Primary Theoretical Themes Explaning Capital Structure Vagueness

Capital structure is one the arguable area of financial research and the mystery of debt and equity equation in firms’ capital structure is not completely clarified. However, the tax shield benefit of debt financing obviously accepted and understood by both financial managers and researchers. There are three approaches of capital structure. At on extreme, net income (NI) approach (Durand, 1952) states that firm can lessen its cost of capital and thus increase its value by debt financing. In contrast, net operating income (NOI) approach, also proposed by Modigliani and Miller (1958) claims that firm’s value and capital structure are independent and debt and equity financing create the same value.

Solomon (1963) introduced intermediate approached of capital structure, also known as traditional approaches, which explains that the firm’s value increase when financial leverage rises and it becomes constant on designated level of debt and finally the firm’s value decrease. In fact this approach holds the concept of optimal capital structure. In other word, the companies should have a target capital structure and follow it in order to increase firms’ value. Various theories of capital structure have been developed during past five decades that mainly tried to illustrate relation between capital structure and firms value, and also find important factors of effect capital structure selection. At the same time, vast amount of empirical studies have tried to test and confirm capital structure theories, however, they have shown various results regarding effectiveness of these theories.

The aim of this chapter is to introduce the primary theoretical themes that have evolved to explain capital structure vagueness. It is also intended to review the main empirical research that have been studied to test correlation between firms characteristics and capital structure to present some of the evidence that have been collected. The structure of this chapter is as follows. Main capital structure theories are explained in section 2.2, in section 2.3 firms’ characteristics and capital structure are discussed, and results of selected empirical studies are reviewed in section 2.4.

2.2 Capital structure theories

Modigliani and Miller (1958) introduced modern theory of capital structure known as MM theory that basically considered as a foundation of modern corporate finance. Modigliani and Miller theorem consist of two distinct propositions under certain assumptions. The two propositions declared under assumption of perfect capital market and in the absence of bankruptcy cost, transaction cost, symmetry information and the world without tax.

MM Proposition I: argue that the firm’ value and capital structure are independent, it means that whatever capital structure selected for the firm the value would be the same. In other word under this proposition, the value of levered firm (VL) is the same as unlevered one (VUL) and managers should not worry about the firm capital structure and they can freely choose whatever composition of debt and equity.

VL=VUL

MM Proposition II: claims that cost of equity increase with leverage because risk to equity rise as well, so weighted average cost of capital remain constant as lower cost of debt compensate with higher cost of equity. In other world, cost of equity remains constant with any degree of leverage, and it is a linear function of debt equity ratio.

However, Modigliani and Miller (1963) evolved their propositions under presence of corporate tax rate (t) while keeping other assumptions. They argue that the value of firms increase with rise of financial leverage as they do not pay tax on their interest paid (D) to debt holders. Furthermore, weighted average cost of capital is not constant and result of linear function of debt to equity ratio. Because ,firm do not pay tax on interest paid to debt holders ,weighted average of cost of capital decreases as financial leverage rises.

VL=VUL+ tD

Friend and Lang (1988) states that there is a negative relation between profitability and Debt which is inconsistent with MM theory as the more profitable firm should use more debt in order to increase tax shield benefit of debt. Modigliani and Miller propositions are difficult to test directly (Myers,2001).Furthermore, Fosberg and Paterson (2010) points out MM theory have been rarely tested by researchers in an exact form described by MM; however there has been some testing of application of theses propositions. Fosberg and Paterson (2010) tested MM equation in the exact form specified by MM and concluded that:

“…neither the MM tax nor the no-tax valuation equations are accurate predictors of firm value. Specifically, the value of the unlevered firm accounts for much less of firm value than predicted and the sign of the coefficient of the interest tax shield variable is negative, instead of positive as MM predict.”

However, MM theory is not applicable in real world with transaction and bankruptcy cost.

2.2.1 Pecking order theory

The pecking order theory (Myers and Majluf, 1984) is a capital structure model based on asymmetry of information between insiders and outsiders that first introduced by Donaldson (1961). The main idea of this theory is that managers have private information about firm’s performance, projects and prospective which are not available for outsider investors, so the selection of firm’s capital structure shed light on outside investors about information of insiders. Consequently, investors will perceive investment decision without issuing securities as a positive signal, while they considered issuing share as negative sign that reduce share price which they willing to pay. The information asymmetry may bring about manager give up positive NPV projects in order to avoid share price falling, since they assume to act in interested of shareholders. To eliminate this underinvestment problem, managers try to finance new projects in a way that is not undervalued by market.

According to this theory (Meyer, 1984), there is no specific target capital structure for the firms. It states that in pecking order model firms adopt hierarchical order of financing, which means that managers prefer internal financing over external financing and debt over equity whenever external funding is unavoidable; also mangers prioritize short debt over long term debt. Internal funds compel no floatation cost and need no disclosure of financial information and firm prospects including firm’s potential gain and investment opportunities. The pecking order theory envisages that amount of debt goes up when investment exceeds internal funds and decrease when amount of investment is fewer than internal financing resources. So as long as firm‘s cash inflow exceed firm’s capital expenditure, there is no need for external financing.

Since introducing pecking order theory in 1984, some empirical studies have been conducted to test this theory, Shyam-Sunder and Myers (1999) studied small sample of firms from 1971 to 1989 and find supporting result for pecking order model. Frank and Goyal (2003) used a large sample of the firm and find less supportive result for pecking order theory .However, they point out that larger firms show better pecking order model performance than smaller firms which is in line with to pecking order theory. Since smaller firms have higher potential for information asymmetry than larger firms, which is main deriver of pecking order theory. De Jong et al (2010) studied US firm over 1971-2005 and find that small firms do not behave according to pecking order theory that support notion of asymmetry information in pecking order model.

Vidal and UGED (2005) describe limitation for M