Capital structure refers to the combination of asset financing from different available sources. Normally the companies have two choices, either to finance the assets from internal source that is termed as retained earnings or from external source that splits into debt and equity. A firm’s capital structure is than the composition of its liabilities. In reality, capital structure of firms may be highly complex and consist of number of sources. These sources start from the retained earnings and ends in hybrid securities.
The source of funding a capital is also diversified into short term and long term financing. Modigliani-Miller theorem The thinking of capital structure was initiated by the Modigliani-Miller theorem, proposed by Franco Modigliani and Merton miller. They made two findings under perfect market conditions. Their first proposition was that the value of a firm is independent of its capital structure and the second proposition stated that the cost of equity for a leverage firm is equal to the cost of equity for an un-leveraged firm with addition of premium for financial risk.
They extended their analysis by including the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable. It means the increase in proportion of debt in capital decreases the cost of capital. And eventually the optimal structure would have no equity at all. Later on it was revealed that the imperfections of real world must be the cause of capital structure relevance to firm value. The trade-off and pecking order theory try to address some of these imperfections, by relaxing the M&M assumptions. Trade-off theory
Trade-off theory adds another variable called financial distress in the previous studies and explains that although there is an advantage of debt financing and that reaps from the tax benefit shield. But a time come when the high debt give birth to bankruptcy cost and when the optimal level of capital structure is exceeded than the marginal benefit from the tax shield become less attractive than the cost of financial distress occurred due to debt financing. Therefore there exist an optimal debt and equity combination and companies should follow this optimal level of debt and capital ratio.
This ratio is similar within one industry but may be different for different industries. The missing point of this theory is that it doesn’t explain the difference in the optimal capital structure ratio of the same industry. Pecking order theory Pecking order theory tries to capture the costs of asymmetric information. That means the managers of a company has more and complete information about the company than investors. The theory states that company’s priorities their financing sources and prefer internal source of funding to external.
The hierarchy of sources is such that whenever company needs new funds it tries to fulfill its requirement first from retained earnings than from debt and raise equity as last resort. The pecking order theory is famous by Myers & Majluf(1984) when they argues that equity is a less preferred means to raise capital because when managers issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.
The capital structuring plays vital role in the long run financial decisions of the company. In this paper my focus is on debt financing decisions of the company. I have explored why the companies use this source and what are the factors that determine company’s capital structure decision. The capital structure was firstly discussed by Modigliani & Miller in 1958. Modigliani & Miller (1958), the theorem states that, in a perfect market, how a firm is financed is irrelevant to its value.
Gay B. Hatfield (1994), demonstrated that the firms which issues debt are moving toward the industry average from below, the market will react more positively than when the firm is moving away from the industrial average on the basis of this they classified firms leverage ratios as being above or below their industry average before announcing a new debt issue. They test whether this has an effect on market return for share holders and they have founded that the relationship between a firm’s debt level and that of its industry does appear to be of concern to the market.
Laurence Booth(2001), finds whether capital structure decisions differ significantly between developing and developed countries or not? He collected data of 10 developing countries by the international finance corporation and use panel data technique for comparative analysis. They found that the variables that are relevant for explaining capital structures in the United States and European countries are also relevant in developing countries. Jorgensen & Tera(2003), stated that there are many, industrial, accounting, managerial and macroeconomic factors that affect the capital structure decisions.
They used sample data of capital structure determinants of 700 companies for the Latin American economies for the period 1986-2000. The study concluded that firms are impacted by company fundamental and macroeconomic forces. Deesomsak, Paudya, & Pescetto(2004), explore about capital structure for the Asian pacific countries. The countries discussed in their study are Malaysia, Singapore, Thailand and Australia. The study explores that environmental and operational factors affect the decisions made for capital structure. The study also investigates that financial crisis of 1997 also affect the capital structure organizations.
Shah & Hijazi(2004), investigate the performance of non financial firms for the Pakistan perspective. The observed variables for capital structure are debt ratio, size, growth, leverage and profitability. The results show that there is a positive relationship between size and leverage. The growth is negatively correlated to leverage and the study finds consistent relationship between profitability and leverage. Shah & Khan(2007), investigate the relationship between firm fundamental factors and leverage ratios for the period of 1994 to 2002.
They used pool regression model to achieve their purpose. The findings show that earning volatility and depreciation variable are not correlated to leverage ratio. The agency theory is lead by growth factor and pecking order theory bear out by profitability variable. The trade off theory is lead by firm’s size. Daskalakisa & Psillaki(2008), investigate the small and medium firms of Greek and French industries for the period of 1998 to 2002. The similar factors of the firms are used in this study because the same capital structure is employed in these two countries.
There is a negative relationship among asset structure, profitability and leverage. The study finds that growth of France industry is statistically significant compare to Greek industry market. The study argues that there are firm specific differences among the countries non country factors. Psillak & Daskalakis(2009) studied small and medium size firm’s performance. The capital structure determinants are size, growth, profitability and risk. The results show that small and medium entrepreneurs affect the performance in a same way.
The study explore there is a positive relationship between size and leverage and a negative relationship among growth, profitability and risk factors. Dilek Teker(2009), investigate the fundamentals of the capital structure theories, they assumed determinants can be related to find out whether some priori assumed macroeconomic determinants can be related to leverage parameters of interest or not. For this purpose, they conducted an empirical research that covers 42 selected firms traded at the Istanbul Stock Exchange ISE-100 index.
Following the developments in the contemporaneous estimation techniques that allow us to use time series and cross section data concurrently, the panel data methodology has been applied to the actual data to compute the leverage ratios for each firm within the time period 2000-2007. From this, they highlight the issue of what properties the leverage ratios have and to satisfy our interest about how can the macroeconomic determinants affect the leverage ratios under various groupings such as tangibility, size, growth opportunities, profitability and non debt tax shields.
Our main results return on assets and tangibility of assets have a positive and statistically significant impact on the firm’s leverage ratio, while the ratio of total depreciation to total assets and profit margin on sales seem to have some negative and significant impacts on Firms’ leverage degree. Tugba Bas(2009), worked on determinants of capital structure of small and medium enterprises in emerging markets. They used pooled data for 25 countries obtained from World Bank enterprises survey and applied panel data OLS technique for analysis.
They found that tangibility is inversely related with leverage hence opposite for small firms. Profitability follows the pecking order theory and is also negative related. Firm size and GDP growth has positive relation with leverage. Inflation has negative impact on the leverage but interest rates pose positive relationship. Shun-Yu Chen(2011), the purpose of this paper is, to present empirical evidence on the determinants of capital structure and firm value in a newly industrialized country.
The firm characteristics are analyzed as determinants of capital structure according to different explanatory theories. The findings of this study suggest that firm size, profitability and asset structure can be considered explanatory variables of capital structure. The firm size, profitability and capital structure affect book value. So the determinants of market value are profitability and firm size. Furthermore the capital structure negatively affects market value in electronic firms, but does not affect market value in non-electronic ones.