Capital Structure Theory

1. Capital Structure Theory Nia Christina 16598

2. Article from CRP • Title: An Empirical Study on the Determinants of the Capital Structure of Listed Indian Firms. • Theory used by the article / research: • Trade-off theory, a firm’s optimal debt ratio is viewed as determined by a trade-off of the cost and benefit of borrowing, holding the firm’s assets and investment plan constant. • The signaling theory based on asymmetric information problems. • The agency theory, based on asymmetric information problem that is principal-agent conflict. • Pecking order theory, use their retain earning, and then move to debt when their internal fund run out.

3. Hypothesis of research: Traditional factors affect financing decision, namely profitability, tangibility, taxes and growth. • Variable use in research: • Dependent variables: • Book leverage • Market leverage • Explanatory Variable: • Non-debt tax shield (NDTS) • Tangibility • Profitability • Business Risk • Growth opportunities • Growth • Size • Agency variables

4. Method of analysis: Regression model, used to analyze the determinants of Indian firms’ capital structure • Result of analysis : • There has been significant decrease in mean debt-equity ratio in post liberalization period across the group and industries. • Except growth rate and size all other explanatory variables have significant correlation with leverage during pre-liberalization period whereas all the explanatory variables are significantly correlated with leverage during post-liberalization period. • The estimated coefficient of non-debt tax shield, cash operating profit, market-to book value ratio are consistently significant and have predicted sign across the equations. • Foreign investors are not adopting high leverage to discipline management.

5. Conclusion: Measure of traditional factors that hypothesized to affect financing decision, namely profitability, tangibility, taxes and growth are all significant.

6. Article from students • Title: Testing trade-off and pecking order theories financing SMEs • Topic: Capital Structure Theory • Theory used by the article / research: • Trade-off theory, companies seek to obtain optimum capital structure and weigh up the advantages and disadvantages of an additional monetary unit of debt. • Pecking order theory, use their retain earning, and then move to debt when their internal fund run out.

7. Hypothesis of research: • Based on trade-off model • The effective tax rate is expected to be positively related to the debt level. • Non-debt tax shields should be negatively related to firm debt. • Default risk should be negatively related to the firm’s debt ratio. • Companies with greater growth opportunities will have a smaller debt ratio. • There should be a positive relationship between debt ratio and firm profitability. • The size of the company should be positively related to the level of debt. • SMEs face significant transaction cost which keep them far from their target.

8. Based on pecking order • The financing deficit of SMEs should be positively related to the change in the level of debt. • Firm debt should be negatively related to the volume of firm cash flow. • Firm with few investment opportunities and high cash flow should have a low level of debt, while firms with strong growth prospects and reduced cash flow should have high debt ratio. • The age of the company should be negatively related to its level of debt.

9. Variable use in research: • Total debt ratio (D) • Effective tax rate (ETR) • Non-debt tax shield (NDTS) • Default risk (DR) • Growth opportunities (GO) • Profitability (ROA) • Size • Cash flow (CF) • CFGO • AGE

10. Method of analysis: Panel data methodology, by simultaneously combining cross-section and time series data • Result of analysis : • Spanish SMEs seem to find the cost of an unbalanced position less of a burden than the cost of adjusting. Hypothesis 7: accepted. • Current Spanish tax regulation does not provide relevant advantages to SMEs. Hypothesis 2:accepted but Hypothesis 1: is not • SMEs also prone to having large growth prospects and high debt ratios, thus making them very sensitive to Myers’ underinvestment problem. Hypothesis 4: accepted. • Firm size and leverage are found to be positively connected. Hypothesis 6: accepted. • All Hypothesis 9, 10,11 are found to be overwhelmingly confirmed. As expected, cash flow is negatively related to firm leverage; so the SMEs that generate the most internal resources are the least levered. The result consistent with pecking theory prediction. • A positive and significant relationship between the interactive variable CFGO and firm leverage is obtained. Hypothesis 10 is fulfilling. • Older SMEs may have generated sufficient internal resources to not depend as much on debt as younger SMEs, whose dependence on external resources will be greater.

11. Conclusion: • Regarding the trade-off theory, results clearly indicate that SMEs face high transaction costs which are probably derived from typical agency problems and financial restriction in capital markets. • Empirical evidence confirms that internal resources represent the main source of financing for SMEs. • Empirical evidence prove that NDTS, growth opportunities and internal resource play an important role in the decision making process. • SME and large firms display significantly distinct financial behavior, thus confirming the presumable financial restriction of SMEs.

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