Authors: Apostolos Dasilas, Georgios Kolias

Title: How the capital structure puzzle is explained by the modern portfolio theory: Evidence from the UK

Abstract

This paper examines the optimal capital structure based on the modern portfolio theory. In particular, the paper considers a portfolio consisted of two securities, that is, total debt and equity employing a dataset of all non-financial firms listed on the London Stock Exchange for a period spanning from 2008 to 2017. We use random coefficient models on panel data to find the optimal capital structure as obtained from the efficient frontier of the combinations of equity and debt. Furthermore, the minimum variance portfolio and the tangency portfolio are estimated. The results show a positive effect of equity on earnings and an adverse effect of debt on earnings. Τhe minimum variance (tangency) portfolio has an expected portfolio return of 5.77% (8.68%) and a standard deviation of 5.52% (6.77%) implying a proportion of 51.90% (39.34%) debt and 48.10% (60.66%) equity.