AN EXPLANATION of the THEORIES on CAPITAL STRUCTURE

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Every organization has its financing strategies to operate their business. The term capital structure and leverage are the similar terms that how the investments should utilize to manipulate the assets and the whole business in the long run. The essay covers determinants of capital structure with the help of trade off theory (Kim,1978; Kraus and Litzenberger,1973;Miller and Modigliani,1963) , pecking order theory (Myers and Majluf,1984), agency cost theory (Jensen and Meckling,1976) and Miller and Modigliani theory which are significant to determine the main factors of capital structure which are growth, size, non debt tax shield, volatility in earnings in the age of the firm, tangibility, assets valuation and structure, uniqueness and profitability. The theories and all these determinants of leveraging structure are discussed briefly below. All these theories are very significant and has a great influence on the capital structure of organizations under their assumptions therefore it is very necessary for firms to make their capital structure under the light of these theories .First of all trade off theory is considered which indicates tradeoff between debt and equity along with the presence of debt tax shield and bankruptcy cost. While in the pecking order theory leveraging structure consider the cost of financing, growth and profitability. The first choice for the firm is internal financing rather debt which usually the second choice and the last one is equity. The utilization of debt proportion in the financing on large scale lead the firms towards agency cost like debt payments and interest on the principle Eldomiaty (2007). The fourth theory is different and proposed that capital structure can be build by equities or debt or no matter with both along with the absence of debt tax shield and bankruptcy cost, the company value is unaffected and can follow any financing policy Modigliani and Miller(1963) .

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DETERMINANTS OF CAPITAL STRUCTURE

GROWTH

Titman and Wessels (1988) give detailed about the firms which operate through equity finance have power to invest accordingly to maximize wealth from the firm’s bondholders. The influence of agency cost is very high for firms in growing surroundings and creates opportunities for future investments. According to Myer instead of long term firm should relay on short term debt which helps the firm to eliminate agency issues because long term financing than negatively associated to future growth. According to Smith and Warner cost incurred by agencies in the firm can be restricted if the organization issue convertible debt which may associate positive opportunities of growth. Sheikh F Rehman et all ,(2006) found that the higher risk could lead to higher growth .The capital structure and growth has negative relation (Archer et al ,1966 cited by Shiekh F Rehman et all,2006) but a few researcher argued that growth and capital structure can be negative or positive in relation and totally relay on long and short term debt ratios (Hall et all,2000 cited by Shiekh F Rehman et all,2006) the long term debt ratio is negative associated with the growth while the short term debt ratio react positive to growth. Further investigation also indicating the same correlation of long and short term debt components the behavior is same as above researchers that the growth opportunities react positively with short period debt and negatively with long period debt Bevan and Danbolt( 2000).

ASSEST VALUATION AND STRUCTURE

The structure and value of assets are different in every firm and the different types of assets can also affect the capital structure of the firm. Few researchers suggests selling of secure debts may result increase in the value of equity from the current unsecured creditors and the firm with assets can issue more debt to enjoy the benefits of this opportunity (Mayers et all 1977 and Scott (1972),cited by Titmans and Wessels 1988).The conveniences in debt financing terms for creditors may peruse the organizations to use equity. And the overall finding by few authors like Ferry and Jones (1979),Kim and Sorensen (1986) and Titman and Wessels( 1988) indicated negative relationship between leverage structure and asset structure. The main reason for this negative correlation is the need of lower tax shields when the higher fixed assets occur. On the other hand few authors argued that the relationship is positive between capital structure and asset structure and the main cause propose for this finding is both long and short term debt ratio are positive with short-term and long term assets (Brealey and Myers 1990, cited by Shiekh F Rahman et all 2006).According to Rajan and Zingales (1995) the higher non-current assets may provide the opportunity of debt at very low rates and create the probable chance to secure the borrowing with the assets. Another finding by Chittenden et al.,1996 also proposed positivity in the relationship between short term debt ratio and asset structure. The higher the ratio of long term debt can lead the higher value on asset structure and in the same way if the short term debt ratio is lower the ratio of fixed assets lead the higher toward the total assets so in short the long term debt representing the positive combination while the short term is indicating negative relation (Hall et al.2000 cited by Shiekh F Rahman et all 2006)

VOLATILITY IN EARNINGS IN AGE OF THE FIRM

According to many researchers the decreasing function of volatility of earnings is a measure of firm’s optimum level of debt .But the findings of Barton et all, 1989 exposed about the age of the firm can matter. The older or well established business experienced higher debt ratio and low volatility in earnings. Hall et all (2000) discussed about the pecking order theory that the mature firms can easily arrange the equity and funds which results them to not relay on short or long term debt facilities. Although the research of ( Shiekh F Rahman et all 2006) support that the age is positive in relation to long and short term debt .

SIZE:

Holmes and Dunstan, 1994 in their findings revealed that banks tend to favour large ventures as compare to small ventures. Cassar (2004) gives various reasons for relationship between capital structure and venture size. Smaller ventures as compare with large ventures have high cost of information imbalances with its loaners.the reason for this is that small ventures will not have accurate and reliable financial statements . Romano,Tanewski and Smyrnios (2001) in their findings found that in family owned ventures, size of ventures is positively related to both the amount of debt and equity use for funding assets. Fama (1985) suggested that there is negative relation between monitoring cost and venture size. Amidu (2007 ) and Titman, S and R Wessels (1988) they both had similar findings that leverage and profit have negative relationship although they found positive correlation between leverage and tax. This also supports pecking order theory as higher profits increase level of internal reserves. Although it has been noted that larger companies are now taken securitized debt rather than long term bank debt & this is one of the reason that banks now gives long term debt to small organizations.

Profitability :

Modigliani and Miller (1963) argue that debt is preferable than equity due to the deduction of tax from interest payments. Companies that are high profitable would choose high levels of debt to get the benefit of tax shield. Some researchers suggest that companies prefer raising capital from retained earning then from debt and last from raising new equity. Barbosa and Moraes (2003) argue that it is widely accepted that there is negative relation between the concept of capital structure and profitability .Marsh (1982) argues that the need that if equity were increased from profitability then debt funding would decrease. Some authors such as Jensen (1986) have argued that managers would prefer a low debt ratio. This shows that there is less demand for debt financing when a company is profitable, it has less need for debt financing (see,for instance, Rajan and Zingales, 1995). Hall et al. (2000) use this argument in their study on SMEs, when they hypothesize that profitability would indicate less need for financing from debt. There are some authors (see Roden and Lewellen, 1995 ; Gale, 1972) where researchers have argued that the relationship between profitability and capital structure is positive.

Non Debt Tax shield

Masulis & DeAngelo devised a model of optimum capital structure that integrates the affect of personal and corporate taxes and non debt related tax shields. In their study they found the substitutes for the tax benefits of debt financing that are tax deductions for investment tax credits and for depreciation. According to them less debt is found in capital structure of those companies who have large non debt tax shields. Ratios that indicate the non debt tax shields are as follows: Non debt tax shields over total assets, Depreciation over total assets, investment tax credits over total assets.

Uniqueness:

In March 1984 titman devised a model in which bankruptcy status is linked with companys liquidation decision, this means that the liquidation cost which company impose on their employee and client are relevant to their capital structure decisions. The relation between debt ratios and uniqueness is said to be negative because of the following reasons: In the event of liquidation the company who produce unique product may pass its customers and client high costs.And as the product is unique the customers may find it difficult to get alternate product and the company’s employee’s specific skills may become useless. Ratios that indicate uniqueness are as follows Quit rates ,selling expenses over sales & Research and development over sales. R& D ratio calculates uniqueness because companies that sell products with close substitute’s are likely to do less research and development since their innovations can be more easily duplicated. In addition, successful research and development projects lead to new products that differ from those existing in the market. Firms with relatively unique products are expected to advertise more and, in general, spend more in promoting and selling their products. Hence, SEIS is expected to be positively related to uniqueness. However, it is expected that firms in industries with high quit rates are probably relatively less unique since firms that produce relatively unique products tend to employ workers with high levels of job-specific human capital who will thus find it costly to leave their jobs.

Tangibility:

The effect of the values of assets on company’s leverage level is determined by the tangibility of asset, In the event of financial distress the value for debt is higher than the liquidation value of the asset, the lender face low risk with tangible asset so thereford charge low risk premium. Loaners face risk of moral hazard and negative selection due to the conflict of interest between debt providers and shareholders. To measure the tangibility some author use fixed assets to the total assets ratio. Tangilibily has negative relation with long term bank borrowing where as short term debt elements therefore tangibility has influence on bank borrowing whether long term or short term.

Conclusion & Recommendations:

In this heading I have given conclusion of this assignment I made above and I ended this by giving my recommendations. Many determinants of capital structure have been identified to be influential for capital decision making of the organization. Profitability & Tangibility of assets positively correlated with long term debt. no significant correlation was found in total current liabilities. During 1991-1997, larger companies preferred long-term securitized debt instead of long-term bank debt (Bevan and Danbolt, 2000) But the latter result proposed that bankruptcy Amidu, 2007 research revealed information of Banking sector of Ghana, in his research positive relation between tax, earning and size and leverage where as negative relation is found between profitability and leverage.According to Titman and Wessels, 1988, that small companies prefer short-term loan to rely on rather than long term loan which led them towards high cost. Thus Small firms are unable to cope with long term debt financing and the only viable option is to utilised short term borrowing facilities & with this assumptions smaller firms are more likely to be in the bankruptcy phase. Uniqueness is negatively co-related with debt component of capital structure however no association is found among volatility, asset structure and non-debt tax shields. Operating income, Growth of total assets & Bankruptcy cost has negative relation to leverage on the other hand debt tax shield helps to increase its leverage. Hence in long term debt finance growing firms suffer more, relative to other firms.

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AN EXPLANATION OF THE THEORIES ON CAPITAL STRUCTURE. (2017, Jun 26). Retrieved February 7, 2023 , from
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