Risk and Capital Structure

Kale et al (1991) suggests that the level of risk is one of the main determinants of a firm`s capital structure. By looking at the trade off theory we might expect a negative association when risk and leverage are concerned. If firms have high earnings volatility, for some obvious reasons, they would not want to indulge in debt financing. It follows that when firms are exposed to bankruptcy and agency costs greater is the incentive to reduce the level of debt otherwise the more volatile a firm`s earnings are, the more risk is there of defaulting and being exposed to such costs. As stated by Viviani(2008) firms that have high operating risk can lower the volatility of the net profit by reducing the level of debt. Empirical studies which show this negative relationship are Booth et al(2001); Fama and French (2002); Jong et al (2008). Growth: As stated by the pecking order arguments growth should have a positive relationship with debt ratio of a firm (Myers, 1984). These tend to be so because of asymmetric information problem across outside investors and firms managers that has more growth opportunities than the asset they have (particularly small firms). The perking order theory therefore implies a positive relationship between growth and debt level (Benito, 2003; De Angelo and Masulis, 1980; Hall et al., 2000; Jensen, 1986; Myers, 1984; Myers and Majulif, 1984; Zou and Xiao, 2006). On the contrary there is a negative relationship between growth and debt level which is stated by the trade-off theory (Jensen and Meckling, 1976; Myers, 1977; Stulz, 1990). This is due to firm financial distress cost rising as with growth opportunities firm would bear more risk.Auberch (1985) argues that since fast growing firms have non-debt tax shields, the tax deductibility of interest payment is less valuable which conclude that leverage is inversely related to growth. Rajan and Zingales (1985) also found a negative relationship between growth and leverage. Recent studies has