Capital structure decisions are one of the most exploited topics in corporate finance. Moreover, capital structure decision is one of the most critical decisions made by managers. Capital structure decision includes determining the proportional of debt and shareholders’ equity to be used when raising capital for the company. It deals with formulations and designing of the sources of capital or leverage. It is essential for managers to formulate the most appropriate capital structure because it determines the success of business. When a company has an optimal capital structure, managers can achieve the objective of reducing the overall cost of capital. Moreover, the company can maximize the wealth of shareholders by increasing profitability (Kara & Erdur, 2015). Capital structure decisions help a company to reduce risk.
Outsourcing money from different sources of finance helps managers to do the adjustment in the capital structure to reduce overall risk. This report seeks to analyze critically common theories, which explain the benefits of making sound capital structure decisions to (or “intending to”) maximizing the value of a firm. They include Jensen, Meckling and Myers’s theory, pecking order theory, agency theory and Modigliani-Miller theory. Moreover, it critically analyzes the market efficiency, financial market structure, and availability of information in the market.
Data and methodology
This paper uses data and literature from four capital structure theories. These theories explain the importance of capital structure decisions in corporate finance. They include:
- Jensen, Meckling and Myers’s theory
- Pecking order theory
- Agency theory
- Modigliani-miller theory
Modigliani and Miller
The theory of Modigliani and Miller (1958) was among the first theories to examine the effect of capital structure decisions on a firm. They argued that in a perfect market, capital structure decisions do not affect the value of a firm. This theory argues that the market value of a company is determined by the earning power and the risk associated with its assets. Moreover, the value of a company is independent of the capital structure or distributed dividends. This means that capital structure decisions are irrelevant because the value of a company depends on the ability of its assets to create value and it does not matter whether the assets were bought using internal or external finances (Yang, Chueh & Lee, 2014). While considering taxation, Modigliani and Miller argued that a company should finance its investment using debt capital. They noted that a firm benefited more when using debt finance because of tax shield. When debt capital finances a company, managers can charge tax shield, which reduces the tax payable. This allows the company to create value by maximizing the wealth of shareholders. However, this theory is based on the following assumptions:
- There are no taxes
- There is no transaction fee
- There is no bankruptcy
- The information in the market is symmetry; all players in the market have access to the same level of information.
However, the assumptions of this theory are unrealistic because, in real the world, there are taxes, transaction fees and players in the market have different levels of information about the market.
Jensen and Meckling (1976)
According to Jensen and Meckling (1976), there are many agency problems facing companies. There two types of agency costs, which include that of debt capital and equity capital. The conflict between shareholders and debt-holders results to agency cost of debt while the conflict between shareholders and managers leads to agency cost of equity. The conflict between shareholders and managers arises because managers want to achieve their goals which differ with the wealth maximization goals of shareholders. Shareholders might try to use their power to influence management decisions and behaviors. The control actions of shareholders result to agency costs of equity (Roshaiza & Azura, 2014).
The conflict between debt holders and managers arises because executives might try to transfer the value of the firm to shareholders. Usually, the interest rate charged on debt capital is based on the risk associated with a firm. Therefore, the monitoring and control action of debt holders leads to the agency cost of debt. This theory shows the exposure of a company to bankruptcy and agency costs against the tax benefits of using debt capital. Although this model has been widely studied, it assumes that:
- there are no taxes,
- no trade credit,
- a firm does not have conversion bonds or preferential shareholders
- there is no trade credit available
Jensen and Meckling model also assume that there is no diversification of conflicts between shareholders and managers. However, all the assumptions made by Jensen and Meckling are inapplicable in real life because a firm cannot ignore the presence of taxes, trade credits and preferential shareholders.
Pecking order theory
The pecking order theory argues that firms should fund their projects using internal sources of finances. It notes that firms should choose their sources of capital from internal finance, debt, and equity. The pecking order theory assumes that there is information asymmetry between insiders and investors. Ideally, managers have more information about the market, and they tend to favor old shareholders. The pecking order theory states that firms should use internal sources of capital first (retained earnings) before debt and equity finances. If a company does not have retained earnings, it should use debt finance. Equity capital should be an alternative of the last result because it is considered expensive. The pecking order is important because it acts as a signal to shareholders how the firm is performing. If managers opt to use debt capital, it shows that they have confidence and the company will meet its obligations. If a firm uses internal sources of capital, it is a signal that the company is financially strong. However, if managers decide to use equity capital, it is a sign that the company is financially weak. Pecking order theory believes that managers use equity capital because they think the company’s shares are overvalued and managers are seeking to increase its value when the share prices decrease.
The pecking order theory is considered one of the most relevant theories of capital structure because it shows adverse selection relating to equity issues. This theory implies that profitable firms prefer to use internal sources of finance such as retained earning rather than debt capital or issuing shares. Although there is adequate prove that debt capital is cheaper than equity, Kaya (2014) argues that it is because the information in the market is asymmetry. This notion is supported by Köksal and Orman (2015) who suggested that profitable companies are less leverage compared to non-profitable firms. Large companies accumulate debts to pay dividends compared to small companies that do not accumulate debt capital to pay dividends. For instance, in research conducted in the US on 6000 firms showed supporting evidence of pecking order theory. The research concluded that non-US companies supported the pecking order theory.
The agency theory
The agency theory establishes the relationship between managers and shareholders. It shows how management decisions are used to influence capital structure decisions of a company. These decisions have a potential impact on the method of financing a firm. Various evidences have demonstrated the relationship between ownership structure and the value of a firm. The distribution of equity ownership between managers and debt holders shows a substantial influence on the degree of leverage. Companies differ regarding the degree of ownership concentration between insiders (managers) and outsiders (investors). This relationship may affect management opportunism, which has a direct impact on a firm’s value and capital structure. The agency theory has a direct impact on a firm’s capital structure because of the conflict between shareholders and managers. According to the agency theory, the conflicts between managers and shareholders can be resolved through indebtedness. Canarella, Nourayi and Sullivan (2014) noted that indebtedness causes managers to be more aggressive in developing policies that will increase a firm’s profitability because they have to meet its obligations. It also allows shareholders to discipline managers by holding more information about management. As shareholders try to discipline managers, they alter the capital structure of the company. Therefore, the conflict between managers and shareholders has a direct impact on a firm’s leverage which means it affects the entire capital structure of the company.
Factors affecting working capital management
Many factors affect the value of a firm. They include the size of a firm and country specificity. Working capital is defined as the differences between current assets and current liabilities. Establishing the working capital requirement of firm is critical in corporate finance because it ensures a company is financially healthy. It also ensures a balance between profitability and liquidity of a company to maximize the wealth of shareholders. The size of a firm affects the working capital needs. Big companies increase their bargaining power with suppliers and customers due to mass production compared to small firms. Therefore, it becomes easier for large companies to negotiate with customers and suppliers on favorable terms of payments. Although SMEs are considered dynamic, they are perceived to be riskier compared to large enterprises which have more financing options resulting to high working capital needs. When a company requires high working capital, it tends to meet this requirement using debt finance. Consequently, the capital structure will be affected because it will increase the debt levels in the company.
Country specificity influences the working capital needs of a firm. These factors include corporate financing, economic growth, and political aspects. The working capital needs of a company can be affected by the country specificity if the capital structure is affected by national characteristics. However, there is less empirical evidence to support the direct relationship between a country’s specificity and working capital needs.
Influences of working capital on capital structure
The working capital needs of a firm are financed using both short-term and long-term finances. The long-term funding sources include equity and long-term debt which is used to finance a small proportion of the working capital. According to capital structure theories, firms should only finance permanent portions of working capital using long-term finance. The permanent working capital is measured as the difference between current assets and current liabilities. The short-term sources of finances include trade credit, bank overdraft and tax provisions. They should be used to finance temporary working capital. However, if a working capital deficit exists, short-term funds are used to fund a proportion of the non-current assets, and the company is said to be adopting an aggressive working capital policy. The influence of working capital on the capital structure can be explained by the pecking order theory which argues that firms tend to use cash credit as the first choice for funding their working capital requirement. In many industries, long-term sources of finance are used to fund the working capital needs of a company. This notion is supported by the pecking order theory which argues that firms with high financial leverage opt for a more aggressive working capital policy. These strategies include reducing the credit period of debtors and tightening credit policy in order to avoid equity finances. These policies show a positive correlation between pecking order theory using internal sources of finance. In an empirical study by Bhagat, Bolton and Subramanian (2011, p. 1592) showed that there is an inverse relationship between debt capital and low working capital needs when a company uses external funds because they increase the leverage ratios.
The capital structure theories argue that a firm should use debt, equity or retained earnings to financial their operations. To establish the amount of debt capital that can be issued to maximize the value of the firm, it is critical to combine the bankruptcy costs and tax benefits. This argument is supported by the trade-off theory which notes that every firm targets an optimal capital structure which will enable the company to maximize its value. Both MM and tradeoff theory assumes that information in the company is asymmetry. This means that managers and other stakeholders hold similar information about the market. However, it is worth noting that this assumption does not apply in real world because insider information is a reality. Managers usually have access to more information that shareholders and bondholders. One of the major challenges of information asymmetry is adverse selection that supports the existence of the pecking order theory.
The pecking order theory argues that if managers have more inside information, there must be a situation when that information will compel them to act in the best interest of old shareholders by refusing to issue shares. This means that managers might be willing to forego a very profitable investment opportunity to protect the interest of old shareholders. If managers do not issue shares, investors will be ignorant to interpret the decision as “good news.”
Although adverse selection can potentially affect the price underestimation of debt, it is lower than that of equity because the value of debt is determined by interest rates rather than private information held by insiders (Adrienn, 2014). However, a company can be able to finance itself using retained earnings. This can be interpreted in the by market players to mean that managers believe stocks are undervalued. This will force managers to fund major investments using retained earnings or debt. This notion converges with the pecking order theory that does not recognize optimal leverage ratios due to variation in its ability to generate revenues. Although many papers have been dedicated to capital structure theories, there is no consensus on which theory should be considered superior to others (O’Brien, David, Yoshikawa & Delios, 2014).
The Modigliani and Miller’s model demonstrates the irrelevance of financial decisions in a perfect market (Bolaji Tunde, Wan & Annuar, 2015, p. 486). MM theorem believes there is a fully efficient market. However, in reality, a perfect market does not exist because there are taxes, bankruptcy costs and transaction costs. Moreover, the assumption that all players have the similar information does not exist. Ideally, managers usually have access to critical information that affects share prices. In fact, asymmetric information such as cash flow and lucrative business opportunities help managers to predict share prices in the market. However, when there is little access to internal information by investors, there are high chances that share prices will be undervalued. Thus, asymmetric information has a negative impact on share prices.
The needs of working capital have a direct impact on the capital structure of a company. The impact of working capital on a firm’s capital structure can be tested by the cash conversion cycle. The higher the cash conversion cycle, the greater the finance needs of the company. If a firm is not able to meet its obligations, managers might consider acquiring new finances through equity capital. The result of capital structure theories is analyzed in the table below.
Modigliani and Miller
|Agency theory|| |
|Jensen and Meckling||– Shareholders use debt finance to control management decision |
– Shareholders encourage managers to acquire debt capital which increases pressure on management to develop new strategies that increase profitability.
|Pecking order theory|| |
Capital structure decision is one the critical decision that managers have to make. It has been explained by different theories such as Jensen, Meckling and Myers’s theory, Pecking order theory, Agency theory and Modigliani-miller theory. The paper concludes that there is a common trend in capital structure theories, which point to the market value of a company being determined by the earning power, and the risk associated with its assets. Moreover, there is a general trend that the value of a company is independent of the capital structure or distributed dividends. Capital structure theories assume that information in the company is asymmetry. However, it is worth noting that this assumption does not apply in the real world because insider information is a reality. This can be interpreted to mean that managers and other stakeholders hold similar information. However, it cannot be applicable in real world.
There is a positive relationship between capital structure and working capital needs. For instance, companies that have a higher leverage ratio choose aggressive working capital strategies. The influence of working capital on the capital structure is explained by the pecking order theory, which argues that firms tend to use cash credit as the first choice for funding their working capital requirement. Firms with low working capital needs tend to be financing most of their operations using debt capital.
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