Capital Structure: Concepts and Theories

Overview of early capital structure literature

Traditional studies on capital structure investigated securities individually or separately, but the new approach analyses the various securities and the whole capital structure as one theory of contingent with securities having each own price. In other words, the securities are combined, and debt and equity are seen as a way to provide project financing.

Firms are faced with many challenges, particularly on the question of finance decisions. They have to pay for various operating expenses, acquire assets, or provide more funds for various projects. All activities need funds, and firms have to decide what funds to use. They can source funds from debt, earnings, or from capital.

Capital structure refers to the combination of ‘equity and debt’ used by firms to emphasise their value (François & Morellec 2004, p. 387). Different kinds of securities are incorporated in the capital structure, which is regarded as the ‘menu’ of the firm. There are other contents important to the firm that should be known and open to the shareholders and investors, for example, stock equity, loans, and bonds.

Equity and debt are sources that provide leverage. Equity is capital from shareholders and debt is money borrowed from banks. Firms vary in their capital structure; some are dominated by equity and without any debt, while others are dominated by high debt structure and low equity (François & Morellec 2004).

There is significant empirical research that has tested the determinants of capital structure. Prior research studies relied predominantly on firm-level ordinary least square (OLS) regression, with leverage as the dependent variable and firm-specific determinants as the explanatory variables. The problem with this kind of research and the cross-sectional models associated with it is that the theories are not precise enough to produce a limited set of determining variables, which invariably leads to data mining. According to Sturm and Jakob (2005), OLS regression is sensitive to outlying observation, and one country might drive all the results.

Asset structure is a significant factor in the construct of capital structure. If a firm has more tangible assets, it can liquidate so easily with high value (Titman & Wessels, 1998 as cited in Abor 2008). Investments in tangible assets result in higher leverage because debts using tangible assets as collateral have ‘lower interest rates’ (Abor 2008, p. 6). Debts of this kind can also be used for many projects. In using tangible assets as collateral, some costs are reduced (e.g. ‘adverse selection and moral hazards’).

Using tangible assets can result in ‘higher liquidation value’ and availability of finances with lower interest rates, and reflection of higher financing in the capital structure. For small firms, using collateral minimises under-investment issues since firms can easily obtain credit. It can also reduce conflicts between the firms and credit financiers because of the availability of the collateral. Empirical studies also showed that leverage is positively related with asset structure (Bradley et al. 1984; Wedig et al. 1988 as cited in Abor, 2008, p. 8).

In the study of capital structure, researchers focus on empirical studies of determinants which are important in providing inferences of the dominance of the theories on capital structure (Swinnen, Voordeckers, & Vandemaele 2003). Theorists prove their theories through empirical studies and regression. Some theories have remained as theories, but many have been applied in the construct of capital structure and in financing decisions. Modern finance researchers posit that theories affect capital structure, while other theories do not. Modigliani and Miller’s (MM) theory focused on irrelevance, but before it there was Durand’s relevance theory.

The impact of capital structure on the value of firms

  • Durand’s relevance theory: the impact of relative costs of debt and equity on the value of firms
  • The Net Income (NI) approach: David Durand suggests that the value of the firm can be increased by reducing the cost of capital or equity, which means that a firm’s value relies on its capital structure choices (Chandra Bose 2006, p. 66). Issuing bonds or equity security will enhance the firm’s value. Durand’s relevance theory states that capital structure and the firm’s value are related positively. The theory also stipulates that the firm’s value includes the cost of capital. If the firm’s value decreases, the cost of capital has to increase (Rastogi 2010, p. 35).
  • The Net Operating Income (NOI) approach: This is the first of the irrelevance theories, which says that there is a negative relationship between capital structure and the firm’s value. Durand (as cited in Chandra Bose, 2006) argues that the value of the firm is not related to its capital structure. This means any variation of the capital structure does not affect the firm’s value, but increasing debt for the purpose of capitalisation increases equity. Financing decisions are negatively related with the firm’s cost of capital. Moreover, this approach states that there is no optimal capital structure for a firm. The MM model is one of the theories that support this assumption (Kapil 2011, p. 295).
  • Optimal capital structure approach: This approach is used to maximise the investments of the shareholders. Trial capital structures are executed considering the market values of debt-equity, in which shareholders’ wealth are calculated using this particular capital structure. The process is done several times until the optimal capital structure is reached. In analysing the capital structure, the following important steps are done: (1) Provide calculations using estimation the interest rate the firm is committed to pay; (2) Calculate the cost of equity; (3) Calculate the WACC; (4) Calculate the value of operations which reflect the free cash flows minus the WACC (Ehrhardt & Birgham 2012, p. 608).

David Durand is one of the critics of the MM theory (1959 as cited in Cheremushkin 2011, p. 153). He first introduced the ‘relevance theory,’ which is opposed to the MM theory. Durand argues that capital structure influences the value of firms as the costs of debt and equity influence ‘the weighted average cost of capital’ Ahmadimousaabad et al. 2013, p. 891). WACC is the factor that judges the firm’s value. The theory further states that it is the cost-effective source of funds that adds value to the firm by reducing the entire cost of capital.

Durand argues against MM’s restrictive assumptions by pointing out that the theory has disregarded closely-held businesses such as proprietorships, partnerships, and combined companies with business in marketable securities. These firms cannot just buy or sell shares in capital unlike corporations. The MM theory of no-arbitrage does not apply to these firms, according to Durand. In other words, the actual capital markets cannot behave as stated in the MM model. It is also questionable to say that individuals have equal access to capital markets and can acquire debts just like firms do (Cheremushkin 2011).

Durand further argued that individuals cannot borrow on the same conditions as firms, and have credit limit. However, researchers ignored these arguments considering that constraints mentioned by Durand could not be available in ‘a perfect market’ (Cheremushkin 2011, p. 153).

Modigliani and Miller’s theory (1958)

Before, theorists were still looking for foundations for capital structure theories. Theories before this were characterised with unrestraint statements about investors and investments, rather than logical statements that could be formally regressed (Brigham & Ehrhardt 2008). When financial researchers Modigliani and Millier (1958) proposed their theory on capital structure, everyone tried to explain and oppose it and provide their own theory. Economists have focused on firms’ capital structure and financing strategies and provided other theories (Morelle 2004)

The MM theory is a remarkable theory on capital structure that changed all pre-existing concepts. The theory states that the firm’s capital structure is not affected with the way the firm pays for its projects. The MM model forms the one-firm framework and does not consider the inter-relationships among firms in the stock market or in buy-sell relationships.

The literature on the MM theory has assumptions about capital structure and predictions on firm values, and focus on the effect of firms’ financial and working capital expenses (Lyandres 2006). Research has also centred on finding optimal capital structure and in proving or disproving Modigliani and Miller’s theory that there is no relation between leverage and firm value (Hatfield, Cheng, & Davidson 1994, p. 1).

MM’s debt-equity theory states that in a world without imperfections, i.e. no tax payment, no adjustment costs, and no transaction costs, optimal profits and optimal market value are equal, or in theoretical parlance there is equivalence (Frank & Goyal 2008). This is the first of the irrelevance theories, although modified by MM themselves after many opposing theories evolved from their own assumptions.

The MM theory further assumes that any firm has expected cash flows, equally apportioned between debt and equity holders, and which relies on the expected relation of debt and equity by the firm to find funds for its projects. MM assume that firms have to adjust to financial targets because of the factors affecting financing decisions. In a market without imperfections (or a world with perfect capital market), financial targets come already complete; but in a market with tax payments and other costs, firms cannot change their desired ratio (Sinnen, Voordeckers, & Vandemaele 2003).

A strong contention of MM is that using equity or debt does not change the capital structure. MM proposes the irrelevance of capital structure to the firm’s overall value, which is one of the basic arguments used in financing decisions. However, this has been argued by researchers who have provided evidence on the limitations of the theory and that capital structure has indeed relevance in financing decisions. The arbitrage principle must have an important role in the capital structure decision (Swanson, Srinidhi, & Seetharaman 2003, p. 25).

The challenge of imperfect markets

MM suggests that in a perfect market, optimal profits and optimal market value are equal. A perfect market refers to situations where: there are enough buyers and sellers in the market and no individual investor can exert pressure on security prices; there is no asymmetric information; there are no adjustment costs and transactions costs; and investors have the same rate in borrowing or lending (Moyer et al. 2008, p. 477). The theory states that these imperfections cause uncertainty, which also causes the equality to disappear. Using debt instead of equity to finance projects ‘may increase the expected return to the owners but only at the cost of increased dispersion of the outcomes’ (Cheremushkin 2011, p. 151). When there are imperfections, leverage does not affect the firm value or the capital value (Botta 2014).

Put it another way, an entity’s market value does not rely on the capital structure but on its anticipated return at an exact rate corresponding to its class. In other words, the ‘average cost of capital’ is not related with the capital structure (Ogilvie 2008, p. 168). MM refer to a situation that there are perfect capital markets by focusing on expected return for the firm’s equity. The assumption is the rule of one price for ‘absolute substitutions, arbitrage possibilities’ and the chances for investors to provide the equal leverage in their investment through borrowing (Cheremushkin 2011, p. 152).

Some simplifications were introduced by MM to explain their theory. First, they divided the firms into ‘risk classes’ and presumed that firms in the different classes can equally substitute for one another. MM used evidence by contradiction. If proposition is untrue, investors could use arbitrage opportunities and provide a sudden increase in their investment, regardless of the consequences, by selling what they have borrowed and buying ‘equivalent underpriced stock representing identical income streams in all respect except price’ (Cheremushkin 2011, p. 153).

The situation reverses when there are imperfections and these imperfections must be present in order for capital structure to be relevant. MM added taxes which are used to reduce interest payments, a situation that tells there is an association of capital structure and firm value (Hatfield et al. 1994, p. 1). Miller (1997 as cited in Hatfield, Cheng, & Davidson, 1994) toned down the MM theory and suggested that personal taxes can be added in the analysis, although this can be used predominantly on a ‘macro-level’ and not on the ‘firm level’. The concept of firm value and capital structure relevance has led to other theories, in particular, the trade-off theory and the pecking-order theory.

The ‘irrelevance’ of capital structure can be given light by way of several situations. This has two types, which are: ‘the classic arbitrage-based,’ which presents a situation wherein arbitrage allows the firm’s value free of the leverage (Frank & Goyal 2008, p. 140), and another that relates to several situations involving ‘equilibrium’ that divides debt and equity. A 1998 study has shown that this theory failed in some respect because of several factors (e.g. taxes, bankruptcy costs, and several others). But because of these many factors, other theories were formulated by other finance researchers (Frank & Goyal 2008).

Critics of the MM theory argue that the theory seems not to conform to common norms. However, it helps explain the relationship between capital structure and the firm’s financial difficulties. Frank and Goyal (2005) argue that the theorem failed considering some circumstances. The elements in this theorem include the use of taxes, contractual costs, expenses for bankruptcy, agency costs, unfavourable choice, insufficient assortment between financing and operations, and shareholder-investor conflicts.

Cheremushkin (2011) added that traditional belief was that ‘a moderate amount of debt increases the value of a firm’s common stock because debt is less expensive than equity, which implies U-shaped cost of capital function of leverage’ (p. 151). Accordingly, there were other questions posed by MM. How can managers assure that the risk preferences correspond to benefits and the tastes of stockholders? How can economists and investors invest in a situation that projects are worth their money and that the situation depends on who actually owns the firm this time?

In answering these questions, MM provided the principle that guide rational investment and financial strategy in an uncertain world. MM introduced ‘the market value maximization criterion’ that has been a theory and a subject of various researches.

More criticisms include the irrelevance assumption of MM theory which cannot be proved with strong evidence. Firms are motivated by profits and other opportunities which prevent a test on the theory through regression. Criticisms stem from the arbitrage proof. Some doubt the ability of individual investors to duplicate ‘a corporate portfolio of stock and debt’ (Cheremushkin 2011, p. 153). MM introduced the idea of ‘arbitrage’ in their theory construct. Arbitrage is about two assets, which might be ‘levered’ and ‘unlevered’. Like any action in the market, any arbitrageur will purchase the low-priced and sell the high-price to get profit. In the long run, market forces will put the prices on the same level, and they have to be on equal footing to make the arbitrage work. That is as far as MM is concerned (Brigham & Ehrhardt 2008).

An argument for MM is that even if it has weaknesses, it shows the significance of financing. It has influenced other finance theories, and also financing decisions. Trade-off and pecking theories were both influenced by this.

Concerned with the various reactions in the academe and the business world, Modigliani and Miller modified their propositions by adding the income tax and its interests. Tax payments affect cash flows that can be given in the form of shares, and thus adds value to the firm (Fabich, Schellenberg, & Wölfer 2012, p. 147).

The arbitrage assumption is now accepted, and the proofs are happening. Black and Scholes (1973 as cited in Cheremushkin 2011) applied the arbitrage proof in getting their popular ‘option pricing formula’. Sharpe (1964 as cited in Cheremushkin 2011) also used this in formulating the asset pricing model (CAPM). The arbitrage proof is now used in many financial analyses. But skepticism over the authenticity of the MM assumptions and their applications for corporate finance still exist.

Jensen and Meckling’s (1976) trade-off theory and agency cost theory

Two of the most studied theories on capital structure are the static trade-off and pecking order theories. Modigliani and Miller (1958) gave their assumptions on these theories: that investment matters are not related with firm’s capital structure, and the latter can only be affected with so-called market imperfections. These imperfections allow firms to get ‘optimal, equity ratio’ (Swinnen, Voordeckers, & Vandemaele 2003). Firms lose the advantages and gain the disadvantages. In contrast, the pecking order theory assumes choosing funds by means of hierarchy.

Myers (1984) finds that firms that follow the trade-off theory set a target debt level and then gradually towards it. Although the use of debt is associated with the advantage of paying taxes, it is risky for a firm to rely heavily on debt due to the high changes of defaulting and the cost of bankruptcy. On the subject of debt financing, evidence has shown that a firm can fully rely on debt to finance projects. The trade-off theory states that firms must be able to offset bankruptcy risk by increasing debt level.

Trade-off refers to providing equilibrium between marginal costs and marginal benefits. Firms are able to find their optimal capital structure by determining the difference between debt benefits and cost of debts (Ahmadimousaabad et al. 2013). Debt can be used to attain benefit because debts are tax deductibles. Tax benefits influence financing decisions, although most of the work on this have not been too clear on how debt factors influence firm value (Graham 2000).

Jensen and Meckling’s (1976) agency cost theory assumes that an optimal capital structure can be determined by reducing conflicts of interest between the involved beneficiaries (managers, shareholders and holders of debt securities). The two authors state that debt motivates managers to be efficient in operating their firms and maximising the shareholders’ wealth. For example, if a firm faces financial distress, management is pressured by shareholders to take debt from creditors. Managers have to make interest payments to creditors because they have legal redress, and if they fail, they could lose their jobs, which will make them run the firm more efficiently. Hence, debt and interest payments reduce the agency costs between managers and shareholders.

Original trade off

‘Tradeoff’ theory evolved from Modigliani and Miller’s theory. Predictions by the trade-off theory states that financial leverage can be associated with the firm’s sise, profits, and capability of the assets to be assessed at an approximate value. When there are high growth chances, firms have difficulty in meeting their financial obligations (Klapper, Sarria-Allende, & Zaidi 2006).

The trade-off theory assumes that firms which are more likely to get into financial distress do not borrow to support their projects. Payments for financial distress may vary among firms, but this relies on how collateral can easily be transferred. Apart from payments and costs, tax-deductible debts can augment present funds for the firm, which means there are benefits from debts. Consequently, firms will tend to borrow more because of the tax rate (Hillier et al., 2011; Shyam-Sunder & Myers 1999 as cited in Oolderink, 2013).

The firm’s management has to choose which funds to use, whether internal or external. But mostly, the manager would prefer the internal or trade it off with external, for example debt. Internal funds are often selected first before external ones, which means equity (Frank & Goyal 2005).

Myers (1984) argued that the trade-off and the pecking order theories are two viewpoints on corporate debt. First, the equilibrium between tax savings obtained from debt and bankruptcy costs refers to the trade-off theory; on another context, due to unfavourable choice, firms refer to earnings before debt and equity in financing a project (Frank & Goyal 2005).

A manager who decides for the firm assesses the expenses and profits of substitute gearings. However, an assumption is formed that internal resolution can be attained so that minor costs and benefits can be equally weighted (Frank & Goyal 2008, p. 141). The manager optimises job tenure which can be under threat of ‘a financial distress and a takeover’ (Novaes 2003, p. 51).

Most of the studies on capital structure have focused on leverage ratios. Past strategies and financial policies affect the ratios. For example, a series of unpredictable high earnings will allow leverage below the expected ratio (Dittman 2004). Firms will have to change their capital structure. However, there are factors that will not allow immediate changes, so a deviation from the aimed leverage ratio will have to be done. Gearing and profit are affected, and research has found that these two are not related. Correlation of profits and growth perspectives which do not reflect in growth metrics reflects the assumption of the trade-off theory (Dittman 2004).

Moreover, the trade-off theory contains two ideas: ‘the fundamental’ and ‘Modigliani-Miller’ ideas. The fundamental one theorises that firms in the same sector of industry must have the same leverage ratio while they try to save as much tax incentives as possible. High tax saving provides lower cost of debt and the measured capital. When the leverage

is raised the tax saving is lowered in case there is bankruptcy declaration and the cost thereof. The MM idea has been explained earlier.

The trade-off theory appears to form the best possible leverage in which the measured standard cost of capital is reduced to the minimum at the same time maximising the ‘share price’ (Abosede 2012, p. 5). During this time, the tax advantage taken from the leverage level will be the same as the expected ‘bankruptcy costs’ (Abosede 2012, p. 5). But according to researchers in business finance, even with the presence of this theory the desired capital structure cannot be established.

The Modigliani-Miller (1963 as cited in Abosede, 2012) theory is contrasted to this trade-off theory, as it theorises that the total value of the firm’s assets cannot be emphasised and clearly stated in the capital structure, if the firm uses the finances for the operating income to assess the effect of leverage on the firm’s value. However, this statement was changed by levelling the states’ ‘zero corporate tax,’ which says that a firm that pays interest on debt will pay less because this kind of interest (on debt) cannot be taxed (Abosede 2012).

Moreover, when the leverage level rises, the cost of capital goes down. With this, cash flows’ value rises and eventually the firm’s value which can lead to ‘over gearing’ and a possible bankruptcy also increases. Bankruptcy expenses are greater than the purported tax savings. Leverage therefore is disadvantageous to the firm because it increases risks and lowers share price. Shareholders’ expectations are tantamount to mistrust on the management (Abosede 2012, p. 5).

Myers (1984) argues that the major inference of the trade-off theory is that leverage shows expected change so that changes from the objective are removed. Moreover, the main prediction of this theory is the stern arrangement of financing. Myers provides these theories as comprehensive ordering frameworks that may in the future help some aspects of the theories. But it is comprehensible that trade-off and pecking order theories can be part of a larger set of reasons that can be viewed as determinants of the firm’s capital structure (Frank & Goyal 2005). Myers (1984) indicated that when trade-off theory is applied to a firm, it provides the firm ‘target debt-to-value ratio’ and the movement is slowly aimed at the target.

Static trade-off

Frank and Goyal (2005) argues that the proposition that leverage shows ‘target adjustment’ does not give the firm logic to have equilibrium for tax savings and bankruptcy costs. Target adjustment, according to Frank and Goyal (2005) can be correctly placed as another hypothesis. There is another hypothesis for this, which is termed ‘static trade-off’ theory which proposes that ‘bankruptcy and taxes’ are the main reasons that establish leverage in a static model (Frank & Goyal 2005, p. 3).

Target adjustment can be explained by other theories of change. This can refer to taxes and other costs, for example bankruptcy, but there can be other reasons. However, the target adjustment concept has been supported by empirical studies than the two theories (Frank & Goyal 2005).

The static model introduced by Lyandres (2006) forms in two stages. Firms penetrate the market and select their capital structures, which are presented by the debts’ values until these debts come to mature. The shareholders or the manager acting on behalf of the shareholders select the debt level with the aim of emphasising the firm’s maximised value while at the same time considering the original value of the firm and those of the competitors’ values and strategies.

In the next stage the shareholders select their output market method and its effect on the firm’s internal cash flow. The impact of the shock, along with the strategies of the firm and the competitors, will tell if the firm can still compete with cash, or will now declare bankrupt and will default. If the so-called shock is below ceiling, the firm will default (Lyandres 2006, p. 2384). These are some of the realisations in the capital structure formulations.

Dynamic trade off

Another kind of trade-off theory is the ‘dynamic trade-off’ (Frank & Goyal 2005, p. 13). The dynamic model postulates that the accurate financing decision relies on the collateral that the firm places. There are those who wanted to provide funds for the next period, and some also raise funds for the current period. Funds that should be raised maybe either debt or equity. Firms usually combine equity and debt (Frank & Goyal 2005).

The tradeoff theory can be well explained with a situational example set by Frank and Goyal (2005). For example, there is a firm earning high profit. The management of the firm can choose, either to raise funds or to distribute dividends to its shareholders. Frank and Goyal (2005) provided a logical answer, saying that the action depends on ‘the tax rates and on rates of return that the firm can earn relative to the returns that the shareholders can obtain directly’ (p. 13). The firm can choose to invest the money because investment opportunities are at the taking any time for the firm. The firm can hold on because it has investment opportunities. Firms which have high profits value their earnings.

A second example was also provided by Frank and Goyal (2005) to expand the understanding of the tradeoff theory further. The situation stems from the decision to invest the money earned by a firm. The firm has the option of retaining it today because it has plans of spending it after a year or two. When time comes that it needs new funds, it could draw from new equity. But there is a problem with taxes. Payment to shareholders will have cost in the form of taxes. In other words, if the firm retained the funds, the shareholders could not have been required to pay taxes.

Frank and Goyal (2005) indicated that the two examples are illustrations about the dynamic and trade-off theories. But they said that modelling the dynamic trade-off theory is difficult to achieve, considering that dynamic models have characteristics that permit the trade-off theory to provide good situations where firms can finance their projects.

Trade-off theories provide analysis of debt that can be incurred by firms, but cannot provide how debt should be structured. The theorists who formulated these theories may have skipped on the debt structure. There are models that provide estimates about market debt, and we have to know that there are some creditors do not want to negotiate.

There are questions that the theory wants answered. What is the combination of bank debt and market debt? What would these two prefer when it comes to requirements about firms?

It is also one of the criticisms of the theory, i.e. it does not provide ideas about debt structure. Hart and Moore (1995 as cited in Hackbarth, Hennessy, & Leland, 2007) argued that trade-off has no clarification for debt claims. What should the firm do? What does the creditor do when there are debt claims?

In trying to look for answer, finance scholars searched some areas where they believe there are explanations, for example, the areas of market segmentation, and also significant subjects of scale economies, or bank documents, and so on. It is found that the firm has the right to enter capital markets, in fields where investors can talk. The bank can is in the position to renegotiate and adjust to the requests of the firm. When a firm is in the bankruptcy procedure, it is in the hands of the new owners who will provide recapitalization. Strong firms can use debt because they have the capability. Small ones cannot.

On the other hand, static trade-off refers to the firm’s reaching the ‘optimal structure’ that is associated to the ‘trade-off between debt gains’ and other costs from leverage (Oolderink 2013, p. 2). Swinnen, Voordeckers, and Vandemaele (2003, p. 3) indicated that the theory assumes that ‘optimal debt ratio’ enhances the value of the firm, and this can be attained when the value after several constraints (e.g. benefits from debt issues) compensates for the increased costs relative to debt issuance (Myers, 2001 as cited in Swinnen, Voordeckers, & Vandemaele 2003, p. 3). Some tax laws provide tax exemptions in case of debt issuance, and that is a benefit. However, a complication occurs when there are personal taxes and ‘non-tax shields’ (Swinnen, Voordeckers, & Vandemaele 2003, p. 3). Managers do have some leeway in wasting cash flows, but debt financing maximises ‘free cash flows’ which solves the agency cost (Jensen & Meckling 1976).

In the static trade-off, optimal capital structure is attained in an imperfect market. The agency cost and static trade-off propose that firms should issue more debts to avoid financial distress due to bankruptcy risks. On the other hand, the dynamic trade-off states that expected and adjustment costs are affected by time in what is called single-period models. The theory states that right financing decisions should consider the financing margin to predict the right decision for the next period.

There are several choices for firms, such as payment of funds and raising funds via debt and equity. Some firms consider paying out and raising funds concurrently. Predicting the optimal during the next period, increasing debts or equity in funding, can be the best choice.

A number of firms make changes to their current capital structure by following the assessment of what is optimal in the future. Kane et al. (1984) and Brennan and Schwartz (1984) were among the first to analyse continuous time models and to consider tax against bankruptcy as a cost, excluding the transaction cost. Firms use increased debts to acquire tax benefits due to reactions from financial shocks even without attaining costs in the processing of adjustment.

Agency cost

Agency theories were developed by Jensen and Meckling (1976 as cited in Frank & Goyal 2005). This stemmed from the ‘general agency’ theories. This theory examines the relationship between the principal and the agent. Information asymmetry has been the common subject when talking of the agency cost. The manager has more information about the inside of the firm than do the shareholders.

The concept of using internal funds than external ones is an old concept and firm managers during the Great Depression must have known it before hand. This is where the manager and the shareholders contradict.

This theory assumes that an optimal capital structure can be determined by reducing conflicts of interest between the involved beneficiaries (managers, shareholders and holders of debt securities). Jensen and Meckling state that debt motivates managers to be efficient in operating their firms and maximising their shareholders’ wealth. For example, if a firm faces financial distress, management is pressured by shareholders to take debt from creditors. Managers have to make interest payments to creditors because they have legal redress, and if they fail, they could lose their jobs. This will motivate them to run the firm more efficiently. Hence, debt and interest payments reduce the agency costs between managers and shareholders.

Economists and bankers associate growth with ‘financial deepening,’ which means there is heavy use of sources from investors and by a gradual removal of misrepresentations in the credit channel. Adverse conditions in the financial market may worsen the effects of a recession, which was what happened during the Great Depression (Azariadis & Chakraborty 1999).

Studies and researches on this theory started in 1976. Jensen and Meckling found in their research that risks can be properly dealt with by rational people and debt incurred through ‘agency costs’ will be added to the equity or other forms of security such as government bonds. ‘Agency cost of equity’ refers to the prices relative to the division of possession from management (Watson & Ezzamel 2005, p. 45).

Agency cost has several connotations. It refers to internal conflicts or problems between shareholders and managers. Shareholders and creditors are two contrasting parties, therefore, they cause conflicts. Agency costs are reduced if the firm is managed effectively.

Agency theories focus on ‘optimal capital structure’ which supports shareholders’ investment so that shareholders can receive their investment dividends or income derived from their capital which has become a part of the firm’s capital; increase of capital and shareholders’ ownership of the firm. Within the range of these theories, sub-theories also evolved, such as ‘normative agency’ and ‘positive agency’ theories (Abosede 2012, p. 7).

The normative agency theory provides the best ‘debt equity ratio’ to increase the share price of shareholders, while the positive agency theory provides prediction on managers’ profits within the limitations of the shareholders’ wealth. Accordingly, the theory considers short terms over the long run in getting profits, and so the firm misses the competitive business opportunity.

The traditional concept is that external financing demands from managers to describe in detail the facts about the project to new investors, which will allow these external investors to monitor the project. Certainly, managers do not like this situation. With this, managers prefer to retain earnings instead of external financing. However, managers cannot really tell the relation of debt and equity when looking for external funds.

There are many situations that point to agency costs. Myers (2003 as cited in Frank & Goyal, 2005) argued that agency theory focuses on hierarchy.

Agency cost theory emphasises the asymmetric information provided by borrowers and lenders on the results of investments and the information provided by shareholders. An example is this: corporate managers may find funds for a project, or spend funds to buy other corporations, without giving adequate information to the shareholders. Borrowers observe the activities or the results, but banks provide verification or auditing cost.

Some aspects of agency costs focus on studies of financial intermediaries. Williamson (1987) and Bernanke and Gertler (1989 as cited in Azariadis & Chakraborty, 1999) emphasised the major instrument which is the relation between ‘borrower net worth’ and the ‘external finance premium’.

Investment goals are inseparable, cannot be passed on to other stakeholders and have fixed sise. Firms cannot solely finance the entire project from their recent earnings, and must have to draw funds from external sources, such as funds from financial institutions. Banks are primary sources of funds. When borrowing from these sources, firms need intermediaries and they have to pay agency cost (Azariadis & Chakraborty1999).

Azariadis and Chakraborty (1999) indicated that verification for bankruptcy is a costly process and lenders require an ‘external finance premium over and above their own cost of capital’ which relies on the borrower’s net worth, and ‘Since the borrower’s net worth tends to be procyclical, the external finance premium is countercyclical, and so are agency costs per unit loan’ (Azariadis & Chakraborty 1999, p. 223). All costs of intermediation come from the firm but also allow external sources.

Agency conflicts have a negative effect on a firm’s capital structure. There are costs associated with agency conflicts. Conflicts may result into lower debts issued. Debt is sometimes a management tool to reduce problems between management and shareholders. This is because debt results in efficiency among managers who must strive to pay the debts while at the same time restrain themselves from financing unwanted projects. However, this may also be the cause of managers avoiding projects deemed profitable. The trade-off theory of costs and benefits is much pronounced in this instance (Novaes 2003).

Typically, a firm is managed by paid self-interested individuals who will not take the initiative, such as reorganising the firm’s assets to increase value. So-called asset reorganisation can take in the form of divesting some of the firm’s non-performing assets. Firm management and shareholders sometimes do not agree when it comes to reorganization. Shareholders may find that the manager is not the right person for the corporation. Shareholders can devise a system wherein the manager can commit to them and focus on reorganisation plans. But in the long run the shareholders can choose to change the manager who is not a decision manager (Novaes 2003).

Problems between firm management and shareholders have an effect on capital structure. This is because both have distinct objectives in mind. Managers have different regard for investment than shareholders. First, specific projects like debt financing can cause a firm’s value to rise. It can be best for shareholders to add gearing if they find that managers prefer personal aims over firm’s value. Then, if managers have a say over financing decisions, there is lesser debt issuance (Morellec 2004, p. 258).

Managers are encouraged to make the most of ‘equity value’ and not ‘total firm value’ (Bessler, Drobetz, & Kazemieh 2011). However, those who handle debt financing are likely to take more risks when knowing they have more cash flow at their disposal. In particular, they prefer high-risk projects that are more beneficial for shareholders when the project is successful but more losses to bondholders when the project is a failure.

Investors of bonds have knowledge of this sort of ‘overinvestment,’ and so they ask for a ‘risk premium’ and high interest to compensate for such predicament. These costs force firms not to provide more debt. This kind of ‘underinvestment’ is one of the hypotheses statements mentioned by Myers in the agency cost theory (1977 as cited by Bessler, Drobetz, & Kazemieh, 2011, p. 18). On the other hand, firms have to use debt to discipline managers who are afraid of not being able to pay; debts can reduce management quality and shareholders will have reason to replace the manager.

Risk shifting is an agency problem mentioned by Jensen and Meckling (1976 as cited in Frank & Goyal, 2005). This concept arises when the firm is run on equity wherein cash flows are important. The firm has the tendency to run projects which have a lot of risks but with big ‘payoffs’. This is a common occurrence when a firm is in desperate situation.

Myers and Majluf’s (1984) pecking order theory (POT)

This is the most influential among the theories. Myers and Majluf (1984) have been the most quoted researchers on the subject of the pecking order theory.

Successful funds management and intelligent analysis of capital structure are significantly needed to cause a well-executed operational performance. Any wrong analysis and application of the capital structure will result in financial loss for the firm or eventual closure, perhaps (Chen & Chen n.d.).

During the 1990s, there was a dominance of ‘equity financing’ which was a contradiction to the theory espoused by Myers and Majluf, made popular in 1984, which states that debt concerns control equity concerns (Autore & Kovacs 2004). In this first situation, there is a conflicting example which also reflects some of the empirical studies which are also conflicting for the pecking order theory. Leverage and profitability are not associated and this applies with the pecking order behavior proposed by Myers and Majluf, but not consistent with the other theory known as tradeoff theory. In this latter theory, there is equilibrium between tax deductions and bankruptcy costs in the context of debt financing (Frank & Goyal 2003).

The pecking order theory promulgated by Myers and Majluf (1984) stresses the importance of information costs and ‘signalling effects’. This theory is a consequence of Myers’ (1984) asymmetric information, which means that managers have more information about the rate of internal cash flow, investment opportunities and the value of the company compared to investors, thus affecting the choice between internal and external financing. Firms do not need to attain optimal capital structure, and debt ratios rely on the firms’ requirement for external funds to finance new projects.

The pecking order theory explains how profitability is associated with capital structure as firms choose to use internal funds instead of external funds to finance projects (Abor 2008). The hierarchy method begins with the one that is not too sensitive and not too risky due to ‘asymmetric information,’ which will be clearly discussed further in this paper. Firms which obtain high profits attain ‘lower debt ratios’ because they use internal funds to finance projects.

According to this theory, firms prefer internal financing (retained earnings, depreciation expenses) over external financing in funding their projects because it does not have any issuing costs and is less expensive. However, if internal funds are insufficient, firms prefer to use debt rather than equity to minimise the problem of information asymmetry between firm managers and external investors.

Frank and Goyal (2003) provide a scenario wherein firms can choose on how to finance projects. This is also a question of financing decision which firms follow, according to Myers and Majluf. There might be three sources of firm financing which managers and shareholders can choose, and these sources are: ‘earnings, debt, and equity’ (Frank & Goyal 2003, p. 4). There is no question about retained earnings as this can be selected to fund projects anytime. There are doubts about equity while there is lesser adverse selection on debt. ‘Adverse selection costs’ can be largely accrued on equity, and less on debt. Firm insiders, such as managers, shareholders and board members, prefer that retained earnings should be used instead of debt, but debt can be used in ‘equity financing’. If earnings are not anymore available, the firm will have to use debt financing. Normally, therefore, equity must remain and not to be used (Frank & Goyal 2003).

This theory, which according to Myers (1984 as cited in Swinnen, Voordeckers, & Vandemaele, 2003) can be used in place of capital structure, has much influence in corporate studies of gearing or leverage. The theory predicts that firms requiring large financing, will have ‘high debts’ because managers do not want to issue equity. However, Smith and Watts (1992 as cited in Frank & Goyal, 2003) countered this with their statement that firms with high-growth ratios use fewer debts.

The theory states that firms provide funds from sources acquired in hierarchical order, for example, funds from internal source, from debt source, and from equity, but equity is seldom used because of misproportioned, or asymmetrical, information between firms and investors (Leary & Roberts 2004). Managers use external funds through issuance of safer securities (Chang & Song n.d.). This stems from a situation when managers do not want to weaken shareholders’ trust and will only provide overpriced stocks (Autore & Kovacs 2004).

Myers (1984 as cited in Fama & French, 2002, p. 1) suggests that firms develop the pecking order which emanates when the costs in the issuance of new bonds supersede dividends. Corporate debts can be deviated so as to compensate for the deficit.

As a result, if we consider the pecking order theory, Frank and Goyal (2003, p. 218) argued that ‘in a regression of net debt issues on the financing deficit, a slope coefficient of one is observed’. This is supported by Shyam-Sunder and Myers (1999 as cited in Frank & Goyal) in their survey of 157 firms which had conducted business for the period 1971 to 1989. The pecking order has been introduced as a strained empirical test of corporate leverage but reasonable. In many instances, the pecking order theory is applicable in its predictions, as provided in the literature.

However, Abosede (2012) argues that the theory can be seen or explained from the behavioural side. Corporate managers tend to act according to their experience and talent by choosing methods where they could get no conflicts from shareholders. There is no room for inefficiency when their organisations are seeking ways to multiply gains (Abosede 2012).

The pecking order theory gets its initial ideas that suits naturally with some of the facts about how firms use outside finance. External finance covers a relatively little part of capital formation, and most of external finance is debt, and it often goes beyond investment. Equity finance is an important element of external finance (Frank & Goyal 2003).

However, on average, ‘net equity issues commonly exceed net debt issues’ (Frank & Goyal 2003, p. 218). What is more remarkable is that ‘net equity issues’ can trace the financing deficit quite effectively than do ‘net debt issues’ (Frank & Goyal 2003, p. 218).

The pecking order theory has been tested to be true and provided positive outcomes in an empirical study conducted by Meier and Tarhan (2007 as cited in Abosede, 2012). The technique assessed the behaviour of the participants (all managers) in the area of ‘information asymmetry,’ which produces problems of unfavourable choice. Providing for debt instruments can preserve shareholders’ stocks but risks may be raised. In turn, managers will gain the trust of shareholders (Abosede 2012, p. 4). This is what is meant by pecking order.

Empirical tests have weaknesses. One of these studies proved the weakness. Chirinko and Singha (2000 as cited in Frank & Goyal 2003) had doubts of the results of the Shyam-Sunder test. In that test equity issues produced negative bias. They showed that firms can issue equity, but in the Shyam-Sunder test, firms can use debt and equity without variation but ‘in fixed proportions’.

As mentioned elsewhere, there are two sources that combine to form the capital structure of firms. Selection of equity is much pronounced than debt issues because of what analysts say ‘information asymmetry’. Out of this situation, several theories have sprung up (Abosede, 2012).

The pecking-order theory is one of the theories that describe the firm’s capital structure. ‘Specific debt ratios’ are not the main aim and that external funds can only be resorted to when internal ones are not enough to finance projects. Myers and Majluf (1984 as cited in Klapper, Sarria-Allende, & Zaidi 2006) related a story wherein SME managers were running assets which needed some funding and the profitability of these SMEs was not known by a great number of people.

The story continues that if managers should consider the interest of old shareholders, they may avoid new investment, and refrain from providing shares at a lower price. Investors consider the ‘not-issuing’ scenario as a good sign and the issuing of new shares as a not-good symptom. Along with this concept of asymmetric information, Myers and Majluf (1984 as cited in Klapper, Sarria-Allende, & Zaidi 2006) introduced the pecking-order theory.

POT also predicts how debt matures and should be prioritised. Securities which have very low ‘prediction costs’ must be made priority in issuance before securities that cost a lot for the firm. In other words, the firm has to issue all short-term ones before issuing long-term debts. There were some instances, however, that this is not true, as what Barclay and Smith (1995 as cited in Frank & Goyal, 2003) had discovered in their surveys of firms.

Moreover, firms having concrete asset structure that can provide debts with collateral have higher debt statement in their ‘financial structure’ (Klapper, Sarria-Allende, & Zaidi 2006). Firms which are not transparent and do not reveal much of their requirements and have poor accounting practices that aggravate information asymmetries are a great example of this theory (Klapper, Sarria-Allende, & Zaidi 2006, p. 16).

Evidence from empirical studies points to the consistency of the POT, but still some researchers provide arguments on the contrary. A strong contention is profitability is not associated with capital structure (Friend & Lang, 1988 as cited in Arbor 2008). This assumption is supported by other studies. But one study, that of Petersen and Rajan (1994 as cited in Arbor, 2008), found that profitability was related with debt ratio.

Empirical studies (Trade-off and POT)

Empirical studies have weaknesses, but they prove theories or set of principles. In finance decisions, theories can be used to guide firms. What firms should do is to weigh the advantages and disadvantages and act according to experience. In the final analysis, applications of theories can be successful by combining it with lessons learned through experience.

Empirical studies were conducted on financing officers of U.S. firms to determine the relationship of corporate decisions and capital structure theory. Four thousand participants were asked about the circumstances surrounding their financing decisions. From this number, only 392 Chief Finance Officers (CFOs) responded. Majority of the participants responded that they would usually use practical and informal principles in making capital structure decisions. Eighty percent of the managers surveyed also provided practical answer, saying that they tended to be flexible in providing ‘target debt ratio’ (Graham & Harvey 2001 as cited in Bessler, Drobetz, & Kazemieh, 2011, p. 21). The theories helped, but not all the time. It really depends on how the CFOs view and weigh the evidence on finance problems in their respective firms.

The participants provided the concept of financial flexibility in financial decisions. Most of the participants supported the pecking order theory but were negative about ‘information asymmetry’. Consideration for profits and ‘cash flow volatility’ were significant in deciding debt issues. The trade-off and the pecking order theories forecast that instability is negatively related with leverage, or in the calculation of gains and losses. Majority of the participants also saw the importance of tax deductibles, an advantage in issuing debt as a prediction of the trade-off theory. They were negative of what theorists call imperfections, such as ‘transaction costs, under- or over-valued equity, industry debt levels, and customer/supplier comfort’ (Bessler, Drobetz, & Kazemieh 2011, p. 22).

Credit rating is another significant issue in providing debt. If credit rating is considered a substitute for possible financial distress expenses, this is quite supportive of the trade-off theory. But when the participants were asked about the effects of ‘bankruptcy and financial distress costs,’ with regards to their financing decisions, a few, about 20 percent, considered the issue as significant (Bessler et al. 2011, p. 21).

Still in the same survey, it was found that profits and ‘cash flow volatility’ were significant in deciding debt issues. The trade-off and the pecking order theories forecast that instability is negatively related with leverage, or in the calculation of gains and losses.

Baker and Wurgler’s (2002) market timing theory

Made popular in 2002, the ‘market timing theory’ refers to the technique of firms to issue shares during the time when its price shares are believed ‘overvalued’ and buying them back when the price tends to be undervalued (Baker & Wurgler 2002 as cited in Albanez, Augusto, & Franco de Lima, 2014, p. 308). In summary, it is buying equity when they are low and selling when they are high. In this sense, the capital structure is explained as the collective result of the firm’s effort to find right timing in the market (Baker & Wurgler 2002). Myers and Majluf’s theory, discussed above, is a kind of market timing.

The purpose of this practice is to take advantage of the perceived fluctuations in the prices of equity and its relations to the other prices of the different forms of capital. In our discussion of Modigliani and Miller (1958 as cited in Baker & Wurgler, 2002), the costs are no different if they can be taken individually, and so there is no point in buying and taking advantage for such reason. In sectional capital markets, shareholders are benefited by marketing. Thus, managers gain if they time the market.

In the past, highs and lows of price stocks were examined and theories correlated on those prices, with a number of works provided to explain and predict the market, but not until Baker and Wurgler (2002) did a new explanation and provide a somewhat clear vision of the workings in the market. The theory however focused on the works of several researchers and made its own analysis.

Baker and Wurgler (2002) make use of timing in their theory of capital structure. This theory proposes that firms can issue new stocks when they are overpriced and buy them again when they are undervalued. However, the instability of stock prices can affect the capital structure of firms.

Baker and Wurgler’s (2002) theory has two types. One version assumes that economic agents are rational, so equity is issued after a positive information release. This reduces the information asymmetry problem between managers and shareholders. The other one assumes the irrational nature of economic agents: managers believe that they can time the market, which causes the time mispricing of stocks. Managers would attempt to issue equity when the price is low and repurchase it when it is high. The theory states that market timing affects leverage and results of previous period influences a firm’s capital structure.

Baker and Wurgler (2002) provided an indepth analysis of the ‘market timing’ concept, at first the subject of various debates by authors and researchers, and gave their own new and expert views. Market timing influences capital structure. The two researchers aimed to determine when the ‘market-to-book ratio’ would influence the capital structure. They did this by giving out shares and if this could provide a long-term change in the leverage. However, if the firms are able to ‘rebalance’ the effect of the financial decisions, the capital structure would be unaffected (Albanez & Lima 2014, p. 311).

Empirical studies have been conducted focusing on debt and equity and the key role of these two in the firm’s capital structure (Baker & Wurgler 2007). Also, empirical data revealed that market timing has a significant role in providing financing benefits and aggravates the departure from ‘leverage’ goals in the short term (Leary & Roberts 2005, as cited in Bessler, Drobetz, & Kazemieh, 2011, p. 21). This explains the fact that firms which have constant ‘market-to-book’ ratios are considered growth firms.

Firms use this strategy because experience tells them it is successful. A theory by Zwiebel (1996 as cited by Bessler et al., 2011) supports market timing. Studies showed that analyses were conducted to analyse the relationship of stock price and the amount of securities and studies proved success for market timing. First, firms’ past actions show that they would issue equity and not debt during ‘high’ time as revealed in book values, and then repurchase them during ‘low’ time. There seems to be season for the ‘highs’ and ‘lows’ of market values.

Second, long-run terms after some decisions tend to reveal the success of market timing, i.e. firms tend to issue equity when they are low and then buy them again when they are high. Third, scrutiny of expected earnings and the happenings of equity issues reveal that firms provide equity in the market when investors are there ready and too interested to take those equity prospects (Baker & Wurgler 2002).

Finally, it has been found in surveys that managers confess having practiced market timing. The Graham and Harvey (2001 as cited in Baker & Wurgler, 2002) survey explained and used as case study above tells us that two-thirds of the surveyed CFOs admitted that they took special consideration in looking at their stock values, on how much they were ‘undervalued or overvalued’ since this is significant in determining the stock price, in which they can sell also at a high price (Baker & Wurgler 2002, p. 2).

However, market timing has to be proven in empirical studies and a question has to be answered whether this affects capital structure, in the short term or in the long term. Baker and Wurgler (2002) argued that their results proved the hypothesis about the determined impact of market timing on capital structure.

The primary finding of Baker and Wurgler’s (2002) studies is firms with low gearing would raise funds when they had high valued stocks, as revealed in their ‘market-to-book’ ratio. Firms with high leverage raise funds ‘when their market valuations were low’ (Baker & Wurgler 2002, p. 3).

The authors documented their finding using regressions and the importance of leverage. The result showed that leverage is not related at all with past ‘market valuations’ (Baker & Wurgler 2002, p. 3). But capital structure is strongly affected by past market valuations and with strong statistical support. In the study, there was a recorded relationship when leverage was weighed in market values.

The two author-researchers used regressions concentrating on ‘market-to-book’ and argued that a variation in the regression explained the fact that variations influenced change in capital structure. The two argued further that variations in market value have long-term effects on the capital structure, but they posit that it is difficult to provide arguments for this trend using traditional theories.

The trade-off theory tells managers of the temporary fluctuations and the corresponding temporary impact. Baker and Wurgler’s (2002) evidence showed that there were unrelenting effects in the ‘market-to-book ratios’.

On the other hand, in the pecking-order theory, unfavourable choice would force managers to shun from giving out equity completely. One form of the theory states that firms with forthcoming investment chances may reduce gearing to shun from providing equity in the long run. However, it is difficult to understand a concept of the pecking order theory that tells of a robust relationship between leverage and a chain of investment chances (Baker & Wurgler 2002).

The accepted account of the pecking order theory tells us that seasons of high leverage will forward leverage higher for a debt capability, but it should not be going down, which is the result of the studies of Baker and Wurgler (2002). Zwibel’s (1996 as cited in Baker & Wurgler, 2002) theory argued that high assessments would tell managers to provide equity but make the managers embed, ‘resisting the debt finance necessary to restore debt to the optimum’ (Baker & Wurgler 2002, p. 3).

Extreme bound analysis (EBA)

Extreme-bound analysis was first introduced by Leamer (1985) and has been devised by researchers, economists, scientists, and many others interested in looking for and perfecting knowledge. Researchers also use EBA to determine a causal relation between low wages and increase in crimes (Fowles & Merva 1996 as cited in Hlavac n.d.). Others use it to examine the relation of globalisation and human rights.

This theory states that ‘a coefficient of theoretical interest is robust to the extent that this coefficient exhibits a small range of variation to the presence or absence of other explanatory variables’ (Hafner-Burton 2005, p. 687).

The basic concept of EBA can be viewed as simplistic. The researcher is interested in looking for variables from a particular grouping which might be ‘robustly’ related with a dependent variable. This can be done by using a regression.

Leamer (1985 as cited in Durham, 2003) argued that assumption is used when choosing the right side in the multivariate regression. There are strong inferences only when the assumptions are accompanied with independent variables coming from previous researches and studies, using statistical significance.

EBA computes a variety of expected coefficients from a group of statistics and offers an instinctive way for finding whether an empirical study is strong or has little (or no) evidence (Ericsson 2008, para. 1).

Leamer (1983 as cited in Barker, 2010, p. 41) calls it ‘model of uncertainty’ as he proposed to test the different results to other models, and if this is attained, ‘extreme bound analysis’ has been performed. This is the application of different variables to test the model wherein the most distinct coefficient results from the regression analysis are used to compare with the original variable. The assumption here is that the results which rely on specified ‘model specification’ will not reflect on a fundamental truth on a certain population, and will reveal the peculiarities of the pertinent ‘data sample’ being studied (Barker 2010).

‘Robustness’ literally means strength. Leamer (as cited in Ericsson, 2008) defined this term in relation to ‘fragility’ by applying coefficients and some statistics (‘class of models’). Ericsson (2008) proved that inclusion does not mean it is necessary to make robustness. He explained that EBA emphasises the disparity of approximated coefficients across some ‘models’ (Ericsson 2008, para. 3). Coefficient variation is interested on important variables (with causes). EBA respects every variation, even those without causes.

Inferences are considered ‘robust’ once the assumptions are associated with independent variables that were taken from reliable literature and the coefficient results provide statistical significance (Durham 2003). Nevertheless, an assumption no matter how statistically significant cannot provide a real understanding of the cited variable if there are no further information and explanation.

This kind of analysis or ‘specification search’ has been criticised because it does not conform to common theoretical processes. McAleer and colleagues (1985 as cited in Barker, 2010) provided strong arguments, saying that it is illogical to not include a variable from a regression analysis if it has to be included according to standard norm, because the exclusion of a particular variable can lead to unclear results.

Researchers Ehrlich and Lieu (1999 as cited in Barker, 2010) argued that an eliminated ‘control variable’ could lead to weak inference. Leamer’s strongest argument states that extreme bound is ‘the highest or lowest estimate from the model reestimations, plus and minus two standard deviations’ (Barker 2010, p. 42). A situation reached where the relationship is not ‘robust’ refers to the ‘upper and lower bounds’ of the regression (upper positive, and lower negative), which means it oversteps zero.

Relying on a few results can be unreliable. Leamer (1985) has pointed this out, arguing that under uncertainty of model selection one has to show how much result depends on which variable are included in the regression, and then it has to be changed.

Levine and Renelt (1992 as cited in Zarra-Neshad, Hosseinpour, & Arman, 2014) used Leamer’s EBA to identify robust relations shown in empirical studies. Levine and Zervos (1993 as cited in Zarra-Neshad, Hosseinpour, & Arman, 2014) added that EBA helps elucidate the level of confidence that can be applied to the partial correlations between one dependent variable and a number of independent variables. If in the regression there is a significant correlation on the dependent variable, then the researcher should feel more confident about the independent variable than an indicator which has a weak link.

Granger and Uhlig (1990)

Granger and Uhlig (1990) explained the limits on the basis of a portion of approximate ‘coefficients’ and higher R2. Granger and Uhlig (1990 as cited in Barker, 2010) described the bounds on some expected coefficients which are the results of regressions with high observational results (R square). They explained that a low R2 in a regression analysis is incorrect result and therefore should be excluded in the bounds. McAleer et al.’s (1985) analysis of interest and inflation did not produce conclusive results of the long-run terms of interest and inflation.

Sala-i-Martin provides his own version of EBA, arguing that it approximates the standard regression where the coefficients are presumed to be especially spread across different types, but the generic one does not make any supposition (Singh 2014, p. 245).

Sala-i-Martin (1997 as cited in Barker, 2010) indicated that the definition provides a lot of problems to what researchers call ‘real-world relationships’. We can draw results from regression but if we have to do several tests, we can get different results in the coefficients. The definition also suggests that a robust relationship could never be attained (Sturm & de Haan 2005 as cited in Barker, 2010, p. 42).

Sala-i-Martin (1997 as cited in Durham 2003) reviews the regression for EBA. This calculates the ‘sensitivity’ of a specific variable. The regression formula is stated below.


The variables represented are:

Formula the dependent variable

Formula the ‘doubtful variable’

Formula represents the ‘free variables’

Formula also represents the Formula variables, and

Formula other doubtful variables’.

The EBA involves providing Formula regressions focusing linear models of several variables from Formula in Formula, but the factors must be specified.

Sala-i-Martin and colleagues (2004 as cited in Ngeleza, 2007, p. 4) provided a Bayesian method to ‘sensitivity analysis’ in finding the variables significantly associated to the subject they were searching, e.g. growth in developing countries. With enough information in the literature, they were able to find those economic variables and applied the regression.

A meta-analysis can be applied with regression, as in the Sala-i-Martin’s method using a lot of information from the literature. The regression introduced in Sala-i-Martin focuses on all coefficients and not only on the extreme bounds. Sala-i-Martin takes into account all the variables in the regression. He places some trust on the robust variables.

Extreme bounds are packaged in a software to provide ease for researchers to do their regression. A software package supports both Leamer’s and Sala-i-Martin’s concepts of EBA.

Sala-i-Martin (1997 as cited in Zarra-Neshad, Hosseinpour, & Arman, 2014) argued that the criteria used in EBA are not so flexible and difficult for any variable for analysis and thus would not pass. His version provided a confidence level to stop giving the level of one or zero to the variables, and applied the whole distribution of coefficients of the M-variable, (Formula). This was followed with a computation of the fraction of cumulative distribution function which was situated on each side of zero and called the greatest area CDF(0). Sala-i-Martin (1997 as cited in Zarra-Neshad, Hosseinpour, & Arman, 2014) argued that ‘even though each individual (Formula) follow a t student distribution, ‘all estimates might be scattered in an unrecognized fashion’ (Zarra-Neshad 2014, p. 918). Sala-i-Martin’s approach is quite different. Sala-i-Martin and many brilliant researchers (e.g. Levine and Renelt, 1992) approximated their models using of a cross-section data.

One disadvantage of EBA is that the initial separation of variables into the M and in the Z vector is likely to be illogical or subjective. The regression should be able to consider all the other variables and not just one.

Theatrical predictions and empirical studies

Researchers usually rely on existing theories and literature in determining variables that are relevant to include in a regression. However, the existing literature does not provide a clear path to direct empirical work on capital structure. There is no model that specifies a full set of descriptive variables to be included in a regression. Consequently, there is an emphasis on using EBA to reveal the robustness, fragility or insignificance of various determinants of capital structure. EBA can provide a faithful analysis of factors affecting capital structure.

Rajan and Zingales (1995) studied factors that affect capital structure among G-7 countries. They found a similarity in the determinants of firm leverage across G-7 countries and advocated a deeper understanding of the determinants and effects of institutional differences. Their findings support the theories on capital structure.

Bevan and Danbolt (2002) studied factors of capital structure in the UK, focusing on 822 firms for the period 1991 and 1997, and found that the determinants of leverage are different for as long as the components of debt are different. In studying the capital structure of firms of developed and developing economies, Demirguc-Kunt and Maksimovic (1999) found that capital structure choices, whether large or small firms, are influenced by institutional rules and culture.

Many other studies (such as Marsh, 1982; Titman and Wessels, 1988; and Antoniou et al. 2008) investigated the determinants of capital structure for developing countries. These studies argue for the use of firm determinant effects as well as institutional and environmental differences, which profoundly influence capital structure choice.

Bhabra, Liu and Tirtiroglu (2008) investigate the capital structure decisions of listed firms in China between 1992 and 2001. They adopted a similar approach to Demirguc-Kunt and Maksimovic (1999) and Booth et al. (2001), and tested the role of various categories of ownership structures (with different monitoring abilities and legal rights) on sample firms’ long-term leverage ratios in an environment without a significant external corporate control market. The researchers found that Chinese firms use very little long-term debt and that the Chinese stock market does not motivate the long-term leverage market to grow. Their results regarding firm-specific determinants are consistent with the results of other studies on developed and emerging economies.

Other studies, such as Booth et al. (2001), Claessens, Djankov and Nenova (2001), and Bancel and Mittoo (2004), have found that in addition to firm determinants of capital structure, country determinants also influence capital structure. De Jong, Kabir and Nguyen (2008) found the significance of factors like ‘firm-specific’ and ‘country specific’ in finding leverage of firms. Country-specific factors can directly or indirectly affect the capital structure of firms. The researchers also found that country determinants and institutional differences affect the leverage choice of firms. Their findings support theory predictions of capital structure, emphasising size, risk, growth structure and profits of firms. However, some of their findings on firm-specific factors did not conform with theory predictions.

Moosa et al. (2011) investigate the firm-specific determinants of capital structure on 344 publicly listed firms in China. They used extreme-bound analysis (EBA) to test the robustness of 9 variables (‘size, liquidity, profitability, tangibility, growth opportunities, payout ratio, stock price performance, age of firm and income variability’) reported as important in previous studies. There were strong and fragile variables found in the study. The fragile variables were tangibility and stock price performance, while the remaining variables were insignificant.

Theatrical predictions

Liquidity – This is a characteristic of a firm that converts asset into cash or any money equivalent in the present operating series in connection with the firm’s expected cash expenses. Liquidity is needed to fund operations but if this is not properly managed, it becomes wasted. Liquidity can be similar to financial slack, although the latter refers to excess of liquidity with respect to the next operating cycle (Graham 2000).

Risk – Risk levels are one of the main elements of capital structures. Firms have the option not to use their tax incentives according to the static trade-off theory. Because of these costs, they tend not to utilize debt and its benefits. The operating risk allows the firm to default its financing sources. If firms have weaker earnings they experience lower cash flows, and those with high level of risks cannot sustain high financial risks.

Payout ratio – refers to the dividends which the stockholders receive relative to the corporate profits. This is calculated by means of dividing common dividends with net income. Another way of calculating it is by using ‘per share amounts’. Corporations provide varying dividends to their shareholders (Rich et al. 2012, p. 613).

Share price performance – can be considered strategic for a firm and is sometimes revealed to the public in connection with the firm’s corporate social responsibility (CSR). Along with CSR, share price performance must be disclosed to the firm’s shareholders and the stakeholders in general. This is usually done by public organisations. The share value of the organisation is levelled up more than organisations who do not disclosed their CSR activities (Robinson, 2010 as cited in Moss, 2014, p. 3).

Asset utilisation – also refers to asset performance. This refers to the ways or methods in using the firm’s assets to produce cash or revenues for its various operations. Some of the ratios involved fall under the turnover ratio. An example of turnover ratio in asset utilisation shows the number of times the firm’s entire inventory changes in a particular accounting cycle.

Age of the firm – In humans, age does matter, so does in firms. It is an average measure of how its capital structure model holds. As it grows in age, the firm creates a reputation as a strong company and so it has the capability to take what others have difficulty to hold, debt.

Income variability – refers to how a firm provides variability in order to acquire earnings or profits from its products or businesses. The way a firm conducts variability affects the level of business risks the firm faces in the course of its operations. The risk therefore is measured by the stability of the company’s operating income in a particular accounting period (Reilly & Brown 2012, p. 194).

Tax rate – Taxes affect debt and equity, more so on firms’ financing decisions. ‘Marginal tax rate’ greatly influences a firm’s financing decision. Tax shields influence a firm whether to go on debt financing or not. However, the effect of taxes on financial decisions is not ‘large’ (Graham 1999). There are other tax shields that can substitute debt, and these are depreciation, R&D costs of firms, tax deduction for investments, etc.

Tax shield effects – One of the known tax shields is investment tax credit (ITC). One of the moral-hazard theories state that firms with more tangible assets are more have a great chance of issuing debt because of assets that can be used as collateral. ITC can be used but there is the danger of financial distress. Firms can use tax shield effects to reduce financial distress (MacKie-Mason 1990, p. 91).

Inventory – The literature on inventory emphasises on production and obtaining supplies as a major determining factor of a corporation’s inventory policy. Trade-off theory on this aspect states that ordering and warehousing costs are the main features in the transaction approach. Management frameworks have also been added on this context that includes ‘material requirements planning systems’ (MRP), enterprise resource planning (ERP), just-in-time (JIT) concept, and others (Koumanakos 2008, p. 355).

Uniqueness of the product – Titman and Wessels (1988) provide three possible measures that firms should have to make an effective selling. The concept of ‘Selling Expenses/Sales’ emphasises that unique products should be given rigorous selling endeavour. The next is ‘R&D/Sales,’ which means unique products are the result of intensive R&D. Finally, employees who come from industries with unique products cannot just leave the firm because it is too costly. Titman and Wessels state that firms which emphasise on R&D and have more selling expenses have the tendency to have low debt ratios.

Expected inflation – Inflation is about the rise of prices of primary commodities in a particular year, and this is measured by the consumer price index (CPI). What economists call nominal interest rates go together with expected inflation. Nominal interest rate is calculated using ‘real interest rate’ along with expected inflation. These two factors tend to move together, thus pushing stock prices down.

Capital intensity – refers to the amount of capital that a firm should produce to create a dollar of revenue. Higher capital-intensity means more assets for the firm to generate more sales.

Managerial insiders have to be watchful of the various risks in the firm, for example bankruptcy risk accrued through debt financing, and they should be able to minimise risk by not too excessive in using the money of the company. Insiders who have greatly invested in the firm tend to be more careful in using debt financing. Moreover, the insiders’ ‘locus of control’ determines where sources of funds should be taken. For example, when the manager decides for the firm, s/he will choose equity over debt because the manager will protect the wealth s/he has invested in the company. The manager has to get away from the performance pressure afforded by debt requirements. The reverse will happen if the locus of control is placed upon shareholders who have no role in management. In this case, the firm will have more debt which limits managerial judgment.

Growth rate variables

Growth opportunities – Jensen and Meckling (1976) and Myers (1977) agreed that levered firms (companies that finance their operations through loans) can work on ‘asset substitution and underinvestment’ (Bessler, Drobetz, & Kazemieh 2011, p. 25). A firm’s growth will require internal funds which motivates more borrowing (Hall et al. 2004). Higher growth means ‘higher debt ratios’ (Marsh 1982 as cited in Abor, 2008, p. 9). SMEs will have to acquire more external funds, but financing does not necessarily mean growth; it could be the opposite (Abor 2008). While firms grow and pass through different stages as firms, they should also change financing sources; they have to shift from internal funds to externally-sourced funds (Aryeetey 1998 as cited in Abor 2008). Previously-attained growth has an effect on future growth. Future financing situations are associated with short-term leverage.

Change in assets – Firm insiders (such as managers, directors, officers) have different outlook because they have high stakes in the firm, having placed investment and personal wealth in the firm. Most of these investments are in the form of common stock and the human capital they have spent for the time they have worked for the firm. Any financial distress or bankruptcy can impact on the firm insiders.

Change in sales – With change of ownership, sales strategies have to change according to manager’s and owner’s perceptions. Everything is affected in the sales process.

Capital expenditures – refer to funds used by firms to finance existing projects and to increase the value of the firm. Funds are needed by firms to finance activities. They may come from equity or debt.

Tangible assets – The pecking order theory states that tangible assets are needed to avoid more asymmetric information problems. Tangibility refers to the measure of the degree of guarantee a firm can provide to its issuers. Debtors can be given high ratio with much security, considering that assets can be liquidated for bankruptcy. But a low ratio provides small collateral during bankruptcy. Tangibility guarantees debts to be less unsafe, but the capital structure is still not clear. If creditors can be paid through assets, there is a chance of recovery. The trade-off theory states that if there is a low chance of financial distress and low agency costs, there is a positive correlation between ‘tangible assets and leverage’ (Bessler, Drobetz, & Kazemieh 2011, p. 24).

Firm size – An argument states that large firms are more diversified than small ones, and so do not fail often. The trade-off theory states that size is inversely proportional to the possibility of bankruptcy, and so there is a positive correlation between size and leverage. But size can be considered as a substitute for information asymmetry between managers and capital markets. Large firms are subject of research by analysis, or there are always in the forefront.

Profitability – The trade-off theory proposes that factors like bankruptcy and taxes, including agency costs, provide more leverage for firms. Forecasted bankruptcy charges go down when earnings go up. Additionally, firms prefer more debt financing due to deductible interest which reduces the firms’ income subject to tax. Jensen (1986) argues that the firm’s high leverage controls agency issues by allowing managers to give more from the firm’s flowing cash. The manager’s commitment to use money from its earnings for payments would reflect that leverage increases profitability, or there is a strong relationship between the two. This concept tells us that theories in the capital structure are true, or can be proven, where firms can use debt to indicate and forecast a positive future for the company (Ross 1977 as cited in Bessler, Drobetz, & Kazemieh, 2011).

Country specific determinates

Creditor right protection – Just like any individual or group, creditors have rights that should be protected by law. This is to encourage creditors to lend more for the development of a group or country (La Porta et al., 1997 as cited in Beugelsdijk & Maseland, 2011, p. 266). Creditors should be given the right to own the collateral to a loan in case of default, and to be protected once firms go to court regarding a credit or a loan.

Bond market development – Bond markets are used for developing countries. The job is focused on central banks which involve big amounts to finance projects for country development, and mostly this is aimed at countries with budget deficits. Central banks or monetary boards are responsible for developing monetary policies for the development of bonds.

Stock market development – The stock market and returns influence the firm’s capital structure, or the returns determine how the capital structure should work out. Moreover, stock returns seem to be more important than the rest of the factors, although this is only for the short term.

Shareholder right protection – There are a number of rights that shareholders should have as part owner of the firm. If the company earns, the shareholders must also gain through dividend. They have voting rights on important decisions for the firm, are part owner of the firm, entitled to dividends, and can go to court to protect their rights.

Capital formation – refers to additional expenditures to a country’s fixed assets. This also includes changes in the inventories. A developing country’s fixed assets may include land improvements, machineries, equipments, roads, highways, public buildings, and even private buildings and commercial establishments.

GDP growth – refers to the average growth of the gross domestic product of a country. Gross domestic product includes products and services created or produced annually by a developed or developing country.

Market timing – The prediction of the market timing theory states that managers will not stand by, or stay idle, and create no actions in case the firm’s value is affected by market forces. Instead, they will act and work for effective strategies through equity issues when the stocks are low. The pecking order theory is consistent in its assumption of an adverse selection that leverage is not related with stock prices. The hypothesis states that firms go on issuing equity for as long as stock prices increases. If information asymmetry is not constant, that is to say ‘time varying,’ the intensity of the outcome on selection costs can be controlled by the firm, and so the firm’s manager will react by issuing equity because the manager hopes that there will be less undesired results.

Equity premium – refers to differential returns on the stock market, whether it is historical, expected, incremental, and implied or assumption of the correctness of the market price (Fernández 2006).

Term-structure of interest rates – This plays a key role in a country’s economy. It refers to hopes of market players about possible positive modifications in interest rates and their comments of current monetary policies.

GNP – the gross national product of a country may be stated in statistics that refer to its production or utilisation of products and services. GNP refers to a country’s growth. It is also similar to GDP or gross domestic product in that it represents how a country is growing.


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