Explaining Firm Capital Structure: The Role of Agency Theory vs. Transaction Cost Economics

The study of capital structure has increasingly gained importance in strategic management research. Paradigms derived from organizational economics have also gained popularity in explaining firm actions. Agency theory and transaction cost economics represent two such paradigms that rely on the notion of market imperfections. Notwithstanding the similarities between them, these two offer different explanations of the role of debt and equity in a firm. The governance abilities of the financing structures and the nature of assets of the firm provide two key sources of differences. Viewing capital structure from transaction cost economics gives rise to predictions that are contradictory to those presented by agency theory. It is argued that the extant evidence mainly supports the transaction cost viewpoint. Two organizational phenomena—leveraged buyouts and product diversification—are used to highlight the comparison.