Determinants of Capital Structure
Abstract
Decision on capital composition is a crucial decision for firms as it has major financial and profitability implications. The objective of this paper is to identify the determinants of capital structure and discuss the key theories on capital structure. The paper discusses they key theories of capital structure, providing evidence of the theory and listing its limitations. The MM theory is the foundation for the other modern theories of capital structure. The trade-off theory is an extension to MM theory relaxing the assumption of bankruptcy. Pecking order theory highlights the firm’s preference of internal cash flows as source of funds than external funds. Basis these theories, the paper finds that the key determinants of the capital structure are growth, firm’s size, profitability and prevailing uncertainties.
Introduction
Capital structure is an important decision for any organisation and primarily pertains to the contribution of debt and equity in a firm’s total capital employed. It is the structure of the liability side of a balance sheet that represents the sources from which funds flow into an organisational system. These funds are used up of creating short term and long term assets for the company. The optimal capital structure differs from firm to firm and depends upon a number of factors. Various theories on capital structure have differing view on the optimal capital structure of an organisation.
The objective of this paper is to discuss the key theories on capital structure and identify the determinants of capital structure. The paper is divided into three broad sections. The first section of the paper discusses the underlying theories on capital structure. The second section of the paper identifies the determinants of capital structure. The third section concludes the paper.
Theories of Capital Structure
Researches have different views on the definition of optimal capital structure. Broadly, capital structure theories are of two types, traditional theories and modern theories. Traditional and modern theories of capital structure are discussed in this section.
Traditional Theories of Capital Structure
Traditional theories of capital structure are diverse in their view of capital structure. While some of these theories suggest relevance of capital structure, others propose its irrelevance in impacting a firm’s value.
Net Income Theory
According to Baral (2004), the net income theory was initially suggested by David Durand. The theory proposes that the proportional of debt in a firm’s capital employed can affect its value. The theory assumes that debt is a low-cost source of finance as compared to equity. Thus, as the amount of debt rises in a firm’s capital, its overall capital cost reduces and overall market valuation increases. The limitation of the theory is that it ignores the increase in the cost of increased financial vulnerability that debt exposes a firm to. An over-leveraged firm has more threat of becoming insolvent due to its inability to serviced debt obligations. Equity financing has the ability of absorbing such risks.
Net Operating Income Theory
According to Baral (2004), the views of the net operating income theory contradict the proposition of the net income theory. Baral (2004) also suggests that there is no correlation between a firm’s value and its financial leverage. Financial leverage is defined as the magnitude of debt used in firm’s capital structure. It implies that composition of debt and equity does not affect changes in the firm’s market value.
Traditional Theory
According to Baral (2004), Solomon propounded the traditional theory of capital structure. Baral (2004) also maintains that this theory has features of net income theory as well as the net operating income theory. But, in contrast to the other two theories, traditional theory has a more balanced approach. This theory suggests that optimal capital structure is achieved in stages of increasing/decreasing constituents of capital in the overall capital employed.
Modern Theories of Capital Structure
The modern theories of capital structure serve as a foundation for the present day corporates and help them with their corporate capital structure employment.
Modigliani-Miller (MM) Model
The modern theory of capital structure has its roots from the research presented by Modigliani and Miller in 1958 (Harris and Raviv, 1991). The theory comprises of two main propositions considering tax free regime and another proposition with applicable taxes:
MM Proposition 1:
According to James (2012), the first proposition of MM assumes a scenario of no external costs in making capital employment decisions. It assumes that external costs like tax, insolvency and information access do not exist. James (2012) states that, under MM’s first proposition and given these assumptions, capital composition does not affect firm’s value. The theory is commonly known as capital structure irrelevance theory (Pietersz, 2012). The theory postulates that the composition of debt and equity does not change firm’s market value because it does not lead to change in firm’s cash flows. Thus, it does not impact total value of the firm. This proposition assumes a tax-free regime and treats debt and equity similarly, in terms of the claim of bond holders and shareholders.
MM Proposition 2:
In real life, bond holders have a superior claim over firm’s cash flows than shareholders. The latter have a residual claim over the earnings of a firm, thereby increasing their investment risk. This is the key distinction between MM’s first and second proposition. Unlike first proposition, second proposition assumes a superior right of bond holders on firm’s earnings than the shareholders. As a result, debt costs less than equity. But James (2012) asserts that the difference in cost of equity and debt do not impact the firm’s market value because higher equity returns net-off by higher earnings required on equity funding.
MM Proposition with taxes:
In real life, earnings are mostly taxed and interest expense is deducted from earnings reducing the overall tax burden of the firm. The third proposition of MM considers that interest is tax deductible (James, 2012). Thus, debt becomes cheaper than equity financing and firm maximizes its value at 100% debt in its capital structure. But, the proposition ignores cost of financial distress and leverage risk associated with higher amount of debt in total capital.
The importance of MM theory is that it points the direction for further research by depicting the scenarios that deem the capital structure showing immaterial (Harris and Raviv, 1991). It, thus, forms the foundation of modern theories on capital structure. According to Myers (2001), MM propositions are apt end result for regulators.
The limitation of MM theory is that it supports debt up to 100% in a firm’s capital and justifies leverage by attributing it to increased economic activity in a country. But, it ignores the fact that high leverage also adds on the higher risk of uncertainty and failure of financial structures as witnessed during 2008 global crisis (Bloomsbury Information Ltd, 2012). Moreover, in real world scenario, firms will 100% equity composition exist, but 100% debt financing do not exist (Mathiesen, 2012). This contradicts MM theory. Zhang and Li (2008) ascertain that agency costs are an important element in deciding upon firm’s capital structure. Scott Jr. (2004) highlights the possibility of bankruptcy and imperfection of secondary asset markets. Also, MM theory is based on assumptions that are applicable in a perfectly competitive market and not in real world scenarios. The further theories relax one or more of MM’s assumptions to make it relevant for real life scenarios of capital structure optimisation.
Trade-off Theory
While debt reduces the firm’s financing cost, it also increases risk of financial distress. The trade-off theory suggests the cost-benefit analysis of using debt. According to Luigi and Sorin (2009), the trade-off theory is of two types: static and dynamic. The theory was postulated by Kraus and Litzenberger and propounds that capital composition reveals a balance between tax advantages of debt financing and rise in probability of insolvency (Miglo, 2010). For example, if a firm continues to borrow funds from external sources to avail related tax benefit, there may be a point where the firm is not able to generate additional cash flows proportional to pay off the additional debt. An indirect implication of increasing debt in capital composition is the reduced capacity of to withstand external shocks.
A study conducted by Titman and Wessels in 1988 finds that the smaller firms of the United States are more prone to higher operational costs when composition of longer duration debt increases (Ziad, 2009). This study suggests that, for small firms, transaction costs may influence the composition of capital. Another research done by Bevan and Danbolt in 2004 finds that bigger firms utilise a combination of longer and shorter duration debt more often than smaller firms and firms with higher profit margins have higher inclination to use debts of short duration (Ziad, 2009). Fewer than 50% of all companies actually follow this theory (Murraystate.edu, n.d.).
Pecking Order Theory
Pecking order theory considers a real life scenario where information asymmetry exists. Given the prevalence of imperfect information between the firm and its financiers, the firm tends to will use the internally generated revenues over external debt finance, which is preferred over equity (Chen and Chen, 2010). Chen and Chen (2010) also conclude that based on pecking theory, growth and profitability are the chief determinants of capital structure.
A study conducted in Jordan on information asymmetry ascertains the pecking order theory. Ziad (2009) finds that Jordanian market is small with uneven distribution of information that requires premium for debt or equity issue. This is because the cost of monitoring such projects is high. The theory also suggests that if cash flows generated by firms are higher than the cost of financing new projects, firm’s use internal funds to pay off external obligations.
Determinants of Capital Structure
The capital structure theories highlight the key determinants of capital structure that are listed in this section.
Firm’s Profitability
Profitability is the main determinant of capital employment. The debt-equity ratio of the firm should be such that the shareholders’ value is maximised. Azhagaiah and Gavoury (2011) conducted a study that supports a positive correlation between capital composition and profitability of firm and the former has significant influence on the latter. The study also shows that the firms in IT industry tend to achieve declined net margins when the debt component in capital is increased. Ahmadini, Afrasiabishani and Hesami (2012) in their study reiterate the close relationship between capital structure and profitability based on which they suggest ways to minimise risk. Another study conducted by Xu (2012) suggests that a positive relation exists between book leverage and future expected profitability. Hence, as expectation of profitability decreases in a competitive import driven market, the leverage of the firm is also reduced. Xu also concludes that import competition alleviates uncommitted cash-flow problem by reducing profitability. Since, the profitability is less, the firm’s act in a more disciplined manner ensuring less free cash flow and availing lesser debt.
Growth and Size of Firm
Growth is the second determinant of capital structure. According to the pecking order theory, firm’s leverage and its growth are positively correlated (Ziad, 2009). This means that firm’s requirement of external funds increases as it grows bigger. On requisite of external funds, firms tend to prefer debt over equity.
Size of firm significantly influences the composition of capital structure. Chen and Hammes (2004) also suggested that firm’s size is directly correlated to firms' leverage. Kjellman and Hansen (1995) suggest that smaller firms are found to be more likely to save their proprietorship in their company.
Prevailing Uncertainties
The prevailing uncertainties pertaining to external and internal business environment significantly affect firm’s capital structure. External financing significantly reduces during slowdown of market, when economic outlook is not positive. Similarly, the existing capital structure of the firm impacts its future capital structure. If there is no existing debt in a firm, it is difficult for it to take big debt exposure in immediate futures as creditors will be apprehensive about getting back the money. High debt exposure in firm increases its financial distress cost and discourages to add on to debt exposure.
Masulis argues that markets respond favourably when companies move closer to its industry average and vice-versa (Hatfield, Cheng, Davidson, 1994).
Geography
Capital structure decision is also impacted by regional variance. Researches have had different views on this subject. On one hand, Rajagopal (n.d.) offer evidence that backs the argument that capital structure theory are portable across developed and developing nations. On the other hand, Booth, Aivazian, Kunt and Maksimovic (2001) find that although some insights of modern capital structure theories are applicable across, differences in institutional features across countries do impact capital structure decisions.
Conclusion
Capital structure is an important decision for any organisation. It pertains to the contribution of debt and equity in a firm’s total capital employed. The foundation of modern theory of capital structure was laid by Modigliani and Miller in their capital structure irrelevance theory. The theory establishes the scenarios in which capital structure will be irrelevant for firms. But, the limitation of the theory is that it does not consider distress cost and concludes that debt up to 100% can be advisable for firms. But, in real life, risk of insolvency is very high, especially in the prevailing uncertain environment. The trade-off theory incorporates the cost of bankruptcy and financial distress in the capital structure. Pecking order theory suggests that capital infusion in a firm follows a preference pattern where internal funds are preferred over external funds. Based on the theories discussed, the determinants of capital structure are profitability, growth, firm size, and prevailing uncertainties.
References
Ahmadini, H., Afrasiabishani, J. and Hesami, E., 2012. A Comprehensive Review on Capital Structure Theories. The Romanian Economic Journal, 15 (45), 3-26.
Azhagaiah and Gavoury, 2011. The Impact of Capital Structure on Profitability with Special Reference to IT Industry in India vs. Domestic Products. [Online]. Available at: < http://ideas.repec.org/a/mgt/youmgt/v9y2011i4p371-392.html> [Accessed 16 Nov 2012].
Baral, K.J., 2004. Determinants of Capital Structure: A Case Study of Listed Companies of Nepal. The Journal of Nepalese Business Studies, 1 (1), p. 1-11.
Bloomsbury Information Ltd, 2012. Understanding Capital Structure Theory: Modigliani and Miller. [Online]. Available at: < http://www.qfinance.com/balance-sheets-checklists/understanding-capital-structure-theory-modigliani-and-miller> [Accessed 17 Nov 2012].
Booth, L., Aivazian, V., Kunt, A.D. and Maksimovic, V., 2001. Capital Structure in Developing Countries. The Journal of Finance, 56 (1), p. 87-130.
Charalambakis, E.C., Espenlaub, S.K. and Garrett, I., 2008. On the Impact of Financial Distress on Capital Structure: The Role of Leverage Dynamics.
Chen, Li-Yu and Chen, Shun-Yu, 2010. How the Pecking-Order Theory Explain Capital Structure. [Online] Available at: < http://www.jimsjournal.org/10%20Li-Ju%20Chenpdf.pdf> [Accessed 17 Nov 2012].
Chen, Ying Hong and Hammes, Klaus, 2004. Capital Structure Theories and Empirical Results – A Panel Data Analysis. [Online] Available at:
Harris, Milton and Raviv, Artur, 1991. Milton Harris and Artur Raviv. The Journal of Finance, 46 (1), pp. 297-355
Hatfield, G.B., Cheng, L.T.W and Davidson III, W.N., 1994. The Determination of Optimal Capital Structure: The Effect of Firm and Industry Debt Ratios on Market Value. Journal of Financial and Strategic Decisions, 7 (3), p. 1-14
James, Chad M., 2012. Modigliani-Miller and Capital Structure Theory. [Online] Available at: < http://financetrain.com/modigliani-miller-and-capital-structure-theory/> [Accessed 17 Nov 2012].
Kjellman, A. and Hansen, S., 1995. Determinants of Capital Structure: Theory vs. Practice. Scandinavian Journal of Management, 11 (2), p. 91-102.
Luigi, P. and Sorin, V., 2009. A Review of the Capital Structure Theories. [Online] Available at: < http://steconomice.uoradea.ro/anale/volume/2009/v3-finances-banks-and-accountancy/53.pdf> [Accessed 19 Nov 2012].
Mahmud, Muhammad, 2003. The Relationship between Economic Growth and Capital Structure of Listed Companies: Evidence of Japan, Malaysia, and Pakistan. [Online] Available:
Mathesien, H., 2012. Model: The irrelevance of capital structure in perfect capital markets. [Online] Available at: < http://e.viaminvest.com/A7CapitalStructures/Perfect/Model_IrrelevOfCapStruc.asp> [Accessed 17 Nov 2012].
Miglo, Anton, 2010. The Pecking Order, Trade-off, Signalling, and Market-Timing Theories of Capital Structure: A Review. [Online]. Available at: < http://www1bpt.bridgeport.edu/~amiglo/ReviewCapStrSSRN.pdf> [Accessed 17 Nov 2012].
Murraystate.edu (n.d.). optimal Capital Structure. [Online] Available at: < http://campus.murraystate.edu/academic/faculty/lguin/FIN330/Optimal%20Capital%20Structure.htm> [Accessed 17 Nov 2012].
Myers, S.C., 2001. Capital Structure. The Journal of Economic Perspectives, 15 (2), p.81-102.
Pietersz, Gareme, 2012. Capital Structure Irrelevance. [Online] Available at:
Rajagopal, Sanjay, n.d. The Portability of Capital Structure Theory: Do Traditional Models Fit in an Emerging Economy? Journal of Finance and Accountancy, p. 1-17
Scott Jr, J.H., 1976. A Theory of Optimal Capital Structure. The Bell Journal of Economics, 7 (1), p. 33-54
Tong, G. and Green, C.J., 2004. Pecking Order or Trade-off Hypothesis? Evidence on the Capital Structure of the Chinese Companies. [Online] Available:
Xu, Jin, 2012. Profitability and Capital Structure: Evidence from Import Penetration, Journal of Financial Economics, [Online]. Available at: < http://www.sciencedirect.com/science/article/pii/S0304405X12000979> [Accessed 17 Nov 2012].
Zhang, He and Li, Steven, 2008. The Impact of Capital Structure on Agency Costs: Evidence from UK Public Companies. [Online] Available at:
Ziad, Zurigat, 2009. Pecking order theory, trade-off theory and determinants of capital structure: empirical evidence from Jordan. [Online]. Available at: < http://www.ros.hw.ac.uk/bitstream/10399/2244/1/ZurigatZ_0309_sml.pdf> [Accessed 17 Nov 2012].
