capital stracture

Topics: Finance, Corporate finance, Balance sheet Pages: 5 (1147 words) Published: September 20, 2014
E. Capital structure

5.1 Key factors that affect structure choice
5.1.1 Profitability and variation of profitability
Profitability is one of the most tested company characteristics in empirical research regarding companie’s choice of capital structure. The trade-off theory predicts that higher profitability is associated with increased debt levels and the reason for this is twofold. First, companies achieving high profitability have less risk of financial distress and bankruptcy, so the cost of debt is lower. Second, higher profitability means that companies can achieve higher utilization of the interest tax shield by increasing the amount leverage and hence the promised interest payments each period. Similarly, increased debt will serve as a disciplinary factor for managers when free cash flow likely increase with increased profitability. However, as dynamic trade-off theory predicts adjustment costs will prevent companies from adjusting the capital structure immediately and the unlikelihood of companies being at their refinancing points at the time of measurement causes the prediction of the found relationship between leverage and profitability to be negative due to the static nature of the determinant analysis. Retained earnings are the favored financing according to the pecking order theory which contradicts the predictions made by trade-off theory. Higher profitability should enable the company to retain more earnings which is the preferable source of funding, and as such, the amount of leverage needed by the company should decrease. Empirically, profitability is consistently found to be negatively related to leverage, as predicted by both theories. Therefore the following hypothesis is made

5.1.2 Asset Tangibility (Asset in place)
The thought behind asset tangibility as a determinant is that tangible assets provide more security for potential investors as assets can serve as collateral. This will reduce the risk for debt holders and ultimately reduce the cost of debt for the companies and they will be able to operate with higher leverage ratios without incurring higher financial distress costs. Accordingly, the trade-off theory predicts that companies in which tangible assets accounts for a large part of the asset structure should include larger debt levels than companies with a relatively larger amount of intangible assets. Furthermore, collateralized debt makes it difficult for investors to conduct asset substitution as the debt holders have collateral in specific assets. Therefore agency costs should be lower between shareholders and debt holders, and companies should use more debt relative to the amount of tangible assets they own. The pecking order theory makes the opposite prediction as it suggest that tangibility will generate less information asymmetries between potential investors and shareholders, and hence the cost of issuing equity will fall, resulting in lower levels of debt. Arguably, the argumentation used to predict this relationship could also be used to predict that the cost of debt will fall as they will now be able to have collateralized debt. So unless the cost of equity falls below the cost of debt, the pecking order theory implies that companies will use the cheapest sources of funding, debt would still be the preferred funding to equity, at least for moderate amounts of debt. Therefore the prediction of the pecking order theory might not be as unambiguous as some researchers argue. Based on predictions of these theories and the consistent findings in previous empirical research the following relationship between asset tangibility and leverage is expected.

5.1.3 Growth Opportunity
Growth opportunities calls for a similar reasoning as previously used to explain the predictions of asset tangibility’s effect on leverage, although with opposing conclusions. The first notion of the relationship between growth opportunities and leverage is made by Myers, who states that the...
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