The capital structure theory is used to identify the optimum level of the capital structure which could be used by company to strengthen its return on capital employed and keeping the low cost of capital. However, determining the optimum capital structure is based on the internal and external factors of the business. It is analyzed that if company has higher debt to capital then it will not only increase the overall financial leverage but also result to lower cost of capital. Only the company which is having good amount of profitability in its business could go for having higher deb capital in its capital structure. Each and every company needs to establish the equilibrium point between the cost of capital and financial leverage. The higher financial leverage should be based on the assessment of the gearing ratio and how far company could bear the interest payment out of the available EBIT in its business. In this essay, there are several other theories and approaches have been discussed in literature such as trade-off, pecking order and agency cost theory which will help in identifying the optimum capital structure. Nonetheless every company will have different debt to equity ratio when it wants to set up optimum debt to equity capital. The main reason is that every company has its other externals and internal factors.
The MM theory has showcased the relation between the cost of capital and financial leverage while determining the capital structure of company. However, it was criticized to a great extent as the assumption on which it was framed does not exist in real world In the field of corporate finance, capital structure is one of the important components as it comprises of the debt and equity elements of a firm. Many debates are conducted to figure out the association between firm’s value and capital structure. Looking at the urge of finding an optimal capital structure, many researchers have developed various theories in the same context. In 1956, Modigliani and Miller developed a theory which started a conversation regarding the connection between capital structure and value of the firm. After that many literatures were created which highlighted the same and point outs the debate on the topic that whether an optimal capital structure exists for a firm or whether the portion of debt and equity affect the firm’s value (Berk, DeMarzo, Harford, Ford, Mollica & Finch, 2013). According to Parrino and Kidwell, preferred structure of capital is gained when a company maximizes its total value and minimizes its cost of financing. It is said that every firm should practice a best mixture of financing as the proportion of debt and equity in a firm’s capital is highly influenced by the factors such as availability of sources, market conditions and several macroeconomic variables. However, it is observed that the capital structure of the firm changes time to time arising due to the changes in the internal and external factors as modifications in capital market and regulatory frameworks (Gitman, Juchau & Flanagan, 2015).
Going through the literature, there are various capital structure theories developed by many researchers to understand the relation between firm’s value and its structure of capital. The work was initiated by Modigliani and Miller (1958) which later on become a debating issue in corporate finance and accounting literature. The MM approach is known as capital structure irrelevance theory which states that the financial leverage is irrelevant while determining the firm’s value. According to MM theory, the value of the firm which is its stock price does not depend upon its structure of capital. The premise of the theory is based on some set of assumptions which does not stand true in real world. They include no taxes, no information asymmetry, perfect capital market conditions and no transaction costs. The approach suggested that the total market value of the firm’s financial assets is determined by the risk and return of its real assets and the fact about mix of issued securities is considered to be an immaterial factor in the calculation of the same. The main ideology behind Modigliani and Miller’s theory is that a capital structure can be created by a rational investor according to his/her opinions and preferences (Harris & Raviv, 2011). Thus, it has been interpreted that the company should not put more efforts on making its capital structure perfect. The crux of MM theory is that if the investor is highly indebted then the risk and return on firm’s stock will be the same if the firm was highly levered. The findings of the theory suggested that if the firm is highly levered then it will not only give high returns but also high risks to the investors. Modigliani and Miller further developed a hypothesis which stated that there is set a nexus between the debt and equity of the capital part of company. The approach further elaborates the fact that the profitable companies tend to use more debt in order to avail the tax benefit derived from taking debt financing into account. As described by MM, in all equity firms, only the tax authorities and shareholders have the right on the firm. The value is owned by the shareholders and taxes paid are just considered as the cost. There are three claimants of levered firm who are debt holders, government and shareholders as per the theory. Therefore, in case of the firms having leverage, the value is determined by adding the value of debt and value of equity (Berger & Di Patti, 2006).
It is analyzed that many debates are conducted to figure out the association between firm’s value and capital structure but only MM theory has possibly identified the method to determine the optimum capital structure. However, MM theory was criticized to a great extent as the assumption on which it was framed does not exist in real world. They are quite unrealistic and it is not always necessary to have a perfect capital market. Moreover, the theory follows an arbitrage process which is of no use in imperfect market and as a result, variations will arise between the market value of levered and unlevered firms. Furthermore, the transaction costs and corporate taxes do exist in the real world.
Other approaches of capital structure include agency cost theory which covers one of the crucial concepts explained by Jensen and Meckling. They argue that ownership structure does not change according to the probability of cash flow. Besides this, the theory also defines agency relationship between agents, principals and managers. The agents are required to work in the best interest of principal and this may create a conflict between them. Two types of agency problems arise; one is between managers and shareholders and other is between debt holders and shareholders. Companies having high cash outflow and inflow have been used for financing the positive NPV generally have conflicts between managers and shareholders. Also the shareholders fail to achieve the benefit of the entire earnings and also availability of excess cash allows the managers to use the same for the projects having negative NPV. Therefore, it has become important to introduce debt element to control the activities of managers. Also, it was argued by Jensen that the problem of excessive cash can be solved by going ahead with debt financing which makes the manager obliged towards various requirements of creditors. The researchers suggested that the second type of conflict arise as there arise issue of the debt equlity. In simple terms, the profits will be enjoyed by the shareholders in case the project is successful while the debt holders have to face loss in situation where the project fails. This created problems of overinvestment and underinvestment. There are several other theories and methods which could be used to determine right amount capital structure in business. According to MM theory, the main thing which we could notice here is that the equity value of the firm which is its stock price does not depend upon its structure of capital. It is varied due to the market factors and other associated sensitive market information which could impact the true value of the equity capital of organization. The premise of the theory is based on some set of assumptions which does not stand true in real world. They include no taxes, no information asymmetry, perfect capital market conditions and no transaction costs. However, if by using the debt portion , company has low cost of capital and higher advantages of the tax deduction then keeping debt portion somewhere may increase the overall equity capital value. The main reason of increasing equity value is that if company has low cost of capital then it will eventually increase the overall return on capital output. If it happens then it the same will increase the benefit available to equity shareholders. The higher benefits available to equity shareholders will also create value on the equity shares in market. It is analyzed that if company is having higher cash inflow and outflow then that company should keep higher equity capital in its business. As it is determined that higher cash outflow and inflow will also increase the overall cost of capital which might be negative indicators and shows higher financial leverage. This could be only reduced when company kept high equity capital in tis business. The equity capital should be high in the business where company faces issues of the profitability. If company fails to manage its interest payment out of the available earning then it might negatively impact the business sustainability and may result to business liquidation in long run.
Few studies have been undertaken based on agency cost theory which highlighted different capital structure models. Out of them, one model estimated that firms which have high market value generally experiences low investigation costs and high market value which eventually result in more debt and high probability of default. Thus, as per this model it can be said that the financial leverage, cost of capital and and firm’s value has horizontal relation with each other. In contrast to it, model given by Stulz (1990) argued that an optimal debt can be achieved by balancing the debt benefit and ignoring the decreased value. This will lead to a trade-off between underinvestment and reduced free cash flow. On a whole, the agency theory concludes that a firm can create an optimal capital structure by resolving its agency problems and the structure of capital can influence the firm’s value by motivating the managers and encouraging shareholders to supervise their activities. The advantage of this theory is that it helps in understanding the investment and funding behavior of the investors. However, it has some limitations such as it provides partial models for identifying the sources of conflicts and for figuring out the optimal solutions for the same (Leland, 2008).
Trade-off theory is proposed by Miller and is considered as one of the biggest dominant theory of the financial capital structure. This theory determines the capital structure by creating a balance between different benefits and cost of debt financing. According to this approach, if firms are more profitable then they will prefer debt financing over equity financing in order to increase and improve their profits. Furthermore, it has also been argued by the theory that the firm can improve its performance by mitigating the differences between managers and shareholders related to free cash flow, risk amount and optimal investment strategy. On the other side, debt cost consist of direct and indirect bankruptcy cost which allows the firms to manage its FCF in terms of interest and principal which increases the bankruptcy and likelihood of financial default. Thus, the tradeoff theory gives a conclusion that the firms with high income are more profitable and should issue debt in order to take tax benefits. The trade-off theory focuses on maximizing the value and assumes a static capital structure. Trade off theory pay more emphasis on debt and bankruptcy cost which clearly defines the advantage of using debt financing. Also the theory is considered to be a dominant one and it helps to determine the debt to equity ratio (Hackbarth, Hennessy & Leland, 2007).
Another theory developed was pecking order theory which suggested that the firms prefer raising funds from internal sources and if they require external financing, they issue the safest security first. This theory was discussed by Myers (2014), Myers and Majluf (2014) and Fama & French (2012). According to it, firms that have positive net present value will generally go for internal financing and if that is not enough, then firm issue debt first and kept equity as a last option. However, the theory may lead to the conflicts between shareholders and creditors as the money lenders want to increase the interest rate and an additional cost will also be incurred for managing such conflicts (Frank & Goyal, 2013). The theory begins with the asymmetry of information in the firm. The word asymmetric reflects the unequal distribution of information. Generally, the top management is accompanied with the company’s performance, position, prospects and the risks as compare to the investors and creditors. It has been seen that the firms operating on large scale and who have less asymmetric information and more diversified stable cash flow are inclined towards having more equity portion in its busienss than debt portion, thus have low probability of bankruptcy and lower leverage (Muritala, 2018). The results declared by Myers (2014) got confirmed by other researchers also which believed that increase of leverage will decrease the profitability. On a whole, the pecking order theory highlights the conflicts arises between the managers and shareholders to the existence of information asymmetry regarding the investment opportunities. This lead to high leverage that results in poor performance. The main strength of applying this theory is that it provides a preferred financing structure which can be easily adopted by the firms. Limitations of the theory explains that it does not takes into account the influence of taxes, security issuance costs, financial distress, agency costs and the available investment opportunities for the firm. Furthermore, it avoids the problems that may arise from the managers’ end at time of accumulating financial slack which make them immune to market slack. However, both the trade- off theory will help the firms to have a better understanding about the financing decisions (Myers, 2014).
The theories discussed above highlight the debt and equity. It can be said that on the basis of MM theory, many other theories and approaches have been formed in literature such as trade-off, pecking order and agency cost theory. All these approaches are based on theoretical model which uses empirical studies to figure out the determinants of capital structure. The theories discussed are not universal and not applied to every country. On a whole, the literature provides insights about the association between firms’ value and capital structure (Myers, 2011). The theory developed by Modigliani and Miller does not stand true in real world as it first suggested that the capital structure is irrelevant for finding out the value of firm. However, the researchers further developed their hypothesis considering the impact of taxes and its second proposition states that the degree of financial leverage is directly proportionate to the cost of equity. In contrast of irrelevance theory, MM developed a tradeoff theory which determines the tax benefits. All the other theories in the literature also focused on the establishing the relationship between these two elements (Titman & Wessels, 2008). These all theories have been discussed on the basis of the given information and facts on the equity and capital of the organization. if these are handled in proper manner then it will not only increase the overall outcomes but also assists companies to keep the business on sustainable basis. The crux of this all the theories and capital and debt portion determination is that if company wants to survive in the long run then it will have to set up nexus between the cost of capital and financial leverage. Company facing highly fluctuated business should not focus on raising more capital by using the debt funding as it might be highly risky for managing the interest payment out of the available earning. On the other hand, company low fluctuated business and good profitability should focus on raising more capital by using the debt funding as it would also help in lower down the cost of capital of the business.
References
Berger, A. N., & Di Patti, E. B. (2016). Capital structure and firm performance: A new approach to testing agency theory and an application to the banking industry. Journal of Banking & Finance, 30(4), 1065-1102.
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V., & Finch, N. (2013). Fundamentals of corporate finance. Australia: Pearson Higher Education AU.
Frank, M. Z., & Goyal, V. K. (2003). Testing the pecking order theory of capital structure. Journal of financial economics, 67(2), 217-248.
Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Australia: Pearson Higher Education AU.
Hackbarth, D., Hennessy, C. A., & Leland, H. E. (2007). Can the trade-off theory explain debt structure?. The Review of Financial Studies, 20(5), 1389-1428.
Harris, M., & Raviv, A. (2011). The theory of capital structure. the Journal of Finance, 46(1), 297-355.
Leland, H. E. (2014). Agency costs, risk management, and capital structure. The Journal of Finance, 53(4), 1213-1243.
Muritala, T. A. (2018). An empirical analysis of capital structure on firms’ performance in Nigeria. IJAME.
Myers, S. C. (2014). The capital structure puzzle. The journal of finance, 39(3), 574-592.
Myers, S. C. (2001). Capital structure. Journal of Economic perspectives, 15(2), 81-102.
Titman, S., & Wessels, R. (2008). The determinants of capital structure choice. The Journal of finance, 43(1), 1-19.
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