This blog post examines how the trade-off theory and the pecking order theory interpret corporate size and growth potential differently, providing a balanced understanding of the core principles governing debt ratio decisions.
The Modigliani-Miller theory, often expressed as the proposition that capital structure is irrelevant to firm value, is a capital structure theory based on the assumption of a perfect capital market—that is, the premise that all friction factors that could cause capital market imperfections are entirely absent. According to this theory, under conditions where there are no taxes on corporate operating profits, including corporate income tax, no transaction costs exist, and all firms face the same level of risk, the value of a firm is completely unaffected whether it utilizes internal surplus funds or equity capital like shares, or whether it utilizes debt capital like loans. The significance of the Modigliani-Miller theory lies not so much in providing a practical explanation for reality, but rather in establishing the starting point for modern capital structure theory.
Following its introduction, various capital structure theories emerged, focusing on the unrealistic assumption of perfect capital markets and incorporating factors like taxes, bankruptcy costs (costs incurred during corporate bankruptcy), and information asymmetry—differences in information held by economic agents such as managers, investors, and creditors. Among these theories premised on imperfect capital markets, the trade-off theory and the pecking order theory are particularly prominent.
The trade-off theory determines a firm’s optimal capital structure by comparing the benefits and costs associated with debt usage. While multiple factors constitute these benefits and costs, for simplicity, we can assume that benefits are limited to the corporate tax shield effect and costs are limited to bankruptcy costs. The tax savings effect referred to here means the reduction in taxes resulting from debt interest being treated as an expense. Under this assumption, the trade-off theory posits that as debt usage increases, corporate value rises due to the tax savings effect, but simultaneously, the expected bankruptcy cost also increases, leading to a decrease in corporate value. Ultimately, it explains that the debt ratio maximizing corporate value—the optimal debt ratio—is determined at the point where these opposing effects reach equilibrium.
In contrast, the pecking order theory posits that capital is raised in order of decreasing information asymmetry. According to this theory, when investment is needed, a firm first uses its internal surplus funds. If these funds fall short of the investment amount, it then raises external funds. Furthermore, even when external funds are required, firms tend to prefer debt over issuing equity due to information asymmetry.
The trade-off theory and the pecking order theory offer differing predictions regarding the factors determining a firm’s debt ratio. For instance, concerning firm size, the trade-off theory predicts that larger firms will have a higher debt ratio. This is because larger firms typically have greater diversification, lower bankruptcy risk, and lower expected bankruptcy costs, resulting in greater debt-bearing capacity. Additionally, they will seek to borrow more debt to maximize the benefits of the corporate tax rate reduction. Conversely, the pecking order theory posits that larger firms, benefiting from greater accounting transparency, experience fewer problems arising from information asymmetry with investors. Therefore, they prefer raising capital through the stock market rather than borrowing via financial intermediaries, resulting in a lower debt ratio. The two theories also reach different conclusions regarding high-growth firms. The Contradiction Theory posits that companies with high growth potential will have a lower debt ratio because the expected bankruptcy costs outweigh the benefits of corporate tax cuts. Conversely, the Capital Structure Hierarchy Theory predicts that growth companies will have a higher debt ratio due to their greater investment needs.
In response to various theories assuming imperfect capital markets criticizing the Modigliani-Miller theory, Miller proposed his own theory, which modified and supplemented the Modigliani-Miller theory. He judged that the influence of bankruptcy costs on explaining capital structure was negligible and thus did not warrant consideration. Simultaneously, noting that the effect of corporate tax reductions did not significantly impact corporate capital structure decisions, he sought to redefine the effect of taxes on capital structure decisions. In reality, not only corporate taxes but also income taxes are levied on the interest income creditors receive from investing in firms. These income taxes can influence creditors’ asset investment behavior, ultimately affecting corporate financing. Reflecting this reality, Miller presented a theory of optimal capital structure determination at the aggregate economic level by systematically explaining investor demand behavior and firm supply behavior in the bond market.
According to Miller’s theory, when the overall economy’s capital structure is optimal, the corporate tax rate and the interest income tax rate precisely coincide. In this case, from the perspective of individual firms, using debt capital does not change the firm’s value. Ultimately, this leads to the conclusion that there is no optimal capital structure at the firm level, and that capital structure and firm value are unrelated.
