How do companies determine their capital structures?

The two most influential theories of capital structure are the tradeoff and pecking order theories. The first, the tradeoff model, argues that companies trade off the benefits of additional debt (tax deductibility of interest expenses, reduced agency costs of free cash flow) against the costs (bankruptcy risk) and at the margin equate the two. The second approach, the pecking order model, argues that adverse selection issues in raising funds by different methods dominate other considerations in the tradeoff model such that a hierarchy of funds results. Firms will use internal funds first, then debt and only when such options are exhausted will they resort to using new equity finance.