Capital Structure

Topics: Corporate finance, Capital structure, Finance Pages: 13 (4922 words) Published: December 9, 2012
1. Introduction to the Research Problem

The capital structure of a firm put simply is the ratio of debt to equity capital used by the firm in financing its assets and operations, also known as leverage or gearing. It is the approach that a firm takes in financing itself through a composition of equity, bonds, and loans. In financing its operations, a firm will tend to use a combination of debt and equity that best maximises the value of the firm.

There has been considerable debate over the relevance of capital structure and its relationship with firm value. Modigliani & Miller (1958) pioneered this debate when they put forward their argument that when perfect capital markets exist, capital structure is irrelevant and a firm’s value is determined by its earning power and the risk of its underlying assets. Since then, there has been empirical departure from the assumptions made by Modigliani & Miller. Some of this theoretical departure includes the “Trade off Theory”, which states that as the debt-equity ratio increases, there is a trade-off between the interest tax shield and bankruptcy costs, causing an optimum capital structure to exist. Many other theories like Agency theory and Pecking order theory have generally recognized the relevance of capital structure to the value of a firm. Evidently, Corporate firms make choices in terms of the capital structure that maximizes their value. The factors that determine this choice has generated a lot of academic research Furthermore, there is a lack of studies that have investigated the transformations of the capital structure over time, especially through the global economic downturn that all companies have been trying to survive through. It is a burning question that needs to be answered, on how the company’s observed modify their capital structure during a period of economic stability, and also a period of economic instability. Therefore, a ten-year observation period seems fit to be able to accurately paint a picture of both the transformation of the firm’s capital structure, and also the movements in the firm’s value. As in theory these are closely correlated, the former should have an effect on the latter, which will be analysed through regression analysis during the undertakings of this study. Moreover, it would be naïve to think that all firms behave in the same way, however through the study by Rajan and Zingales (1995) the firm’s size is regarded as being a factor affecting the firms capital structure. Thus it would be interesting to observe whether all large, medium, and small firms behave alike in the same size category, and if not, why is that not the case.

The study will aim to build on Rajan and Zingales (1995) study, by testing the sensitivity of the determinants of capital structure, the gearing ratio, to two explanatory variables, firm Size and the level of tangible assets. It is evident from their study that Rajan and Zingales’ (1995) results are highly dependent upon the precise definition of gearing being examined. Thus it may be necessary to dividing the debt element the gearing measures (WACC), in order to more accurately test the relationship that each element has to the specified explanatory variables over the ten-year period. As of 1995, there was no clear theory to explain the effect which size should have on gearing. Rajan and Zingales (1995) stated in there paper that “The effect of size on equilibrium leverage is more ambiguous. Larger firms tend to be more diversified and fail less often, so size (computed as the logarithm of net sales) may be an inverse proxy for the probability of bankruptcy”. However at the time prior empirical evidence with regard to the relationship between size and gearing was rather sparse, with Rajan and Zingales (1995) concluding from their work that gearing for UK companies is positively related to sales, which is as they initially hypnotized. In addition, larger companies are more likely to have an...

References: * Modigliani, F and Miller, M.H (1958) “The Cost of Capital, Corporate Finance, and the Theory of Investment”, American Economic Review, 32(2), 261­297
* Modigliani, F., & Miller, M
* Fama, Eugene F.; French, Kenneth R., 2004, The Capital Asset Pricing Model: Theory and Evidence, The Journal of Economic Perspectives, Vol. 18, No. 3., pp. 25-46.
* Copeland, T. E. & Weston, J. F., 1992,"Financial Theory and Corporate Policy", 3rd edition, Addison-Wesley Publishing Company, Reading, Massachusetts.
* Fama, Eugene F. and Kenneth R. French. 2004. The Capital Asset Pricing Model: Theory and Evidence, The Journal of Economic Perspectives, Vol. 18, No. 3. (Summer, 2004), pp. 25-46.
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* Brealey, R.A. and Myers, S.C. (1996) Principles of Corporate Finance, 5th international edition, McGraw-Hill.
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