Corporations fund their operations by raising capital from a variety of distinct sources. The mix between the different sources, generally referred to as the firm’s capital structure has attracted considerable attention from academics and practitioners. Debt and equity are raised by firms to finance new investment projects. As such, both of them are sources of funds for the business. Debt usually consists of bank loans either long term or short term whereas equity consists of stocks and bonds. Hence, capital structure refers to the mixture of debt and equity finance used by a company to finance its activities.
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The correct choice of the mix of debt and equity is questionable. Financial managers ‘problem is to find out the combination of securities that have the greatest overall appeal to investors. Moreover individual firms often change their debt ratios over time, perhaps responding to changes in investment opportunities, agency costs and so on. According to R Charles Moyer, James R. McGuigan and William J. Kretlow (1982), leverage is closely related to capital structure in the financial field.
2.1.1 Importance
It is found that there are basically three types of financing decisions taken by firms namely the (i) the distribution of earnings which is the consumption decision, (ii) the capital budgeting decision,i.e, the investment decision and (iii) the capital structure decision. The capital structure decision is fundamental in order to carry out the other two financing decisions, i.e how much cash should the firm lend or borrow in order to carry out the consumption and investment decision. The capital Structure decision is important since profits of various organizational constituencies are maximized as well as the organization is able to deal with its competitive milieu.
2.2 Theories of Capital Structure
2.2.1 Traditional View
The traditional view specifies that when a firm uses the right mix of debt and equity, the lowest its WACC, the more it will maximize the firms’ value due to the tax advantage of debt. If a firm wants to make an optimal capital structure decision, it will have to choose those sources of finance that gives the lowest cost of capital which will in turn lead to the lowest WACC. However, it is to be noted that as gearing increases, the cost of equity and consequently the bankruptcy risk will increase which will in turn lead to an increase in the cost of debt.
However, the validity of this theory has been criticized since there is no underlying theory which shows by how much the cost of equity should increase due to increased leverage and by how much the cost of debt should increased due to increased in bankruptcy risk.
2.2.2 Modigliani and Miller Theory
In their landmark paper in 1958, the Modigliani Miller Theorem (Modigliani and Miller, 1958, 1961) says that the value of a firm and the investment decisions should be autonomous from its capital structure. In other words, leverage should have no effect on investment decisions. However, the Modigliani Miller Theorem assumes a world with no taxes, information asymmetries or agency costs. Assuming perfect capital markets, they propounded to what is today widely known theory of ”capital structure irrelevance” which means that the capital structure that a company chooses does not affect its value. Later theories argue that leverage clearly can matter due to the effect of taxes, information and agency costs (Myers, 2001).
Later, in 1963, Modigliani and Miller took taxation under consideration and proposed that companies should employ as much debt capital as possible in order to achieve the optimal capital structure. Along the lines with corporate taxation, numerous studies also analyzed the case of personal taxes imposed on individuals. Miller (1977) suggests tax rates in the tax legislation of the some of the OECD countries that evaluate the total value of the company. These are the corporate tax rate, the tax rate on income in the form of dividends and the tax rate on interest income. According to Miller, the value of the company depends on the relative percentage and importance of each tax rate, compared with the other two.
With respect to theoretical studies, there are two widely acknowledged competitive models of capital structure namely the static trade off model and the pecking order hypothesis.
2.2.3 Tradeoff/ Static Theory
This approach presents capital structure as a balance between positive and negative effects of leverage respectively linked to a firm’s tax advantages and financial risk. The trade off theory introduces into the capital structure debate the benefit of the debt tax shield on one hand and the cost associated with financial distress on the other. The implication of this theory is that each firm has an optimal debt ratio that maximises value, although this level may vary between firms. Moreover, the trade off theory is often further extended to incorporate agency considerations. This is in the spirit of Jensen and Meckling (1976) who note that debt is valuable in reducing the agency costs of equity but at the same time debt is costly as it increases the agency costs of debt.
However, there are factors that this theory cannot explain such as why companies are generally conservative in using debt finance, for example, some successful companies such as major pharmaceutical manufacturers continue to operate with low leverage. Furthermore, this theory cannot explain why leverage is negatively related to profitability as reported by Myers (1993), Titman and Wessels (1988) and Fama and French (2000).
2.2.4 Pecking Order Theory
Pecking Order Theory is considered as one of the most influential theories of capital structure According to Myres (1984), this theory advocates an order in the choice of finance due to different degrees of information asymmetry and related agency costs embodied in distinct sources of finance. As such, retained earnings are used first since they constitute the cheapest means of finance, hardly being affected by any information asymmetry. Second, debt is used as there is low information asymmetry due to fixed obligations acting as an effective monitoring device. Finally, external equity is used only as a last resort as it conveys adverse signaling effect as explained by event studies.
This theory also claims that there is no optimal capital structure that maximises the firm’s value. The attraction of interest tax shields and the treatment of financial distress are therefore assumed to be second order of importance, because debt ratios change when there is an imbalance of internal cash flows net of dividends and real investment opportunities. Profitable firms work down to low debt ratios, while those whose viable investment opportunities exceed internally generated funds tend to borrow more and more.
The pecking order form of financing is also influenced by information asymmetries which are where investors make inferences about a firm’s prospects based on management’s financing decisions. A positive impact on the share price only occurs if management chooses to refinance with debt rather than equity, because the firm’s prospects are then viewed as being good (i.e. by investors). Managers thus avoid the alternative scenario (a decline in the share price due to new equity issues) by maintaining a borrowing capacity or financial slack that consists of retained earnings and/or marketable securities.
2.2.5 Agency Theory
Jensen and Meckling (1976) pinpoint the existence of the agency problem which arises due to the conflicts either between managers and shareholders (agency cost of equity capital) or between shareholders and debt holders (agency cost of debt capital). Promoters with major shareholding usually consider the impact of raising funds via equity financing. However, more equity shareholders would imply a dilution of control. Therefore, in order to retain control over management, some firms prefer debt financing. Theory supports that leverage matters due to the effect on agency costs. Leverage is predicted to reduce the agency costs from the manager-shareholder conflict; thereby mitigating the investment inefficiency resulting from this conflict.
The Free Cash Flow theory (Jensen, 1986) suggests that debt reduces the agency cost of free cash flow. He also argues that, since debt commits the firm to pay out cash, it reduces that amount of free cash flow available to managers to engage in self interest activities. Debt financing ensures that the management is disciplined to making efficient investment decisions which will maximize the firm’s value and that they are not pursing individual decisions which will increase the profitability of bankruptcy. The mitigation of the conflicts between managers and shareholders constitutes the benefit of debt financing.
Furthermore, Jensen argues that debt also imposes strong control effects on managers. Debt holders can exert a stronger control of the firm than shareholders. A promise to shareholders to payout a certain amount in dividends is considered weak since it is not binding (dividends can be reduced in the future). Debt creation, however, forces managers to effectively bond their promise to pay out future cash flows. The debt holders have the right to take the firm to bankruptcy court if the firm cannot make its debt service payments. The threat caused by failure to make debt service payments serves as an effective motivation force for managers to make their firms more efficient. Thus, through the reduction of free cash flows and control effects, leverage is presumed to mitigate the manager-shareholder conflict and overinvestment.
According to Harris and Raviv (1990), the role of debt in allowing investors to generate information useful for monitoring management and implementing efficient operating decisions. Debt-holders use their legal rights to force management to provide information. The optimal amount of debt is determined by trading-off the value of information and opportunities for disciplining management against the probability of incurring costs. Monitoring costs would be incurred by debt-holders to ensure that the managers do not increase the risk of the firm by investing in risky projects. However, by investigating in risky projects, free cash flows can fluctuate and debt holders might not be paid. To prevent this, banks will have to monitor the firm and will thus impose a number of conditions, for example, the firm will keep a particular liquidity ratio as decided by the bank’s analysis. Subsequently, the cost of debt will increase since it will include the agency costs. As a result WACC will increase and eventually the value of the firm will decrease. Hence, the firm will not be able to take maximum of debt since the cost of debt will increase because of the monitoring costs that have to be adhered to. Therefore, firms with relatively higher agency costs due to the inherent conflict between the firm and the debt-holders should have lower levels of outside debt financing and leverage.
2.2.6 The Signaling Hypothesis
The Signaling Theory is based n the assumption that managers possess superior knowledge as insiders as opposed to outside investors who know much less about the economic health of a firm. This hypothesis suggests that managers may choose financial leverage as means to send signals to the public about the future of the company. Ross (1977) claimed that greater average financial leverage is used by managers to signal an optimistic future about the firm. Furthermore, Leland and Pyle (1977) argued that an owner’s willingness to invest in his own project conveys a positive information to the market since it can be used as a signal for project quality.
2.2.7 Bankruptcy Cost
Arguments against/For debt (put I table in Appendix in case in excess)
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