F&E
Article: Capital structure theory and new technology firms: is there a match?
(Coleman & Robb, 2012)
Capital structure theory
- Capital Structure Basics:
o Capital structure is the mix of debt and equity used to finance a firm's long-term (fixed) assets.
o Debt is borrowed capital that must be repaid, while equity is a permanent investment from
owners/shareholders.
o Firm’s capital structure → the combined cost of debt and equity is known as the Weighted
Average Cost of Capital (WACC).
- Modigliani and Miller (M&M) Theory:
o M&M proposed that firms choose a debt-equity mix that maximizes firm value and minimizes
WACC.
o M&M also assumes that firms have access to the full range of debt and equity alternatives → In
the case of new firms in general and technology-based firms in particular, informational
asymmetries abound.
▪ Their theory assumes no transaction costs and perfect information between investors
and managers.
o Not ideal for small/private firms, which lack access to the full range of financing options.
o Challenges for Small/Privately Held Firms:
▪ Small firms often face "informational asymmetry," where outsiders have limited
information, increasing perceived risk
▪ These firms rely on personal funds, bank loans, private investors, venture capital, or
government funding, as issuing public stock/bonds is costly.
- Pecking Order Theory (Myers & Majluf, 1984):
o According to this theory, insiders have information about the firm that outsiders do not
necessarily have → because of this informational asymmetry, outside share purchases will tend to
underprice a firm’s shares.
o There is a ‘pecking order’ if financing sources geared toward allowing the business owner to
retain the maximum amount of control for as long as possible,
o Firms prioritize financing: internal equity first, then short-term debt, long-term debt, and finally
external equity.
o This order minimizes reliance on outside investors and preserves owner control.
1
, o Particularly relevant for small/private firms due to high informational asymmetry.
- Life Cycle Theory (Berger & Udell, 1998):
o States that firms use different types of financing at different growth stages.
o Small and privately held firms, in particular, are ‘informationally opaque’ and thus have a more
difficult time obtaining external sources of financing.
▪ These firms tend to be more reliant on insider financing, such as the personal financial
resources of the firm owners, and, in instances where the firm is profitable, retained
earnings.
o When firm owners do have to turn to external sources of financing, their preference is for debt
rather than equity because debt does not require them to give up ownership or control of the
firm.
o Informational asymmetries are particularly severe for early-stage firms, those in the seed or
developmental stages.
o As the firm moves through its life cycle, however, it becomes less ‘opaque’ and has access to a
broader array of funding sources.
- New Technology-Based Firms-→ case that is particularly challenging:
o Often have high informational opacity, especially with proprietary technologies.
o Face pressures for rapid growth, increasing demand for both internal and external funding.
o Research aims to examine if these firms follow traditional capital structure theories.
Summary and Conclusion
- Research Focus:
o Studied initial financing strategies of new technology-based firms vs. non-technology-based firms.
- Key Findings:
o Technology-based firms raised more capital than all firms, especially those with rapid growth
(over $100k revenue in startup year).
o These firms relied more on external equity and less on owner financing and external debt
compared to non-technology-based firms, challenging pecking order and life cycle theories.
- Financing Patterns:
o Technology-based firms used a higher ratio of external equity than owner-provided funds or
external debt.
o High-performing tech firms (rapid growth, high credit quality) raised more external debt and
external equity, especially when intellectual property was involved.
- Theories’ Limitations:
2
, o Pecking order and life cycle theories partially align with general tech firm patterns, but not with
high-performing subsets, which used higher external financing.
- Implications for Tech Firms:
o High growth, credit quality, and intellectual property may signal firm potential to investors,
reducing information asymmetry.
o Technology-based firms with strong prospects can access substantial external funding by
demonstrating growth potential and competitive advantage.
- Conclusion:
o Technology-based firms differ from non-tech firms in financing, with potential to attract external
investors by emphasizing growth potential and intellectual property.
Article: A REVIEW OF THE CAPITAL STRUCTURE THEORIES (Luigi & Sorin, 2009)
Introduction
Three major theories of capital structure:
- Trade-off theory → assumes that firms trade off the benefits and costs of debt and equity financing and
find an ‘optimal’ capital structure after accounting for market imperfections such as taxes, bankruptcy
costs, and agency costs.
- Pecking order theory→ Argues that firms follow a financing hierarchy to minimize the problem of
information asymmetry between the firm’s managers-insiders and the outsiders-stakeholders.
- The market timing theory of capital structure → this theory states that the current capital structure is the
cumulative outcome of past attempts to time the equity market.
o Market timing implies that firms issue new shares when they perceive they are overvalued and
that firms repurchase their own shares when they consider these to be undervalued.
The Modigliani-Miller Theorem
- The Modigliani-Miller Theorem (1958) introduced the capital structure irrelevance proposition, laying the
foundation for modern business finance theory.
- Before Modigliani and Miller, there was no unified theory of capital structure.
- The theorem assumes that firms have specific expected cash flows, which are divided among investors
regardless of the debt-equity ratio used.
- Both firms and investors are assumed to have equal access to financial markets, enabling investors to
create or eliminate leverage independently of the firm's capital structure.
- The main conclusion is that the leverage (debt-equity mix) does not impact the firm's market value.
- Two types of irrelevance propositions emerged:
o Arbitrage-based irrelevance: Arbitrage by investors maintains firm value, irrespective of leverage.
o Dividend irrelevance: A firm's dividend policy does not influence share price or total shareholder
returns, assuming perfect markets.
- In perfect markets, neither capital structure nor dividend policy decisions matter.
- The theorem spurred research to test its validity, revealing that it fails under certain conditions, such as
taxes, transaction and bankruptcy costs, agency conflicts, and more.
3
, Trade-off theory
- It describes a family of related theories.
- In all of these theories, a decision-maker running a firm evaluates the various costs and benefits of
alternative leverage plans. Often, it is assumed that an interior solution is obtained so that marginal costs
and marginal benefits are balanced.
- The trade-off theory emerged as a response to the Modigliani-Miller theorem, incorporating corporate
income tax to explain debt benefits.
- Adding tax effects showed that debt financing shields earnings from taxes, suggesting an incentive for
100% debt financing in the absence of offsetting costs.
- Key points in Myers' definition of the trade-off theory:
o Unobservable Target: The optimal debt level is not directly visible and requires assumptions to
infer it.
o Complex Tax Code: The real-world tax code is more intricate than assumed, impacting conclusions
on the ideal debt target (reviewed by Graham, 2003).
o Bankruptcy Costs: These must be considered deadweight, not simple transfers, with the nature of
these costs significantly affecting analysis (discussed by Haugen and Senbet, 1978).
o Transaction Costs: To allow gradual adjustments, transaction costs must increase with larger
adjustments. Leary and Roberts (2005) examined various adjustment cost assumptions.
Static trade-off theory
- Suggests firms aim for an optimal capital structure by balancing the costs and benefits of debt and equity.
- Trade-off between the tax benefit and the disadvantage of higher risk of financial distress.
o Debt Benefits: Debt provides a tax shield, offering a tax-related advantage.
o Debt Disadvantages: Excessive debt increases financial distress risk, which the firm weighs against
tax benefits.
- Additional Costs: Agency costs arise from stakeholder conflicts and asymmetric information, adding to the
complexity of the debt-equity balance → incorporating agency costs into the static trade-off theory means
that a firm determines its capital structure by trading off the tax advantage of debt against the costs of
financial distress of too much debt and the agency costs of debt against the agency cost of equity.
- Capital Structure Targeting: Firms are expected to adjust their leverage to return to the optimal level if
deviations occur.
- The theory’s core prediction is that firms actively manage their capital structures to achieve a target
balance.
o I.e. if the actual leverage ratio deviates from the optimal one, the firm will adapt its financing
behavior in a way that brings the leverage ratio back to the optimal level.
The dynamic trade-off theory
- Unlike static models, it incorporates the role of time, expectations, and adjustment costs in financing
decisions.
- Financing Decisions Over Time: Optimal financing choices depend on expected future needs, such as
raising or paying out funds, and can involve debt, equity, or a mix.
- Dynamic trade-off models can also be used to consider the option values embedded in differing leverage
decisions to the next period.
- The optimal financing choice today depends on what is expected to be optimal next period.
4
Article: Capital structure theory and new technology firms: is there a match?
(Coleman & Robb, 2012)
Capital structure theory
- Capital Structure Basics:
o Capital structure is the mix of debt and equity used to finance a firm's long-term (fixed) assets.
o Debt is borrowed capital that must be repaid, while equity is a permanent investment from
owners/shareholders.
o Firm’s capital structure → the combined cost of debt and equity is known as the Weighted
Average Cost of Capital (WACC).
- Modigliani and Miller (M&M) Theory:
o M&M proposed that firms choose a debt-equity mix that maximizes firm value and minimizes
WACC.
o M&M also assumes that firms have access to the full range of debt and equity alternatives → In
the case of new firms in general and technology-based firms in particular, informational
asymmetries abound.
▪ Their theory assumes no transaction costs and perfect information between investors
and managers.
o Not ideal for small/private firms, which lack access to the full range of financing options.
o Challenges for Small/Privately Held Firms:
▪ Small firms often face "informational asymmetry," where outsiders have limited
information, increasing perceived risk
▪ These firms rely on personal funds, bank loans, private investors, venture capital, or
government funding, as issuing public stock/bonds is costly.
- Pecking Order Theory (Myers & Majluf, 1984):
o According to this theory, insiders have information about the firm that outsiders do not
necessarily have → because of this informational asymmetry, outside share purchases will tend to
underprice a firm’s shares.
o There is a ‘pecking order’ if financing sources geared toward allowing the business owner to
retain the maximum amount of control for as long as possible,
o Firms prioritize financing: internal equity first, then short-term debt, long-term debt, and finally
external equity.
o This order minimizes reliance on outside investors and preserves owner control.
1
, o Particularly relevant for small/private firms due to high informational asymmetry.
- Life Cycle Theory (Berger & Udell, 1998):
o States that firms use different types of financing at different growth stages.
o Small and privately held firms, in particular, are ‘informationally opaque’ and thus have a more
difficult time obtaining external sources of financing.
▪ These firms tend to be more reliant on insider financing, such as the personal financial
resources of the firm owners, and, in instances where the firm is profitable, retained
earnings.
o When firm owners do have to turn to external sources of financing, their preference is for debt
rather than equity because debt does not require them to give up ownership or control of the
firm.
o Informational asymmetries are particularly severe for early-stage firms, those in the seed or
developmental stages.
o As the firm moves through its life cycle, however, it becomes less ‘opaque’ and has access to a
broader array of funding sources.
- New Technology-Based Firms-→ case that is particularly challenging:
o Often have high informational opacity, especially with proprietary technologies.
o Face pressures for rapid growth, increasing demand for both internal and external funding.
o Research aims to examine if these firms follow traditional capital structure theories.
Summary and Conclusion
- Research Focus:
o Studied initial financing strategies of new technology-based firms vs. non-technology-based firms.
- Key Findings:
o Technology-based firms raised more capital than all firms, especially those with rapid growth
(over $100k revenue in startup year).
o These firms relied more on external equity and less on owner financing and external debt
compared to non-technology-based firms, challenging pecking order and life cycle theories.
- Financing Patterns:
o Technology-based firms used a higher ratio of external equity than owner-provided funds or
external debt.
o High-performing tech firms (rapid growth, high credit quality) raised more external debt and
external equity, especially when intellectual property was involved.
- Theories’ Limitations:
2
, o Pecking order and life cycle theories partially align with general tech firm patterns, but not with
high-performing subsets, which used higher external financing.
- Implications for Tech Firms:
o High growth, credit quality, and intellectual property may signal firm potential to investors,
reducing information asymmetry.
o Technology-based firms with strong prospects can access substantial external funding by
demonstrating growth potential and competitive advantage.
- Conclusion:
o Technology-based firms differ from non-tech firms in financing, with potential to attract external
investors by emphasizing growth potential and intellectual property.
Article: A REVIEW OF THE CAPITAL STRUCTURE THEORIES (Luigi & Sorin, 2009)
Introduction
Three major theories of capital structure:
- Trade-off theory → assumes that firms trade off the benefits and costs of debt and equity financing and
find an ‘optimal’ capital structure after accounting for market imperfections such as taxes, bankruptcy
costs, and agency costs.
- Pecking order theory→ Argues that firms follow a financing hierarchy to minimize the problem of
information asymmetry between the firm’s managers-insiders and the outsiders-stakeholders.
- The market timing theory of capital structure → this theory states that the current capital structure is the
cumulative outcome of past attempts to time the equity market.
o Market timing implies that firms issue new shares when they perceive they are overvalued and
that firms repurchase their own shares when they consider these to be undervalued.
The Modigliani-Miller Theorem
- The Modigliani-Miller Theorem (1958) introduced the capital structure irrelevance proposition, laying the
foundation for modern business finance theory.
- Before Modigliani and Miller, there was no unified theory of capital structure.
- The theorem assumes that firms have specific expected cash flows, which are divided among investors
regardless of the debt-equity ratio used.
- Both firms and investors are assumed to have equal access to financial markets, enabling investors to
create or eliminate leverage independently of the firm's capital structure.
- The main conclusion is that the leverage (debt-equity mix) does not impact the firm's market value.
- Two types of irrelevance propositions emerged:
o Arbitrage-based irrelevance: Arbitrage by investors maintains firm value, irrespective of leverage.
o Dividend irrelevance: A firm's dividend policy does not influence share price or total shareholder
returns, assuming perfect markets.
- In perfect markets, neither capital structure nor dividend policy decisions matter.
- The theorem spurred research to test its validity, revealing that it fails under certain conditions, such as
taxes, transaction and bankruptcy costs, agency conflicts, and more.
3
, Trade-off theory
- It describes a family of related theories.
- In all of these theories, a decision-maker running a firm evaluates the various costs and benefits of
alternative leverage plans. Often, it is assumed that an interior solution is obtained so that marginal costs
and marginal benefits are balanced.
- The trade-off theory emerged as a response to the Modigliani-Miller theorem, incorporating corporate
income tax to explain debt benefits.
- Adding tax effects showed that debt financing shields earnings from taxes, suggesting an incentive for
100% debt financing in the absence of offsetting costs.
- Key points in Myers' definition of the trade-off theory:
o Unobservable Target: The optimal debt level is not directly visible and requires assumptions to
infer it.
o Complex Tax Code: The real-world tax code is more intricate than assumed, impacting conclusions
on the ideal debt target (reviewed by Graham, 2003).
o Bankruptcy Costs: These must be considered deadweight, not simple transfers, with the nature of
these costs significantly affecting analysis (discussed by Haugen and Senbet, 1978).
o Transaction Costs: To allow gradual adjustments, transaction costs must increase with larger
adjustments. Leary and Roberts (2005) examined various adjustment cost assumptions.
Static trade-off theory
- Suggests firms aim for an optimal capital structure by balancing the costs and benefits of debt and equity.
- Trade-off between the tax benefit and the disadvantage of higher risk of financial distress.
o Debt Benefits: Debt provides a tax shield, offering a tax-related advantage.
o Debt Disadvantages: Excessive debt increases financial distress risk, which the firm weighs against
tax benefits.
- Additional Costs: Agency costs arise from stakeholder conflicts and asymmetric information, adding to the
complexity of the debt-equity balance → incorporating agency costs into the static trade-off theory means
that a firm determines its capital structure by trading off the tax advantage of debt against the costs of
financial distress of too much debt and the agency costs of debt against the agency cost of equity.
- Capital Structure Targeting: Firms are expected to adjust their leverage to return to the optimal level if
deviations occur.
- The theory’s core prediction is that firms actively manage their capital structures to achieve a target
balance.
o I.e. if the actual leverage ratio deviates from the optimal one, the firm will adapt its financing
behavior in a way that brings the leverage ratio back to the optimal level.
The dynamic trade-off theory
- Unlike static models, it incorporates the role of time, expectations, and adjustment costs in financing
decisions.
- Financing Decisions Over Time: Optimal financing choices depend on expected future needs, such as
raising or paying out funds, and can involve debt, equity, or a mix.
- Dynamic trade-off models can also be used to consider the option values embedded in differing leverage
decisions to the next period.
- The optimal financing choice today depends on what is expected to be optimal next period.
4
