The Evolution of Modern Capital Structure Theory: A Review

Abstract

Capital structure has been one of the most controversial and debatable topics in corporate finance theory since the birth of Modigliani and Miller’s (MM) first capital structure irrelevancy theory in 1958. Following MM’s (1958) first quantitative theorem, several finance economists and scholars across the globe have theorized and empirically investigated to clarify the nature of corporate capital structure and the impact of a firm’s capital structure decision on its value and financial performance. This review article briefly overviews the evolution of modern capital structure theory in the corporate finance literature, from its classical root (MM capital structure irrelevance theory) to its recent development (BFO theory). The paper compares and contrasts the arguments of invaluable theoretical papers to comprehend the strengths and weaknesses of each theory. The review indicates that there is no universal capital structure theory that comprehensively explains the real-world financing behavior of firms and the capital structure-firm performance nexus. In other words, the capital structure puzzle is still unsolved in corporate finance literature.