Optimal Capital Structure

Paper Summary:

An examination of the theory of optimal capital structure. Emphasis is placed on the conflict between the traditional approach to the assessment of the role of capital structure and that of the MM theory holding that capital structure is irrelevant in a perfect capital market. The literature indicates that the jury is still out on the question of the relevance of capital structure to stockholders' value.

From the Paper:

"Some theorists contend that a firm's optimal capital structure is that combination of debt and equity at which agency costs are minimized. Agency costs are the incremental costs associated with having an agent make decisions for a principal. Within the context of this consideration of the determination of optimal capital structure, management is an agent, while stockholders are the principals. Other theorists point out, however, that, while issuing debt typically produces positive outcomes for firms, the determination of an optimal capital structure for a firm is a dynamic process that, in addition to agency costs, must account for the effects of both corporate and personal income taxes, potential bankruptcy costs, transaction costs, and the degree of control over a firm's investments that will be delegated by stockholders to the firm's management (Brealey & Myers, 1996)."

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