Capital Structure by Stewert C
Myers | Journal of Economic Perspectives, Spring 2001
this article, a well known scholar examines the tradeoffs underlying
the use of debt and equity. Contrary to what Miller and Modigliani
mentioned, capital structure does matter because of taxes,
differences in information and agency costs. Accordingly, Myers
examines three theories in detail. The trade off theory tries to
balance the tax advantages of debt and the possibility of distress.
The pecking order (differences in information ) theory states that
firms will first borrow rather than raise equity when they are short
of funds. The free cash flow (agency costs) theory argues that cash
flows belong to equity holders. Even dangerously high levels of debt
can create value for shareholders if the free cash flows are more
than the investment opportunities.