Assignment No. 2
Determinants of capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. Simply, capital structure refers to the mix of debt and equity used by a firm in financing its assets. The capital structure decision is one of the most important decisions made by financial management. The capital structure decision is at the center of many other decisions in the area of corporate finance. These include dividend policy, project financing, issue of long term securities, financing of mergers, buyouts and so on. One of the many objectives of a corporate financial manager is to ensure the lower cost of capital and thus maximize the wealth of shareholders. Capital structure is one of the effective tools of management to manage the cost of capital. An optimal capital structure is reached at a point where the cost of the capital is minimum. Whether or not such an optimal capital structure exists? What are the potential determinants of such optimal capital structure? These are the questions to be answered by a researcher.
The first paper on capital structure was written by Miller and Modigliani in 1958. They conceptually proved that the value of firm in not dependent upon the capital structure decision given that certain conditions are met. Because of the unrealistic assumptions in MM irrelevance theory, research on capital structure gave birth to other theories. The trade off theory says that a firm’s adjustment toward an optimal leverage is influenced by three factors namely taxes, costs of financial distress and agency costs. Baxter (1967) argued that the extensive use of debt increases the chances of bankruptcy because of which creditors demand extra risk premium. He said that firms should not use debt beyond the point where the cost of debt becomes larger than the tax advantage. Kraus and Litzenberger (1973) argue that if a firm’s debt obligations are greater than its earnings then the firm’s market value is necessarily a concave function of its debt obligations. DeAngelo and Masulis (1980) worked further on Miller’s differential tax model by including other non-debt shields such as depreciation charges and investment tax credits. They concluded that each firm has an internal optimal capital structure that maximizes its value. The capital structure is determined only by the interactions of personal and corporate taxes as well as positive defaults costs. Altman (1984) was the first to identify direct and indirect costs of bankruptcy. By studying 12 retail and 7 industrial firms, he found that firms in the sample faced 12.2% of indirect bankruptcy costs at time t-1 and 16.7% at time t. He concluded that capital structure should be such that the present value of marginal tax benefits is equal to marginal present value of bankruptcy costs. Bradley, Jarrell and Kim (1984) used a model that synthesized modern balancing theory of optimal capital structure. They found strong direct relationship between non-tax shields and the firm’s debt level. Agency theory suggests that there exists an optimal debt level in capital structure that can minimize the above agency costs. To mitigate the agency problems, various methods have been suggested. Jensen and Meckling (1976) suggest either to increase the ownership of the managers in the firm in order to align the interest of mangers with that of the owners or increase the use of debt which will reduce the equity base and thus increase the percentage of equity owned by mangers. (Grossman and Hart, 1982) suggest that the use of debt increases the chances of bankruptcy and job loss that further motivate managers to use the organizational resources efficiently and reduce their consumption on perks. Jensen (1986) present free-cash flow hypothesis. Free cash flow refers to cash...
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