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Explanations of Capital Structure Vagueness

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Published: 6th Dec 2019

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Primary Theoretical Themes Explaning Capital Structure Vagueness

Capital structure is one the arguable area of financial research and the mystery of debt and equity equation in firms’ capital structure is not completely clarified. However, the tax shield benefit of debt financing obviously accepted and understood by both financial managers and researchers. There are three approaches of capital structure. At on extreme, net income (NI) approach (Durand, 1952) states that firm can lessen its cost of capital and thus increase its value by debt financing. In contrast, net operating income (NOI) approach, also proposed by Modigliani and Miller (1958) claims that firm’s value and capital structure are independent and debt and equity financing create the same value.

Solomon (1963) introduced intermediate approached of capital structure, also known as traditional approaches, which explains that the firm’s value increase when financial leverage rises and it becomes constant on designated level of debt and finally the firm’s value decrease. In fact this approach holds the concept of optimal capital structure. In other word, the companies should have a target capital structure and follow it in order to increase firms’ value. Various theories of capital structure have been developed during past five decades that mainly tried to illustrate relation between capital structure and firms value, and also find important factors of effect capital structure selection. At the same time, vast amount of empirical studies have tried to test and confirm capital structure theories, however, they have shown various results regarding effectiveness of these theories.

The aim of this chapter is to introduce the primary theoretical themes that have evolved to explain capital structure vagueness. It is also intended to review the main empirical research that have been studied to test correlation between firms characteristics and capital structure to present some of the evidence that have been collected. The structure of this chapter is as follows. Main capital structure theories are explained in section 2.2, in section 2.3 firms’ characteristics and capital structure are discussed, and results of selected empirical studies are reviewed in section 2.4.

2.2 Capital structure theories

Modigliani and Miller (1958) introduced modern theory of capital structure known as MM theory that basically considered as a foundation of modern corporate finance. Modigliani and Miller theorem consist of two distinct propositions under certain assumptions. The two propositions declared under assumption of perfect capital market and in the absence of bankruptcy cost, transaction cost, symmetry information and the world without tax.

MM Proposition I: argue that the firm’ value and capital structure are independent, it means that whatever capital structure selected for the firm the value would be the same. In other word under this proposition, the value of levered firm (VL) is the same as unlevered one (VUL) and managers should not worry about the firm capital structure and they can freely choose whatever composition of debt and equity.


MM Proposition II: claims that cost of equity increase with leverage because risk to equity rise as well, so weighted average cost of capital remain constant as lower cost of debt compensate with higher cost of equity. In other world, cost of equity remains constant with any degree of leverage, and it is a linear function of debt equity ratio.

However, Modigliani and Miller (1963) evolved their propositions under presence of corporate tax rate (t) while keeping other assumptions. They argue that the value of firms increase with rise of financial leverage as they do not pay tax on their interest paid (D) to debt holders. Furthermore, weighted average cost of capital is not constant and result of linear function of debt to equity ratio. Because ,firm do not pay tax on interest paid to debt holders ,weighted average of cost of capital decreases as financial leverage rises.


Friend and Lang (1988) states that there is a negative relation between profitability and Debt which is inconsistent with MM theory as the more profitable firm should use more debt in order to increase tax shield benefit of debt. Modigliani and Miller propositions are difficult to test directly (Myers,2001).Furthermore, Fosberg and Paterson (2010) points out MM theory have been rarely tested by researchers in an exact form described by MM; however there has been some testing of application of theses propositions. Fosberg and Paterson (2010) tested MM equation in the exact form specified by MM and concluded that:

“…neither the MM tax nor the no-tax valuation equations are accurate predictors of firm value. Specifically, the value of the unlevered firm accounts for much less of firm value than predicted and the sign of the coefficient of the interest tax shield variable is negative, instead of positive as MM predict.”

However, MM theory is not applicable in real world with transaction and bankruptcy cost.

2.2.1 Pecking order theory

The pecking order theory (Myers and Majluf, 1984) is a capital structure model based on asymmetry of information between insiders and outsiders that first introduced by Donaldson (1961). The main idea of this theory is that managers have private information about firm’s performance, projects and prospective which are not available for outsider investors, so the selection of firm’s capital structure shed light on outside investors about information of insiders. Consequently, investors will perceive investment decision without issuing securities as a positive signal, while they considered issuing share as negative sign that reduce share price which they willing to pay. The information asymmetry may bring about manager give up positive NPV projects in order to avoid share price falling, since they assume to act in interested of shareholders. To eliminate this underinvestment problem, managers try to finance new projects in a way that is not undervalued by market.

According to this theory (Meyer, 1984), there is no specific target capital structure for the firms. It states that in pecking order model firms adopt hierarchical order of financing, which means that managers prefer internal financing over external financing and debt over equity whenever external funding is unavoidable; also mangers prioritize short debt over long term debt. Internal funds compel no floatation cost and need no disclosure of financial information and firm prospects including firm’s potential gain and investment opportunities. The pecking order theory envisages that amount of debt goes up when investment exceeds internal funds and decrease when amount of investment is fewer than internal financing resources. So as long as firm‘s cash inflow exceed firm’s capital expenditure, there is no need for external financing.

Since introducing pecking order theory in 1984, some empirical studies have been conducted to test this theory, Shyam-Sunder and Myers (1999) studied small sample of firms from 1971 to 1989 and find supporting result for pecking order model. Frank and Goyal (2003) used a large sample of the firm and find less supportive result for pecking order theory .However, they point out that larger firms show better pecking order model performance than smaller firms which is in line with to pecking order theory. Since smaller firms have higher potential for information asymmetry than larger firms, which is main deriver of pecking order theory. De Jong et al (2010) studied US firm over 1971-2005 and find that small firms do not behave according to pecking order theory that support notion of asymmetry information in pecking order model.

Vidal and UGED (2005) describe limitation for Myers and Majluf (1984) model of pecking order theory. Firstly, they claim that Myers and Majluf model refers to American market which firms offered their share mostly through firm commitment underwriting and not right issue .Hence, when the share price is undervalued, the wealth shift form current share holder to new share holders, while in right offering current share holder can benefit from priority of buying share which reduce probability of wealth transfer. Secondly, they argue that this theory mainly describes listed companies and relinquishes non listed companies. Basically small –medium enterprise (SME) have limited access to capital market (Holmes and Kent, 1991) and financing choice for them is restricted to retain earning and loan.

Fama and French (2005) challenged pecking order theory as they find companies issue equity frequently and issue equity even when the internal funding is available or they can issue debt.

2.2.2 Trade off theory

This theory holds (DeAngelo and Masulis ,1980) an optimal capital structure based on balance between advantage and disadvantage of debt financing. In other word the optimal capital structure is a debt equity ratio that benefits of debt compensate with financial distress arising from marginal debt.

Advantage of debt financing: Debt financing reduce amount of tax revenue as a portion of interest paid to creditors (Modigliani and Miller, 1963), moreover it lessen agency cost between shareholders and mangers. This kind of agency problem refers to interest conflict between owners of firms and managers (Jensen and Meckling, 1976). This theory state that corporate manager, agents, will follow their own interest ,they looking for high salary, job security, prerequisites , better facility and may even assets and cash flows of the companies. Furthermore, managers tend to increase investment and develop the size of the company even if there is no benefit for the shareholders. This behavior of manager is known as empire building. However investors can control agent by methods of monitoring and controlling, but these methods are more costly and subject to decreasing return. Based on Free cash flow theory(Jensen ,1986) debt can reduce this kind of agency cost, in a way that company must pay interest to creditors which reduce available cash flow to the managers. So, instead of inefficient use of money by managers part of cash flow is given to creditors.

Disadvantage of debt financing :The disadvantage of financial leverage comprise of bankruptcy cost and agency cost occurring between shareholders and debt holders (Jensen and Meckling, 1976) .This sort of agency cost arising from interest conflicts between shareholders ,or their agents, and debt holders. If investors perceive this kind of risk, they demand higher return for their investment which consequently increase cost of debt financing.

There are three types of conflicts happen between bond holders and shareholders. The first conflict is asset substitution problem (Jensen and Meckling, 1976) .in which manger has incentive to take riskier projects when amount of debt increase. it is simply because if project succeed ,shareholders obtain benefits and ,if project fail debt holder get disadvantage since shareholders have limited liability. The second conflict is wealth transfer from debt holder to shareholders (Smith and Warner ,1979) in a way that board of directors , as representative of shareholders, increase amount of dividend as expense of debt holders. Third conflict between shareholders and debt holder is underinvestment problem (Myers,1977) that mainly occur under financial distress .Since under this situation gains from new projects is taken by bond holders ,shareholders have less incentive to undertake these projects even with positive present value.

According to trade off theory profitable firms should use interest tax shield as they have more taxable income (Myers, 2001). In other word, trade off theory doesn’t support negative relation between profitability and debt. Moreover this theory is consistent with some clear fact, for instance, the companies with moderately safe, tangible assets tend to use more debt than companies with variable and intangible assets.

Figure 1

2.3 Determinant of capital structure

There are different factors that can affect firm’s capital structure. These factors can be classified in two groups as external and internal factors (Antoniou et al, 2002). The external factors arising from firm’s environment and basically could not be controlled by firm’s mangers such as country’s economic, institutional factors. Rajan and Zingales (1995) find that institutional factors including tax code, bankruptcy law, and development of capital market affect firm capital structures. Holmstrom and Tirole’s (1997) argue that small firms have tougher constrain than larger firms for external financing, and so, macroeconomic and institutional factors have higher impact on their leverage .

Demirg and Maksimovic (1995) investigate relationship between domestic capital market development and firm leverage and find significant negative relation between domestic market development and leverage. Schmukler and Vesperoni (2001) studied relation between counry’s financial liberalizations and leverage .They find that financial librization do not change leverage ratio ,but it change debt structure and rises portion of short term debt. Deesomsak et all (2004) studied determinant of capital structure among Asian pacific countries and find that capital structure is affected by firm environment. They show that 1997 Asian economic crisis have had a significant effect on firm’s capital structure . .Voulgaris et all (2004) studied determinant of capital structure of Greek companies and find that strict monetary and fiscal regulation have more impact on small firms than large firms. De Jong et al (2008) studied determinant of firm capital structure across the world and demonstrate that specific determinant of capital structure vary across the counties and also shows country’s specific factors have indirect effect on firm specific determinant of capital structure.

Internal factors are those attribute that can be controlled, may not completely, by firm’s managers such as firm’s characteristics. This study focus on important factor of capital structure in both developed (Rajan and Zingales, 1995) and developing (Booth et al,. 2001) countries including asset structure, profitability, growth opportunity , liquidity,and business risk.

2.3.1 Growth

According to pecking order theory growth and leverage have positive relationship. The main idea behind this relationship is that growth firms need more fund than lower growth firms ,and hence, they probably require external financial recourses ,and preferably debt financing, for new projects ( De Jong,1999). Jung et al. (1996) argue that firm with growth opportunity should use equity financing in order to reduce agency cost between managers and shareholders. Whereas companies with less growth opportunity should use debt financing (Stulz,1990).

Organizational life stage theory is another explanation for growth opportunity and debt financing. In fact organizational life stage theory design for strategic management field ,but there is a rational link between this theory and capital structure . The simple premise of organizational life stage theory is that firms, the same as living creature, have different life phases and pass through startup , growth, maturity and decline stage (Black ,1998). It states that business risk reduce over firm life stage as firm become more stable and it allow financial risk rises (Bender and ward, 1993). In other word there is a negative relation between business risk and financial risk which is mainly concluded from trade off theory of capital structure. Hence ,based on organizational life stage theory, firms should finance with equity in earlier stage and use more debt as they develop. Chang et all (2009) studied determinant of capital structure and find that growth is the most important determinant of firm’s capital structure.

Relationship between growth opportunity and debt has been studied by many researchers. Long and Malitz(1985) ,Titman and( Wessels 1988) Chung (1993) ,Rajan and Zingales (1995),Barclay and smith (1999) find that there is a negative relation between firm growth opportunity and leverage. While Hall et al. (2000) demonstrate that growth opportunity is positively related to short debt ratio and negatively related to long term debt ratio.

2.3.2 Asset structure

Asset structure is another determinant of capital structure. There are mainly two groups of asset, tangible and intangible, and each group of assets has own effects on firm capital structures. As tangible asset can be used as collateral , companies with more tangible assets can use debt as financial resources with lower cost . Furthermore, tangible assets reduce moral hazard risks ,because tangible assets convey a positive signal to creditors in case of firms default and selling of firms assets. According to trade off theory, when tangible assets use as collateral, reduce bankruptcy cost which turn increase credibility and accessibility to debt market . Also based on pecking order theory tangibility reduce asymmetry information between insider and outsider. Pecking order theory predicts positive relation between tangibility and debt financing. However, Berger and Udel (1994) ague that firms who have close relationship with creditors need less collateral, because they convey more information to creditors and reduce asymmetry information risk.

While majority of studies show positive relation between tangibility and leverage ( Rajan and Zingales, 1995; Frank and Goyal, 2003;Niu.2008;Liu et al 2009), some studies demonstrate negative relation between tangibility and leverage (Booth et al, 2001; Huang and Song ,2002). It is state that relationship between tangibility and leverage affected by type of debt. Hall et all (2004) studied determinant of capital structure among European companies and find that tangibility negatively related to short term debt while positively correlated to long term debt. Also, Sogorb-Mira (2005) find supportive result for negative relation between tangibility and short term debt ,and argue that negative relation between tangibility and short term debt may explain with maturity matching principle, where firms try to finance fixed assets with long term debt and working capital needs with short term debt.

2.3.3 Profitability

Profitability can effects debt financing in two directions .Based on pecking order theory there is a negative relation between profitability and debt financing. Since, profitable companies generated enough cash which turn can be used as source of internal financing. Shyam-Sunder and Myers (1999) argue that avers relation between profitability and leverage is consistent with pecking order theory. On the other hand trade off theory predicted positive relation between profitability and leverage. As profitable company generates more available cash for management opportunities for using cash inefficiency and unnecessarily manners that increase agency cost between managers and shareholders. So, Debt financing is the best remedy for overcoming this problem (Jenson, 1986).

Effect of profitability on leverage has been studied by many researchers . Morri and Cristanziani (2009) studied capital structure of UK Property companies and assert that profitability is the most important determinant of capital structure for UK property companies , and it aversely related to leverage.Many studies (Titman and Wessels 1988; Rajan and Zingals,1995;Fama and French 2002;Hovakimian et al 2004) find negative relation between profitability and debt level . Whereas some researchers argue there is positive relation between profitability and leverage. MacKay and Phillips (2001) state that leverage positively correlated with profitability. Gaud et all (2007) studied debt equity choice among European firms and find that ROA, as proxy of profitability, positively correlated with “debt issue versus Equity issue”. They argue that for European profitable firms, debt financing use as a disciplinary device for controlling mangers performance.

2.3.4 Liquidity

Liquidity is another determinant of capital structure which has been described in many capital structure literatures. Based on pecking order theory firm ‘s liquidity has negative impact on leverage. The rationale behind this relationship is that liquidity reduce need for debt financing as more liquid firms have more cash to use and vice versa. Also trade of theory predict negative relation between liquidity and leverage, since shareholder of firm with more liquid assets can easier use them at the expense of bondholders which create interest conflict for both parties. Myers and Rajan (1998) state when out side creditors face agency cost arising from high liquidity, they limit amount of debt available to the firm.

2.3.5Business risk

Business risk can be considered as an influential factor on the firm capital structure choice. Business risk will increase financial distress cost and so rise cost of external financing. According to both trade off and pecking order theory ,there is a negative relationship between business risk and debt ratio.

2.4 Review of selected article

2.4.1 Review of main articles in developed countries

The capital structure theories mentioned in the perviuos sections relate to effects of firm characteristics on capital structure. The empirical studies regarding determinant of capital structure started in 1980s and one the major studies was performed by Titman and Wessels in 1988 that studied determinant of capital structure among US companies from 1974 to 1982. They introduced an analytical model regarding important factors of capital structure selection and studied impact of firm’s size, uniqueness, asset structure, growth, profitability, volatility and non-debt tax shield on the firm’s capital structure and find that firm past profitability and uniqueness negatively related to debt equity ratio ,while firm size positively related to long term debt and aversely correlated with short term debt. They also indicate that firm’s asset structure, future growth, volatility and non-debt tax shield have no impact on capital structure choice. Another study which widely cited in capital structure literatures comes from Rajan and zingals (1995) research. They studied determinant of capital structure among G7 countries ( United states ,Japan ,Germany, United Kingdom ,Canada, Italy and France) and analyze institutional differences and impact of firm’s size, growth opportunity, profitability and asset structure on capital structure choice across these countries . Rajan and zingals (1995) find that firm’s size and tangibility positively correlated with leverage, while firm’s profitability and growth opportunity negatively related to leverage across G7 countries, except Germany where firm’s size negatively and profitability positively related to leverage. Their findings are consistent with capital structure theories, however in the case of Firm’s size and leverage in Germany, they do not find any rational explanation for their result.

Miguel and Pindado (2001) investigates impact of firm and institutional characteristics on capital structure of Spanish companies based on trade off theory of capital structure .The target adjustment model was employed to clarify firm characteristics and institutional factors that affect capital structure. Financial information of 133 non listed Spanish companies for the period of 1990 to 1997 is used in this study. They used two proxies for leverage based on book value and market value of assets, and they employed four independent variables including no-debt tax shield, financial distress cost, investment and free cash flow. The results show that financial distress cost and non-debt tax shield negatively correlated with leverage while investment and leverage positively related. Also there is a negative relationship between cash flow and leverage which shows firm prefer to use internal source over external source of fund.

Bevan and Danbolt (2002) studied determinant of capital structure among UK firms from 1987 to1990.They extended Rajan and zingals analysis of UK Firms by investigating impact of firm’s size, growth opportunity, profitability and tangibility on level of gearing and find the same result as previous Rajan and zingals did. Their study find that short term debt negatively correlated with tangibility, while long term debt show positive correlation. Furthermore, they find firm size aversely correlated with short term bank borrowing, and positively relate to long term debt and short term paper debt.

Hovakimian and Tehranian (2004) studied determinant of capital structure by investigating dual equity and debt issuers from 1992 to 2000. They tested theoretical theories of capital structure including trade off theory, pecking order theory and market timing theory by examining impact of market and operating performance factors on firm optimal capital structure. Their result imply that firm with high growth opportunity have a low target debt ratio which is consistent with pecking order theory. On the other hand, in line with market timing theory, their result demonstrate that high stock return amplify possibility of equity issuing ,but possibility of debt issuing is not influenced by stock return. They also find that unprofitable firms tend to issue equity in order to counterbalance excessive leverage arising from cumulative losses.

Gaud, Jani, Hoesli and Bender (2005) analyze determinant of capital structure for Swiss companies listed on Swiss stock exchange based on pecking order and trade off theory. They used financial information of 104 Swiss companies from 1991 to 2000. The study used two proxies for leverage based on book value and market value of total debt divided by total assets, and employed five explanatory variables including tangibility, growth, size , financial distress cost and profitability. The result shows size and tangibility positively correlated with leverage, while profitability and growth adversely related to leverage. The relationships between variables shows that capital structure of Swiss firm can be explained by both trade off theory and pecking order theory ,however it is more in line with trade off theory. Also they claim that macroeconomic factors have important impact on capital structure.`

Chang and Lee (2009) extended study of Titman and Wessels (1988) by applying “Multiple Indicators and Multiple Causes (MIMIC)” model and find more rigorous result than Titman and Wessels. They find that firm growth opportunity is the most important determinant of firm’s debt and equity choice which followed by profitability, tangibility, volatility, non-debt tax shield and uniqueness. However, firm size excluded from their study due to unmet statistical criteria needed by MIMIC model .Their study demonstrates growth opportunity and profitability have both negative and positive impact on leverage depending on measurement of growth opportunity and profitability. Also they find mixed result regarding relationship between uniqueness and leverage based on applying different proxy for firm uniqueness.

2.4.2 Review of selected articles in developing countries

Eriotis (2007) explores relationship between firm characteristics and capital structure of Greek companies listed on Athens Stock Exchange (ASE). Numbers of 129 Greek companies that all listed in the market in 1996 and none of them was expelled during the period 1997-2001 were chosen in this study. They point out that debt ratio positively related to firm size. While, liquidity and interest coverage ratio are negatively related to leverage, also negative relation between the growth of the firm and debt ratio is observed. According to the results of the dummy variable, they find strong evidence that there is a capital structure differentiation among the firms which heavily use debt capital (more than 50 per cent of their total assets) and those that use less debt capital.

Karadeni , Kandir , Balcilar and Onal (2009) studied capital structure of lodging companies listed on Istanbul Stock Exchange (ISE) based on pecking order theory and trade off theory. Financial information of five listed lodging companies out of eight companies for the period of 1994 to 2006 and dynamic fixed effects panel data model were used in this study . Study finding shows that profitability, tangibility and effective tax rate are conversely related to leverage, while free cash flow, non-debt tax shield, growth and net commercial position have insignificant parameter estimates at the 5 per cent level and do not appear to be related to the debt ratio of lodging companies. The findings partially support the pecking order theory, however the capital structure of Turkish lodging company fully explained by neither trade off theory nor pecking order theory.

Ramlall (2009) investigates capital structure of non-listed and non-financial Mauritian companies based on modified pecking order theory. He employed financial information of 450 non listed companies for the period of 2005 to 2006, however and final sample due to presence of outlier reduced to 395 firms. On interesting is that he used nine dependent variables as proxy of leverage including total liability, long and short term liability, long and short term loan, long and short term lease, long and short term lease and overdraft. Also he employed eight exploratory variables including size, tangibility, profitability, non-debt tax shield, liquidity, age, investment and growth. The study find that non-debt tax shield, profitability and growth do not significantly correlated with leverage. In line with pecking order theory, tangibility and leverage have positive correlation; also liquidity has negative impact on leverage. Also he find that investment and lease positively related, but investment and loans negatively correlated. Moreover, age has negative impact on loan and debt. He find that firm firstly use lease and then get a loan ,also in case of leases firm use short term lease prior to ling term leases.

Liu , Ren, and Zhuang ( 2009) studied determinant of capital structure of Chinese IT companies. They investigate relationship between six independent variables including firm size, tangibility, liquidity, profitability, growth potential and growth opportunity with firm leverage as a dependent variable. The study find firm size and leverage positively but not significantly correlated, profitability and leverage negatively correlated since firms use retained profit as a quickest financial recourse compare to security issuing. They find that there is a positive relationship between tangibility and leverage and negative relationship between liquidity and leverage. They claim that firm with higher liquidity ratio can use internal source of fund rather than external ones. The study shows that both potential growth and growth opportunity have negative but not significant relation with leverage. The study concluded that determinant of capital structure for Chinese IT firms are the same as determinant of capital structure in western companies.

2.4.3 Review of selected cross countries articles

Deesomask,Paudyal and Pescetto (2004) investigate impact of country and firm specific factor on capital structure by selecting companies from four Asia Pacific countries which has different legal, financial and corporate governance systems, also investigate the potential influence of the 1997 financial crisis on the capital structure decision process. The sample consist of 294 Thai, 669 Malaysian, 345 Singaporean, and 219 Australian non-financial firms listed in the related national stock exchanges for the period of 1993 to 2001.They find that ,first firm size has positive impact on debt ratio, while growth opportunity, liquidity and business risk have negative impact on debt ratio. Second, the capital structure determinant is different among countries ,for instance firm size has no significant impact on capital structure of Singapore companies and prof

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