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ABSTRACT
Over the years, numerous theories and studies on Capital structure have appeared. ... In 1958 they put forward their “M&M capital structure irrelevance proposition. ...
The paper then goes on to build in the effects of taxes, bankruptcy and it’s attendant costs until the ‘mainstream’ Trade-off Model also (known as the Optimal Capital Structure model) emerges. ...
The Pecking Order theory, and the closely related Signaling theory are intriguing alternatives to the explanation of Capital Structure. ... The paper examines these two competing theories and determines which one better explains a firm’s Capital Structure decision. Finally, it observes what influences Capital Structure choices between countries and different industries.
The paper concludes that although Capital Structure is important, Capital Structure theories on their own fail to explain a firm’s Capital Structure decision completely.
Instead, it seems that firms follow a combination of the theories, with each theory filling a gap of the Capital Structure puzzle. ... What is Capital Structure ? ... Theories on Capital Structure 4
3. ... The Capital Structure Decision : International Evidence 19
7. ... INTRODUCTION
Capital Structure theory is one of the most puzzling issues in the corporate finance literature. Even after four decades of numerous studies and theories on the subject of capital structure, researchers are still puzzled by their inability to provide a simple and concise answer.
Franco Modigliani and Merton Miller were who sparked interest in capital structure theory. ...
Much the financial literature since then has revolved around different theories that try to explain just exactly what does matter in determining capital structure. ... One of them is the Static Trade-off theory based on the trade-off between advantages and disadvantages of using debt and the attainment of an optimal capital structure. ... firms do not maintain a target capital structure. ...
The paper concludes with a look at which theories South African managers follow in practice and whether capital structure choices are influenced by the same factors across different countries. ... WHAT IS CAPITAL STRUCTURE?
Capital Structure refers to the mix of different securities issued by a firm to finance the investments. In a simplified context, it is the proportion of financing from debt and from equity capital. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The capital structure decision centres on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value. But aside from this decision, a firm must manage its capital structure. Imperfections in capital markets, taxes, and other practical factors influence the managing of capital structure. Imperfections may result in a capital structure less than the theoretical optimal. (Groth et al, 1997)
Essentially, managers should choose the capital structure that they believe would have the highest firm value, as it is this capital structure that maximizes shareholders’ interests. ... THEORIES ON CAPITAL STRUCTURE
3.1 THE MODIGLIANI AND MILLER THEOREM
France Modigliani and Merton Miller opened the debate on capital structure. ... ) Capital markets are perfect
· Information is free of costs and available to everyone. ...
M&M with zero taxes (1958)
Proposition I: Capital Structure irrelevance:
The value of a firm is independent from its capital structure; therefore the value of a levered firm will be equal to the value of an otherwise identical unlevered firm.
(Ross et al, 2001)
Therefore a firm’s capital structure is irrelevant. ...
VU = VL = PBIT
WACC
Where:
VU = value of an unlevered firm
VL = value of a levered firm
PBIT = profit before interest and taxes
WACC = the weighted average cost of capital
Proposition II:
The required rate of return on equity in a levered firm increases with the degree of leverage. ...
Do real-world managers follow M&M by treating capital-structure decisions with indifference? ...
For this reason, adding debt to a company’s capital structure lowers its expected tax liability and increases its after-tax cashflow.
Therefore, once we include taxes, capital structure definitely matters. ... This leads us to the illogical conclusion that the optimal capital structure is 100% debt. (Ross et al, 2001)
Observing the behaviour of the weighted average cost of capital when taxes is included can also see this conclusion: the firm’s WACC will decrease as the firm relies more heavily on debt financing (refer to figure 2). ...
Proposition II :
The cost of equity, RE, is (Ross et al, 2001):
RE = RU + ( RU - RD ) x D/E x ( 1 - TC )
Where: RU is the unlevered cost of the capital. ... that they should have (almost) 100% debt in their capital structures. ... This section lists some of the market imperfections M&M refused in their theory and their influence on the capital structure of a firm. ... But some investors who receive equity income (Capital Gains) are taxed at a lower rate and can defer any tax by choosing not to realize those gains. ...
The value of a levered company (with Personal and Corporate Taxes) is now expressed as (Ross et al, 2002):
VL = VU + [ { 1 - ( 1 - TC ) x ( 1 - TS ) x D ]
( 1 - TD )
Where: TD is the personal tax rate on debt income (ordinary income)
TS is the personal tax rate on equity income (capital gains)
Leverage may increase, decrease or have no effect on firm value depending on the tax rates, TD and TS, (Ross et al, 2002) :
· If TD = TS , both interest and dividends are taxed at the same personal rate. ... However, personal income tax favour equity over debt (because stocks provide tax referral and a lower capital gains tax rate). ...
Companies whose values consists primarily of intangible investment opportunities – will choose low-debt capital structures because such firms are likely to suffer the greatest loss in value from this underinvestment problem. ... Whether or not the firm ultimately goes bankrupt, the net effect is a loss of value because the firm chose to use debt in its capital structure. ... 2 THE STATIC TRADE-OFF THEORY
The theory begins with the idea of an optimal capital structure. ...
This naturally leads us to the idea that a firm’s capital structure decision can be thought of as a trade-off between the tax benefits of debt and the costs of financial distress. The trade-off theory is easily understood under the basic underlying tenet of optimizing value – and thus shareholder wealth – by choosing a capital structure combination which elicits the lowest possible cost of capital for the firm (refer to fig. ...
Another assumption of the model is that the optimal capital structure is a function of several variables including the business risk of the company i. ... Overtime, as the industry’s business risk change, one would expect the firm’s optimal (target) capital structure to change. The (lower) higher the business risk of a company, the greater (less) the proportion of debt it should use in it’s financial structure. Finally, the theory implies that all firms of the same industry will be knowledgeable of the same target capital structure. (Claggett, 1991)
Its important to note that no equation exists to exactly determine a firm’s optimal capital structure. ... 1 EMPIRICAL EVIDENCE
Much of the documented evidence on capital structure supports the conclusion that there is an optimal capital structure and that firms make financing decisions and adjust their capital structure to move closer to this optimum. ... ( Ross et al, 2002)
The theory poses some important implications for capital structure: since dividends leave the firm, they reduce free cash flow. ... Recognition of this information asymmetry between managers and investors has led to two distinct but related theories of capital structure decisions, namely: the Signaling theory and the Pecking Order theory. ... Thus, adding more debt to a firm’s capital structure can serve as a positive signal of higher future cashflows and that the firm feels strongly about it’s ability to service debt into the future. ... A recent study has found that 68% 0f firms capital expenditures come from retained earnings, 31% from debt financing, and the remaining 1% from common stock issuing. ... THE TRADE-OFF THEORY
The trade-off model implies a static approach to financing decisions based upon
a target capital structure, while the pecking order theory allows for the dynamics
of the firm to dictate an optimal capital structure for a given firm at any particular
point in time. ... (Ross et al, 2002) :
· There is no target or optimal capital structure, rather firms follow a pecking order of incremental financing choices that places internally generated funds at the top of the order, followed by debt issues, and finally, only when a firm reaches it’s ‘debt capacity’, new equity financing. ...
The pecking order theory, however, does not explain the influence of taxes, financial distress, security issuance costs, agency costs, or the set of investment opportunities available to a firm upon that firm’s actual capital structure. ... 1 Reported practice
Two surveys (Liesz, 2002) examining capital structure decisions revealed very
similar results. ... The results are shown below:
Reported Use of Financing Decision Methodologies (Liesz, 2002)
RESPONDENT % USING % USING
GROUP TARGET HIERARCHY
CAP STRUCTURE
Fortune 500 Firms 31% 69%
Large OTC firms 11% 89%
It is obvious that in practice financial managers are much more likely to use a
hierarchical approach than a target capital structure rationale when making financial
decisions. ... capital markets. ... Empirical evidence
Numerous conflicting studies have emerged to determine which of the predominant theories of capital structure, the Pecking order or Trade-off theory, best describes the financing choices of corporations (Lemmons, 2002) :
· Shyam-Sunder and Myers (1999) reject the static theory and find strong confirmation for pecking order behaviour. ... Capital structure choices of some firms can be described by the static theory, while others by the pecking order. ... THE CAPITAL STRUCTURE DECISION : INTERNATIONAL EVIDENCE
We now turn to a brief examination of the empirical validity of the trade-off and pecking order theories across different countries and across different types of firms taking into account institutional settings and constraints. ...
· The effect of taxes on leverage: the existing literature on international capital structure difference claims that taxes have no explanatory power. ... The effect of ownership concentration on capital structure is slightly ambiguous. ...
Next, Rajan and Zingales (1995) tried to determine whether capital structure in other countries are influenced by the same (within country ) factors that influence the capital structure of U. ... CONCLUSION
It is evident that capital structure is important for a firm. However, financial economists are still not sure how companies choose their capital structure. Apparently, economic reality is too complex to fit in a theory; thus, none of the theories, on their own, can completely explain the capital structure of a firm. ... Each theory fills in a small gap of the capital structure puzzle. ... While the traditional trade-off model is useful for explaining corporate debt levels, the pecking order theory is superior for explaining capital structure changes.
Recent research suggests that perhaps a hybrid theory, between the trade-off theory and the pecking order theory, is the next step in the ongoing quest to explain how firms manage the capital structures. In fact, most dominant approaches of capital structure theory and empirical research assume that managers mechanistically make a conscious choice to follow either a target or pecking order approach, ignoring the possibility that they could be using a combination of both. ...
With regard to international evidence of capital structure decisions, firm leverage and influencing factors are fairly similar across the first world countries – although the differences that exists are not easily explained by institutional differences, as previously thought. ... (1991), Capital Structure Convergent and Pecking Order Evidence
Review of Financial Economics, 1 (1)
· Dissanaike, G. ... , (2001), Differentiating Debt Target from Non-Target Firms : A Empirical Study on Corporate Capital Structure
· Groth. ... , (1997), Capital Structure : Perspective for Managers, 35 (7/8)
· Lemmon, M. ... (2001), Debt Capacity and Tests of Capital Structure Theories {on line}. ... Target Adjustment Model against Pecking Order model of Capital Structure {on line}. ... Doc
· (No date) Capital Structure Theory { on line }. ... edu / yang / finan665 / notes / capital structure 3 . ... Does Capital Structure really matter ? ... (1995), What do we know about Capital Structure ? ... , (1999), Testing Static Trade-off against Pecking Order Models of Capital Structure. ...
SAAA Biennial International Conference Proceedings, Port Elizabeth, June, 649-671
DIAGRAMS
FIGURE 1:
The cost of equity and the WACC : M&M Propositions I and II with no taxes
FIGURE 2:
The cost of equity and the WACC : M&M Proposition II with taxes
FIGURE 3:
The Static theory of capital structure: The optimal capital structure and the value of the firm.
FIGURE 4:
The Static theory of capital structure : The optimal capital structure and the cost of capital.
ABSTRACT
Over the years, numerous theories and studies on Capital structure have appeared. ... In 1958 they put forward their “M&M capital structure irrelevance proposition. ...
The paper then goes on to build in the effects of taxes, bankruptcy and it’s attendant costs until the ‘mainstream’ Trade-off Model also (known as the Optimal Capital Structure model) emerges. ...
The Pecking Order theory, and the closely related Signaling theory are intriguing alternatives to the explanation of Capital Structure. ... The paper examines these two competing theories and determines which one better explains a firm’s Capital Structure decision. Finally, it observes what influences Capital Structure choices between countries and different industries.
The paper concludes that although Capital Structure is important, Capital Structure theories on their own fail to explain a firm’s Capital Structure decision completely.
Instead, it seems that firms follow a combination of the theories, with each theory filling a gap of the Capital Structure puzzle. ... What is Capital Structure ? ... Theories on Capital Structure 4
3. ... The Capital Structure Decision : International Evidence 19
7. ... INTRODUCTION
Capital Structure theory is one of the most puzzling issues in the corporate finance literature. Even after four decades of numerous studies and theories on the subject of capital structure, researchers are still puzzled by their inability to provide a simple and concise answer.
Franco Modigliani and Merton Miller were who sparked interest in capital structure theory. ...
Much the financial literature since then has revolved around different theories that try to explain just exactly what does matter in determining capital structure. ... One of them is the Static Trade-off theory based on the trade-off between advantages and disadvantages of using debt and the attainment of an optimal capital structure. ... firms do not maintain a target capital structure. ...
The paper concludes with a look at which theories South African managers follow in practice and whether capital structure choices are influenced by the same factors across different countries. ... WHAT IS CAPITAL STRUCTURE?
Capital Structure refers to the mix of different securities issued by a firm to finance the investments. In a simplified context, it is the proportion of financing from debt and from equity capital. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The capital structure decision centres on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value. But aside from this decision, a firm must manage its capital structure. Imperfections in capital markets, taxes, and other practical factors influence the managing of capital structure. Imperfections may result in a capital structure less than the theoretical optimal. (Groth et al, 1997)
Essentially, managers should choose the capital structure that they believe would have the highest firm value, as it is this capital structure that maximizes shareholders’ interests. ... THEORIES ON CAPITAL STRUCTURE
3.1 THE MODIGLIANI AND MILLER THEOREM
France Modigliani and Merton Miller opened the debate on capital structure. ... ) Capital markets are perfect
· Information is free of costs and available to everyone. ...
M&M with zero taxes (1958)
Proposition I: Capital Structure irrelevance:
The value of a firm is independent from its capital structure; therefore the value of a levered firm will be equal to the value of an otherwise identical unlevered firm.
(Ross et al, 2001)
Therefore a firm’s capital structure is irrelevant. ...
VU = VL = PBIT
WACC
Where:
VU = value of an unlevered firm
VL = value of a levered firm
PBIT = profit before interest and taxes
WACC = the weighted average cost of capital
Proposition II:
The required rate of return on equity in a levered firm increases with the degree of leverage. ...
Do real-world managers follow M&M by treating capital-structure decisions with indifference? ...
For this reason, adding debt to a company’s capital structure lowers its expected tax liability and increases its after-tax cashflow.
Therefore, once we include taxes, capital structure definitely matters. ... This leads us to the illogical conclusion that the optimal capital structure is 100% debt. (Ross et al, 2001)
Observing the behaviour of the weighted average cost of capital when taxes is included can also see this conclusion: the firm’s WACC will decrease as the firm relies more heavily on debt financing (refer to figure 2). ...
Proposition II :
The cost of equity, RE, is (Ross et al, 2001):
RE = RU + ( RU - RD ) x D/E x ( 1 - TC )
Where: RU is the unlevered cost of the capital. ... that they should have (almost) 100% debt in their capital structures. ... This section lists some of the market imperfections M&M refused in their theory and their influence on the capital structure of a firm. ... But some investors who receive equity income (Capital Gains) are taxed at a lower rate and can defer any tax by choosing not to realize those gains. ...
The value of a levered company (with Personal and Corporate Taxes) is now expressed as (Ross et al, 2002):
VL = VU + [ { 1 - ( 1 - TC ) x ( 1 - TS ) x D ]
( 1 - TD )
Where: TD is the personal tax rate on debt income (ordinary income)
TS is the personal tax rate on equity income (capital gains)
Leverage may increase, decrease or have no effect on firm value depending on the tax rates, TD and TS, (Ross et al, 2002) :
· If TD = TS , both interest and dividends are taxed at the same personal rate. ... However, personal income tax favour equity over debt (because stocks provide tax referral and a lower capital gains tax rate). ...
Companies whose values consists primarily of intangible investment opportunities – will choose low-debt capital structures because such firms are likely to suffer the greatest loss in value from this underinvestment problem.
Approximate Word count = 15214
Approximate Pages = 60.9
(250 words per page double spaced)
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