Theories of Capital Structure: Analysis of Capital Structure Determinants

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Theories of Capital Structure: Analysis of Capital Structure

Determinants

Mohd Shahid Ali

Assistant Professor,

Motilal Nehru (E) College,

University of Delhi,

Mail:[email protected]

Rachna Yadav

Assistant Professor,

Motilal Nehru (E) College,

University of Delhi,

Mail:[email protected]

Md. Arshad. Jamal

Research Scholar,

Deptt.of Comm.& Business Studies,

Jamia Millia Islamia, Mail:- [email protected]

ABSTRACT

The objective of this paper is to investigate the determinants of the capital structure on the

basis of reviewed theories such as Static Trade-off Theory, Pecking order theory Information

Asymmetry and Agency Theory, We examined different dependent variables of the capital

structure such as debt ratio,short term debt ratio and long term debt ratio, and number of

independent variables such as tax shield, assets structure, profitability, growth opportunities,

liquidity, company size and dividend policy.On the basis of literature determinants under

pecking-order theory are Liquidity, Firm size having negative relation with leverage, and

profitability, asset tangibility having positive effect on the debt-to-capital ratio. Determinants

of capital structure in static trade-off theory are; Non-debt tax shield in which having

negative relation; and Profitability, Firm size, and Asset tangibility having positive effect on

the debt-to-capital ratio. Assets tangibility, size and age having positive relation with debt-to-

equity ratio on the basis of Information Asymmetry theory.Growth having negative relation

with the debt-equity ratio as per agency theory.The famous theories on capital Structure are

Pecking Order & Trade off theory. Finding of the study is that pecking theory in capital

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structure decision prevail, but some time moderate support for the trade-off theory as well as

agency theory and Information Asymmetry theory.

Keywords: capital structure, pecking order theory, trade-off theory, leverage, agency theory

Introduction

Modigliani and Miller (1958) were the first ones to landmark the topic of capital structure

and they argued that capital structure was irrelevant in determining the firm’s value and its

future performance. On the other handLubatkin and Chatterjee (1994) as well as many other

studies have proved that there exists a relationship between capital structure and firm

value.The irrelevance theory states that if a company’s investment policy is given, then in a

world of perfect markets (without taxes, transaction costs, bankruptcy costs etc.) the level of

debt in afirm’s capital structure not affects the value of a firm(Chen, 2004; Modigliani &

Miller, 1958). Jianjun Miao (2005) provided an equilibrium model to test the relationship

between optimal capital structure and industry dynamics. The study revealed that while the

firms make financing and investment decisions subject to idiosyncratic technology shocks, it

proved that the capital structure decisions reflect the tradeoff between tax benefits of the debt

component and associated bankruptcy and agency costs. The earlier studies on capital

structure mainly focuses on the analysis of certain firm characteristics – e.g., profitability,

tangibility, size, etc. – as determinants of leverage. In addition, capital structure may vary

across time (e.g., Korajczyk and Levy, 2003), which suggests the existence of an optimal

level of leverage. Rajan, R.G., andL.Zingales, (1995)found that the leverage decision of the

firms across countries was fairly similar and the factors identified by earlier studies in the U

S were similarly correlated with other countries, also found that the theoretical propositions

of capital structure decisions were still unresolved. Brav (2009) analyses the data from public

and private firms, and finds that private firms have a heavy dependence on debt financing and

are more sensitive to performance changes when it comes to deciding on the capital structure,

and desire to maintain control and possible information asymmetry have resulted in private

equity being costlier than public equity.

Explanation of Variables

This section provides information about the measurement of the variables and discussion on

it on the basis of detail study on the literature. This paperanalysed capital structure

determinant on the basis of the review. A number of variables that are probably responsible

for determining capital structure decisions in companies can be found in the literature. In this



study, the selection of explanatory variables is based on the available alternative capital

structure theories and previous empirical work. As shown in the table (1) for dependent and

in table (2) for independent varibles.

Dependent Variables: Surprisingly, there is no particular definition of leverage in the academic

literature. The differences between the measures worry mainly two things. The first relating

to the nature of debt included. Some authors adopt a more inclusive measure of debt that is

total debt. Others analyze only with long-term debt & the Short-term measures are used

rarely. Additionally, many researchers have observed & reported that results achieved with

the narrow and the broad concepts are either very similar or better with the use of the broader

concept. There are several problems are arising in obtaining market value of the corporate

debt. The choice always depends on objective of the analysis. Rajan&Zingales (1995) apply

and suggest four alternative definitions of leverage. The first and important definition of

leverage is the ratio of total liabilities to total assets, denoted as DR. This can be viewed as

substitute of what is left for shareholders in case of liquidation. In addition, this measure of

leverage is potentially affected by reserves and provisions, such as end of service liabilities.

Therefore we divide the ratio into layers the short term debt (the ratio of short term debt /

total assets), denoted as STDR. This measure of leverage only covers debt in a short sense

(i.e. current liabilities) and excludes provisions and to ratio of total long term debt to total

assets. This measure of leverage is denoted as LTDR and is unaffected by non-interest

bearing debt and working capital management.

Independent Variables

Tax: Modigliani and Miller (1963) showed that the tax impact in their model is no more

effective if tax was taken into consideration since tax subsidies on debt interest payments will

cause a rise in firm value when equity is traded for debt.Murray Carlson and Ali Lazrak

(2010) developed a model to predict if the leverage of the U S based firms trades off the tax

benefit of the debt against the utility cost of ex-post asset substitution. The authors found a

positive relationship between cash to stock and leverage ratios of the firms.Jianjun Miao

(2005) proved that the capital structure decisions reflect the tradeoff between tax benefits of

the debt component and associated bankruptcy and agency costs.

Debt Tax Shields:Some literature concludes tax have no effect onleverage.Literature

conclude that more profitable firms have lower leverage,the result being weaker in countries



where dividends are preferentially taxed, which isconsistent with the idea that personal taxes

can influence payout policies and in turninfluence capital structure

Non-Debt Tax Shield: The relative attractiveness of debt financing canbe mitigated by the

existence of non-debt related corporate tax shield, such asdepreciation on investments,

investment tax credits, pension funds and R&D expenses, toreduce corporate tax payments.

Firms can use such non-interest items to reduce their taxbills and help their bottom-line.

Firms with higher NDTS are likely to use less debt.

Bankruptcy Costs: Per the Trade Off theory, thebenefits from debt financing are limited by

increasing bankruptcy costs. Bankruptcy costsand laws play a huge role in leverage and debt

contracts, per research done by Harris andRaviv (1991). Variations in bankruptcy procedures,

especially the extent of liquidationover renegotiations of claims can have a lasting impact on

firm’s choice of capitalstructure.

Bank Influenced: There are major differences inthe power of banks and financial institutions

in various countries. Through their studies, Demirguc-Kunt and Maksovic (2001) conclude

that legal and institutional differences among countries explain a large part ofthe leverage and

debt maturity choices of firms.

Ownership Structure: Ownership concentration varies among countries. Ownership structure

benefits capital structure bymaintaining a concentrated shareholder presence on the board,

increased aversion to debtand a reduction in agency costs. Through their studies, They also

conclude that shareholder concentration has a neutral to abeneficial effect on firm leverage,

primarily due to the nature of ownership.It is suggests that to control this problem, by

increasing the stake of managers in the business or byincreasing debt in the capital structure,

thereby reducing the amount of “free” cashavailable to managers (Jensen (1986); Stultz

(1990)).

Assets Structure (Tangibility): According to the static trade-off theory, there should be a

positive relationship between fixed assets and debt. On the other hand, the pecking order

theory predicts that firms holding more tangible assets will be less prone to asymmetric

information problems and thus less likely to issue debt. This argument suggests a negative

relationship. Results (Rajan and Zingales 1995; Titman and Wessels 1988) confirm positive

influence of assets structure on debt ratios. Leverage ispositively associated with liquidation

value (Harris and Raviv, 1991).Jensen and Meckling’s(1976) and Myers’ (1977) version of



trade-off theory that debt level should increasewith more fixed tangible assets on balance

sheet.

Profitability: Profitability is a one of major point of dispute b/w the two theories i.e. Pecking

Order Theory (POT) and Static Tradeoff Theory (STT). In the STT, the higher the

profitability of the firm, the more reasons it will have to issue debt, it is reducing its tax

liability. On the other hand, the POT assumes that larger earning amount lead to the increase

of the main income source firms choose to cover their financial deficit in the form retained

earnings. Therefore, the Static Trade off Theory expects a positive relationship between

profitability and leverage, whereas the Pecking Order Theory expects exactly the negative

relation between profitability & Leverages. Myers (1984) conclusion has been made that

profitable firms do not rely on external financing and have much dependence on internal

financing; Titman and Wessels (1988) agreed also with this conclusion. In previous studies,

the measure of profitability used was operating earnings before interest payments and income

tax.

Free Cash Flow:Free cash flow means cash available after funding entire projects with

positive cash flows. Manager has less than 100 percent share in organisation maytryto use the

free cash flows sub-optimally or use them to their own advantage ratherthan to increase value

of the firm. Jensen (1986) suggests that to control this problem, by increasing the stake of

managers in the business or byincreasing debt in the capital structure, thereby reducing the

amount of “free” cashavailable to managers (Jensen (1986); Stultz (1990)).

Growth: Myers (1984) argued that leverage is negatively related to growth opportunities

since growing firms have more opportunities to make investment in risky projects at the

expense of debt holders (the cost of debt increases). Alternatively, according to the POT

approach, high growth firms have higher need of funds and, therefore, may be expected to

more borrowings. They will especially issue securities less subject to informational

asymmetries, i.e. short-term debt. Empirical evidence in support of the negative relationship

can be found in Titman and Wesssels (1988),Rajan and Zingales (1995) found growth

opportunities to be positively correlated with total debt. There are two proxies commonly

used in literature to measure growth opportunities, which are applied in this study: average

growth rate of total asset and average growth rate of revenues from sale.

Size of the Firm: The costs of issuing debt or equity are also related to firm size. Small firms



have to pay much more than large firm to issue new equity or debt. This suggests that small

firms may be more leveraged than large firms but short firm prefer to borrow short term

rather than long- term debt to lower cost. For the Static Trade-off approach, the larger the

firm, the greater the possibility it has of issuing debt, resulting in a positive relationship

between debt and size. Another reasons for this is that the larger the firm the lower is the risk

of bankruptcy of being more diversified & have less chances of bankruptcy (Titman and

Wessels 1988). With respect to the Pecking Order Theory, Rajan and Zingales (1995) argued

that this relationship could be negative. Taxdeductibility of interest payments, it is argued

that highly profitable companies tend tohave high levels of debt (Modigliani and Miller,

1963). Another observation stresses thatlarger firms are more diversified and less prone to

bankruptcy (stable), resulting infavorable debt terms than smaller firms (Rajan and Zingales,

1995).

Dividend Policy: Dividend payout(Policy) is very lessly included in empirical studies on the

determinants of capital structure choice. The dividend policy is always related to the

investment decision firm. According to pecking order theory, firms aim to finance

investments initially from retained earnings rather than using external funds. This tendency

led the firm to follow & adopt dividend policy accordingly. It the reason on the basis of that

we can said there is positive relationship between payout ratio and debt can be expected.

Liquidity: As explained by pecking-order theory, firms prefer internal financing to external

financing. Therefore, firms are always likely to create liquid reserves from retained earnings.

If liquid assets are sufficient to finance the investments. Myers, Stewart C. (1977), used in

liquidity in his study on “Determinants of corporate borrowing” The firms will have no

requirement to raise funds from external source. Hence, liquidity is supposed to be

negatively related with leverage.

Information Costs and Signalling Effects: Level of information, which the outsiders have

about the investment opportunitiesand income distribution of the firm. Information

asymmetry may result in twodifferent outcomes for capital structure.The first effect on

capital structure because of information is called signaling with proportion of debt. Ross

(1977) says that managers have better knowledge ofthe income distribution of the firm.

Myers and Majluf (1984) say that investors generally perceive thatmanagers use private

information to issue risky securities when they are overpriced.Krasker (1986) says thesame

that equity prices fall when new issue of stock is given.Firms usually avoid to issue new


International Research Journal of Management Science & Technology http:www.irjmst.com 01

equity for financing newproject; relatively they will first fulfil their requirements of financing

from inside generatedfunds then issue debt if further financing is required and finally issue

equity as a lastresort. This has been termed as “Pecking Order Theory”.

Agency Problems: Agency problems exist when managers pursue activities suchas excessive

perk taking or maximizing sales or asset growth that benefit them at theexpense of outside

shareholders. There are many ways to reduce this problem. Debtfinancing reduces this cost

not only by reducing free cash flow available for managers toinvest, but also by encouraging

lenders to monitor. However, the magnitude of agencycosts varies from firm to firm and

country to country. Booth et al. (2001) show that thereis a country effect on the determinants

of capital structure.

Conclusion & Summary

The firms are more preferred the external debt financing over the internal debt. Tradeoff

theory urges that internal finance are less available due to low liquidity and firms prefer to

rely on external finance, and hence companies with low liquidity tend to adopt external

financing.We examined different dependent variables of the capital structure such as debt

ratio, short term debt ratio and long term debt ratio, and number of independent variables

such as tax shield, assets structure, profitability, growth opportunities, liquidity, company

size and dividend policy. On the basis of literature determinants under pecking-order theory

are Liquidity, Firm size having negative relation with leverage, and profitability, asset

tangibility having positive effect on the debt-to-capital ratio. On the basis of determinants of

capital structure in static trade-off theory are Non-debt tax shield and Business Risk having

negative, Profitability, Firm size, and Asset tangibility having positive effect on the debt-to-

capital ratio. Assets tangibility, size and age having positive relation with debt-to-equity ratio

on the basis of Information Asymmetry theory.Growth having negative relation with the

debt-equity ratio as per agency theory.

Table(s)

Table (1): Definition of the leverage proxies

Class Variable Definition

Debt Ratio DR Total debt ratio as total liabilities divided by total

liabilities plus net worth.



Table (2): Explanatory important variables definition of the independent variables with

their relationship with proxies

Class Variable Definition

Debt Tax Shields: DTS Financial Expenses x rate of tax

Assets structure TANG Fixed assets/total assets

Profitability PF Operating profit/net revenues from sales

Growth G R1 Percentage change of total assets

Opportunities G R2 Percentage change of net revenues from sales

Size SZ1 Natural Log of Total Assets

Business Risk SZ2 Natural Log of Sales

Dividend policy DIV Dividend/net profit

Liquidity LIQ Current Assets over Current Liabilities

Long-term debt

ratio LTDR

Total liabilities minus current liabilities divided by total

liabilities plus net worth

Short-term

Debt STDR

Current Liabilities divided by Total Liabilities+ Net

worth



References & Bibliography

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in

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4. Harris, M.; Raviv, A. (1991), The Theory of Capital Structure,The Journal of Finance,

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and financial constraints. Journal of Financial Economics 68, Pp.75–109.

Table (3): Summary of Expected Results

Where

"+" means that leverage increase with the determinant

"-" means that leverage decrease with the determinant

Determinants Proxy used in this Study

Expected

Relationship References for Results

Tangibility of

Assets Fixed Assets/ Total Assests +

Titman and Wessels

(1988) &Rajan and

Zingales (1995)

Profitabilty

Operating Profit/ Net Revenues

From Sales - Rajan and Zingales (1995)

Growth % Change of Total Assets -

Titman and Wessels

(1988) &Rajan and

Zingales (1995)

Opportunities

% Change of Net Revenues from

Sales - Rajan and Zingales (1995)

Size Natural Log of Total Assets + Rajan and Zingales (1995)

Natural Log of Sales + Rajan and Zingales (1995)

Dividend Policy Dividend / Net Profit + Rajan and Zingales (1995)

Liquidity

Current Assests/ Current

Liabilities -

Myers, Stewart C.

(1977),Titman and

Wessels (1988) &Rajan

and Zingales (1995)



9. Krasker, W. (1986) Stock Price Movements in Response to Stock Issues under

Asymmetric Information.Journal of Finance41, Pp.93–105. 10. Lubatkin, M. and Chatterjee, S. (1994). Extending modern portfolio theory into the

domain of corporate diversification: Does it apply?, Academy of Management

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the theory of investment. American economic Review 48, Pp.261-197.

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Managers Risk Shift, Journal of Finance, vol. LXV, No. 6, Pp.2323-2362.

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Firms Have Information Investors Do Not Have. Journal of Financial Economics 13,

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ofFinancial Economics26, Pp.3–27. 19. Titman, S. &Wessels, R.(1988), The Determinants of Capital Choice,TheJournal of

Finance, Vol. XLIII, No. 1, Pp. 1-19.

Theories of Capital Structure: Analysis of Capital Structure Determinants

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