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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
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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
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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
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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
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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
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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.
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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
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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)
IRJMST Volume 4 Issue 3 Online ISSN 2250 - 1959
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9. Krasker, W. (1986) Stock Price Movements in Response to Stock Issues under
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