In 1958, Franco Modigliani and Merton Miller revolutionized the whole area of corporate finance with their article “The cost of capital, corporate finance and the theory of investment”. Before Modigliani’s and Miller’s article, literature on the topic mainly focused on descriptions of methods and institutions. Theoretical analysis was very rare (Pagano 2008). Under the assumption of perfect capital markets, the Modigliani-Miller Proposition I states that “the average cost of capital to any firm is completely independent of its capital structure and is equal the capitalization rate of a pure equity stream of its class” (Modigliani, Miller 1958). In Proposition II, Modigliani and Miller argue that “that the expected yield of a share of stock is equal to the appropriate capitalization rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-equity ratio times the spread between” the capitalization rate and the return on debt. The most important implication of this theory is that if there is an optimal capital structure for a firm, this has to be the result of market imperfections. The Modigliani-Miller Theorem has thus become a starting point for further research and a benchmark for testing new theories on capital structure, that incorporate the impact of different market imperfections.
The following text will focus on two of these theories, the static trade-off theory and the pecking order theory. The first part will contain a description of the two theories and an analysis of the market imperfections underlying them. The second part will compare and contrast the predictions of the two chosen types of theories, followed by an empirical investigation of the explanatory power of the two models.

The static trade-off theory tries to explain how companies choose their capital structure by balancing the benefits of interest