Review one page for the Article $$CAPITAL STRUCTURE THEORY: A CURRENT PERSPECTIVE$$

A firm's capital structure is a complex decision$-$making process that determines funding sources, risks, and control rights. Key decisions include debt and equity mix, debt maturity structure, voting control allocation, security issuance timing, and financial claims. Finance scholars' approach to capital structure reflects a progression of thought, resulting in various theories.

Classical Theory$$Perfect Capital Markets

Early capital structure theory focused on a fixed amount of operating cash flow, with the key choice being the best split between debt and equity. Modigliani and Miller's $1958$ work laid the foundation for perfect capital markets, which had no taxes, transactions or distress costs, common objectives among decision$-$makers, and perfect information available to all. The evolution of capital structure theory involved relaxing these assumptions, recognizing corporate tax benefits and transaction costs, leading to the modern traditional theory of capital structure.

The Modern $$Traditional$$ Theory$$A Partial Synthesis

The modern traditional view of capital structure suggests that firms can choose the optimal mix of debt and equity by balancing the tax benefits of debt with the potential costs of financial distress. This tradeoff occurs when debt tax benefits erode due to income loss or the potential costs of financial distress. The focus is on dividing operating cash flows between debt and equity, with minimal government involvement and financial distress costs. This view overlooks other aspects of capital structure, such as equity source and control rights allocation. Decision$-$makers aim to maximize firm value, rather than pursue their own agenda.

Recent Developments in Theory

Perfect capital markets focus on individual decision$-$making and imperfect information, leading to costs from information imbalances. The "size of the pie" approach considers how capital structure affects decision$-$makers' incentives and actions, reducing potential conflicts among capital providers. Agency theory aims to reduce conflicts among capital providers by recognizing and avoiding diverging interests. Security design is crucial to lower monitoring costs, curb opportunistic behavior by agents, and reduce agency costs.

Agency Costs of Equity

Capital structure can create agency costs if it conflicts with shareholders' interests. Solutions include increasing equity ownership, monitoring managers, imposing discipline through debt, and using leverage to increase control rights. These measures aim to reduce overinvestment and maximize firm value.

Agency Costs of Debt

The above suggests that firms may benefit from additional debt because it reduces the agency costs of equity. Before one concludes that the firm should rely more on debt, however, we must recognize that greater debt usage creates the potential for additional conflicts of interest that do not arise in an all$-$equity financed firm. Debt usage can give rise to conflicts between the

interests of shareholders $($perhaps including management$)$ and those of creditors. Conflicts between debt$-$holders and equityholders arise because the debt contract gives equityholders an incentive to invest suboptimally. There are two ways in particular that debt contracts can result in suboptimal investment. In the literature, these are described as the asset substitution problem and the debt$-$overhang problem.

Asset substitution and incentives for overinvestment

Debt contracts have limited upside potential, with equityholders gaining most of the gain and debt$-$holders bearing consequences. This creates conflict, especially in financial distress, leading to overinvestment in risky projects. Equityholders can limit capital expenditures through covenants in the debt contract, but these costs must be considered when seeking external capital.

Debt overhang and underinvestment can occur when a firm has excessive debt relative to its assets, leading to underinvestment and potential loss in value. This issue is more severe when a firm's value is based on future growth opportunities rather than assets. Setting limits on debt in relation to assets can help reduce the likelihood of this situation. Agency costs arise from relationships between firms and customers, as well as the size of the debt load. Imperfect information can exacerbate agency problems, increasing capital raising costs. Capital structure choice involves five elements: tax benefits of financing, explicit costs of financial distress, agency costs of debt, agency costs of equity, and the signaling effect of security issuance. The optimal capital structure is a tradeoff between leverage$-$related benefits and costs, with agency costs and information effects supplementing traditional tax features and explicit costs of financial distress.