TRENDS IN CAPITAL STRUCTURE
TRENDS IN CAPITAL STRUCTURE
INTRODUCTION
Money is the root of all progress. In academic and profession jargon, it is termed as finance. The different levels of finance include business finance, personal finance and public finance. Across different levels, the term ‘finance' is used in three senses. First, it refers to stock of money. Second, it refers to arrangements to meet commitments. Third, it refers to make arrangements to raise finance based on cost minimization, because money is scarce and hence money, like goods and services, can be bought and sold for a price. The field of finance deals with the concepts of time, money and risk and how they are interrelated. Since financial capital has a price, its acquisition and future utilization will have to be evaluated carefully. We may describe the task of finance as consisting of three As: (i) Anticipating financial needs, (ii) Acquiring financial resources, and (iii) Allocating funds for economic activities. Hence it is popularly described as the science of funds management.
CONCEPT OF CAPITAL STRUCTURE
The capacity of a firm to operate its activities is based on the availability of funds. Normally, these funds in finance literature are termed as long term funds, which are contributed by owners (shareholders) and outsiders. The owners' funds are represented by equity contributions and internally generated financial resources. A unique characteristic of procuring funds is that a firm may tap any of these sources and hence the blend of these different sources of long term funds is termed as capital structure in finance literature. Capital structure ordinarily implies the proportion of debt and equity in the total capital of a firm. In the term, ‘capital structure,' capital refers to long term funds and structure refers to the proportion of debt and equity in capital. Further, capital is easily comprehended through accounting as the difference between Total Assets and Current Liabilities, and this residual difference is always represented by debt and equity.
Capital structure could be defined in so many ways. In US it is defined as Long-term debt ratio. In emerging countries like BRIC nations companies employ both short term as well as long term debt for financing their assets as well as for financing their current assets.
It is also general for companies in budding countries to replace with short-term debt for long-term debt and roll over short-term debt. Hence, it is more suitable and mainly in the context of developing economies, to define capital structure as total debt ratio.
CAPITAL STRUCTURE ANALYSIS
The domain of capital structure analysis is often presented through structural leverage, which expresses the relationship between owners' capital and debt capital. The main ratios in analyzing capital structure include debt-equity ratios, total debt-equity ratio and debt to net worth ratio. The debt-equity ratio is determined by dividing long-term debt by equity. Total debt to equity ratio is calculated by dividing long-term debt plus short-term liability by shareholders funds. Debt to net worth ratio is determined by dividing long-term debt by shareholders funds. In fact, these structural leverage ratios are also called ‘capital gearing ratios.' It is also important to note that when capital structure analysis is made, often the term, ‘leverage' is popularly used.
THEORETICAL DEVELOPMENTS
Many researchers in finance have developed many theories or generalizations about the capital structure based on the endogenous and exogenous environment. The present study documents only those generalizations related to the present topic of research
Leverage is positively correlated with firm value (Harris & Raviv (1990a), Stulz (1990), Hirshleifer (1964). Leverage is positively correlated with default probability (Harris and Raviv (1990a). Leverage Increases with lack of growth opportunities (Jensen and Meckling (1976), Stulz (1990). Leverage increases with decreases in profitability (Chang (1987). Leverage increases with extent of regulation and Meckling (1976), Stulz (1990). Leverage augment with boost in free cash flow (Jensen (1986), Stulz (1990). Leverage add to with enlarge in liquidation value Williamson (1988), Harris and Raviv 1990a). Bonds can be likely to have agreement prohibiting "asset substitution" (Jensen & Meckling 1976).
Leverage is pessimistically connected with the interest coverage ratio and the likelihood of restructuring next default (Harris and Raviv (1990a).Leverage augment with part of cash flow that is unobservable (Chang (l987) Leverage boost with extent to which the firm is a conquest target or lack of anti-takeover measures (Stulz (1990), Hirshleifer (1964).
Firms with longer track records have lower evasion likelihood (Diamond (1989). Leverage augment with reduce in examination costs (Harris and Raviv (1990a). Leverage increases with extent to which product is not exclusive and does not require dedicated service (Titman ,1984).
Leverage boost with degree of planned communication In the product market (Brander & Lewis (1986). Leverage increases with suppleness of demand for the product (Maksimovic (1988). Leverage increases with the extent to which status for product quality is unimportant (Maksimovic and Titman (Forthcoming).
APPROACHES TO CAPITAL STRUCTURE DETERMINATION
The market deficiencies have led to the materialization of diverse theories of capital structure disclaim the MM hypothesis. In fact, these theories are the move toward or strategies to capital structure decisions. These theories center on the most favorable capital structure, risk level, managerial attitude towards debt, or market conditions. The main theories of capital structure decisions include (i) Trade-off Theory; (ii) Pecking Order Theory; (iii) Agency Cost Theory. (iv) Managerial Entrenchment Theory; and (iv) Market Timing Theory.
(i) Trade-off Theory:
Some of the imperfections that lead to an optimal trade-off are as follows. Higher taxes on dividends indicate more debt (Modigliani and Miller (1963) and Miller and Scholes (1978)). Higher non-debt tax shields indicate less debt (DeAngelo and Masulis (1980)). Higher costs of financial distress indicate more equity.
Little of insolvency, senior debt can force managers to relinquish gainful investment opportunities (Myers (1977)). Agency troubles can call for more or less debt. Too much equity can lead to free cash flow and disagreement of interest between managers and shareholders (Jensen (1986)).
Going for more debts could lead to assets substitution and disagreement of interest amid managers and bondholders (Fama and Miller (1972) and Jensen and Meckling (1976)). Harris and Raviv (1991) survey these and other likely influences on optimal capital structure.
(ii) Pecking Order Theory:
According to Myres(1984) in the pecking order theory, there is no best capital structure. To be more precise, if there is an most advantageous level, the cost of deviating from it is irrelevant in contrast to the cost of raising outside finance.
Relying on external source of finance is a costly affair because managers have more information about the firm's forecast than outside investors and because investors know this. In Myers and Majluf (1984), outside investors sensibly discount the firm's stock price when managers issue equity instead of riskless debt.
(iii) Managerial Entrenchment Theory:
In the vibrant conjecture of capital structure based on managerial entrenchment in Zwiebel (1996), high assessment and good investment opportunities make easy equity finance, but at the identical occasion allow managers to become deep-rooted. They may then reject to raise debt to rebalance in later periods.
This has a market-timing real meaning, since managers float equity when assessment are high and do not afterward rebalance, but a very unusual analysis. Managers are not endeavor to make use of new investors; rather, they are make use of on hand investors ex post by not rebalancing (Booth et al: 2001).
Both views may be valid. However, the first view gains support from the survey evidence and particularly from the evidence on earnings management and the long-run returns following equity issues and repurchases.
(iv) Market Timing Theory:
This theory implies that capital structure develop as the growing result of past effort to time the equity market. There are two side of equity market timing that lead to similar capital structure dynamics.
In the first dynamic form of Myers and Majluf (1984) with rational managers and investors and adverse selection costs that vary across firms or across time. Lucas and McDonald (1990) and Korajczyk, Lucas, and McDonald (1992) study adverse selection that varies across time.Consistent with these stories, Korajczyk et al (1991) find that firms tend to announce equity issues following releases of information, which may reduce information asymmetry.
(v) Agency Cost Theory:
Long back, Adam Smith (1776)observed: "The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartner frequently watch over their own.
Like the stewards of a rich man, they are suitable to think interest to small matters as not for their master's tribute, and very easily give themselves a indulgence from having it. carelessness and abundance, therefore, must always prevail, more or less, in the management of the affairs of such a company."
The agency cost theory is premised on this observation of Adam Smith in the sense that the interests of the company's managers and its shareholders are not perfectly aligned. In their seminal paper Jensen and Meckling (1976) emphasized the importance of the agency costs of equity arising from the separation of ownership and control of firms whereby managers tend to maximize their own utility rather than the value of the firm. These conflicts may occur in situations where managers have incentives to take excessive risks as part of risk shifting investment strategies.
This leads us to Jensen's (1986) ‘‘free cash flow theory" where as stated by Jensen (1986, p. 323) ‘‘the difficulty is how to inspire managers to pour out the cash relatively than investing it below the cost of capital or wasting it on organizational inefficiencies."
Thus soaring debt ratios may be used as a corrective device to reduce managerial cash flow waste in the course of the risk of liquidation (Grossman and Hart, 1982) or through force to produce cash flows to service debt (Jensen, 1986). In these situations, debt will have a positive effect on the value of the firm.
Agency costs can also be present from clash amid debt and equity investors. These variance arise when there is a risk of non-payment. The peril of default may construct what Myers (1977) referred to as an ‘‘underinvestment" or ‘‘debt overhang" problem. In this case, debt will have a negative effect on the value of the firm.
CONCLUSION:
Until the early nineties, corporate financial management in India was moderately a drab and easygoing activity. The financial sector reforms, with the onset of liberalization, privatization and globalization, have altered this placid activity into a flexible and dynamic activity. Corporate finance managers today have to opt from a range of financial instruments. They can now price them or less freely. They are open to book-building process of IPOs. They have access to global financial markets. They have to deal with violent financial intermediaries and institutional investors. They are exposed to instability of interest and exchange rates. They have to take serious not of capital structure decisions and worry about their credit ratings in view of bloodthirsty financial markets. All these challenges for corporate managers have been the result of elimination of capital issues control and the introduction of pricing of equity issues in 1992.
INTRODUCTION
Money is the root of all progress. In academic and profession jargon, it is termed as finance. The different levels of finance include business finance, personal finance and public finance. Across different levels, the term ‘finance' is used in three senses. First, it refers to stock of money. Second, it refers to arrangements to meet commitments. Third, it refers to make arrangements to raise finance based on cost minimization, because money is scarce and hence money, like goods and services, can be bought and sold for a price. The field of finance deals with the concepts of time, money and risk and how they are interrelated. Since financial capital has a price, its acquisition and future utilization will have to be evaluated carefully. We may describe the task of finance as consisting of three As: (i) Anticipating financial needs, (ii) Acquiring financial resources, and (iii) Allocating funds for economic activities. Hence it is popularly described as the science of funds management.
CONCEPT OF CAPITAL STRUCTURE
The capacity of a firm to operate its activities is based on the availability of funds. Normally, these funds in finance literature are termed as long term funds, which are contributed by owners (shareholders) and outsiders. The owners' funds are represented by equity contributions and internally generated financial resources. A unique characteristic of procuring funds is that a firm may tap any of these sources and hence the blend of these different sources of long term funds is termed as capital structure in finance literature. Capital structure ordinarily implies the proportion of debt and equity in the total capital of a firm. In the term, ‘capital structure,' capital refers to long term funds and structure refers to the proportion of debt and equity in capital. Further, capital is easily comprehended through accounting as the difference between Total Assets and Current Liabilities, and this residual difference is always represented by debt and equity.
Capital structure could be defined in so many ways. In US it is defined as Long-term debt ratio. In emerging countries like BRIC nations companies employ both short term as well as long term debt for financing their assets as well as for financing their current assets.
It is also general for companies in budding countries to replace with short-term debt for long-term debt and roll over short-term debt. Hence, it is more suitable and mainly in the context of developing economies, to define capital structure as total debt ratio.
CAPITAL STRUCTURE ANALYSIS
The domain of capital structure analysis is often presented through structural leverage, which expresses the relationship between owners' capital and debt capital. The main ratios in analyzing capital structure include debt-equity ratios, total debt-equity ratio and debt to net worth ratio. The debt-equity ratio is determined by dividing long-term debt by equity. Total debt to equity ratio is calculated by dividing long-term debt plus short-term liability by shareholders funds. Debt to net worth ratio is determined by dividing long-term debt by shareholders funds. In fact, these structural leverage ratios are also called ‘capital gearing ratios.' It is also important to note that when capital structure analysis is made, often the term, ‘leverage' is popularly used.
THEORETICAL DEVELOPMENTS
Many researchers in finance have developed many theories or generalizations about the capital structure based on the endogenous and exogenous environment. The present study documents only those generalizations related to the present topic of research
Leverage is positively correlated with firm value (Harris & Raviv (1990a), Stulz (1990), Hirshleifer (1964). Leverage is positively correlated with default probability (Harris and Raviv (1990a). Leverage Increases with lack of growth opportunities (Jensen and Meckling (1976), Stulz (1990). Leverage increases with decreases in profitability (Chang (1987). Leverage increases with extent of regulation and Meckling (1976), Stulz (1990). Leverage augment with boost in free cash flow (Jensen (1986), Stulz (1990). Leverage add to with enlarge in liquidation value Williamson (1988), Harris and Raviv 1990a). Bonds can be likely to have agreement prohibiting "asset substitution" (Jensen & Meckling 1976).
Leverage is pessimistically connected with the interest coverage ratio and the likelihood of restructuring next default (Harris and Raviv (1990a).Leverage augment with part of cash flow that is unobservable (Chang (l987) Leverage boost with extent to which the firm is a conquest target or lack of anti-takeover measures (Stulz (1990), Hirshleifer (1964).
Firms with longer track records have lower evasion likelihood (Diamond (1989). Leverage augment with reduce in examination costs (Harris and Raviv (1990a). Leverage increases with extent to which product is not exclusive and does not require dedicated service (Titman ,1984).
Leverage boost with degree of planned communication In the product market (Brander & Lewis (1986). Leverage increases with suppleness of demand for the product (Maksimovic (1988). Leverage increases with the extent to which status for product quality is unimportant (Maksimovic and Titman (Forthcoming).
APPROACHES TO CAPITAL STRUCTURE DETERMINATION
The market deficiencies have led to the materialization of diverse theories of capital structure disclaim the MM hypothesis. In fact, these theories are the move toward or strategies to capital structure decisions. These theories center on the most favorable capital structure, risk level, managerial attitude towards debt, or market conditions. The main theories of capital structure decisions include (i) Trade-off Theory; (ii) Pecking Order Theory; (iii) Agency Cost Theory. (iv) Managerial Entrenchment Theory; and (iv) Market Timing Theory.
(i) Trade-off Theory:
Some of the imperfections that lead to an optimal trade-off are as follows. Higher taxes on dividends indicate more debt (Modigliani and Miller (1963) and Miller and Scholes (1978)). Higher non-debt tax shields indicate less debt (DeAngelo and Masulis (1980)). Higher costs of financial distress indicate more equity.
Little of insolvency, senior debt can force managers to relinquish gainful investment opportunities (Myers (1977)). Agency troubles can call for more or less debt. Too much equity can lead to free cash flow and disagreement of interest between managers and shareholders (Jensen (1986)).
Going for more debts could lead to assets substitution and disagreement of interest amid managers and bondholders (Fama and Miller (1972) and Jensen and Meckling (1976)). Harris and Raviv (1991) survey these and other likely influences on optimal capital structure.
(ii) Pecking Order Theory:
According to Myres(1984) in the pecking order theory, there is no best capital structure. To be more precise, if there is an most advantageous level, the cost of deviating from it is irrelevant in contrast to the cost of raising outside finance.
Relying on external source of finance is a costly affair because managers have more information about the firm's forecast than outside investors and because investors know this. In Myers and Majluf (1984), outside investors sensibly discount the firm's stock price when managers issue equity instead of riskless debt.
(iii) Managerial Entrenchment Theory:
In the vibrant conjecture of capital structure based on managerial entrenchment in Zwiebel (1996), high assessment and good investment opportunities make easy equity finance, but at the identical occasion allow managers to become deep-rooted. They may then reject to raise debt to rebalance in later periods.
This has a market-timing real meaning, since managers float equity when assessment are high and do not afterward rebalance, but a very unusual analysis. Managers are not endeavor to make use of new investors; rather, they are make use of on hand investors ex post by not rebalancing (Booth et al: 2001).
Both views may be valid. However, the first view gains support from the survey evidence and particularly from the evidence on earnings management and the long-run returns following equity issues and repurchases.
(iv) Market Timing Theory:
This theory implies that capital structure develop as the growing result of past effort to time the equity market. There are two side of equity market timing that lead to similar capital structure dynamics.
In the first dynamic form of Myers and Majluf (1984) with rational managers and investors and adverse selection costs that vary across firms or across time. Lucas and McDonald (1990) and Korajczyk, Lucas, and McDonald (1992) study adverse selection that varies across time.Consistent with these stories, Korajczyk et al (1991) find that firms tend to announce equity issues following releases of information, which may reduce information asymmetry.
(v) Agency Cost Theory:
Long back, Adam Smith (1776)observed: "The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartner frequently watch over their own.
Like the stewards of a rich man, they are suitable to think interest to small matters as not for their master's tribute, and very easily give themselves a indulgence from having it. carelessness and abundance, therefore, must always prevail, more or less, in the management of the affairs of such a company."
The agency cost theory is premised on this observation of Adam Smith in the sense that the interests of the company's managers and its shareholders are not perfectly aligned. In their seminal paper Jensen and Meckling (1976) emphasized the importance of the agency costs of equity arising from the separation of ownership and control of firms whereby managers tend to maximize their own utility rather than the value of the firm. These conflicts may occur in situations where managers have incentives to take excessive risks as part of risk shifting investment strategies.
This leads us to Jensen's (1986) ‘‘free cash flow theory" where as stated by Jensen (1986, p. 323) ‘‘the difficulty is how to inspire managers to pour out the cash relatively than investing it below the cost of capital or wasting it on organizational inefficiencies."
Thus soaring debt ratios may be used as a corrective device to reduce managerial cash flow waste in the course of the risk of liquidation (Grossman and Hart, 1982) or through force to produce cash flows to service debt (Jensen, 1986). In these situations, debt will have a positive effect on the value of the firm.
Agency costs can also be present from clash amid debt and equity investors. These variance arise when there is a risk of non-payment. The peril of default may construct what Myers (1977) referred to as an ‘‘underinvestment" or ‘‘debt overhang" problem. In this case, debt will have a negative effect on the value of the firm.
CONCLUSION:
Until the early nineties, corporate financial management in India was moderately a drab and easygoing activity. The financial sector reforms, with the onset of liberalization, privatization and globalization, have altered this placid activity into a flexible and dynamic activity. Corporate finance managers today have to opt from a range of financial instruments. They can now price them or less freely. They are open to book-building process of IPOs. They have access to global financial markets. They have to deal with violent financial intermediaries and institutional investors. They are exposed to instability of interest and exchange rates. They have to take serious not of capital structure decisions and worry about their credit ratings in view of bloodthirsty financial markets. All these challenges for corporate managers have been the result of elimination of capital issues control and the introduction of pricing of equity issues in 1992.
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