Question

Hi, I am struggling to understand the Modigliani-Miller tradeoff and Myers-Majluf pecking order theories of capital structure.

Specifically I'm trying to understand what they are trying to advise when it comes to capital structure decision-making?

Answer 1

The Purpose of Capital structure Models: Each Finance managers try to find the optimal ratio of Capital structure for its new project/ existing firm to maximize the return.  

The decision between Debt and Equity: Equity comes with higher expectation of return on Investment increasing overall cost of capital. On the other hand, Debt comes with Interest Tax Shield means savings on tax payment reduce the overall cost of capital. But the question is can a firm Issue unlimited Debt? The simple answer is No. Cause with higher the Debt amount it brings in the risk of bankruptcy of a firm.

So Here comes the Modigliani-Miller tradeoff theory: It is trade-off between the advantage of Cost of Debt by availing interest tax shield Vs the risk of bankruptcy of a firm. So this theory explains up to a certain limit of debt Value of firm increases (Optimal Capital Structure) post that Value of firm tends to decrease as the risk of bankruptcy increases with a higher cost of debt.

Myers-Majluf pecking order theories, on the other hand, explain the scenario in which types of funding we should consider over others. Firms always should focus on Financing its projects through the mode of internal Financing options (Using Reserve/Surplus). For External Funding, preferences should be Debt over Equity. So according to preferences :

1. Internal Financing
2. Debt
3. Equity

The reason behind this logic is the risk/return associated with each type of financing. Internal Financing is always considered a safe source of funds. On the other hand, Debt is more preferable due to interest tax shield and lesser interest rate as compared to a higher cost of capital for equity.