Capital Structure

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CAPITAL STRUCTURE

ABSTRACT

Over the years, numerous theories and studies on Capital structure have appeared. Modigliani and Miller laid down the foundation by being the first to theorize the issue. In 1958 they put forward their "M&M capital structure irrelevance proposition." However, with this first attempt, they failed to include important factors that could explain why daily observations of reality proved the opposite.

In their response that followed in 1963, Modigliani and Miller relaxed one of their initial assumptions, the absence of corporate taxes.

The paper then goes on to build in the effects of taxes, bankruptcy and it's attendant costs until the 'mainstream' Trade-off Model also (known as the Optimal Capital Structure model) emerges. While this approach has some valuable explanatory power, it fails to explain several commonly observed practices in modern corporate finance.

The Pecking Order theory, and the closely related Signaling theory are intriguing alternatives to the explanation of Capital Structure.

The paper also discusses the Free Cash Flow theory- an extension of the Trade-Off model.

It looks at which theories S.A. Managers use in practice: Pecking Order or Trade-off model? , And gives a brief comparison of the pecking order and Trade-off model. The paper examines these two competing theories and determines which one better explains a firm's Capital Structure decision. Finally, it observes what influences Capital Structure choices between countries and different industries.

The paper concludes that although Capital Structure is important, Capital Structure theories on their own fail to explain a firm's Capital Structure decision completely.

Instead, it seems that firms follow a combination of the theories, with each theory filling a gap of the Capital Structure puzzle.

CONTENTS Page

1. Introduction 3

2. What is Capital Structure ? 4

3. Theories on Capital Structure 4

3.1 The Modigliani and Miller theorem 4

3.1.1 Empirical Evidence 8

3.1.2 Shortcomings of the M&M theorem 8

3.2 The Static Trade-Off theory 11

3.2.1 Empirical Evidence 12

3.3 The Free Cash Flow theory 13

3.4 The Information Asymmetry hypothesis 13

3.4.1 The Signaling theory 13

3.4.2 The Pecking Order theory 14

3.4.3 Empirical Evidence 15

4. The Pecking Order model vs. the Trade-Off model 16

4.1 Reported Practice 17

4.2 Empirical Evidence 17

5. Which theory do South African managers use ? 18

6. The Capital Structure Decision : International Evidence 19

7. Conclusion 22

8. Bibliography 23

9. Diagrams 25

1. INTRODUCTION

Capital Structure theory is one of the most puzzling issues in the corporate finance literature. Even after four decades of numerous studies and theories on the subject of capital structure, researchers are still puzzled by their inability to provide a simple and concise answer.

Franco Modigliani and Merton Miller were who sparked interest in capital structure theory. Their original insights (1978) and continued developments (1963, 1965) laid the foundation for modern corporate finance. However, what they failed to discuss were the practical applications of the theory for individual firms or how well the theory explained observed facts, such as corporate leverage ratios and market reactions to security issues.

Much the financial literature since then has revolved around different theories that try to explain just exactly what does matter in determining capital structure. Out of all these theoretical offerings, two models appear to come across strongly. One of them is the Static Trade-off theory based on the trade-off between advantages and disadvantages of using debt and the attainment of an optimal capital structure. The trade-off is influenced by several variables, such as the tax advantages of debt, the risk of bankruptcy and the reduction of agency costs.

The second of these models is that of the Pecking Order model, which states that corporate debt decisions are driven by the firm's desire to finance investment first internally, then with risky debt and finally with external equity i.e. firms do not maintain a target capital structure. There are also other sub-ordinate but relevant theories such as the Free Cash Flow theory and the Signaling theory.

Theory has clearly made some progress on the subject. However, very little is known about the practical relevance of the different theories. This paper provides some of the observed evidence. Although, amidst all the conflicting results, it is difficult to draw a clear conclusion.

The paper concludes with a look at which theories South African managers follow in practice and whether capital structure choices are influenced by the same factors across different countries.

2. WHAT IS CAPITAL STRUCTURE?

Capital Structure refers to the mix of different securities issued by a firm to finance the investments. In a simplified context, it is the proportion of financing from debt and from equity capital. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The capital structure decision centres on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value. But aside from this decision, a firm must manage its capital structure. Imperfections in capital markets, taxes, and other practical factors influence the managing of capital structure. Imperfections may result in a capital structure less than the theoretical optimal. (Groth et al, 1997)

Essentially, managers should choose the capital structure that they believe would have the highest firm value, as it is this capital structure that maximizes shareholders' interests.

(Bodie et al, 2002)

3. THEORIES ON CAPITAL STRUCTURE

3.1 THE MODIGLIANI AND MILLER THEOREM

France Modigliani and Merton Miller opened the debate on capital structure. Their original contribution (1958) and continued developments (1963, 1965) laid the foundation of modern corporate finance. Both Modigliani and Miller won Nobel prizes in economics in 1987 and 1990, respectively. Numerous researchers have built careers on the basis of their work.

The Modigliani-Miller theorem is stated in a perfect market. The only market imperfection they admit are corporate taxes (Modigliani and Miller, 1963). Briefly, the initial assumptions of the M&M theorem are (Pauwels, 2001):

(i.) Capital markets are perfect

· Information is free of costs and available to everyone.

· No transaction costs

· Investors are rational

(ii) All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero growth, and expected EBIT is constant over time.

(iii) Firms can be grouped into homogenous classes based on business risk.

(iv) There are no taxes.

(v) No agency or financial distress costs.

These assumptions were necessary for M&M to prove their propositions on the basis of investor arbitrage.

M&M with zero taxes (1958)

Proposition I: Capital Structure irrelevance:

The value of a firm is independent from its capital structure; therefore the value of a levered firm will be equal to the value of an otherwise identical unlevered firm.

(Ross et al, 2001)

Therefore a firm's capital structure is irrelevant.

Profitability of a firm's activities is the only factor that determines the market value.

VU = VL = PBIT

WACC

Where:

VU = value of an unlevered firm

VL = value of a levered firm

PBIT = profit before interest and taxes

WACC = the weighted average cost of capital

Proposition II:

The required rate of return on equity in a levered firm increases with the degree of leverage. (Ross et al, 2001)

The cost of equity, RE, is :

RE = RA + ( RA - RD ) X D/E

Where:

RA = WACC

RD = cost of debt

D/E = the debt / equity ratio

M&M tells us that the cost of equity depends on three things : the required rate of return on a firm's assets, the cost of debt and the debt / equity ratio.

Figure 1 shows that, as a firm raises it's debt / equity ratio, the increase in leverage raises the risk of the equity and therefore it's cost (RE). (Ross et al, 2001)

The risk of the equity depends on two things: business risk (i.e. The riskiness of the firm's operations) and financial risk (i.e. The degree of financial leverage).

Also note that WACC is independent of the debt / equity ratio i.e. It is the same no matter what the debt / equity ratio is. This is another way of stating M&M proposition 1.

The theory implies that firm's debt-equity ratios could be anything. They are the result of random managerial decisions about how much to borrow and how much equity to issue.

The Modigliani-Miller theorem is certainly one of the most important theories, although not the most realistic.

Do real-world managers follow M&M by treating capital-structure decisions with indifference? Apparently not, virtually all companies in certain industries, such as banking choose high debt-to-equity ratios, whilst companies in other industries, such as pharmaceuticals, choose low debt-to-equity ratios. In fact, almost any industry has a debt-to-equity ratio to which companies in that industry adhere. Thus, in practice, companies do not appear to be selecting their degree of leverage in a random frivolous manner. Because of this, financial economists (including M&M themselves) have argued that real-world factors may have been left out of their theory. (Ross et al, 2002)

Unrealistic assumptions made in the theory are:

· Corporate and personal taxes are ignored

· Bankruptcy costs and other agency costs were not considered

· No transaction costs

· No information costs

Corporate taxes are addressed in the next section. The other remaining costs will be addressed thereafter.

M&M with corporate taxes

Proposition I:

In the presence of corporate taxes, the value of the levered company will be higher than the value of an otherwise identical unlevered company by the present value of the interest tax shield (Ross et al.2001)

VL = VU + TCD

Where: TC is the company tax rate and D is the amount of debt. Their product, TCD, is the present value of the interest tax shield.

The interest tax shield is the tax saving attained by a firm from the interest expense (since interest paid on debt is tax deductible).

For this reason, adding debt to a company's capital structure lowers its expected tax liability and increases its after-tax cashflow.

Therefore, once we include taxes, capital structure definitely matters. From the above equation, we can see that a firm's value increases continuously as more and more debt is used. This leads us to the illogical conclusion that the optimal capital structure is 100% debt. (Ross et al, 2001)

Observing the behaviour of the weighted average cost of capital when taxes is included can also see this conclusion: the firm's WACC will decrease as the firm relies more heavily on debt financing (refer to figure 2). Thus, the firm is better off with debt.

Proposition II :

The cost of equity, RE, is (Ross et al, 2001):

RE = RU + ( RU - RD ) x D/E x ( 1 - TC )

Where: RU is the unlevered cost of the capital. Unlike Proposition 1, the general implications of Proposition 2 are the same, whether taxes are included or not. That is, RE continues to rise as the firm increases debt (refer to figure 2).

3.1.1 EMPIRICAL EVIDENCE

In practice, firms do not follow the M&M model i.e. that they should have (almost) 100% debt in their capital structures. In general, debt ratios average around 30 - 40%, with significant variations across industries.

3.1.2 SHORTCOMINGS OF THE MODIGLIANI & MILLER THEOREM

Modigliani and Miller based their theory on the condition of a perfect market. A perfect market condition is a simplified view of reality. As a result, in the absence of market imperfections, it is logical for firms to finance their businesses entirely with debt.

Because this theory is not very realistic, many experts have found it is easy to disprove it. This section lists some of the market imperfections M&M refused in their theory and their influence on the capital structure of a firm.

3.1.2.1 Personal Taxes

If there were only corporate taxes and no individual taxes on corporate securities, the value of a levered firm would equal that of an identical all equity firm plus the present value of the interest tax shield.

The problem with this reasoning, however, is that it overstates the tax advantage of debt by considering only corporate tax. Many investors who receive interest income must pay taxes on that income. But some investors who receive equity income (Capital Gains) are taxed at a lower rate and can defer any tax by choosing not to realize those gains. Thus. although higher leverage lowers the firm's corporate taxes, it increases the taxes paid by investors. (Chew, 2001)

The Miller Model (an extension of the standard M&M model) illustrates how the gain from leverage is lowered when personal taxes are incorporated.

The value of a levered company (with Personal and Corporate Taxes) is now expressed as (Ross et al, 2002):

VL = VU + [ { 1 - ( 1 - TC ) x ( 1 - TS ) x D ]

( 1 - TD )

Where: TD is the personal tax rate on debt income (ordinary income)

TS is the personal tax rate on equity income (capital gains)

Leverage may increase, decrease or have no effect on firm value depending on the tax rates, TD and TS, (Ross et al, 2002) :

· If TD = TS , both interest and dividends are taxed at the same personal rate. Thus, the conclusion that debt increases firm value still holds.

· However, the gain from leverage is reduced when TS < TD . Here, more taxes are paid at the personal level for a levered firm than for an unlevered firm.

In some cases the lower corporate taxes for a levered firm are exactly offset by higher personal taxes i.e. ( 1 - TC ) x ( 1 - TS ) = (1 - TD ). In other words, the value of a levered firm is equal to the value of an unlevered firm, with the gain from leverage being entirely eliminated.

Thus, corporate tax laws favour debt over equity financing (because interest expense is tax deductible while dividends are not ). However, personal income tax favour equity over debt (because stocks provide tax referral and a lower capital gains tax rate). This lowers the relative cost of equity compared with the standard M&M model and reduces the spread between debt and equity costs. Therefore, some of the advantage of debt financing is lost, making debt financing less valuable to firms .

3.1.2.2 Bankruptcy costs

Debt provides tax benefits to a firm, but as firms use more and more debt financing, they also face a higher probability of future financial distress, or bankruptcy. In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt. Subsequently, ownership of the firm's assets is transferred from the shareholders to the bondholders. Bankruptcy is not a tidy affair and its associated costs may eventually offset the tax-related gains from leverage. (Ross et al, 2001)

· Direct bankruptcy costs

These are the legal and administrative costs involved in the transfer of ownership to the bondholders. Because of these expenses, bondholders will not get all that they are owed (since a fraction of the firm disappears in the legal process - also known as a bankruptcy tax).

Therefore, direct bankruptcy costs are a disincentive to debt financing. (Ross et al, 2001)

· Indirect bankruptcy costs

Because it is expensive to go bankrupt, a firm will spend resources to avoid doing so. Thus, as firms become preoccupied with avoiding bankruptcy, they neglect their business, and assets of the firm lose value.

Normal operations of the firm are disrupted, sales are lost and valuable employees leave. (Ross et al, 2001)

One of the most important indirect costs is the reduction in firm value that results from cutbacks in promising investment, which tends to be made when companies get into financial difficulty. In extreme cases, managers are likely to also make cutbacks in R & D, maintenance, advertising, or training that end up reducing future profits. This is called the Underinvestment problem.

Companies whose values consists primarily of intangible investment opportunities - will choose low-debt capital structures because such firms are likely to suffer the greatest loss in value from this underinvestment problem.

As opposed to mature companies with few profitable investment opportunities (most of their value reflecting cashflows from tangible assets), which incur lower expected costs associated with financial distress. Such mature companies are likely to have significantly higher leverage ratios than high growth firms. (Chew, 2001)

3.1.2.3 Agency costs

When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are attempted to act in their own economic interests and pursue selfish strategies. These conflicts of interests, which are intensified when financial distress is incurred, impose agency costs on the firm.

The following are strategies followed by the shareholders under the likelihood of bankruptcy. These strategies are costly and lower the market value of the firm. (Ross et al, 2002)

· Incentive to take large risk: firms near bankruptcy are more likely to take great risks, because they believe that they are playing with someone else's money (the bondholders).

· Incentive towards underinvestment: the underinvestment is accentuated by conflicts that arise among the firm's different claimholders. Stockholders realize that much of the value created by their investment would go to restoring the creditor's position. In this situation, the cost of new equity could be so high, managers acting on their shareholders' behalf decide to forego investment opportunities.

These are all jointly costs of financial distress (i.e. Bankruptcy and Agency costs). Whether or not the firm ultimately goes bankrupt, the net effect is a loss of value because the firm chose to use debt in its capital structure. It is this possibility of loss that limits the amounts of debt a firm will choose to use. (Ross et al, 2001)

M&M ignored these costs; hence the models show firm value increasing continuously with leverage, implying that firms should choose to use maximum debt. In reality, financial distress costs increase with leverage and reduce the value of the levered firm. This discussion leads us to the next theory which goes beyond the Modigliani and Miller theorem by incorporating both the tax effects and the distress costs of debt.

3.2 THE STATIC TRADE-OFF THEORY

The theory begins with the idea of an optimal capital structure. That is, as a firm's debt increases, the accompanying tax advantages increase and tend to offset the firm's debt-related, expected costs of financial distress and bankruptcy. With additions to debt at relatively low levels of debt, the tax advantages increase faster than expected financial distress costs, therefore, the value of the firm increases. However, if the debt level continues to increase beyond the optimal debt level, then the increasing marginal expected cost of bankruptcy more than overcomes the marginal debt related tax advantage and the value of the firm declines (as illustrated in figure 3).

This naturally leads us to the idea that a firm's capital structure decision can be thought of as a trade-off between the tax benefits of debt and the costs of financial distress. The trade-off theory is easily understood under the basic underlying tenet of optimizing value - and thus shareholder wealth - by choosing a capital structure combination which elicits the lowest possible cost of capital for the firm (refer to fig. 4). Figure 4 illustrates the trade-off theory in terms off WACC and the cost of debt and equity. The WACC declines initially because the after-tax cost of debt is cheaper than equity. At some point, the cost of debt begins to rise because of financial distress costs. It proposes that the firms borrow up to the point where the tax benefit from an extra rand in debt is exactly equal to the cost that comes from the increased probability of financial distress.

In an empirical framework the trade-off model predicts that firms adjust (increase or decrease) their actual debt ratios toward the target (optimum) debt level. This means that the debt financing decisions are not residuals of other financing investments and strategic decisions . Although many researchers argue that there will be an 'optimal deviation' from those targets, because adjustments towards the target is costly (especially for small firms) - in terms of the transaction costs associated with adjusting back to the target relative to the costs of deviating from the target - therefore firms will most likely fluctuate within a target debt ratio range.

Another assumption of the model is that the optimal capital structure is a function of several variables including the business risk of the company i.e. Firms confronting similar business risks, such as those within the same industry, have the same trade-offs between the debt related tax advantages and expected, debt related bankruptcy costs. Overtime, as the industry's business risk change, one would expect the firm's optimal (target) capital structure to change. The (lower) higher the business risk of a company, the greater (less) the proportion of debt it should use in it's financial structure. Finally, the theory implies that all firms of the same industry will be knowledgeable of the same target capital structure. (Claggett, 1991)

Its important to note that no equation exists to exactly determine a firm's optimal capital structure. The reason being that financial distress costs are difficult to express accurately. Therefore, clues and judgement guide the decision. (Ross et al, 2002)

3.2.1 EMPIRICAL EVIDENCE

Much of the documented evidence on capital structure supports the conclusion that there is an optimal capital structure and that firms make financing decisions and adjust their capital structure to move closer to this optimum. (Chew, 2001)

· A study (1967) by Eli Schwartz and Richard Aronson showed clear differences in the average debt to asset ratios of companies in different industries, as well as a tendency for companies in the same industry to cluster around these averages. (Chew, 2001)

· A (1982) study by Paul Marsh concluded that companies do appear to make their choice of financing as though they had target levels in mind for both the long-term debt ratio and the ratio of short-term to total debt. (Claggett, 1991)

· Jalilvand and Harris (1984) hypothesized that 'market imperfections such as adjustment costs may lead firms not to adjust completely to long-term targets, but instead follow a partial adjustment pattern'. They concluded that ' firm targets are a driving force {one of the several} in a firm's financial behaviour'. (Claggett, 1991)

3.3 THE FREE CASH FLOW THEORY

The Free Cash Flow theory is another reason why it is beneficial for firms to issue debt. The theory is built on the on the existence of the agency costs of equity.

Agency costs of equity are viewed as an extension of the Static Trade-off model. When a firm issues new equity the holding of managers with equity interest are diluted, increasing their motive to waste corporate resources. For example, managers with only a small ownership interest have an incentive to obtain more perquisites (a company car, more expense-account meals etc.), since they only bear a small portion of the costs, and reap all the benefits. Thus, firms with a capacity to generate substantial free cash flow (i.e. The balance of money remaining after all positive NPV projects are financed) are more likely to see more wasteful activity, as managers can only undertake such prodigal behaviour if the firm has the cash flow to cover it. ( Ross et al, 2002)

The theory poses some important implications for capital structure: since dividends leave the firm, they reduce free cash flow. Thus, an increase in dividends should benefit the stockholders by reducing the ability of the managers to pursue wasteful activities. Similarly, debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. Although dividends cause fewer problems for managers as the firm is not obligated to pay them. In fact, interest and principal should have a greater effect than dividends on the free-spending ways of managers, because the firm risks bankruptcy if it is unable to make future debt payments. This risk causes managers to lead and organize a firm more efficiently. (Pauwels, 2001)

Therefore, the free cash flow theory suggests that a shift from equity to debt should boost firm value, as debt reduces the opportunity for managers to waste resources. ( Ross et al, 2002 )

3.4 INFORMAL ASYMMETRY HYPOTHESIS

This theory recognizes that market participants do not have homogenous expectations - managers typically have better information about the value of their companies than outside investors. Recognition of this information asymmetry between managers and investors has led to two distinct but related theories of capital structure decisions, namely: the Signaling theory and the Pecking Order theory.

3.4.1 THE SIGNALING THEORY

Assuming that firm managers have superior information about the true value of the company, managers of undervalued firms would attempt to raise their share prices by communicating this information to the market. Unfortunately, economic theory suggests that information disclosed by an obviously biased source (e.g. Management) will be credible only if the costs of communicating falsely are large enough to compel managers to reveal the truth. The challenge for managers is to find a credible signaling mechanism. Increasing leverage is suggested as an effective signaling device i.e. Debt contracts oblige the firm to make interest and principle payments; if these obligations are not met, the firm risks financial distress and ultimately bankruptcy. Equity is more lenient, as managers have more discretion over payments (dividends) and can cut or omit them in times of financial distress. Thus, adding more debt to a firm's capital structure can serve as a positive signal of higher future cashflows and that the firm feels strongly about it's ability to service debt into the future. (Chew, 2001)

Alternatively, a firm's current market valuation may seem to management to reflect excessive confidence about the future (i.e. stocks are overvalued by the market). Managers may attempt to exploit this by 'timing' equity offerings.

(When the market prices exceeds their own assessment of stock value).

Since investors are aware of the existence of the information asymmetry, they will interpret the announcement of an equity issue as a signal that the listed stocks are overvalued (i.e. earnings are likely to decline in the future), which subsequently causes the market price to decline.

Evidence shows that the market systematically responds negatively to announcements of equity offerings, marking down the share prices of the firms by approximately 3% on average. By contrast, the market exhibits a positive price reaction on average to new debt offerings. More generally, it seems leverage - increasing transactions are associated with positive price reactions whilst leverage - reducing transactions are associated with negative reactions.

Therefore, most companies issuing new equity - regardless of whether they are over/undervalued prior to the announcement of the offering - will experience a fall in stock prices. (Chew,2001)

3.4.2 THE PECKING ORDER THEORY

The signaling theory suggests that, in order to minimize the information costs of issuing securities, a firm is more likely to issue debt than equity if the firm appears undervalued, and to issue stock rather than debt if the firm seems overvalued. The pecking order takes this argument one step farther, suggesting that the information costs associated with issuing securities are so large that they dominate all other considerations. Companies maximize value by systematically choosing to finance new investments with the 'cheapest and safest' securities available. (Chew, 2001)

The Pecking Order theory states that firms have a preferred hierarchy for financing decisions. The highest preference is to use internal financing (retained earnings and the effects of depreciation) before resorting to any form of external funds. Internal funds incur no flotation costs and require no additional disclosure of propriety financial information that could lead to more severe market discipline and a possible loss of competitive advantage. If a firm must use external funds, the preference is to use the following order of financing sources: debt, convertible securities, preferred stock, and common stock. This order reflects the motivations of the financial manager to retain control of the firm (as only commonstock has a 'voice' management), reduce the agency cost of equity, and avoid the expected negative market reaction to an announcement of a new equity issue. (Liesz, 2002)

Aside from the assumption of asymmetric information, the theory also assumes that managers act in the best interest of existing shareholders. Therefore, managers may forgo a positive NPV project if it would require the issue of new equity, since this would transfer much of the project's value to new shareholders at the expense of the old.

In this sense, the theory suggests that the trade-off theory costs and benefits to debt financing be of second order importance when compared to the costs of issuing new securities. In fact, the logic of the Pecking Order actually leads to a set of predictions that are precisely the opposite of those offered by the Trade-off theory. (Chew, 2001)

3.4.3 EMPIRICAL EVIDENCE

· This theory does fit empirical evidence quite nicely. A recent study has found that 68% 0f firms capital expenditures come from retained earnings, 31% from debt financing, and the remaining 1% from common stock issuing. Although, there is also evidence that many firms prefer to issue equities, when they can issue investment grade debts. Secondly, it is common practice for firms to reserve some debt capacity for 'rainy days' .

· There is also support for the pecking order theory in form of evidence of a strong negative relation between past profitability and leverage i.e. the lower a company's profits and operating cashflows in a given year, the higher it's leverage ratio. Moreover, in a (1998) article by Stewart Myers and Lakshmi Shyam-Sunder, they showed that this relation explains more of the time series variance of the debt ratios than the target adjustment model {trade-off model}. (Chew, 2001)

· Based on their research, Claggett, (1999), concluded that firms normally behave in a manner consistent with the pecking order theory, however, some industries may choose not to during periods of severe turmoil.

· The above have generally been interpreted as confirmation that managers do not set target leverage ratios - however, this is not the only plausible explanation. Even if companies have target leverage ratios, firms deviate from those targets (due to transaction costs), and work within a target debt range.

4. THE PECKING ORDER THEORY vs. THE TRADE-OFF THEORY

The trade-off model implies a static approach to financing decisions based upon

a target capital structure, while the pecking order theory allows for the dynamics

of the firm to dictate an optimal capital structure for a given firm at any particular

point in time. There are a number of instances where the pecking order is at odds

with the trade-off theory. (Ross et al, 2002) :

· There is no target or optimal capital structure, rather firms follow a pecking order of incremental financing choices that places internally generated funds at the top of the order, followed by debt issues, and finally, only when a firm reaches it's 'debt capacity', new equity financing. (Lemmon, 2002)

· Profitable firms use less debt. Profitable firms generate cash internally, thus a firm that has been very profitable in an industry with relatively slow growth (i.e. few investment opportunities) will have no incentive to issue debt and most likely have debt ratios. High growth firms with lower cash flows will have high debt ratios. By contrast, the trade-off theory says the greater cash flow of profitable firms creates greater debt capacity. Thus, such firms will use more debt to capture the tax shield benefits.

· Companies like financial slack. The pecking order theory is based on the difficulties of obtaining financing at a reasonable cost - and because firms know they will need to fund projects at various times in the future, they accumulate cash today. Financial slack is defined as a firm's highly liquid assets (cash and marketable securities) plus any unused debt capacity. Firms with sufficient financial slack will be able to fund most, if not all, of their investment opportunities internally. The use of internal funds avoids the problems associated with external financing such as covenants that impose restrictions on the firm's future financial decisions in the case of a debt issue, or having to underprice the firm's stock in case of a stock issue.

The pecking order theory explains these observed managerial actions while the trade-off market cannot. It is also capable of explaining stock market reactions to leverage-increasing and leverage-decreasing events, while the trade-off model cannot.

The pecking order theory, however, does not explain the influence of taxes, financial distress, security issuance costs, agency costs, or the set of investment opportunities available to a firm upon that firm's actual capital structure. It also ignores the problem that can arise when a firm's managers accumulate so much financial slack that they become immune to market discipline. For these reasons the pecking order theory is offered as a complement to, rather than a substitution for, the trade-off model. ((Liesz,2002)

4.1 Reported practice

Two surveys (Liesz, 2002) examining capital structure decisions revealed very

similar results. In each, financial executives were asked which of the two major

criteria determined their financing decisions. Further, those who followed a

hierarchy were asked to rank the order in which they would use various internal and

external sources of funding. The first survey was of Fortune 500 firms and second

was of the 500 largest Over-The-Counter firms. The results are shown below:

Reported Use of Financing Decision Methodologies (Liesz, 2002)

RESPONDENT % USING % USING

GROUP TARGET HIERARCHY

CAP STRUCTURE

Fortune 500 Firms 31% 69%

Large OTC firms 11% 89%

It is obvious that in practice financial managers are much more likely to use a

hierarchical approach than a target capital structure rationale when making financial

decisions. While this would seem to be inconsistent with value maximization

arguments, this behaviour is rational considering the motivation of managers and the

vagaries of the U.S. capital markets.

4.2. Empirical evidence

Numerous conflicting studies have emerged to determine which of the predominant theories of capital structure, the Pecking order or Trade-off theory, best describes the financing choices of corporations (Lemmons, 2002) :

· Shyam-Sunder and Myers (1999) reject the static theory and find strong confirmation for pecking order behaviour. Using a simple model and a sample of 157 U.S. firms, they conclude that the pecking order model is a good first-order description of the financing behaviour of these firms.

· Evidence also suggests firms strive for a target debt ratio range and within this range, pecking order behaviour may describe incremental decisions or, over time, firms may switch between target adjustment and a pecking order behaviour.

· While Dissanaike, Lambrecht and Saragga (2001) argue that firms adopt only one theory i.e. Capital structure choices of some firms can be described by the static theory, while others by the pecking order.

· Fama and French (2002) find that short-term variation in earnings and investment is mostly absorbed by debt, as predicted by the pecking order model, but that the pecking order model has other failings, namely, significant equity issues by small growth firms.

· Frank and Goyal (2002) focus on cost differences associated with asymmetric information across groups of firms - what they found is that firms with the greatest potential for asymmetric information, will have the greatest incentive to follow a pecking order.

5. WHAT DO SOUTH AFRICAN MANAGERS PREFER TO USE :

THE PECKING ORDER OR STATIC TRADE-OFF THEORY

Negash and Wu (2002) attempted to determine which of the two competing theories best explains the policy followed by South African managers. Using the JSE listed industrial firm's data over the 1991-1999 period - they found that corporate managers in South Africa tend to adopt Target adjustment behaviour in the long term but had to react using pecking order behaviour when faced with short term earnings and cash-flow stocks. This pecking order behaviour may be a result of the under-developed corporate debt market in South Africa and the high costs and delays associated with equity financing. The study concludes that South African managers adopt target adjustment behaviour in the long term, hoping to adjust their debt ratio gradually to the optimal (target) debt ratio, but they react to short-term stocks using pecking order behaviour. The study also shows that debt and financing behaviours of corporate managers change with the size of the firm and vary with time - both the pecking order and target adjustment behaviour are prevalent across firms of all size. Furthermore, the two models appear to be complementary to one another. Another interesting development in study showed that the pecking order model appeared to be dominant among small firms. Since the pecking order behaviour in South Africa is mainly explained by short-term earnings and cash-flow surprises and the fact - small firms normally have more pronounced cash-flow and earnings surprises, than large firms - explains the the tendency of small firms to exhibit the most significant pecking order effect.

Additionally, it was observed that managers are changing their debt behaviour over time, suggesting that macro-economic factors may affect corporate financing behaviours.

6. THE CAPITAL STRUCTURE DECISION : INTERNATIONAL EVIDENCE

We now turn to a brief examination of the empirical validity of the trade-off and pecking order theories across different countries and across different types of firms taking into account institutional settings and constraints. Based on their research, Rajan and Zingales (1995) have found that the United Kingdom and Germany have the lowest leverage among the G-7 countries (the U.S., Japan, Germany, France, Italy, the U.K. and Canada ), with all other countries having approximately the same amount of leverage.

They then analyzed the major institutional differences across countries and their likely impact on financing decisions.

· The effect of taxes on leverage: the existing literature on international capital structure difference claims that taxes have no explanatory power. However, by including personal taxes, this conclusion may be empty. Unfortunately, the relative tax advantage of debt is highly sensitive to assumptions about the investor's tax rate. For example, a tax exempt investor finds debt more tax advantaged in Germany than in the U.S. - however, this result is reversed if the investor belongs to the top tax bracket in each of the two countries. Similarly, if we had to incorporate personal taxes to both these scenarios, the ranking of the countries according to how tax-advantaged debt changes again. Thus, one cannot easily dismiss the influence of taxes on leverage in a country, but in order to reach any conclusion on the effect of taxes, one has to use the correct effective tax rate.

· Bankruptcy law

Rajan and Zingales show that bankruptcy law has considerable influence on the amount of leverage in a country. Th e G-7 countries vary greatly in their bankruptcy procedures. For instance, bankruptcy laws in the U.S. give the firm's management substantial rights including the ability to propose a reorganization plan. By contrast Germany's code is much more creditor friendly - it's bankruptcy code is not as conducive to reorganizing firms and usually results in many premature liquidations. Therefore, since liquidation values are generally lower than going-concern values, bankruptcy is potentially more costly in Germany. Therefore, it would appear logical that Germany maintains lower leverage than the U.S.

· Bank vs. market based countries

Studies reveal that there is no systematic difference between the level of leverage in bank-orientated countries (e.g. Germany) and in market orientated-countries (e.g. the U.S.). However, it would appear that the difference between bank-orientated and market orientated countries is reflected more in the choice between public (stocks and bonds) and private financing (bankruptcy) than in the amount of leverage. Secondly, despite the greater availability of debt finance from banks, firms in bank-orientated countries may not want to borrow beyond a certain point because of the associated costs of excessive debt.

· Ownership and control

Another major institutionalized difference is the level of ownership concentration. The U.S., the U.K. and Canada have firms with diffused ownership, but also, an active takeover market . Europe and Japan, on the other hand, have highly concentrated ownership. The effect of ownership concentration on capital structure is slightly ambiguous. On the one hand, the presence of large shareholders on the board of directors should reduce agency costs between managers and shareholders and encourage equity issues. On the other hand, if some of these shareholders are banks, they might have vested interest in reducing outside financing and forcing them into borrowing from their banks. Thus, it becomes difficult to determine a clear relationship between concentrated ownership and leverage. Secondly, strong pressure from the takeover market may force firms to increase leverage. Managers take on debt so as to commit the firm to paying out future cashflows - this makes the firm unattractive to raiders. In fact, its no surprise, the U.S. is the only country were equity issues are (on net) negative over the studied period.

Next, Rajan and Zingales (1995) tried to determine whether capital structure in other countries are influenced by the same (within country ) factors that influence the capital structure of U.S. firms.

· Tangibility: if a large fraction of a firm's assets are tangible, then assets can serve as collateral, reducing the agency costs of debt; assets should also retain more value in liquidation. Therefore, the greater amount of tangible assets a firm possesses, the higher the leverage should be. Tangibility is always positively correlated in all countries.

· Investment opportunities: theory predicts that firms with high market-to-book ratios (a proxy for growth opportunities) have higher costs of financial distress, and thus, are negatively correlated with leverage. Therefore, firms expecting high future growth should use a greater amount of equity finance. This result holds true across countries as well.

· Size: the effect of size on leverage is more ambiguous. Larger firms tend to be more diversified and fail less often, so size may be an inverse proxy for the probability of bankruptcy. If so, size should be positively related to debt in countries where costs of financial distress are low. However, Germany points a different picture: firms in Germany are easily liquidated and are also very costly, thus small firms should be wary of debt, yet large firms have substantially less debt than small firms in Germany. Another possible explanation is that size may also be a proxy for information outside investors have, thus increasing their preference for equity.

· Profitability: There are again conflicting results on the effects of profitability on leverage. Myers and Majluf (1984) predicted a negative relationship, because firms prefer to finance with internal funds rather than debt. Jensen (1986) predicts a positive one if the market for the corporate control is effective and forces firms to commit to paying out cash by levering up. However, if it's ineffective, profitable firm prefer to avoid the disciplinary role of debt, which leads to a negative correlation. Profitability is negatively correlated with all countries except Germany.

Overall, the factors correlated with leverage in the U.S are similarly correlated in other

countries. This suggests that the observed correlations are not completely spurious. However, the relationship between the theories and the empirical factors is weak.

( Rajan and Zingales,1995 )

7. CONCLUSION

It is evident that capital structure is important for a firm. However, financial economists are still not sure how companies choose their capital structure. Apparently, economic reality is too complex to fit in a theory; thus, none of the theories, on their own, can completely explain the capital structure of a firm.

Based on my research, it seems that all the theories appear to be supplementary. Each theory fills in a small gap of the capital structure puzzle. (Myers, 1984)

Although, two theories fit the empirical evidence quite well - the pecking order model and the trade-off theory come across as the two most popular theories. While the traditional trade-off model is useful for explaining corporate debt levels, the pecking order theory is superior for explaining capital structure changes.

Recent research suggests that perhaps a hybrid theory, between the trade-off theory and the pecking order theory, is the next step in the ongoing quest to explain how firms manage the capital structures. In fact, most dominant approaches of capital structure theory and empirical research assume that managers mechanistically make a conscious choice to follow either a target or pecking order approach, ignoring the possibility that they could be using a combination of both.

For example, some research reveals that firms strive for a target debt ratio range and within this range pecking order behaviour describes incremental decisions or, over time, firms may switch between target adjustment and pecking order behaviour. The behaviour of South African managers is consistent with this research. Corporate managers in South Africa tend to adopt target adjustment behaviour in the long-term and use pecking order when faced with short-term earnings and cash-flow shocks.

With regard to international evidence of capital structure decisions, firm leverage and influencing factors are fairly similar across the first world countries - although the differences that exists are not easily explained by institutional differences, as previously thought. Thus, further research is required in this area.

8. BIBLIOGRAPHY

· Bodie, Z., Kane, A., Marcus, A., (2002), Investments, Fifth edition

· Brouner., Dirk., Eichholtz., Piet, M.A., (2001), Real Estate Economics, 29(4)

· Chew, D.H.., (2001), Corporate Finance, Where Theory meets practice.

McGraw-Hill International Editions, New York

· Claggett, E.T. (1991), Capital Structure Convergent and Pecking Order Evidence

Review of Financial Economics, 1 (1)

· Dissanaike, G., Lambrecht, B.M., Saragga, A., (2001), Differentiating Debt Target from Non-Target Firms : A Empirical Study on Corporate Capital Structure

· Groth., John, C., and Anderson, Ronald C., (1997), Capital Structure : Perspective for Managers, 35 (7/8)

· Lemmon, M.L. (2001), Debt Capacity and Tests of Capital Structure Theories {on line}.

http : // www . afjof . org / pdf / 2003 program / articles / lemmon zender . pdf.

· Liesz, T.J. (2002). Why should Pecking Order Theory should be included {on line}

http : // www . mountainplains . org / articles / pedagogy / PECKING % 20 ORDER % 20 THEORY . html

· Nuru, J. and Archer, S., (No date). Target Adjustment Model against Pecking Order model of Capital Structure {on line}.

http : // www. odu. Edu. / bpa / efma / jnuri. Doc

· (No date) Capital Structure Theory { on line }.

http : // info . cba . ksu . edu / yang / finan665 / notes / capital structure 3 . pdfs

· Pauwels, J.L. (no date). Does Capital Structure really matter ?

{on line}. http : // staff. Feweb. Vu. Nl / cgilbert / fin2rapport. Doc

· Rajan, R. and Zingales, L. (1995), What do we know about Capital Structure ? Some Evidence from International Data. Journal of Finance 50 (2) : 1421 - 1459

· Ross, S., Westerfield, R., and Jaffe, J., (2002), Corporate Finance (6th edition) -

McGraw-Hill International Edition, New York.

· Ross, S., Westerfield, R., Jaffe, J., (2001), Fundamentals of Corporate Finance (5th edition). McGraw-Hill International Edition, New York.

· Ross, S., Westerfield, R., Jordan, D., Firer, C. (2001), Fundamentals of Corporate Finance (2nd Edition). Erwin and McGraw

· Shyam-Sunder, L. and Myers, S.C., (1999), Testing Static Trade-off against Pecking Order Models of Capital Structure. Journal of Financial Economics, 51, p219-244.

· Wu, G.G. and Negash, M. (2002), Corporate Debt Behaviour in South Africa : Pecking Order or Target Adjustment ?

SAAA Biennial International Conference Proceedings, Port Elizabeth, June, 649-671

DIAGRAMS

FIGURE 1:

The cost of equity and the WACC : M&M Propositions I and II with no taxes

FIGURE 2:

The cost of equity and the WACC : M&M Proposition II with taxes

FIGURE 3:

The Static theory of capital structure: The optimal capital structure and the value of the firm.

FIGURE 4:

The Static theory of capital structure : The optimal capital structure and the cost of capital.

ABSTRACT

Over the years, numerous theories and studies on Capital structure have appeared. Modigliani and Miller laid down the foundation by being the first to theorize the issue. In 1958 they put forward their "M&M capital structure irrelevance proposition." However, with this first attempt, they failed to include important factors that could explain why daily observations of reality proved the opposite.

In their response that followed in 1963, Modigliani and Miller relaxed one of their initial assumptions, the absence of corporate taxes.

The paper then goes on to build in the effects of taxes, bankruptcy and it's attendant costs until the 'mainstream' Trade-off Model also (known as the Optimal Capital Structure model) emerges. While this approach has some valuable explanatory power, it fails to explain several commonly observed practices in modern corporate finance.

The Pecking Order theory, and the closely related Signaling theory are intriguing alternatives to the explanation of Capital Structure.

The paper also discusses the Free Cash Flow theory- an extension of the Trade-Off model.

It looks at which theories S.A. Managers use in practice: Pecking Order or Trade-off model? , And gives a brief comparison of the pecking order and Trade-off model. The paper examines these two competing theories and determines which one better explains a firm's Capital Structure decision. Finally, it observes what influences Capital Structure choices between countries and different industries.

The paper concludes that although Capital Structure is important, Capital Structure theories on their own fail to explain a firm's Capital Structure decision completely.

Instead, it seems that firms follow a combination of the theories, with each theory filling a gap of the Capital Structure puzzle.

CONTENTS Page

1. Introduction 3

2. What is Capital Structure ? 4

3. Theories on Capital Structure 4

3.1 The Modigliani and Miller theorem 4

3.1.1 Empirical Evidence 8

3.1.2 Shortcomings of the M&M theorem 8

3.2 The Static Trade-Off theory 11

3.2.1 Empirical Evidence 12

3.3 The Free Cash Flow theory 13

3.4 The Information Asymmetry hypothesis 13

3.4.1 The Signaling theory 13

3.4.2 The Pecking Order theory 14

3.4.3 Empirical Evidence 15

4. The Pecking Order model vs. the Trade-Off model 16

4.1 Reported Practice 17

4.2 Empirical Evidence 17

5. Which theory do South African managers use ? 18

6. The Capital Structure Decision : International Evidence 19

7. Conclusion 22

8. Bibliography 23

9. Diagrams 25

1. INTRODUCTION

Capital Structure theory is one of the most puzzling issues in the corporate finance literature. Even after four decades of numerous studies and theories on the subject of capital structure, researchers are still puzzled by their inability to provide a simple and concise answer.

Franco Modigliani and Merton Miller were who sparked interest in capital structure theory. Their original insights (1978) and continued developments (1963, 1965) laid the foundation for modern corporate finance. However, what they failed to discuss were the practical applications of the theory for individual firms or how well the theory explained observed facts, such as corporate leverage ratios and market reactions to security issues.

Much the financial literature since then has revolved around different theories that try to explain just exactly what does matter in determining capital structure. Out of all these theoretical offerings, two models appear to come across strongly. One of them is the Static Trade-off theory based on the trade-off between advantages and disadvantages of using debt and the attainment of an optimal capital structure. The trade-off is influenced by several variables, such as the tax advantages of debt, the risk of bankruptcy and the reduction of agency costs.

The second of these models is that of the Pecking Order model, which states that corporate debt decisions are driven by the firm's desire to finance investment first internally, then with risky debt and finally with external equity i.e. firms do not maintain a target capital structure. There are also other sub-ordinate but relevant theories such as the Free Cash Flow theory and the Signaling theory.

Theory has clearly made some progress on the subject. However, very little is known about the practical relevance of the different theories. This paper provides some of the observed evidence. Although, amidst all the conflicting results, it is difficult to draw a clear conclusion.

The paper concludes with a look at which theories South African managers follow in practice and whether capital structure choices are influenced by the same factors across different countries.

2. WHAT IS CAPITAL STRUCTURE?

Capital Structure refers to the mix of different securities issued by a firm to finance the investments. In a simplified context, it is the proportion of financing from debt and from equity capital. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The capital structure decision centres on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value. But aside from this decision, a firm must manage its capital structure. Imperfections in capital markets, taxes, and other practical factors influence the managing of capital structure. Imperfections may result in a capital structure less than the theoretical optimal. (Groth et al, 1997)

Essentially, managers should choose the capital structure that they believe would have the highest firm value, as it is this capital structure that maximizes shareholders' interests.

(Bodie et al, 2002)

3. THEORIES ON CAPITAL STRUCTURE

3.1 THE MODIGLIANI AND MILLER THEOREM

France Modigliani and Merton Miller opened the debate on capital structure. Their original contribution (1958) and continued developments (1963, 1965) laid the foundation of modern corporate finance. Both Modigliani and Miller won Nobel prizes in economics in 1987 and 1990, respectively. Numerous researchers have built careers on the basis of their work.

The Modigliani-Miller theorem is stated in a perfect market. The only market imperfection they admit are corporate taxes (Modigliani and Miller, 1963). Briefly, the initial assumptions of the M&M theorem are (Pauwels, 2001):

(i.) Capital markets are perfect

· Information is free of costs and available to everyone.

· No transaction costs

· Investors are rational

(ii) All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero growth, and expected EBIT is constant over time.

(iii) Firms can be grouped into homogenous classes based on business risk.

(iv) There are no taxes.

(v) No agency or financial distress costs.

These assumptions were necessary for M&M to prove their propositions on the basis of investor arbitrage.

M&M with zero taxes (1958)

Proposition I: Capital Structure irrelevance:

The value of a firm is independent from its capital structure; therefore the value of a levered firm will be equal to the value of an otherwise identical unlevered firm.

(Ross et al, 2001)

Therefore a firm's capital structure is irrelevant.

Profitability of a firm's activities is the only factor that determines the market value.

VU = VL = PBIT

WACC

Where:

VU = value of an unlevered firm

VL = value of a levered firm

PBIT = profit before interest and taxes

WACC = the weighted average cost of capital

Proposition II:

The required rate of return on equity in a levered firm increases with the degree of leverage. (Ross et al, 2001)

The cost of equity, RE, is :

RE = RA + ( RA - RD ) X D/E

Where:

RA = WACC

RD = cost of debt

D/E = the debt / equity ratio

M&M tells us that the cost of equity depends on three things : the required rate of return on a firm's assets, the cost of debt and the debt / equity ratio.

Figure 1 shows that, as a firm raises it's debt / equity ratio, the increase in leverage raises the risk of the equity and therefore it's cost (RE). (Ross et al, 2001)

The risk of the equity depends on two things: business risk (i.e. The riskiness of the firm's operations) and financial risk (i.e. The degree of financial leverage).

Also note that WACC is independent of the debt / equity ratio i.e. It is the same no matter what the debt / equity ratio is. This is another way of stating M&M proposition 1.

The theory implies that firm's debt-equity ratios could be anything. They are the result of random managerial decisions about how much to borrow and how much equity to issue.

The Modigliani-Miller theorem is certainly one of the most important theories, although not the most realistic.

Do real-world managers follow M&M by treating capital-structure decisions with indifference? Apparently not, virtually all companies in certain industries, such as banking choose high debt-to-equity ratios, whilst companies in other industries, such as pharmaceuticals, choose low debt-to-equity ratios. In fact, almost any industry has a debt-to-equity ratio to which companies in that industry adhere. Thus, in practice, companies do not appear to be selecting their degree of leverage in a random frivolous manner. Because of this, financial economists (including M&M themselves) have argued that real-world factors may have been left out of their theory. (Ross et al, 2002)

Unrealistic assumptions made in the theory are:

· Corporate and personal taxes are ignored

· Bankruptcy costs and other agency costs were not considered

· No transaction costs

· No information costs

Corporate taxes are addressed in the next section. The other remaining costs will be addressed thereafter.

M&M with corporate taxes

Proposition I:

In the presence of corporate taxes, the value of the levered company will be higher than the value of an otherwise identical unlevered company by the present value of the interest tax shield (Ross et al.2001)

VL = VU + TCD

Where: TC is the company tax rate and D is the amount of debt. Their product, TCD, is the present value of the interest tax shield.

The interest tax shield is the tax saving attained by a firm from the interest expense (since interest paid on debt is tax deductible).

For this reason, adding debt to a company's capital structure lowers its expected tax liability and increases its after-tax cashflow.

Therefore, once we include taxes, capital structure definitely matters. From the above equation, we can see that a firm's value increases continuously as more and more debt is used. This leads us to the illogical conclusion that the optimal capital structure is 100% debt. (Ross et al, 2001)

Observing the behaviour of the weighted average cost of capital when taxes is included can also see this conclusion: the firm's WACC will decrease as the firm relies more heavily on debt financing (refer to figure 2). Thus, the firm is better off with debt.

Proposition II :

The cost of equity, RE, is (Ross et al, 2001):

RE = RU + ( RU - RD ) x D/E x ( 1 - TC )

Where: RU is the unlevered cost of the capital. Unlike Proposition 1, the general implications of Proposition 2 are the same, whether taxes are included or not. That is, RE continues to rise as the firm increases debt (refer to figure 2).

3.1.1 EMPIRICAL EVIDENCE

In practice, firms do not follow the M&M model i.e. that they should have (almost) 100% debt in their capital structures. In general, debt ratios average around 30 - 40%, with significant variations across industries.

3.1.2 SHORTCOMINGS OF THE MODIGLIANI & MILLER THEOREM

Modigliani and Miller based their theory on the condition of a perfect market. A perfect market condition is a simplified view of reality. As a result, in the absence of market imperfections, it is logical for firms to finance their businesses entirely with debt.

Because this theory is not very realistic, many experts have found it is easy to disprove it. This section lists some of the market imperfections M&M refused in their theory and their influence on the capital structure of a firm.

3.1.2.1 Personal Taxes

If there were only corporate taxes and no individual taxes on corporate securities, the value of a levered firm would equal that of an identical all equity firm plus the present value of the interest tax shield.

The problem with this reasoning, however, is that it overstates the tax advantage of debt by considering only corporate tax. Many investors who receive interest income must pay taxes on that income. But some investors who receive equity income (Capital Gains) are taxed at a lower rate and can defer any tax by choosing not to realize those gains. Thus. although higher leverage lowers the firm's corporate taxes, it increases the taxes paid by investors. (Chew, 2001)

The Miller Model (an extension of the standard M&M model) illustrates how the gain from leverage is lowered when personal taxes are incorporated.

The value of a levered company (with Personal and Corporate Taxes) is now expressed as (Ross et al, 2002):

VL = VU + [ { 1 - ( 1 - TC ) x ( 1 - TS ) x D ]

( 1 - TD )

Where: TD is the personal tax rate on debt income (ordinary income)

TS is the personal tax rate on equity income (capital gains)

Leverage may increase, decrease or have no effect on firm value depending on the tax rates, TD and TS, (Ross et al, 2002) :

· If TD = TS , both interest and dividends are taxed at the same personal rate. Thus, the conclusion that debt increases firm value still holds.

· However, the gain from leverage is reduced when TS < TD . Here, more taxes are paid at the personal level for a levered firm than for an unlevered firm.

In some cases the lower corporate taxes for a levered firm are exactly offset by higher personal taxes i.e. ( 1 - TC ) x ( 1 - TS ) = (1 - TD ). In other words, the value of a levered firm is equal to the value of an unlevered firm, with the gain from leverage being entirely eliminated.

Thus, corporate tax laws favour debt over equity financing (because interest expense is tax deductible while dividends are not ). However, personal income tax favour equity over debt (because stocks provide tax referral and a lower capital gains tax rate). This lowers the relative cost of equity compared with the standard M&M model and reduces the spread between debt and equity costs. Therefore, some of the advantage of debt financing is lost, making debt financing less valuable to firms .

3.1.2.2 Bankruptcy costs

Debt provides tax benefits to a firm, but as firms use more and more debt financing, they also face a higher probability of future financial distress, or bankruptcy. In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt. Subsequently, ownership of the firm's assets is transferred from the shareholders to the bondholders. Bankruptcy is not a tidy affair and its associated costs may eventually offset the tax-related gains from leverage. (Ross et al, 2001)

· Direct bankruptcy costs

These are the legal and administrative costs involved in the transfer of ownership to the bondholders. Because of these expenses, bondholders will not get all that they are owed (since a fraction of the firm disappears in the legal process - also known as a bankruptcy tax).

Therefore, direct bankruptcy costs are a disincentive to debt financing. (Ross et al, 2001)

· Indirect bankruptcy costs

Because it is expensive to go bankrupt, a firm will spend resources to avoid doing so. Thus, as firms become preoccupied with avoiding bankruptcy, they neglect their business, and assets of the firm lose value.

Normal operations of the firm are disrupted, sales are lost and valuable employees leave. (Ross et al, 2001)

One of the most important indirect costs is the reduction in firm value that results from cutbacks in promising investment, which tends to be made when companies get into financial difficulty. In extreme cases, managers are likely to also make cutbacks in R & D, maintenance, advertising, or training that end up reducing future profits. This is called the Underinvestment problem.

Companies whose values consists primarily of intangible investment opportunities - will choose low-debt capital structures because such firms are likely to suffer the greatest loss in value from this underinvestment problem.

As opposed to mature companies with few profitable investment opportunities (most of their value reflecting cashflows from tangible assets), which incur lower expected costs associated with financial distress. Such mature companies are likely to have significantly higher leverage ratios than high growth firms. (Chew, 2001)

3.1.2.3 Agency costs

When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are attempted to act in their own economic interests and pursue selfish strategies. These conflicts of interests, which are intensified when financial distress is incurred, impose agency costs on the firm.

The following are strategies followed by the shareholders under the likelihood of bankruptcy. These strategies are costly and lower the market value of the firm. (Ross et al, 2002)

· Incentive to take large risk: firms near bankruptcy are more likely to take great risks, because they believe that they are playing with someone else's money (the bondholders).

· Incentive towards underinvestment: the underinvestment is accentuated by conflicts that arise among the firm's different claimholders. Stockholders realize that much of the value created by their investment would go to restoring the creditor's position. In this situation, the cost of new equity could be so high, managers acting on their shareholders' behalf decide to forego investment opportunities.

These are all jointly costs of financial distress (i.e. Bankruptcy and Agency costs). Whether or not the firm ultimately goes bankrupt, the net effect is a loss of value because the firm chose to use debt in its capital structure. It is this possibility of loss that limits the amounts of debt a firm will choose to use. (Ross et al, 2001)

M&M ignored these costs; hence the models show firm value increasing continuously with leverage, implying that firms should choose to use maximum debt. In reality, financial distress costs increase with leverage and reduce the value of the levered firm. This discussion leads us to the next theory which goes beyond the Modigliani and Miller theorem by incorporating both the tax effects and the distress costs of debt.

3.2 THE STATIC TRADE-OFF THEORY

The theory begins with the idea of an optimal capital structure. That is, as a firm's debt increases, the accompanying tax advantages increase and tend to offset the firm's debt-related, expected costs of financial distress and bankruptcy. With additions to debt at relatively low levels of debt, the tax advantages increase faster than expected financial distress costs, therefore, the value of the firm increases. However, if the debt level continues to increase beyond the optimal debt level, then the increasing marginal expected cost of bankruptcy more than overcomes the marginal debt related tax advantage and the value of the firm declines (as illustrated in figure 3).

This naturally leads us to the idea that a firm's capital structure decision can be thought of as a trade-off between the tax benefits of debt and the costs of financial distress. The trade-off theory is easily understood under the basic underlying tenet of optimizing value - and thus shareholder wealth - by choosing a capital structure combination which elicits the lowest possible cost of capital for the firm (refer to fig. 4). Figure 4 illustrates the trade-off theory in terms off WACC and the cost of debt and equity. The WACC declines initially because the after-tax cost of debt is cheaper than equity. At some point, the cost of debt begins to rise because of financial distress costs. It proposes that the firms borrow up to the point where the tax benefit from an extra rand in debt is exactly equal to the cost that comes from the increased probability of financial distress.

In an empirical framework the trade-off model predicts that firms adjust (increase or decrease) their actual debt ratios toward the target (optimum) debt level. This means that the debt financing decisions are not residuals of other financing investments and strategic decisions . Although many researchers argue that there will be an 'optimal deviation' from those targets, because adjustments towards the target is costly (especially for small firms) - in terms of the transaction costs associated with adjusting back to the target relative to the costs of deviating from the target - therefore firms will most likely fluctuate within a target debt ratio range.

Another assumption of the model is that the optimal capital structure is a function of several variables including the business risk of the company i.e. Firms confronting similar business risks, such as those within the same industry, have the same trade-offs between the debt related tax advantages and expected, debt related bankruptcy costs. Overtime, as the industry's business risk change, one would expect the firm's optimal (target) capital structure to change. The (lower) higher the business risk of a company, the greater (less) the proportion of debt it should use in it's financial structure. Finally, the theory implies that all firms of the same industry will be knowledgeable of the same target capital structure. (Claggett, 1991)

Its important to note that no equation exists to exactly determine a firm's optimal capital structure. The reason being that financial distress costs are difficult to express accurately. Therefore, clues and judgement guide the decision. (Ross et al, 2002)

3.2.1 EMPIRICAL EVIDENCE

Much of the documented evidence on capital structure supports the conclusion that there is an optimal capital structure and that firms make financing decisions and adjust their capital structure to move closer to this optimum. (Chew, 2001)

· A study (1967) by Eli Schwartz and Richard Aronson showed clear differences in the average debt to asset ratios of companies in different industries, as well as a tendency for companies in the same industry to cluster around these averages. (Chew, 2001)

· A (1982) study by Paul Marsh concluded that companies do appear to make their choice of financing as though they had target levels in mind for both the long-term debt ratio and the ratio of short-term to total debt. (Claggett, 1991)

· Jalilvand and Harris (1984) hypothesized that 'market imperfections such as adjustment costs may lead firms not to adjust completely to long-term targets, but instead follow a partial adjustment pattern'. They concluded that ' firm targets are a driving force {one of the several} in a firm's financial behaviour'. (Claggett, 1991)

3.3 THE FREE CASH FLOW THEORY

The Free Cash Flow theory is another reason why it is beneficial for firms to issue debt. The theory is built on the on the existence of the agency costs of equity.

Agency costs of equity are viewed as an extension of the Static Trade-off model. When a firm issues new equity the holding of managers with equity interest are diluted, increasing their motive to waste corporate resources. For example, managers with only a small ownership interest have an incentive to obtain more perquisites (a company car, more expense-account meals etc.), since they only bear a small portion of the costs, and reap all the benefits. Thus, firms with a capacity to generate substantial free cash flow (i.e. The balance of money remaining after all positive NPV projects are financed) are more likely to see more wasteful activity, as managers can only undertake such prodigal behaviour if the firm has the cash flow to cover it. ( Ross et al, 2002)

The theory poses some important implications for capital structure: since dividends leave the firm, they reduce free cash flow. Thus, an increase in dividends should benefit the stockholders by reducing the ability of the managers to pursue wasteful activities. Similarly, debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. Although dividends cause fewer problems for managers as the firm is not obligated to pay them. In fact, interest and principal should have a greater effect than dividends on the free-spending ways of managers, because the firm risks bankruptcy if it is unable to make future debt payments. This risk causes managers to lead and organize a firm more efficiently. (Pauwels, 2001)

Therefore, the free cash flow theory suggests that a shift from equity to debt should boost firm value, as debt reduces the opportunity for managers to waste resources. ( Ross et al, 2002 )

3.4 INFORMAL ASYMMETRY HYPOTHESIS

This theory recognizes that market participants do not have homogenous expectations - managers typically have better information about the value of their companies than outside investors. Recognition of this information asymmetry between managers and investors has led to two distinct but related theories of capital structure decisions, namely: the Signaling theory and the Pecking Order theory.

3.4.1 THE SIGNALING THEORY

Assuming that firm managers have superior information about the true value of the company, managers of undervalued firms would attempt to raise their share prices by communicating this information to the market. Unfortunately, economic theory suggests that information disclosed by an obviously biased source (e.g. Management) will be credible only if the costs of communicating falsely are large enough to compel managers to reveal the truth. The challenge for managers is to find a credible signaling mechanism. Increasing leverage is suggested as an effective signaling device i.e. Debt contracts oblige the firm to make interest and principle payments; if these obligations are not met, the firm risks financial distress and ultimately bankruptcy. Equity is more lenient, as managers have more discretion over payments (dividends) and can cut or omit them in times of financial distress. Thus, adding more debt to a firm's capital structure can serve as a positive signal of higher future cashflows and that the firm feels strongly about it's ability to service debt into the future. (Chew, 2001)

Alternatively, a firm's current market valuation may seem to management to reflect excessive confidence about the future (i.e. stocks are overvalued by the market). Managers may attempt to exploit this by 'timing' equity offerings.

(When the market prices exceeds their own assessment of stock value).

Since investors are aware of the existence of the information asymmetry, they will interpret the announcement of an equity issue as a signal that the listed stocks are overvalued (i.e. earnings are likely to decline in the future), which subsequently causes the market price to decline.

Evidence shows that the market systematically responds negatively to announcements of equity offerings, marking down the share prices of the firms by approximately 3% on average. By contrast, the market exhibits a positive price reaction on average to new debt offerings. More generally, it seems leverage - increasing transactions are associated with positive price reactions whilst leverage - reducing transactions are associated with negative reactions.

Therefore, most companies issuing new equity - regardless of whether they are over/undervalued prior to the announcement of the offering - will experience a fall in stock prices. (Chew,2001)

3.4.2 THE PECKING ORDER THEORY

The signaling theory suggests that, in order to minimize the information costs of issuing securities, a firm is more likely to issue debt than equity if the firm appears undervalued, and to issue stock rather than debt if the firm seems overvalued. The pecking order takes this argument one step farther, suggesting that the information costs associated with issuing securities are so large that they dominate all other considerations. Companies maximize value by systematically choosing to finance new investments with the 'cheapest and safest' securities available. (Chew, 2001)

The Pecking Order theory states that firms have a preferred hierarchy for financing decisions. The highest preference is to use internal financing (retained earnings and the effects of depreciation) before resorting to any form of external funds. Internal funds incur no flotation costs and require no additional disclosure of propriety financial information that could lead to more severe market discipline and a possible loss of competitive advantage. If a firm must use external funds, the preference is to use the following order of financing sources: debt, convertible securities, preferred stock, and common stock. This order reflects the motivations of the financial manager to retain control of the firm (as only commonstock has a 'voice' management), reduce the agency cost of equity, and avoid the expected negative market reaction to an announcement of a new equity issue. (Liesz, 2002)

Aside from the assumption of asymmetric information, the theory also assumes that managers act in the best interest of existing shareholders. Therefore, managers may forgo a positive NPV project if it would require the issue of new equity, since this would transfer much of the project's value to new shareholders at the expense of the old.

In this sense, the theory suggests that the trade-off theory costs and benefits to debt financing be of second order importance when compared to the costs of issuing new securities. In fact, the logic of the Pecking Order actually leads to a set of predictions that are precisely the opposite of those offered by the Trade-off theory. (Chew, 2001)

3.4.3 EMPIRICAL EVIDENCE

· This theory does fit empirical evidence quite nicely. A recent study has found that 68% 0f firms capital expenditures come from retained earnings, 31% from debt financing, and the remaining 1% from common stock issuing. Although, there is also evidence that many firms prefer to issue equities, when they can issue investment grade debts. Secondly, it is common practice for firms to reserve some debt capacity for 'rainy days' .

· There is also support for the pecking order theory in form of evidence of a strong negative relation between past profitability and leverage i.e. the lower a company's profits and operating cashflows in a given year, the higher it's leverage ratio. Moreover, in a (1998) article by Stewart Myers and Lakshmi Shyam-Sunder, they showed that this relation explains more of the time series variance of the debt ratios than the target adjustment model {trade-off model}. (Chew, 2001)

· Based on their research, Claggett, (1999), concluded that firms normally behave in a manner consistent with the pecking order theory, however, some industries may choose not to during periods of severe turmoil.

· The above have generally been interpreted as confirmation that managers do not set target leverage ratios - however, this is not the only plausible explanation. Even if companies have target leverage ratios, firms deviate from those targets (due to transaction costs), and work within a target debt range.

4. THE PECKING ORDER THEORY vs. THE TRADE-OFF THEORY

The trade-off model implies a static approach to financing decisions based upon

a target capital structure, while the pecking order theory allows for the dynamics

of the firm to dictate an optimal capital structure for a given firm at any particular

point in time. There are a number of instances where the pecking order is at odds

with the trade-off theory. (Ross et al, 2002) :

· There is no target or optimal capital structure, rather firms follow a pecking order of incremental financing choices that places internally generated funds at the top of the order, followed by debt issues, and finally, only when a firm reaches it's 'debt capacity', new equity financing. (Lemmon, 2002)

· Profitable firms use less debt. Profitable firms generate cash internally, thus a firm that has been very profitable in an industry with relatively slow growth (i.e. few investment opportunities) will have no incentive to issue debt and most likely have debt ratios. High growth firms with lower cash flows will have high debt ratios. By contrast, the trade-off theory says the greater cash flow of profitable firms creates greater debt capacity. Thus, such firms will use more debt to capture the tax shield benefits.

· Companies like financial slack. The pecking order theory is based on the difficulties of obtaining financing at a reasonable cost - and because firms know they will need to fund projects at various times in the future, they accumulate cash today. Financial slack is defined as a firm's highly liquid assets (cash and marketable securities) plus any unused debt capacity. Firms with sufficient financial slack will be able to fund most, if not all, of their investment opportunities internally. The use of internal funds avoids the problems associated with external financing such as covenants that impose restrictions on the firm's future financial decisions in the case of a debt issue, or having to underprice the firm's stock in case of a stock issue.

The pecking order theory explains these observed managerial actions while the trade-off market cannot. It is also capable of explaining stock market reactions to leverage-increasing and leverage-decreasing events, while the trade-off model cannot.

The pecking order theory, however, does not explain the influence of taxes, financial distress, security issuance costs, agency costs, or the set of investment opportunities available to a firm upon that firm's actual capital structure. It also ignores the problem that can arise when a firm's managers accumulate so much financial slack that they become immune to market discipline. For these reasons the pecking order theory is offered as a complement to, rather than a substitution for, the trade-off model. ((Liesz,2002)

4.1 Reported practice

Two surveys (Liesz, 2002) examining capital structure decisions revealed very

similar results. In each, financial executives were asked which of the two major

criteria determined their financing decisions. Further, those who followed a

hierarchy were asked to rank the order in which they would use various internal and

external sources of funding. The first survey was of Fortune 500 firms and second

was of the 500 largest Over-The-Counter firms. The results are shown below:

Reported Use of Financing Decision Methodologies (Liesz, 2002)

RESPONDENT % USING % USING

GROUP TARGET HIERARCHY

CAP STRUCTURE

Fortune 500 Firms 31% 69%

Large OTC firms 11% 89%

It is obvious that in practice financial managers are much more likely to use a

hierarchical approach than a target capital structure rationale when making financial

decisions. While this would seem to be inconsistent with value maximization

arguments, this behaviour is rational considering the motivation of managers and the

vagaries of the U.S. capital markets.

4.2. Empirical evidence

Numerous conflicting studies have emerged to determine which of the predominant theories of capital structure, the Pecking order or Trade-off theory, best describes the financing choices of corporations (Lemmons, 2002) :

· Shyam-Sunder and Myers (1999) reject the static theory and find strong confirmation for pecking order behaviour. Using a simple model and a sample of 157 U.S. firms, they conclude that the pecking order model is a good first-order description of the financing behaviour of these firms.

· Evidence also suggests firms strive for a target debt ratio range and within this range, pecking order behaviour may describe incremental decisions or, over time, firms may switch between target adjustment and a pecking order behaviour.

· While Dissanaike, Lambrecht and Saragga (2001) argue that firms adopt only one theory i.e. Capital structure choices of some firms can be described by the static theory, while others by the pecking order.

· Fama and French (2002) find that short-term variation in earnings and investment is mostly absorbed by debt, as predicted by the pecking order model, but that the pecking order model has other failings, namely, significant equity issues by small growth firms.

· Frank and Goyal (2002) focus on cost differences associated with asymmetric information across groups of firms - what they found is that firms with the greatest potential for asymmetric information, will have the greatest incentive to follow a pecking order.

5. WHAT DO SOUTH AFRICAN MANAGERS PREFER TO USE :

THE PECKING ORDER OR STATIC TRADE-OFF THEORY

Negash and Wu (2002) attempted to determine which of the two competing theories best explains the policy followed by South African managers. Using the JSE listed industrial firm's data over the 1991-1999 period - they found that corporate managers in South Africa tend to adopt Target adjustment behaviour in the long term but had to react using pecking order behaviour when faced with short term earnings and cash-flow stocks. This pecking order behaviour may be a result of the under-developed corporate debt market in South Africa and the high costs and delays associated with equity financing. The study concludes that South African managers adopt target adjustment behaviour in the long term, hoping to adjust their debt ratio gradually to the optimal (target) debt ratio, but they react to short-term stocks using pecking order behaviour. The study also shows that debt and financing behaviours of corporate managers change with the size of the firm and vary with time - both the pecking order and target adjustment behaviour are prevalent across firms of all size. Furthermore, the two models appear to be complementary to one another. Another interesting development in study showed that the pecking order model appeared to be dominant among small firms. Since the pecking order behaviour in South Africa is mainly explained by short-term earnings and cash-flow surprises and the fact - small firms normally have more pronounced cash-flow and earnings surprises, than large firms - explains the the tendency of small firms to exhibit the most significant pecking order effect.

Additionally, it was observed that managers are changing their debt behaviour over time, suggesting that macro-economic factors may affect corporate financing behaviours.

6. THE CAPITAL STRUCTURE DECISION : INTERNATIONAL EVIDENCE

We now turn to a brief examination of the empirical validity of the trade-off and pecking order theories across different countries and across different types of firms taking into account institutional settings and constraints. Based on their research, Rajan and Zingales (1995) have found that the United Kingdom and Germany have the lowest leverage among the G-7 countries (the U.S., Japan, Germany, France, Italy, the U.K. and Canada ), with all other countries having approximately the same amount of leverage.

They then analyzed the major institutional differences across countries and their likely impact on financing decisions.

· The effect of taxes on leverage: the existing literature on international capital structure difference claims that taxes have no explanatory power. However, by including personal taxes, this conclusion may be empty. Unfortunately, the relative tax advantage of debt is highly sensitive to assumptions about the investor's tax rate. For example, a tax exempt investor finds debt more tax advantaged in Germany than in the U.S. - however, this result is reversed if the investor belongs to the top tax bracket in each of the two countries. Similarly, if we had to incorporate personal taxes to both these scenarios, the ranking of the countries according to how tax-advantaged debt changes again. Thus, one cannot easily dismiss the influence of taxes on leverage in a country, but in order to reach any conclusion on the effect of taxes, one has to use the correct effective tax rate.

· Bankruptcy law

Rajan and Zingales show that bankruptcy law has considerable influence on the amount of leverage in a country. Th e G-7 countries vary greatly in their bankruptcy procedures. For instance, bankruptcy laws in the U.S. give the firm's management substantial rights including the ability to propose a reorganization plan. By contrast Germany's code is much more creditor friendly - it's bankruptcy code is not as conducive to reorganizing firms and usually results in many premature liquidations. Therefore, since liquidation values are generally lower than going-concern values, bankruptcy is potentially more costly in Germany. Therefore, it would appear logical that Germany maintains lower leverage than the U.S.

· Bank vs. market based countries

Studies reveal that there is no systematic difference between the level of leverage in bank-orientated countries (e.g. Germany) and in market orientated-countries (e.g. the U.S.). However, it would appear that the difference between bank-orientated and market orientated countries is reflected more in the choice between public (stocks and bonds) and private financing (bankruptcy) than in the amount of leverage. Secondly, despite the greater availability of debt finance from banks, firms in bank-orientated countries may not want to borrow beyond a certain point because of the associated costs of excessive debt.

· Ownership and control

Another major institutionalized difference is the level of ownership concentration. The U.S., the U.K. and Canada have firms with diffused ownership, but also, an active takeover market . Europe and Japan, on the other hand, have highly concentrated ownership. The effect of ownership concentration on capital structure is slightly ambiguous. On the one hand, the presence of large shareholders on the board of directors should reduce agency costs between managers and shareholders and encourage equity issues. On the other hand, if some of these shareholders are banks, they might have vested interest in reducing outside financing and forcing them into borrowing from their banks. Thus, it becomes difficult to determine a clear relationship between concentrated ownership and leverage. Secondly, strong pressure from the takeover market may force firms to increase leverage. Managers take on debt so as to commit the firm to paying out future cashflows - this makes the firm unattractive to raiders. In fact, its no surprise, the U.S. is the only country were equity issues are (on net) negative over the studied period.

Next, Rajan and Zingales (1995) tried to determine whether capital structure in other countries are influenced by the same (within country ) factors that influence the capital structure of U.S. firms.

· Tangibility: if a large fraction of a firm's assets are tangible, then assets can serve as collateral, reducing the agency costs of debt; assets should also retain more value in liquidation. Therefore, the greater amount of tangible assets a firm possesses, the higher the leverage should be. Tangibility is always positively correlated in all countries.

· Investment opportunities: theory predicts that firms with high market-to-book ratios (a proxy for growth opportunities) have higher costs of financial distress, and thus, are negatively correlated with leverage. Therefore, firms expecting high future growth should use a greater amount of equity finance. This result holds true across countries as well.

· Size: the effect of size on leverage is more ambiguous. Larger firms tend to be more diversified and fail less often, so size may be an inverse proxy for the probability of bankruptcy. If so, size should be positively related to debt in countries where costs of financial distress are low. However, Germany points a different picture: firms in Germany are easily liquidated and are also very costly, thus small firms should be wary of debt, yet large firms have substantially less debt than small firms in Germany. Another possible explanation is that size may also be a proxy for information outside investors have, thus increasing their preference for equity.

· Profitability: There are again conflicting results on the effects of profitability on leverage. Myers and Majluf (1984) predicted a negative relationship, because firms prefer to finance with internal funds rather than debt. Jensen (1986) predicts a positive one if the market for the corporate control is effective and forces firms to commit to paying out cash by levering up. However, if it's ineffective, profitable firm prefer to avoid the disciplinary role of debt, which leads to a negative correlation. Profitability is negatively correlated with all countries except Germany.

Overall, the factors correlated with leverage in the U.S are similarly correlated in other

countries. This suggests that the observed correlations are not completely spurious. However, the relationship between the theories and the empirical factors is weak.

( Rajan and Zingales,1995 )

7. CONCLUSION

It is evident that capital structure is important for a firm. However, financial economists are still not sure how companies choose their capital structure. Apparently, economic reality is too complex to fit in a theory; thus, none of the theories, on their own, can completely explain the capital structure of a firm.

Based on my research, it seems that all the theories appear to be supplementary. Each theory fills in a small gap of the capital structure puzzle. (Myers, 1984)

Although, two theories fit the empirical evidence quite well - the pecking order model and the trade-off theory come across as the two most popular theories. While the traditional trade-off model is useful for explaining corporate debt levels, the pecking order theory is superior for explaining capital structure changes.

Recent research suggests that perhaps a hybrid theory, between the trade-off theory and the pecking order theory, is the next step in the ongoing quest to explain how firms manage the capital structures. In fact, most dominant approaches of capital structure theory and empirical research assume that managers mechanistically make a conscious choice to follow either a target or pecking order approach, ignoring the possibility that they could be using a combination of both.

For example, some research reveals that firms strive for a target debt ratio range and within this range pecking order behaviour describes incremental decisions or, over time, firms may switch between target adjustment and pecking order behaviour. The behaviour of South African managers is consistent with this research. Corporate managers in South Africa tend to adopt target adjustment behaviour in the long-term and use pecking order when faced with short-term earnings and cash-flow shocks.

With regard to international evidence of capital structure decisions, firm leverage and influencing factors are fairly similar across the first world countries - although the differences that exists are not easily explained by institutional differences, as previously thought. Thus, further research is required in this area.

8. BIBLIOGRAPHY

· Bodie, Z., Kane, A., Marcus, A., (2002), Investments, Fifth edition

· Brouner., Dirk., Eichholtz., Piet, M.A., (2001), Real Estate Economics, 29(4)

· Chew, D.H.., (2001), Corporate Finance, Where Theory meets practice.

McGraw-Hill International Editions, New York

· Claggett, E.T. (1991), Capital Structure Convergent and Pecking Order Evidence

Review of Financial Economics, 1 (1)

· Dissanaike, G., Lambrecht, B.M., Saragga, A., (2001), Differentiating Debt Target from Non-Target Firms : A Empirical Study on Corporate Capital Structure

· Groth., John, C., and Anderson, Ronald C., (1997), Capital Structure : Perspective for Managers, 35 (7/8)

· Lemmon, M.L. (2001), Debt Capacity and Tests of Capital Structure Theories {on line}.

http : // www . afjof . org / pdf / 2003 program / articles / lemmon zender . pdf.

· Liesz, T.J. (2002). Why should Pecking Order Theory should be included {on line}

http : // www . mountainplains . org / articles / pedagogy / PECKING % 20 ORDER % 20 THEORY . html

· Nuru, J. and Archer, S., (No date). Target Adjustment Model against Pecking Order model of Capital Structure {on line}.

http : // www. odu. Edu. / bpa / efma / jnuri. Doc

· (No date) Capital Structure Theory { on line }.

http : // info . cba . ksu . edu / yang / finan665 / notes / capital structure 3 . pdfs

· Pauwels, J.L. (no date). Does Capital Structure really matter ?

{on line}. http : // staff. Feweb. Vu. Nl / cgilbert / fin2rapport. Doc

· Rajan, R. and Zingales, L. (1995), What do we know about Capital Structure ? Some Evidence from International Data. Journal of Finance 50 (2) : 1421 - 1459

· Ross, S., Westerfield, R., and Jaffe, J., (2002), Corporate Finance (6th edition) -

McGraw-Hill International Edition, New York.

· Ross, S., Westerfield, R., Jaffe, J., (2001), Fundamentals of Corporate Finance (5th edition). McGraw-Hill International Edition, New York.

· Ross, S., Westerfield, R., Jordan, D., Firer, C. (2001), Fundamentals of Corporate Finance (2nd Edition). Erwin and McGraw

· Shyam-Sunder, L. and Myers, S.C., (1999), Testing Static Trade-off against Pecking Order Models of Capital Structure. Journal of Financial Economics, 51, p219-244.

· Wu, G.G. and Negash, M. (2002), Corporate Debt Behaviour in South Africa : Pecking Order or Target Adjustment ?

SAAA Biennial International Conference Proceedings, Port Elizabeth, June, 649-671

DIAGRAMS

FIGURE 1:

The cost of equity and the WACC : M&M Propositions I and II with no taxes

FIGURE 2:

The cost of equity and the WACC : M&M Proposition II with taxes

FIGURE 3:

The Static theory of capital structure: The optimal capital structure and the value of the firm.

FIGURE 4:

The Static theory of capital structure : The optimal capital structure and the cost of capital.



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