Capital Structure Theory: Trade-off, Pecking Order, and Market Timing

Abstract

Capital structure—the mix of debt and equity financing that firms use to fund their assets—is one of corporate finance’s most extensively studied questions, beginning with Modigliani and Miller’s (1958) irrelevance theorem establishing that in perfect markets capital structure does not affect firm value, and subsequent work introducing market imperfections (taxes, bankruptcy costs, information asymmetry) that make capital structure choices matter. Three major theories have dominated the field: the trade-off theory (firms balance debt tax shield benefits against bankruptcy costs to reach an optimal leverage ratio); the pecking order theory (Myers and Majluf, 1984—firms follow a financing hierarchy from internal funds through debt to equity to minimize adverse selection costs); and the market timing theory (Baker and Wurgler, 2002—firms issue equity when market valuations are high and repurchase when low, with persistent capital structure effects). This paper reviews each theoretical framework, evaluates the empirical evidence, and examines the dynamic capital structure evidence including leverage adjustment speeds and the cross-sectional determinants of corporate leverage.