Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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JWBT436-c01 JWBT436-Baker February 11, 2011 7:53 Printer Name: Hamilton

2 Capital Structure: An Overview

recently in the economy such as the global financial crisis, the topic of capital

structure and corporate financing decisions is critically important.

Barclay and Smith (1999, p. 8) make the following observation:

A perennial debate in corporate finance concerns the question of optimal capital structure:

Given a level of total capital necessary to support a company’s activities, is there a way of

dividing up that capital into debt and equity that maximizes current firm value? And if so,

what are the critical factors in setting the leverage ratio for a given company?

An optimal capital structure is the financing mix that maximizes the value of

the firm. Yet, mixed views exist about whether an optimal capital structure ac-

tually exists. Some believe that a firm’s value does not depend on its financing

mix, and hence an optimal capital structure does not exist. The modern theory

of capital structure started with Modigliani and Miller (1958), who pioneered the

research efforts relating capital structure and the value of the firm. In their seminal

work, they show that under stringent conditions of competitive, frictionless, and

complete capital markets, the value of a firm is independent of its capital struc-

ture. That is, managers cannot alter firm value or the cost of capital by the capital

structures that they choose. Further, business risk alone determines the cost of

capital. Thus, ...