Capital structure is the way a company finances itself by combining long term debt, specific short term debt, and equity (Ross et al., 2005; Hsiao et al., 2009). It shows how a company finances its overall operations and growth by using different sources of funds. Capital structure of companies varies with its size, type and some other characteristics such as age of company, company size, asset structure, profitability, company growth, company risk and liquidity (Al-Najjar and Taylor, 2008).

The purpose of managing capital structure is to mix the financial sources in order to maximize the wealth of shareholders and minimize the company’s cost of capital (Ross et al., 2005). Therefore, one of a financial manager’s responsibilities is to manage and decide the optimal capital structure for the purposes. His/her decision on capital structure could be critical because it may affect the company values and it involves a trade-off between risk and return. A rise in debt will increase the company’s risk and the expected return. High risk means an increase in debt which could lead to a decrease in stock price and an increase in the expected return of stock price (Brigham and Houston, 2001). Hence, the motivation of an optimal capital structure is to ensure the balance between risk and return in order to maximize the stock price (Brigham and Houston, 2001). Based on the existing literature, which will be discussed below, the decision on capital structure should consider several main factors such as business risk, tax position, financial flexibility, and managerial conservatism or aggressiveness.

Business risk is a risk that involves operating activities of a company, when the company does not finance these activities with debt. Higher business risk means lower optimal debt ratio. According to Brigham and Houston (2001), business risk is the risk associated with the projections of a company’s future return on assets (ROA), or return on equity (ROE) if the company uses no debt. Business risk depends on several factors (Brigham and Houston, 2006).

Variability of demand. Stable demand of a product makes lower business risk, ceteris paribus.

Variability of sales price. A company which sells a product in stable market can avoid from business risk. The stable market refers to market of a company in an industry that tends to be stable.

Variability of input costs. A company with established input costs will have lower business risk.

Ability to adjust output prices for changes in input prices. If the company is able to do adjustment for output prices for changes in input prices, it will reduce business risk.

Ability to develop new products given cost efficiency.

Foreign risk exposure. A high profit which is gained from overseas operation means higher business risk.

Operating leverage. If a company uses more fixed costs than other types of costs and the demand of its products decline, the company has a higher possibility to experience business risk.

Tax position of a company. The main reason to use debt for financing is to decrease earnings before taxes and to increase tax saving (Brigham and Houston, 2006).

Financial flexibility is an ability of a company to get capital to fulfill its needs for funds in a certain condition or under less than ideal conditions (Brigham and Houston, 2006). Gamba and Triantis (2008) stated that financial flexibility indicates the ability of a company to access and restructure its financing at a low cost. Companies which have financial flexibility are able to avoid financial distress and to fund investment when the profitable opportunities come (Gamba and Triantis, 2008). Flexibility means the capital structure should have borrowing power, which can be used in conditions that come due to favorable capital market, and government policies (Ramagopal, 2008). Companies which have strong balance sheet will be able to get funds with reasonable terms than other companies in the period of economic downturn (Brigham and Houston, 2006).

Managerial conservatism or aggressiveness. Most of management in companies tends to use debt financing to increase profit (Brigham and Houston, 2006).

2.2. Theory of Capital Structure

1. Modigliani-Miller Theory

The Modigliani-Miller Theory is the first theory of modern capital structure. It is the fundamental and modern philosophy of capital structure, which states that ca