The Relationship Between Capital Structure

Published Date: 02 Nov 2017

Abstract

Capital structure is the mixture of debt and equity financing, Its choice and determinants related to many different factors. This paper firstly present several traditional theories discussed on capital structure, such as trade-off theory, agency cost theory and theory of pecking-order. Then the paper concluded to know the relationship between the five variables (size ,Tangibility ,Mb, Profit ,NDTS) with capital structure.

Keywords: Capital structure, Pecking-order theory, Agency costs, Tangibility, Growth opportunity.

1. Introduction

The capital structure of a firm describes the way in which a firm raised capital needed to establish and expand its business activities. It is a mixture of various types of equity and debt capital a firm maintained resulting from the

firm’s financing decisions.

More than four decades ago the modern theory of capital structure established after the publication of the celebrated paper of Modigliani and Miller (1958).

Capital structure choice has inspired and fascinated many researchers. Countless studies investigated into the explanations of firms’ capital structure choice, both theoretical studies and empirical ones. There still remains no clear answer to Myers 20 years old question (1984, p575) "How do firms choose their capital structure?" Different theories answer this question from different point of view. For instance, traditional trade-off theory postulates the existing of an optimal capital structure, which indicates the optimal choice of capital structure by firms is a balance of corporate tax shield against the bankruptcy cost and agency cost.

2. relationship between capital structure and the five factors

2.1. relationship between capital structure and the size of the firm (size)

It is generally agreed that size is positively associated with leverage. On one hand, size may be an inverse proxy for the probability of bankruptcy. Larger firms are usually more diversified and have more stable cash flow.

So the probability of bankruptcy is smaller for large firms compared with smaller ones. the large firms prefer to issue long-term debt while small firms choose short-term debt to finance their projects.

And because of the advantage of economies of scale and bargaining power with creditors, large firms bear lower costs in issuing debt and equity compared with small firms. (Michaelas. (1999)).

2.2 relationship between capital structure and the Asset tangibility of the firm (Tangibility)

Theories generally state that tangibility is positively related to leverage. Since the tangible assets can be used as collateral in external borrowing, the presence of a large fraction of tangible assets of a firm help to get bank loans at a lower interest rate and it also helps to reduce the risk the lender suffering from the agency cost of debt. Since the debts can be secured by the collateralization of tangible assets, the firm’s opportunity to engage in asset substitution is reduced by the presence of a large fraction of secured debts For firms.

with more intangible assets, the costs of capital are higher since monitoring is more difficult. Hence, a firm with a large fraction of tangible assets is expected to have more debt. We define tangibility as the book value of property, plants and equipment -total net (PPENT) scaled by total assets. (Stulz and Johnson (1985); Johnson (1997))

2.3 relationship between capital structure and the Market to book ratio (MB)

Theoretical studies generally suggest that there is a negative relationship between growth opportunities and leverage. In an underinvestment situation, firms with high growth opportunities may forgo positive NPV projects because the existing of outstanding debt (Myers(1977)).

Since the returns from such investment will be transferred to Debt holders rather than shareholders. If management pursues growth objectives, management and shareholder interests tend to coincide for firms with strong investment opportunities. In case of overinvestment, in which firms lacking investment opportunities, debt limits the agency costs of managerial discretion. So firms with high growth opportunity may not issue debt in the first place and an inverse relationship between growth opportunities and leverage is expected to hold.

use market-to-book ratio (defined as market value of assets over book value of assets) as a proxy of growth opportunities and argue two main reasons why market-to-book ratio is negatively related leverage: First, firms with high market-to-book ratios suffer higher costs of financial distress; Second, firms prefer to issue stock when the stocks are overvalued. (Rajan and Zingales (1995))

2.4 relationship between capital structure and the Profitability (Profit)

Theoretical predictions yield no consistent conclusions for the correlation between profitability and leverage. Trade-off models argue that profitable firms have greater needs to shield income from corporate tax and should borrow more than less profitable firms. While pecking order theory suggests an inverse relationship between profitability and the level of debt. Firms are assumed to prefer internal financing to external financing in a pecking order framework. This preference leads firms to use retained earnings first as investment funds and move to external financing only when retained earnings are insufficient. When facing the choice between bonds and equity, firms will prefer debt issue to equity issue. In this case, profitable firms are expected to have less debt.(Wessels (1988)).

2.5 relationship between capital structure and Non-debt tax shield (NDTS)

Interest tax shields are not the only method of reducing corporate tax burdens. The existence of non-debt tax shields provides an alternative (and perhaps less costly) means of reducing income taxes and may serve to mitigate the benefit of debt tax shields (Cloyd, 1997).

Indeed there are various non-debt tax shields, such as accelerated depreciation and investment tax credits (Allenand Mizuno, 1989).

Impact of tax effects on capital structure is measured through NDTS and TAX. There is no significant relationship between NDTS and any measure of leverage . Contradicting the theory, the tax and all measures of leverage are negatively related and the relationship is statistically significant. However the result is similar to that found in Booth et al (2001). This suggests that the mangers of PSUs have no incentive to take the advantage of tax shield and go for proper leverage. They do not attach any importance to tax effects while deciding on capital structure.

factors

relationship

size of the firm (size)

+

tangibility of the firm (Tangibility)

+

Market to book ratio (MB)

-

Profitability (Profit)

+ /-

Non-debt tax shield (NDTS)

+/-

3. the hypotheses of the study

H1 : The capital structure is positively related to the size of the firm.

H2 : The capital structure is positively related to the tangibility of the firm.

H3: The capital structure is negatively related to the Market to book ratio.

H4: The capital structure is positively related to the Profitability.

H5: The capital structure is positively related to the Non-debt tax shield.

4. measure for variable

4.1 the size of the firm

- Performance and quality

- Number of shareholders

- Profitability

4.2 the tangibility of the firm

- Reputation

- Brands

- International Agencies

4.3 the Market to book ratio

- Profitability

- Expansion of the company

- Company policy

4.4 the Profitability

- earning per share (returns equity)

- The size of assets and liabilities (return on assets)

4.5 Non-debt tax shield

- Profitability