Capital structure has always been one of the main topics among the studies of finance scholars. Its importance derives from the fact that capital structure is tightly related to the ability of firms to fulfil the needs of various stakeholders. The last century has witnessed a continuous developing of new theories on the optimal debt to equity ratio. The first milestone on the issue was set by Modigliani and Miller, whose model argued on the Irrelevance of the capital structure in determining firms’ value and future performance (1958). However, many authors have successively proved that a relationship between capital structure and firm value actually exists (e.g., Lubatkin and Chatterjee, 1994). The same Modigliani and Miller (1963) asserted that their model was not effective anymore if tax was taken into consideration. They demonstrated that the existence of tax subsidies on interest payments cause the value of the firm to increase when equity is traded off for debt.

Since the publication of Modigliani and Miller’s (1958) paper on capital structure, much of the debate has focused on the Pecking Order Hypothesis (POH), which has become one of the most influential theories of corporate leverage. The work on agency theory (Jensen and Meckling, 1976), information asymmetry (Myers and Majluf, 1984) and signalling theory (Ross, 1977), Myers (1984) proposed that firms prefer internal to external finance and when external funds are necessary, firms prefer debt to equity finance. This hierarchy stems from information asymmetry between managers and investors with the result that, in attempting to raise external capital, investors face an adverse selection problem and demand a premium that raises the required rate of return on external capital. Firms are better off if they meet financing needs from internally.

Structure of Literature Review

Section 2.1 Theoretical Review

capital structure theories, mainly, Trade Off Theory (TOT), Agency Theory, Information Asymmetry and Pecking Order Hypothesis.

Section 2.2 Empirical Evidence

Discussion on the Empirical Evidences, Mainly on the different factors and studies, which many researchers have been considering, using some of the Theories above.

THEORETICAL REVIEW

Section 2.1

Capital Structure Theories:

Many theories have attempted to explain the variation in debt ratios across firms. The theories suggest that firms select capital structure depending on attributes that determine the various costs and benefits associated with debt and equity financing. The explanations vary from the irrelevancy hypotheses (Modigliani and Miller, 1958) to the optimal capital structure, where the cost of capital is minimized and the firm value is maximized, hence, maximizing the wealth of the shareholders. However, these theories have been developed to explain financing preferences focusing on large listed firms. The issue of whether these findings are valid for other firms, especially SMEs, has received limited attention. Three of the most popular explanations of capital structure are the trade-off, the agency costs, and the pecking-order theories. Below a brief overview of these theories are elaborated.

Section 2.1.1 The Trade-off theory (TOT)

The TOT claims the existence of an optimal capital structure that firms have to reach in order to maximize their value. The focus of this theory is on the benefits and costs of debt. The former include essentially the tax deductibility of interest paid Modigliani and Miller (1958), while the latter are originated by an excessive amount of debt and the consequent potential bankruptcy costs, Kraus and Litzenberger (1973). Thus, firms set a target level for their debt–equity ratio that balances the tax advantages of additional debt against the costs of possible financial distress and bankruptcy.

Section 2.1.2 Agency theory

The agency theory concept was initially developed by Berle and Means (1932), who argued that due to a continuous dilution of equity ownership of large corporations, ownership and control become more and more separated. This situation gives professional managers an opportunity to pursue their own interest instead of that of shareholders (Jensen and Ruback, 1983).

In theory, shareholders are the only owners of a company, and the task of its directors is merely to ensure that shareholders’ interests are maximised. However, Jensen and Meckling (1976) observed that mangers do not always run the firm they work for to maximise shareholders’ wealth. From this observation, they developed their agency theory, which took into account the principal-agent relationship as a key determinant in determining firm performance. According to their definition, “An agency relationship is a contract under which one or more persons (the principal[s]) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent”.

The problem is that the interest of the principal and the agent are never exactly the same, and thus the agent, who is the decision-making part, tends always to pursue his own interests instead of those of the principal. It means that the agent will always tend to spend the free cash flow available to fulfil his need for self-aggrandisement and prestige instead of returning it to shareholders as argued by Jensen and Ruback, (1983). Hence, the main problem faced by shareholders is to ensure that managers will return excess cash flow to them (e.g. through dividend payouts), instead of having it invested in unprofitable projects as explained by Jensen, (1986).

Nevertheless, recent research has discovered that capital structure can somewhat cope with the principal-agent problem without substantially increasing agency costs, but simply by trading off equity for debt as explained by Pinegar and Wilbricht (1989). Lubatkin and Chatterjee (1994) argue that firms can discipline managers to run businesses more efficiently by in