Capital Structure
Itay Goldstein
Wharton School, University of Pennsylvania
There are two main types of financing: debt and equity.
Consider a two-period world with dates 0 and 1. At date 1, the firm’s assets are worth X. The firm has debt at face value of D.
The value of debt at date 1 will be 1 , , and the value of equity will be 1 , 0 . Debt is the senior claimant to the firm’s returns and equity is the residual claimant.
Capital structure theory asks what is the optimal composition between debt and equity.
2 Modigliani and Miller (1958): Irrelevance Theorem
A benchmark striking result is that under fairly general conditions, the value of the firm – defined as the sum of value of debt and equity – does not change as we change the capital structure.
Under risk neutrality, this is very easy to see: