Capital Structure Lit Review

Topics: Corporate finance, Finance, Debt Pages: 17 (6250 words) Published: April 15, 2013
Corporate Financial Management
Literature Review on Capital Structure

Date: 7\12\2012
Name: Tudor Gheorghiu
Student Id: 12254888

Theories on Capital Structure3
Modigliani and Miller theory on capital structure3
Other theories relating to the firm`s capital structure4
Trade-off theory4
Pecking order theory5
Agency theory6
Choosing between theories7
Empirical evidence7
Developed countries:7
Emerging markets:9
Capital structure of privatised firms10
Factors affecting the optimal level of capital structure11
Personal taxes11
Cross-country determinants of capital structure11
Are determinants country or firm specific- small and medium enterprises12
Supply side determinants of capital structure12

One of the most debated issues in financial literature relates to the topic of capital structure. The theory of capital structure is important for firms as they are constantly making investment choices driven by financing decisions. Theories on this topic attempt to explain the sources and the financial strategies the firms might attempt to follow. The purpose of this paper is to provide a review of some of the financial literature relating to the determinants of capital structure. The most cited theoretical frameworks used to explain the firm`s financing decisions will be presented as well as empirical evidence to support those theories. Furthermore, studies conducted on specific market segments, such as emerging or developed markets will be reviewed along with the main factors affecting the optimal level of capital structure. The outline of the paper is as follow: Section 1 will present the Modigliani and Miller theory as well as three other theoretical frameworks: the trade-off theory, the pecking order theory and the agency theories. Section 2 presents evidence relating to capital structure at an international level, focusing on emerging and developed markets as well evidence relating to privatised firms. Following this, section 3 will provide an overview of the main factors affecting capital structure and lastly section 4 will present the conclusion. Theories on Capital Structure

Modigliani and Miller theory on capital structure
In order to understand the theory of capital structure it is essential that the Modigliani and Miller theory (1958) if firstly presented and analysed. According to the first M&M theory “financing and risk management choices will not affect firm value” given a perfect capital market, a frictionless market. That is, the degree to which a firm is financed by either debt or equity will not have any effect on the value of the firm, inferring that there is no optimal leverage ratio. The MM theory applies if the following assumptions hold: 1. Total cash flows to a firm`s shareholders are unaffected by these choices and 2. the “perfect capital markets” condition holds. The first assumption is also referred to as “exogenous total cash flow assumption” (Titman 2002) and it implies no taxes and no bankruptcy costs. The second M&M theory incorporates tax advantage as a potential determinant of capital structure. According to latter theory, a firm can maximise its value due to the tax shield advantage associated with using debt. Therefore, a firm should employ more debt than equity in their capital. The first MM theorem is mentioned in the financial literature as the “neutrality proposition” or “invariance proposition”, as it shows the irrelevance of the choice of capital structure for a firm. According to the theorem, a firm`s value (the market value of its shares and debt) is equal to the present value of the its discounted cash flows, using the appropriate risk adjusted rate of return. Additionally, the theorem infers that the average cost of capital is independent of the amount of debt the company holds. This is because the effect from an increase in the amount of leverage held by a...
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