Lesson 6 of 6 · All lessons in this module
- The cost of capital and WACCVideo lesson
- How much financing, and what kind: business model and life cycle
- What drives the costs of debt and equity
- Modigliani-Miller without taxes: capital structure irrelevanceVideo lesson
- Modigliani-Miller with taxes, and the cost of financial distressVideo lesson
- Optimal and target capital structures, pecking order and agency costsVideo lesson
Lesson 6 of 6 · 15 min
Optimal and target capital structures, pecking order and agency costs
In practice firms balance the tax benefit of debt against expected distress costs, aim for a target range usually expressed in book values, and adjust for signalling and agency effects that the pecking order and free cash flow hypothesis describe.
In short
- Static trade-off theory: ; the optimal capital structure is at D*, where the marginal tax benefit equals the marginal expected distress cost.
- D* cannot be estimated precisely, so managers set a target (often a range); actual structure drifts with market values and opportunistic issuance.
- Targets are usually in book values: market values fluctuate, management cares about capital invested *in* the business, and lenders and rating agencies use book figures.
- Analysts estimate target weights from current market weights, trends and management statements, or peer averages; .
- Pecking order (asymmetric information, signalling): internal funds first, then private debt, then public debt, equity last; no optimal structure.
- Free cash flow hypothesis (agency costs): more debt disciplines managers to use cash wisely.
Unlock this lesson free for 7 days
Create a free account to get 7 days free: every lesson, video and flashcard, and the question bank. No card needed.