Capital structure is the way a company finances itself by combining long term debt, specific short term debt, and equity (Ross et al., 2005; Hsiao et al., 2009). It shows how a company finances its overall operations and growth by using different sources of funds. Capital structure of companies varies with its size, type and some other characteristics such as age of company, company size, asset structure, profitability, company growth, company risk and liquidity (Al-Najjar and Taylor, 2008).
The purpose of managing capital structure is to mix the financial sources in order to maximize the wealth of shareholders and minimize the company’s cost of capital (Ross et al., 2005). Therefore, one of a financial manager’s responsibilities is to manage and decide the optimal capital structure for the purposes. His/her decision on capital structure could be critical because it may affect the company values and it involves a trade-off between risk and return. A rise in debt will increase the company’s risk and the expected return. High risk means an increase in debt which could lead to a decrease in stock price and an increase in the expected return of stock price (Brigham and Houston, 2001). Hence, the motivation of an optimal capital structure is to ensure the balance between risk and return in order to maximize the stock price (Brigham and Houston, 2001). Based on the existing literature, which will be discussed below, the decision on capital structure should consider several main factors such as business risk, tax position, financial flexibility, and managerial conservatism or aggressiveness.
Business risk is a risk that involves operating activities of a company, when the company does not finance these activities with debt. Higher business risk means lower optimal debt ratio. According to Brigham and Houston (2001), business risk is the risk associated with the projections of a company’s future return on assets (ROA), or return on equity (ROE) if the company uses no debt. Business risk depends on several factors (Brigham and Houston, 2006).
Variability of demand. Stable demand of a product makes lower business risk, ceteris paribus.
Variability of sales price. A company which sells a product in stable market can avoid from business risk. The stable market refers to market of a company in an industry that tends to be stable.
Variability of input costs. A company with established input costs will have lower business risk.
Ability to adjust output prices for changes in input prices. If the company is able to do adjustment for output prices for changes in input prices, it will reduce business risk.
Ability to develop new products given cost efficiency.
Foreign risk exposure. A high profit which is gained from overseas operation means higher business risk.
Operating leverage. If a company uses more fixed costs than other types of costs and the demand of its products decline, the company has a higher possibility to experience business risk.
Tax position of a company. The main reason to use debt for financing is to decrease earnings before taxes and to increase tax saving (Brigham and Houston, 2006).
Financial flexibility is an ability of a company to get capital to fulfill its needs for funds in a certain condition or under less than ideal conditions (Brigham and Houston, 2006). Gamba and Triantis (2008) stated that financial flexibility indicates the ability of a company to access and restructure its financing at a low cost. Companies which have financial flexibility are able to avoid financial distress and to fund investment when the profitable opportunities come (Gamba and Triantis, 2008). Flexibility means the capital structure should have borrowing power, which can be used in conditions that come due to favorable capital market, and government policies (Ramagopal, 2008). Companies which have strong balance sheet will be able to get funds with reasonable terms than other companies in the period of economic downturn (Brigham and Houston, 2006).
Managerial conservatism or aggressiveness. Most of management in companies tends to use debt financing to increase profit (Brigham and Houston, 2006).
2.2. Theory of Capital Structure
1. Modigliani-Miller Theory
The Modigliani-Miller Theory is the first theory of modern capital structure. It is the fundamental and modern philosophy of capital structure, which states that capital structure does not influence company’s value. There are some assumptions which support this theory (Brigham et al., 1999; Brigham and Houston, 2001).
There are no agency costs.
There are no taxes.
Investors may have debt at the similar interest rate as corporations.
Investors have similar information such as managing about prospect of a company in the future.
There is no bankruptcy cost.
The use of debt does not influence earnings before interest and taxes.
Investor are a price takers
Asset can be sold at market value, if the company experiences bankruptcy.
It assumes capital in a perfect capital market. In addition, it assumes that financing decisions do not influence the investment decisions. It does not matter if the capital of a company is raised by issuing stock or selling debt instrument such as bonds and what the company’s dividend policy is (Dybvig, and Zener, 1991, Brigham and Houston, 2001). Therefore, the MM theory is also often called as the capital structure irrelevance principle (Eriotis et al, 2007).
According to the assumptions above, this theory has two prepositions which are called “MM prepositions without tax” (Brigham and Houston, 2001).
Preposition I. Value of a debtor company is similar to a non-debtor company. It means that the value of a company is independent of its capital structure. The capital structure does not influence the company’s value and the way of the company combines debt and equity does not affect its weighted average cost of capital (WACC).
Preposition II. Cost of capital will increase, if a company uses external financing. The risks of equity depend on business risk and financial risk. Because of that, MM without tax theory is considered as unrealistic. Modigliani and Miller further added tax factors to the theory, which is known as MM with tax.
Taxes to government means cash outflow. Debt is only used for tax saving, where the interest of debt can be used to reduce tax. Hence, based on the MM with tax theory, there are another two prepositions (Brigham and Houston, 2001).
Preposition I. Value of a debtor company is similar to a non-debtor company plus tax saving. It means that the optimal capital structure of a company is 100% debt.
Preposition II. Cost of capital will rise as debt increases. It means the use of debt will increase tax saving and the cost of stock and thereby it reduces weighted average cost of capital.
MM with tax theory stated that a company should use more debt for financing. Basically, there is no company which use more debt because higher debt level means higher possibility of experiencing bankruptcy (Lin et al., 2010). The debt may lead a company to bankruptcy when the payment is due and the company does not have sufficient cash on hand.
Trade-off theory states that the company will borrow when the marginal value of tax shields on additional debt is just offset by an increase in the present value of possible costs of financial distress (Brigham and Houston, 2001). According to Myers (2001), a company will have debt at a certain level, and the tax shields (tax saving) from additional debt is similar to the cost of financial distress. The cost of financial distress leads to the costs of bankruptcy or reorganization, and creates the agency costs that arise because the company’s creditworthiness is in doubt.
When determining the capital structure, the trade-off theory includes several factors such as taxes, agency costs, and cost of financial distress (Amidu, 2007). It also incorporates the assumptions of market efficiency and symmetric information as the benefit of using debt. The optimal debt is reached when tax shields reaches a maximum amount of the cost of financial distress (Myers, 2001).
The tradeoff theory states that profitability is positively related to capital structure. The theory predicts that the profitable companies will use more debt because they are possible to have a high tax burden and low risk of bankruptcy (Ooi, 1999 cited in Amidu, 2007). However, there are a lot of empirical evidences which are contradicted with the trade-off theory. Myers (2001) argued that there is an inverse correlation between profitability and financial leverage. It is supported by the same findings from Rajan and Zingales (1995) for G7 countries. The authors stated that in the short run, dividends and investment are fixed. However, if debt financing is the dominant mode of external financing, the changes in profitability will be negatively correlated with the change of leverage. In addition, the increasing of company size should make strong negative influence on profitability (Rajan and Zingales, 1995). Similarly, Titman et al (1988) found that there is a significant and negative relationship between profitability and debt ratios.
Pecking Order Theory
Pecking order theory assumes that the purpose of a company is to maximize the shareholders’ wealth. This theory states that there is a hierarchy in choosing sources of financing (Smart et al, 2004).
A company will prefer to use internal financing than external financing. The internal financing is from the retained earnings that are earned by doing operational activities.
The company will choose securities with lower risks, if it needs external financing.
There is a constant dividend policy where the company will decide a constant amount of dividend payment. The amount of dividend payment is not influenced by the company’s loss or profit.
The company will use portfolio of investment to anticipate insufficient cash because of the dividend policy, fluctuation in profitability, and investment opportunities.
This theory states that the main problem of determining the capital structure of a company is asymmetric information between managers and investors (Amidu, 2007). In fact, this theory argues that the manager of a company will act on the existing stakeholder’s interests (Abor, 2005). Consequently, the new investors will have a perception that the manager does not support their interests.
The evidences of pecking order theory are as follow. According to MacKie-Mason (1990), the importance of asymmetric information gives a reason for companies to care about those who provide the funds because different fund providers would have different access to information about the company and different ability to monitor the company’s behavior. This is consistent with the pecking order theory since private debt will require better information about the firm than public debt. Sunder et al (1999) asserted that companies follow the pecking order in their financing decisions where companies with a positive financial deficit are more likely to issue debt.
This theory stated that management is the agent on behalf of shareholders, the owner of a company. The shareholders expect management to accommodate their interests. Costs, which emerge because of controlling activities of management, are called agency costs (Morri and Beretta, 2008). It illustrates that company’s capital structure is determined by agency costs, which includes the costs for both debt and equity issue. Agency costs exist due to the conflicts of interest between the owners of the companies and managers. The costs which are related to equity issue may be included as the monitoring expenses for the equity holders, and the bonding expenses for the agent (Niu, 2008). Agency costs are the costs to justify whether management acts consistently according to contractual agreement of company with the shareholders (Jensen and Meckling, 1976). In addition, the agency costs of debt include the opportunity costs which are caused by the impact of debt on the investment decisions of the company (Hunsaker, 1999 cited in Niu, 2008).
There are two types of conflicts: conflicts between shareholders and managers, and conflicts between shareholders and bondholders (Jensen and Meckling, 1976).
This kind of conflict is from the separation of ownership and control. If managers do not own 100% of the company, they can only get a fraction gain from their investment activities and bear the whole cost of these activities at the same time (Harris and Raviv, 1991). The shareholders-managers conflicts take several forms (Jensen and Meckling, 1976). First, different shareholders’ interests in a company’s value maximization makes managers prefer to do less work and to have greater additional facilities, such as luxuriant office and corporate jets, etc (Eriotis, 2007; Niu, 2008). Second, since the debt forces managers to pay cash, the managers reduce the company’s free cash flow by purchasing additional facilities. They may prefer choosing short-term projects because these investments could produce positive short-term earnings and improve their reputation quickly (Niu, 2008). Third, managers may choose less risky investments and lower leverage to reduce the possibility of bankruptcy. Lastly, managers aim to stay in their positions, and therefore, they wish to minimize the possibility of employment termination. In addition, management may resist takeovers and change corporate control irrespective of their influences on shareholder values (Niu, 2008).
Managers and shareholders may also have different preferences on making decisions. According to Harris and Raviv (1991) managers will continue operate the company’s businesses although liquidation is preferred by shareholders. Furthermore, Stulz (1991) argued that managers are preferable to investing most funds in projects, whereas the shareholders want dividends to be paid.
These conflicts arise when the shareholders make decisions to transfer wealth from bondholders to shareholders. Indeed, the bondholders are aware of any situation that could occur. Hence, they will demand a higher return on their bonds or debts (Niu, 2008). Bondholders receive only the specific payment in the debt contract and no cash flow outside the specific payment. High risk projects reduce the expected payment to bondholders. It is called asset substitution problem (Myers, 1977). When the bondholders have money paid in advance to the stockholders, the stockholders will have an incentive for taking on high risk projects than what the bondholders would prefer. The bondholders recognize the incentive and will state a higher price for debt capital (Balakrishnan and Fox, 1993).
There are some positive net present value projects which shareholder will accept if the company is fully equity financed, but they will refuse when the company is financed by debt partially (Balakrishnan and Fox, 1993). While the payment to the investment may be large enough for being profitable, they may not be sufficient for repaying the debt holders. Therefore, the lenders will get rights for the positive payment while the stockholders will get nothing. This problem is called “the under-investment problem” (Balakrishnan and Fox, 1993). These problems are serious for assets which give the company the option for undertaking growth opportunities in the future. The larger of company’s investment in such assets, the lower it will choose debt financimg. It indicates that there is negative relationship between growth and capital structure (Balakrishnan and Fox, 1993).
2.3. Company Characteristics
The company characteristics such as asset structure variable, growth, profitability, size of a company, age, revenue employee, and liquidity can influence the decision on sourcing capital (Talberg, 2008; Sibilkov, 2009).
1. Asset Structure
Choate (1997) claimed that the debt ratio depends on the asset specificity. Asset specificity is a feature of an asset which makes it useful for specific purposes such as specialized machine and emergency power plant. It may affect the capital structure of a company through bankruptcy costs that reflects the loss in a company’s value due to the possibility of financial distress (Balakrishnan and Fox, 1993). Debt financing is suitable for the low specificity assets, and equity is suitable for the high level specificity assets (Kochhar, 1997). The total debt is positively related to the fixed asset turnover (Talberg, 2008). If the level of tangible assets in the companies is high, the possibility to obtain debt financing would be greater (Serrasqueiro, 2009).
A company with a high growth level tends to resist the company’s position by having lower debt level in order to avoid issuing new stock for financing investment in the future. Notwithstanding the company needs debt financing to finance its business activities, bear in mind that it does not mean that the company would be free from risks. The use of debt financing creates risk which could make higher expected return (Hall et al., 2004). Based on the pecking order theory, the reason is that the issuance of new company shares may cause its stock price to fall and subsequently, the company may experience losses.
Modigliani et al (1958) argued that the use of debt will improve a company’s value as high as tax shield. Therefore, companies with a high profit tend to have a high debt level, probably long term debt, in order to get benefit from the tax shield. Nevertheless, Lemmon et al. (2008) asserted that profitability has negative influence on leverage.
There are many reasons as to why company size is related to the capital structure of a company. Most of the large companies have higher credit ratings than smaller companies. Thus, they have easier access to debt financing due to low information asymmetry (Voulgaris et al., 2004). Because they diversify their businesses in various forms, these companies hope to borrow more debt in order to obtain benefits from the tax shield (Rajan and Zingales, 1995; La Rocca et al., 2009). Uglurlu (2000) asserted that larger companies have higher leverage because the bankruptcy costs of debt are smaller. On the contrary, smaller companies are difficult to resolve information asymmetries with lenders and financiers and that could incur high costs. Therefore, smaller companies are often offered less capital and this reduces the use of outside financing (Viviani, 2008).
Age of a company is a standard measure of reputation for capital structure models (Abor, 2009). It is identified by finding the year when the company commenced its operation. The age is used to identify the relationship between age of a company and total long term debt (Talberg, 2008).
6. Revenue per Employee
Every company in different industries needs labours in order to keep the continuity of business operations and earning profits. Different industries have different rate for revenue per employee. It depends on the qualifications and the field of industries where the labours work (Talberg, 2008).
Previous studies found some evidence that the relationships between capital structure and asset liquidity exist. According to Alderson et al (1995), companies with high liquidation and assets are preferable to the capital structure which contains less debt. These companies will increase their borrowing during the period of financial distress (Kim, 1998).
2.4. Previous Studies
Previous studies found that the relationships exist between company characteristics and capital structure. Talberg et al. (2008) examined the capital structure across different industries for 50 largest companies listed on a stock exchange and headquartered in the United States. The research found that asset structure, growth, profitability, size, age, revenue per employee, and liquidity influence the capital structure across industries. In addition, the research proves that there is significant difference in the capital structure depending on the industry.
Vasiliou and Neokosmidi (2007) studied how firm characteristics affect capital structure. This research used 129 Greek companies listed in the Athens Stock Exchange during 1997 and 2001. This research found that firms’ size is positively related to their capital structure. In addition, the research also found that the growth, quick ratio, and interest coverage ratio is negatively related to the capital structure.
Sibikov (2009) examined the effect of asset liquidity on capital structure by using data from a broad sample of U.S public companies. This research found that the asset liquidity is positively related to capital structure. Similarly, Al-Najjar and Taylor (2008) asserted that asset liquidity affects the capital structure.
Furthermore, Harris and Raviv (1991) found that leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size, but it decreases with volatility of earnings, advertising expenditure, the probability of bankruptcy, profitability and uniqueness of the product.
However, the research outcomes regarding the relationship between the company characteristics and capital structure are inconclusive and sometimes different across countries. For instance, Deesomsak et al. (2004) found that the capital structure in an Eastern Asia and Australian companies are mainly influenced by company size, non-debt tax shield, liquidity, and share price performance. Fattouh et al. (2005) argues that company size, non-debt tax shield, asset tangibility, and profitability influence the capital structure of Korean companies dominantly. In addition, Titman et al. (1988) found that there is no relationship between debt ratios and a company’s expected growth, non-debt tax shields, volatility, or the collateral value of its assets (Titman et al., 1988).
2.5. Conceptual Framework
Based on previous literature review, the following illustration is the research conceptual framework
Revenue per Employee
Research Conceptual Framework
2.6. Research Hypothesis
Asset structure is one of the important factors that influence the capital structure of a company. Asset structure will influence financial resources of a company in various manners. First, if a company which has half of its capital is invested in fixed assets, it prefers to finance using its own equity. Moreover, the company may incur higher fixed costs because of using external sources to finance fixed assets. Second, if the company is dominated by fixed assets, it may need to finance by using long term debt in order to keep liquidity within the company (Brigham et al., 1999). In fact, this is proven by Huang et al. (2006), where the authors found a positive relationship between asset structure and debt levels.
H1 : Asset structure is positively related to capital structure
Agency theory of debt states that conflicts between owners and lenders will lead to a negative relationship between growth and debt levels (Jensen and Meckling, 1976). High growth companies tend to face agency problems because they are more flexible in choosing future investments (Bhaduri, 2002; Al-Najjar and Taylor, 2008). Consequently, the expected growth rate will negatively influence the capital structure (Al-Najjar, and Taylor, 2008). Hovakimian et al. (2004) suggested that high-growth companies will give more capital gains to investors. Therefore, growth may be considered as a positive sign of high future returns for investors. These companies with growth opportunities will use less debt to reduce agency problems (Myers, 1977). Rajan et al. (1995) postulated that there are two main reasons of negative relationships between growth and capital structure. First, the increasing growth opportunities will reduce the cost of financial distress. Second, a company is preferable to issue equity when the stock is overvalued.
H2 : Growth is negatively related to capital structure
Profitability of a company indicates the ability of the company to generate future earnings. It is one of the important determinants of capital structure (Al-Najjar and Taylor, 2008). Pecking order theory states that a company which has high ability to earn profit in the past will have lower leverage rate (Salehi, 2009). This is because the company tends to preserve its profits as retained earnings in order to earn higher earnings in the future. Commonly, it is done by the company that has high earning rate (Bhole and Mahakud, 2004). The retain earnings could be used to finance its investments and reduce the needs of using debt.
Furthermore, the pecking order theory states that companies prefer financing by using retained earnings and raise debt capital if their initial funds are insufficient. Nevertheless, the availability of internal capital depends on the profitability of the firm. The company would prefer using internal financing than external financing when the cost of capital is high. Hence, these explanations indicate a negative relationship between profitability and leverage (Myers and Majluf, 1984; Sunder and Myers, 1999).
H3 : Profitability is negatively related to capital structure
Size of a company will influence its capital structure. Larger companies may need higher external financing. They may need to acquire more funds. Barclays and Smith (1995) asserted that the size of a company will affect the capital structure for two reasons. First, issuance costs for public issues have a large fixed component which results the significant economies of scales in the large company. Second, large companies prefer to have foreign operations and manage their currency exposure. This means that the companies want to use debt (Barclay and Smith, 1995). Most of the earlier researches stated that there is a positive relationship between size of a company and capital structure. For instance, Bhaduri (2002) found that there is a positive relationship between size of company and its debt level.
H4 : Size is positively related to capital structure
Trade off theory states that a company’s debt capacity increases as it matures, indicating that a positive association between age of the firm and leverage. Meanwhile, the pecking theory argues that the company establishes its reputation as it matures because it is easier for them to access to equity markets. Therefore, this implies a negative association between age of the company and leverage (Hall, 2004).
H5 : Age is positively related to capital structure
The need of workforce is one of the specific characteristics for each industry. Some industries are very labor intensive, while other industries do not need much labor in order to generate revenue (Talberg, et al, 2008).
H6 : Revenue per employee is positively related to capital structure
Companies with assets that have greater liquidation value have easier access to finance and lower costs of financing, leading these companies to have a higher level of debt or external financing in its capital structure (Cassar and Holmes, 2003). The companies with high liquidity ratios may have higher debt ratios because they have the ability to pay their obligations. Therefore, the companies with more liquid assets may use such assets as financial sources to fund future investment opportunities (Al-Najjar and Taylor, 2008). Hence, there is a positive relationship between liquidity and debt capacity (Benmelech et al, 2005). In the literature, it is common to use current ratio and debt-to-equity ratio to measure the liquidity and leverage of a company (Chen and Jaggi, 2000; Gul and Leung, 2004).
H7 : Liquidity is positively related to capital structure
According to Hall et al (2000), there are differences between unquoted small and medium-sized UK enterprises. Similiarly, Harris et al. (1991) showed that there are differences in capital structure across industries. Inspired by the studies above, the thesis is aimed to prove this hypothesis.
H8: There is significant difference in capital structure across industries
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