is related to retained earnings and external financing could be in the form of borrowing or issue of equity. Firms continuously invest because of sustain and growth, for these reasons firmsí financing decisions are very important. Traditional trade-off theory and pecking order theory are most acceptable theories of capital structure. As the traditional trade-off theory asserts, firms have one optimal debt ratio (target leverage). In comparison the pecking order theory implies firmsí preference to internal finance over external finance and debt over equity. From the literature it cannot be concluded whether debt has any tax benefit on balance or not. But it can be said that the share price increases with the debt issuing announcement and falls after announcement of equity issue. As agency models anticipate, leverage is directly related to the value of firm, default probability, free cash flow, extent of regulation, liquidity value, interest coverage, cost of investigation of firmís prospects and the probability of reorganization upon default. On the other hand, leverage is expected to have inverse relationship with the growth opportunities and the importance of managerial reputation. And also, there are no conclusions about the effects of managerial ownership on leverage.


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