Traditional Theory Of Capital Structure

A company uses two main methods to raise money to do all the stuff companies do, like buy machinery, purchase break room snacks, and import illegal fireworks for the Fourth of July company picnic.

To get the cash for this stuff, companies can borrow, or they can sell equity. Borrowing involves getting money through a loan. Selling equity means you find investors who buy a portion of the company in exchange for cash. Loans have the benefit that the owners of the company don't have to dilute their stakes in the firm. They get to stay in charge. They just have to make the regular interest and principal payments. However, selling equity has its upsides as well. Mostly, the company doesn't have to pay back the funds. The investors take a risk that the company will earn profits in the future. If it goes bust, they lose the investment.

The traditional theory of capital structure describes the ideal mix of borrowing and equity. Since owners have an interest (literally) in preventing their holdings in the firm from getting diluted, they have a tendency to rely on borrowing. It's like building your business with someone else's money.

However, the traditional theory of capital structure says there's a limit to this strategy. It states that, at a certain point, too much borrowing puts a cap on a firm's value.

That extra money coming in from the additional loans doesn't do anything to build the owners' fortunes, because the company becomes overleveraged. This situation caps the upside potential of the firm. Therefore, companies should strive to find an optimal mix of equity and debt to build their business.