Capital Structure Literature Review

apter 2: Literature Review

The basic aim of any organization-despite what their mission statement might state – is to make profits. And the way that it is financially structured can have an impact on its profitability and returns. An appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to various stakeholders, but also because of the impact such a decision is the organization’s ability to deal with its competitive environment. The optimal capital structure exists which balances the risk of bankruptcy with the tax savings of debt (Modigliani and Miller, 1958). Once establish this optimal capital structure should provide greater returns to

So as to reduce WACC, the traditional theory encourages companies to take on debt, since the increased cost of equity is not important at low gearing levels. Returns are expected by both shareholders and lenders to be increases at high gearing levels pushing WACC higher. However the shareholder wealth is maximized just before the shareholder’s wealth begins to increase and at this point the WACC is at its maximum. The Modigliani and Miller (1985) MM view on capital structure is that shareholders would require a higher return when debt is introduce. However the low cost of debt compensate for the high expectation of returns, therefore the effect on WACC is zero. MM is based on assumptions that a firm is not affected by the amount of debt a firm issues, has no corporate taxes nor does it face the possibility of going bankrupt (Scott, 1976). Modigliani and Miller theory was later revised to exclude tax as this was seen unrealistic. Based on MM theory, trade-off theory suggests that there should be balance struck between bankruptcy cost and tax shield (Graham and Leary 2011).

Nirmala (2011) said that as debt content in the firm’s capital structure decreases, its share price rise and vice versa. This shows that increased use of debt lowers the earnings available for equity shareholders and investors become apprehensive about their returns, so investors

They provide an evidence that firms operating within legal systems that provide better protection for financial claimants tend to have capital structures with more long-term debt and less total debt as a proportion of total debt. Further they found that firms that choose to cross-list tend to use more long-term debt and equity. They also find that taxes and the characteristics of the financial institutions that supply capital have an influence on how firms are financed. More additionally, they found that the cross-sectional determinants of leverage differ across countries. Particularly, the association between leverage and profitability tends to be stronger in countries with weaker investor protection (Fan, Titman and Twite,