Capital Structure and Firm Performance

Past literature attempts to resolve the issue of the motivation behind managers' choice of a given capital structure. Despite several decades of intensive research, there is still no consensus about which theory dominates capital structure decisions. The present study empirically investigates the relative importance of two prominent theories of capital structure- the trade-off and the pecking order theories by exploring the conditions under which each theory can explain the financing choices of firms. These conditions are defined along two dimensions: (i) a firm's degree of information asymmetry, and (ii) its observed leverage relative to target leverage. The results show that, in the short-run, pecking order theory has more explanatory power in explaining the financing choices of firms. The target leverage theory assumes limited importance: Over-leveraged firms, when faced with low adverse information, are more inclined to adapt to the trade-off policies. In the presence of high information asymmetry, however, firms appear to be more concerned about adverse selection costs and make financing decisions that are more consistent with the pecking order theory. An analysis of the market reaction to seasoned equity issuances during announcement periods reveals that firms with high information asymmetry are penalized more than firms with low information asymmetry. This may explain the contradiction when over-leveraged firms continue to issue debt. However, the situation is reversed in the long run. Firms' long term financing goals appear to follow the leverage re-balancing theory. An analysis of financial activities over a five-year period, subsequent to security issuance decisions when they appear to be inconsistent with trade-off theory, reveals that firms follow an active policy of moving closer to the target leverage. In sum, the notion of target capital structure appears to exist. In the short-term, the management's financing decisions are consistent with the modified version of the pecking order theory, leading to tactical deviations from the optimal capital structure. However, long-term analysis indicates that the pecking order effect is largely transitory in nature and firms actively pursue strategic reversals towards an optimal capital structure.

In this article the authors review almost all the preliminary and fundamental capital structure theories. Evidently, capital structure is still an unsettled puzzle and scholars are constantly in search of those factors that help a firm to articulate optimal capital structure. However, explained theories of capital structure elucidate a theoretical platform for the firm’s management that assist them to select optimal mixture of equity and debt. Therefore, the importance of these theories is not possible to ignore. Though, academic literature has discussed various theories of capital structure but theory presented by Modigliani Miller, Trade Off theory and Pecking Order theory are deliberated broadly. Similarly, the other capital structure theories have their own importance in defining and explaining capital structure choices for firms that enhance their overall financial performance. Certainly, by applying the guideline provided by these theories a firm can easily attain a maximum profit, minimize its cost and also boost its overall market value. This article is an attempt to discuss nearly all capital structure theories to deliver a comprehensive explanation for the firm’s management which help them to formulate their capital structure in accordance with theoretical guidelines.

Numerous empirical studies in the finance field have tested many theories for firms’ capital structure. The pecking order theory and the trade-off theory of capital structure is among the most influential theories of firms’ capital structure. The trade-off theory predicts optimal capital structure, while the pecking order theory does not predict an optimal capital structure. According to pecking order theory, the order of financial sources used is the source of internal funds from profits, short-term securities, debt, preferred stock and common stock last. The main objective of this study is to econometrically test whether the listed companies in Indonesian Stock Exchange follow the pecking order theory or the trade-off theory. Samples in this study are public companies listed during 2009-2010. The research questions are tested by running regression models. The empirical result of this study shows that the pecking order theory is not supported, while the trade-off theory is supported. This suggests that the capital structure of listed companies in Indonesian Stock Exchange is financed based on optimal capital structure, not by the order financial resources.

A Bayesian Approach for Testing the Debt Signaling Hypothesis in a Transitional Market: Perspectives from Egypt

<p><em>Capital structure is a vital component of any business entity. The success and or failure of many business enterprises arise from their capital structures. Many financial institutions adopt different approaches regarding their capital structure arrangement. Some depend entirely on debt financing, others depend more on equity financing and others still mix the two approaches. The question has been which capital structure is the best for financial institutions?  For those firms which prefer mixing the two approaches, what would be the best portion for the two approaches? This paper critically reviews the capital structure theories, which include Franco Modigliani and Merton Miller theorem, Trade-off theory of capital structure and taxes, Pecking order theory, The market timing theory and Agency cost theory. This paper suggests that any financial institution should carefully analyze its operations before making its capital structure decision</em></p>

This article deals with the actual problem of choosing capital structure of a company, because debt ratio has an influence on making strategic decisions of the long-term company’s development, its investment risks, potential interest conflicts between management, owners and lenders. The article analyzes the principles of the construction of capital structure in terms of classical and modern theories of capital structure using methods of scientific knowledge: system analysis, synthesis, logical analysis, empirical researches. According to the first theory of the capital structure, developed by M. Miller and F. Modigliani through a number of strict preconditions, capital structure does not affect the company’s value. By adding a tax factor authors showed that in this case the choice of capital structure affects the company’s value, because debt capital increases it by the value of the tax shield. According to trade-off theory the main determinants of capital structure are the size of the tax shield, the probability of bankruptcy and the credit rating. According to the theory of the signal the capital structure depends on such factors as the information asymmetry and the credit rating. According to the pecking order theory capital structure the choice of it is determined by the hierarchy of sources of financing: firstly companies prefer to use internal sources of financing, then - debt financing. According to the market timing theory the key factors of capital structure are share price fluctuations. Analysis of various theories of the capital structure has showed that most theories have been developed by economists represented countries with developed markets. But developed countries and emerging countries have a lot of differences, which have an impact on choosing capital structure by companies.

This study aims, First, to obtain the empirical evidence about the capital structure of non-financial firms in Indonesia Stock Exchange. Second, to obtain the empirical evidence about the impact of capital structure on the value of non-financial firms in Indonesia Stock Exchange. Third, to obtain the empirical evidence about the impact of profitability, size of the firm, growth opportunity, the structure of assets, and the cost of bankruptcy to capital structure of non-financial firms in Indonesia Stock Exchange.
 To achieve these objectives, conducted research on companies listed on the Indonesia Stock Exchange. Research conducted on 163 companies with the observation period in 2011. All the required data obtained from the Indonesian Capital Market Directory. Furthermore, to explain the determinants of capital structure of the firm to used the t and F test with alpha 10 percent.
 Based on the results of the study, the conclusions as follows: First, the capital structure of the firm has a negative and significant effect on the value of the firm. Second, there is no optimal capital structure on a non-financial corporations. Third, the size of the firm, the structure of assets, and the cost of bankruptcy have positive and significant effect on the capital structure of the firm. Fourth, profitability and the growth opportunities of the firm does not significantly influence to the capital structure. Fifth, variations in the profitability, size of the firm, growth opportunities, the structure of assets, and the cost of bankruptcy are able to explain the variations of capital structure 10,2 percent. Sixth, the coefficient towards research results influence the profitability and bankruptcy costs the company is not in accordance with the trade-offs theory.

The intent of this study is to investigate that factors identified in developed countries which are attributed as imperative ones to attain optimal capital structure, provide compelling justifications for capital structure decisions in insurance companies of Pakistan. Empirical exploration of factors, that drives optimal capital structure apply on panel data of 31 insurance firms from 2004 to 2009. Two econometric panel data techniques, fixed effects and random effects are pertained. Hausman’s specification test is performed in order to test appropriate model for the study. The outcomes of study advocate that, profitability, age and earnings volatility have inverse relation with leverage and are significant. Liquidity also has inverse relationship with debt ratio but it is not significant. Alternatively, size and growth opportunities have direct relationship with leverage but only size is significant. These outcomes are in line with theoretical theories such as pecking order theory and trade off theory. This research has provided an initial foundation to ascertain the factors influencing decisions of capital structure of Pakistan’s insurance sector and it can be a preliminary base for more methodical investigation. Moreover, this can also be helpful for the managers in making decisions about optimal capital structure. This study, to the author’s knowledge, is conducted first time in Pakistan for investigating the capital structure theories and their implications on insurance companies of Pakistan with the most recent panel data available. Furthermore, this study validates that some features have an effect on capital structure of Pakistani insurance companies as acknowledged in developed countries. Key words: Capital structure, insurance association, insurance companies, Pakistan.

This paper contributes to the literature on capital structure and firm performance. Using firm-level data covering over 11,000 firms from 47 countries over a recent period of 1997-2007, we address the effect of different sources of financing on corporate performance, employing a matching process, which allows an adequate `like-for-like’ comparison between high and low level of financing by firms. Robust to different matching estimators, the main findings are consistent with the theories of capital structure, in that firms with high debt-to-equity ratio tend to have lower returns to shareholders (profitability) and lower internal efficiency (productivity). The results become more robust when we separate the firms into advanced and emerging country-groups or countries with high/low levels of financial development. Given the lower level of leverage below 50% on average in emerging markets (or in countries with lower level of financial reforms), firms in these economies face lower risk of financial distress and thereby less adverse effect on firm profitability and productivity, relative to their counterparts in advanced economies. We also find that retained earnings and equity financing improve performance, while debt financing by firms particularly in the form of bank loans leads to lower performance, although not so in the case of debt raised through issuing bonds.

The purpose of this study is to empirically test the determination of the existing capital structure in manufacturing companies in Indonesia. Various capital structure theories (trade-off theory, pecking order theory, agency theory, and free cash flow theory) are reviewed in order to formulate testable hypotheses about the determinants of capital structure in manufacturing firms. The research was carried out on a sample of 896 financial statements using panel data procedures. The results show that Tangibility and liquidity have a significant negative effect on leverage. Profitability and company age have no effect on leverage, while company size has a significant negative effect. This study has laid some groundwork for further investigation into the determinants of capital structure in Indonesian firms, which could be the basis for a more detailed evaluation. Furthermore, empirical findings should assist corporate executives in making the best capital structure decisions. To the best of the authors' knowledge, this is the first study that uses the most recent data to investigate the determinants of capital structure of manufacturing firms in Indonesia. Furthermore, this study appears to confirm that the same factors influence capital structure decisions in developing countries as they do in developed economies.

One of the most contentious issues in the theory of finance has been the theory of capital structure. In recent years, a number of theories have been proposed to explain the variation in debt ratio across firms. The theories suggest that firms select their capital structure depending on attributes that determine the various costs and benefits associated with debt and equity financing. Modigliani e Miller (1958) showed that capital structure decisions do not affect firm value when capital markets are perfect and when corporate and personal taxes do not exist. However, when one or more of the M&M assumptions are relaxed, many authors demonstrate how firm value may vary with changes in the debt-equity mix. Since the discussion regarding to the capital structure of the firms is not finished in financial literature, the aim of this study was to find out what factors are more important when financial executives choose the sources of long term capital that will be used by their companies. For this proposal, a survey instrument was adeveloped and sent to a list of 356 brazilian companies. A total of 40 firms aswered the survey and for this reason, the sample analized in this study is classified as non-probabilistic, and its results can not be representative of the population. This survey showed that 50% of the firms have a target capital structure and 28% follow the Pecking Order Theory. When asked about what is the main motive the affects the debt ratio, 73% of the firms aswered that interest rates are the most important variable that has some influence on the capital structure decision of the company. Other interest results were found in this study and they can help to explain some of the decisions that are taken by financial executives regarding to the capital structure of their firms.

The aim of this study was to explore how various levels of information asymmetry affect the capital structure of listed companies in Taiwan and China. Regression results over the past few decades have indicated that the trade-off theory lacks explanatory power, bringing into question the accuracy of the static trade-off theory and the existence of an optimal capital structure. On the other hand, the financial decisions of companies do not always appear consistent with the pecking order theory. Building on the research of Chou et al. (2011), this study sought to verify the signal factor hypothesis, which combines the trade-off theory with the pecking order theory.This study was the first one to employ the panel KPSS test with sharp drifts, developed by Chang and Ranjbar (2012), as well as the Fourier function to verify that an optimal capital structure does exist for companies with more symmetric information, thereby establishing the trade-off theory. Firms with information asymmetry show adverse selection costs, which supports the pecking order theory and rejects the existence of an optimal capital structure.

Capital structure theories offer a framework to understand how firms determine their mix of debt and equity financing. These theories, such as the trade-off theory, pecking order theory, market timing theory, agency theory, and theories of corporate control and input/output market interactions, provide insights into the roles of internal company characteristics and external economic conditions for corporate financing decisions. They explain firms’ preferences for and access to different financing sources based on factors like tax benefits, bankruptcy costs, agency costs, information asymmetry costs, and market conditions. Internationally, these theories take on additional dimensions due to differences in tax regimes, legal and institutional environments, and market structures. For example, the trade-off theory, which balances the tax advantages of debt against the costs associated with financial distress, varies significantly across countries because of differing bankruptcy and tax laws. Similarly, the pecking order theory, which suggests firms prefer internal financing over external debt, and external debt over equity, is influenced by the development of financial markets and the level of information sharing in different countries. The market timing theory posits that firms capitalize on market conditions by timing their financing decisions based on market valuations of debt and equity, with its applicability differing internationally due to variations in economic cycles and investor sentiment across markets. Agency theory and theories of corporate control delve into how conflicts between managers, shareholders, and debt holders shape financial strategies, with variations arising from different corporate governance structures and enforcement levels globally. The input/output market interactions theory asserts that firms determine their capital structure based on their market position, which can vary significantly due to differing international market demands and competitive landscapes. Empirical research provides insights into how these diverse factors play out across different legal, regulatory, economic, and cultural environments. International studies have shown that leverage determinants like corporate and personal tax rates, corporate governance and ownership structure, market conditions, and institutional frameworks significantly impact capital structure decisions globally. Moreover, cultural differences also play a crucial role in shaping financial decisions, influencing managerial attitudes toward risk. These insights are critical for multinational corporations and policymakers, as they highlight the necessity of considering a broad array of factors, including tax considerations, market conditions, legal and social frameworks, corporate governance and ownership structure, investor behavior, and institutional and regulatory environments, when making decisions about capital structure in an international context. This comprehensive understanding helps in creating conducive environments for effective corporate financing choices on a global scale.

This paper provides general framework for handling time-varying cost of capital, leverage, tax rates, and capital values in a dynamic free cash flow theory of capital structure. That enables efficient analysis of the recent competing theories of capital structure. After including the costs of financial distress and risk premium of debt in the cash flow model, this paper provides a new look at cost of tax shield from the point of view of risk-return relationship. Cost of tax shield is not constant, but depends on leverage and is mostly between cost of assets and cost of debt. Moreover the simulation of firm value and capital structure in presence of taxes, risk, and growth shows that unique optimal leverages exist for each combination of the above factors. The risk-enhanced cash flow theory can explain both the observations, which support pecking order theory, free cash flow theory and tradeoff theory of capital structure. Moreover it fits some evidence, which resists these theories: highly leveraged low growth companies and moderately leveraged large profitable companies.

This paper investigates the impact of capital structure on firm performance using a sample of 3,122 observations of 446 non-financial listed companies on the Vietnam stock market during 2011-2017. Using firm performance measures, namely ROE and Tobin Q, we examined if higher leveraged firms are more efficient or less in their performance. We employed the fixed effect model to prove that there is an inverse U-shaped relationship between leverage and ROE, and then we can find a preferred capital structure for Vietnam non-financial firms. To deal with endogeneity problem of the leverage variable, we employ two stage least squares (2SLS) regression with instrument variable estimators, which helps us strengthen the above results. Keywords Capital structure, firm performance, leverage, efficiency, instrument variable estimator, agency cost theory References [1] J. Abor, The effect of capital structure on profitability: an empirical analysis of listed firms in Ghana, Journal of Risk Finance. 6 (2005) 438-447.[2] M. Baker, J. Wurgler, The Determinants of Capital Structure: Capital Market-Oriented versus Bank-Oriented Institutions, Journal of Financial and Quantitative Analysis. 43 (2002) 59-92.[3] A.N. Berger, E. Bonaccorsi di Patti, Capital structure and firm performance: A new approach to testing agency theory and an application to the banking industry, Journal of Banking and Finance. 30 (2006) 1065-1102.[4] J. Berk, P. DeMarzo, J. Harford, Fundamentals of Corporate Finance, second edition, Prentice Hall, 2012.[5] A.A. Berle, G.C. Means, The Modern Corporation and Private Property, New York: The Macmillan Company, 1932.[6] V. Dawar, Agency theory, capital structure and firm performance: Some Indian evidence. Managerial Finance. 40(12) (2014) Số trang.[7] T.H.V. Duong, A study of the factors affecting the capital structure of the companies listed on Vietnam stock market, Doctoral thesis - National Economics University, 2014.[8] S.J. Grossman, O.D. Hart, Corporate financial structure and managerial incentives, In M. J.J., The economics of information and uncertainy, University of Chicago Press, 1982.[9] M. Jensen, Agency cost of free cash flow, corporate finance and takeovers, American Economic Review Papers and Proceedings. 76 (1986) 323-329.[10] J.C. Jensen, W.H. Meckling, Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics. 3 (1976) 305-360.[11] A. Kraus, R.H. Litzenberger, A State-Preference Model of Optimal Financial Leverage, Journal of Finance. Tập (1973) 911-922.[12] D. Margaritis, M. Psillaki, Capital structure and firm efficiency, Journal of Business Finance and Accounting. 34 (2007) 1447-1469.[13] D. Margaritis, M. Psillaki, Capital structure, equity ownership and firm performance, Journal of Banking and Finance. 34 (2010) 621-632.[14] F. Modigliani, M. Miller, The cost of capital, corporation finance, and the theory of investment, American Economic Review. 48 (1958) 655-669.[15] F. Modigliani, M. Miller, Corporate income taxes and the cost of capital: A correction, American economic Review. Tập (1963) 433-443.[16] S.C. Myer, Determinants of corporate borrowing, Journal of Financial Economics. Tập (1977) 147-175.[17] S.C. Myers, N.S. Majluf, Corporate Financing and Investment Decisions When firms have information that investors do not have, Journal of financial economics. 13 (1984) 187-221.[18] B. Seetanah, K. Seetah, K. Appadu, K. Padachi, Capital structure and firm performance: evidence from an emerging economy, The Business and Management Review. 4 (2014) 185-196.[19] S. Titman, R. Wessels, The determinants of capital structure choice. Journal of Finance. 43(1) (1988) 1-19.[20] L. Weill, Leverage and Corporate Performance: Does Institutional Environment matter? Small Business Economics. 30 (2008) 251-265.[21] J. Williams, Perquisites, risk and capital structure, Journal of Finance. 42 (1987) 29-49.[22] R. Zeitun, M.M. Haq, Debt maturity, financial crisis and corporate performance in GCC countries: a dynamic-GMM approach, Afro-Asian J. Finance and Accounting. 5 (2015) 231-247.