Capital Structure Theories: Modigliani-Miller, Pecking Order
Capital Structure Theories: Modigliani-Miller, Pecking Order
This document presents corrected and polished statements about major capital structure theories, including Modigliani–Miller, the trade-off theory, agency and signaling theories, the pecking order, the Gordon growth model, and implications for SMEs. Each numbered statement below preserves the original content while improving spelling, grammar, capitalization, and clarity.
1. Modigliani-Miller: Irrelevance Thesis
False. According to the original Modigliani and Miller (M&M) irrelevance proposition (without taxes), the value of the firm depends only on its investment policy — specifically the future cash flows generated by its assets — and does not depend on the dividend policy or the chosen funding sources.
2. Trade-Off Theory and Optimal Leverage
False. The trade-off model is characterized by the idea that firms accept an optimal capital structure by balancing the tax benefits of debt against bankruptcy and agency costs. The M&M model departs from strict irrelevance once corporate taxes (and other frictions) are introduced.
3. M&M Model Without Taxes
True. Indeed, under M&M without taxes the current value of the firm's income stream is unaffected by capital structure: the value of a leveraged firm's earnings stream is equivalent to that of an unleveraged firm because required returns adjust to reflect risk.
4. Shareholder Required Return in M&M
True. In the M&M framework, the return required by shareholders (Ke) increases with leverage. It can be understood as the unlevered required return plus a premium for financial risk. A common expression is:
Ke = Ku + (Ku - Kd) × (D/E)
where Ku is the return on unlevered equity (assets), Kd is the cost of debt, and D/E is the debt-to-equity ratio.
5. Agency Theory and Debt
True. Agency theory indicates that higher levels of debt can increase conflicts between shareholders and creditors. These conflicts raise agency costs of debt and can consequently decrease firm value.
6. Signaling Theory and Equity Issues
False. Under signaling theory, issuing new equity is often interpreted as a negative signal: the market may infer that managers issue shares because they believe the stock is overvalued. Such equity issuance can therefore lead to a decline in the share price.
7. Pecking Order Theory Preferences
True. According to the pecking order theory, managers prefer internal financing (retained earnings) first, then debt, and issue equity only as a last resort.
8. SME Financing and Pecking Order
True. Applying pecking order logic to small and medium-sized enterprises (SMEs): SMEs often exhibit greater aversion to loss of control, have limited access to capital markets, and face a higher probability of bankruptcy. As a result, they rely more heavily on retained earnings to finance investments.
9. Gordon Growth Model and Dividends
False. The Gordon growth (constant-growth dividend discount) model shows that share value depends on dividends and the required return by shareholders. The model is:
P = D1 / (Ke - g)
Whether a higher dividend payout increases firm value depends on the relationship between the firm's return on equity (ROE) and the shareholders' required return (Ke): if retained earnings earn returns above Ke, retention can increase value; if returns on retained earnings are below Ke, increasing dividends may raise value.
10. Agency and Signaling Effects of Dividends
True. From the agency-theory perspective, increasing dividends reduces free cash flow available to managers, thereby mitigating agency conflicts between managers and shareholders and potentially increasing firm value. At the same time, signaling theory warns that dividend changes convey information to the market: inappropriate signals about future cash flow prospects can harm firm value.
Note: This text preserves the original numbered statements and intent while correcting language, punctuation, capitalization, and terminological clarity for improved readability and SEO.