Literature Review On Traditional Capital Structure Finance Essay

Chapter 2


2.1 Introduction

In this chapter, relevant academic literatures are reviewed. Models and theories on capital construction play the major portion of the chapter. The aim was to depict and supervise bing researches in the capital construction with mention to theories and theoretical accounts as the “ Professors Franco Modigliani and Merton Miller Modigliani ” or M & A ; M Theory ( once called the “ Modigliani and Miller Theory ” in 1958 ) Modigliani and Miller ( 1958 ) , the Trade off Theory, the Packing Order Theory, Weighted Average Cost of Capital ( WACC ) , the Information Asymmetry Theory and the Agency Costs.

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The literatures review starts by debating and discoursing on the different readings of what capital construction means. As Atrill P. ( 2006 ) viewed that academic research on long term fiscal determinations on capital is really of import. Different position on the mix of fund can significantly impact the overall disbursals of the concern capital. Sing the assorted mix of financess in order to bring forth lower cost and look into on how to finance these financess will act upon how the company will be valued.

2.2 Discussion of Capital Structure

In the academic position, there seems to be no unequivocal understanding on the capital construction of the company. There are several factors that play a cardinal function in finding the extent and fortunes to which the company can borrow. Factors such as touchable assets, growing chances, individuality, sizes, concern hazard, profitableness and repute or age. The basic premise is that these factors will find the capital construction of the company or, in other words, they relate to the degree of debt the company will bear. The higher the value of the correlativity factors, the more influential these factors are.

The definition of capital construction by Ross SA ( 1997 ) is a combination of debt and equity in long term funding of a company ‘s operation. Part of the pecuniary policy of the company includes finance and capital construction where corporation assets are financed through combination of debt, equity and blend securities. Silbiger S. ( 2007 ) defined as “ the funding determinations in a corporation revolve around what is the best mix of debt and equity, that mix is called a company ‘s capital construction policy. ” Theoretically, use of appropriate mix of debt and equity is the optimum ; nevertheless, there is no perfect fiscal expression to accomplish such intent. Nevertheless, a company can categorise its capital construction into two strategies. Company can be entirely equity structured or they can hold assorted capital construction of debt and equity investings with suited proportions.

In state of affairss where the company has a the capital construction of 100 % equity, the investing assessment for the current cost of equity capital can right be determined by utilizing price reduction rate. Cost of capital represents the chances cost of stockholder ‘s capital that influence the return they will gain.

On the reverse, where there is a assorted capital construction which composed of debt and equity part, Weight Average cost of Capital ( WACC ) is used to set the leaden mean cost of each component.

Through the above treatment, the foundation of the company ‘s capital construction is chiefly composed of debt and equity. The Modigliani and Miller had a diverse position otherwise, saying that a house can non alter the entire value of outstanding securities by altering the ratio of the house ‘s capital construction. Related theories on capital construction are as follow:

– Theory of Traditional

– Amedeo modigliano and Miller Theory

– The Trade-off Model

– Pecking Order

– Agency Costss

– Asymmetric Information

2.3 View of traditional

The traditional position use debt funding to make the most favourable point in take downing the weight norm cost of capital. Pike R. and Neale B. ( 2006 ) found that “ the traditional position emphasizes the benefits of utilizing comparatively inexpensive debt capital ” . Explaining farther, the overall cost of capital is reduced due to ab initio the benefits of capital debt is cheaper compared with costs in any addition of equity required to counterbalance stockholders ‘ equity to back up a higher fiscal hazard. However, while pitching additions, higher returns are demanded by stockholders. Consequently, leaden mean cost of capital will increase taking cost to debt to lift which will get down to outweigh the benefits of inexpensive debt finance.

Peter Atrill ( 2006 ) points out that the cost of debt capital is cheaper than the cost of equity capital. Debate suggested that improved purchase costs will cut down overall corporate costs. However, when loans increase, new rates produced by publishing common stocks are set up to counterbalance for the addition in fiscal hazard. In add-on, the lender would besides name for higher returns. However, harmonizing to the traditional positions, the benefits of utilizing dependable low degree of debt will outweigh the cost incurred. Aside, loaners and common stock will non hold involvement in low adoption rates. On the other manus, the higher degree of debt leads to significantly higher degree of hazard, therefore, coercing higher involvement rate demand for compensation.

It is recommended that directors should put importance on bring forthing the suited mix of debt and equity funding to cut down the cost of capital. By that, the value of the concern will be maximized and capital construction is at its optimum.

2.3.1 The cost of capital

The definition of the cost of capital by Harold Bierman ( 1970 ) is defined as the cost of corporate financess or the overall outlooks on returns of investors from their investing in assorted securities. In short, if a company is more profitable than the cost of capital, such investing should be accepted. Unfortunately, the cost of capital extremely depends on the scene of uncertainnesss and hazards that we can non overlook. The cost of capital can be defined as the minimal rate required by suppliers of fiscal services. The cost of capital, explained by Shannon P. Pratt ( 1998 ) as, “ the expected rate of return that the market requires in order to pull financess to a peculiar investing ” . In investing footings, the cost of capital can be referred to as the chance cost. The cost of capital is frequently represented in the signifier of per centum of one-year sum of money that investors expect to obtain. Thereby, it is clearly acknowledged that the cost of capital can non be set by the company. Therefore, it is the consequence to the current market. This means, informations for the rating of the cost of capital for any undertakings are generated from the investing market.

Bierman H. ( 1970 ) examined that the elements in most cost of capital are divided into two constituents: the cost of debt and the cost of equity of stock. The cost of debt is the involvement rates at future contractual payment of involvement and rule, while, The cost of stock equity is future dividends at current market monetary value.

2.4 The position of Modigliani and Miller ‘s

Two American economic experts during the 1950s, Franco Modigliani and Merton Miller ( M & A ; M ) , wrote a paper on capital construction irrelevance which has inspired many researches. They came up with two new schools of capital construction, the MM theoretical account without corporate revenue enhancements and the MM theoretical account that includes the corporate revenue enhancements.

2.4.1 The M & A ; M theoretical account without the corporate revenue enhancements

“ Companies which operate in the same type of concern and which have similar operating hazards must hold the same entire value, irrespective of their capital construction ” and that capital constructions do non act upon the leaden mean cost of capital, harmonizing to Modigliani and Miller ( 1958 ) . Furthermore, in sing the company ‘s value, the degree of hazard and the company ‘s public presentation in line with gross are involved. This hypothesis was subsequently known as the “ Theory of Irrelevance ” . The hypothesis does non utilize mix capital construction as the consequence, optimal capital construction was non achieved. In drumhead, the theory implies that the entire cost of a house can non be altered through altering the ratio of capital construction while cost of capital being changeless at different geartrain degrees. Supporting the thought, Peter Atrill ( 2006 ) besides inputted clip should non be wasted on look intoing the perfect funding mix as no peculiar capital construction is best or worst than others.

Equation 2.1 below demonstrats the thought proposed by M & A ; M theoretical account I ( without corporate revenue enhancements ) that shows the leveraged and unleveraged value is tantamount.

VL = VU Eq2.1


VL = value of levered house

VU = value of unlevered house

Brealey R.A. ( 2006 ) shaped M & A ; M theoretical account I by saying that leveraging increases the net incomes per portion while expected return on assets is equal to runing income divided by the entire securities market value of houses whereby, the expected return on portfolio such as all debts and equity of the houses is changeless and equal to the leaden norm of the expected return of the person. Brealey ‘s proposal is replicated in equation 2.2.

Ra = Eq2.2


Ra= Return on assets.

Rd= Return on debt.

Re= Return on equity.

D= Debt

E= Equity

V= Total value of debt and equity.

Mentioning to the equation above, the expected return on assets can be denotes as the leaden mean cost of capital ( WACC ) , harmonizing to Copeland & A ; Weston ( 1992 ) . Therefore, it is possible to change by reversal equation 2.2 to happen the return on equity as follows:

Re = Ra + ( Ra-Rd ) * Eq2.3

Myers S.C. attempted to reply the inquiry why there is an addition in rate of return when debt ratio addition as stated in M & A ; M ‘s Proposition – II. The expected rate of return on the house purchase depends on the proportion of debt and equity. Which means that increasing expected rate of return produced by debt funding can be offset by increasing hazard ignoring any direct dealingss to capital construction.

2.4.2 The M & A ; M theoretical account with corporate revenue enhancements

The first theoretical account of the MM hypothesis is non applicable to the existent universe where there is no revenue enhancement. The MM indicates that the benefits of the grant will be offset by a higher needed rate of return on common stock. In add-on, stockholders gained revenue enhancement tax write-off from debt funding ( Modigliani and Miller ( 1963 ) ) as equated in 2.4

VL = VU + Tc Eq2.4


Tc = Corporate Taxes

In position of old treatments, the MM of the proposition I without revenue enhancement illustrated the benefits associated of the expected return on equity and purchase. The same thing occurs when corporate revenue enhancements are incurred. ( shown in the equation 2.5 below )

Re = Ra + ( Ra-Rd ) * * ( 1-Tc ) Eq2.5

Figure 2.1 below shows the theory which plot the value of the house ( VL ) and the sum of debt ( D ) . The three lines represent:

Horizontal line ( Vu ) represents of the M & A ; M proposition without revenue enhancements it means capital construction has no consequence to the value of the house.

The following upward inclining consecutive line refers to instance M & A ; M proposition with revenue enhancements.

The 3rd line shows the value of the house increased to the upper limit and so lessenings after the house reach the highest point at VL* . ( Ross S.A ( 2006 ) )

optimum % 20capital % 20structure1


Beginning: Ross S. A. , R.W. Westerfield and J. Jaffe, Corporate finance, 7th edition, 2005, Irwin, McGraw Hill.

The optimal adoption sum ( D * ) is at its maximal value when making ( VL * ) , mathematically express as D* / VL* in debt and 1 – D */ VL * in the equity. As the consequence, difference in the value between the inactive theory and the M & A ; M theory ( with revenue enhancement ) mean the value loss from hurt from fiscal feasibleness and the addition from leveraging the net cost of hurt is represented by the difference in value of the inactive theory and the the M & A ; M ( excepting revenue enhancement ) . ( Ross S.A ( 2006 ) )

2.4.3 The Leaden Average Cost of Capital ( WACC )

WACC is computed by proportionately weighing single capital to happen the house ‘s cost of capital. Beginnings of capital are preferred stock, common stocks, bonds and other long-run debt securities.. Ross S.A ( 2006 ) viewed stated that the “ primary ground for analyzing The WACC ( Weighted Average Cost of Capital ) is that the value of the house is maximized when the WACC minimized. ” Therefore, WACC is at its lower limit, that fiscal construction is chosen. It can be said that one capital construction is better than another if it generates the lower leaden mean cost of capital. In add-on, debt to equity ratio is at its optimal when WACC is at its lowest.

Indicated earlier, capital construction maximizes value to the house by minimising the cost of capital. Figure 2.2 presents the inactive theory of capital construction in footings of leaden mean cost of capital and the cost of debt and equity. On the perpendicular axis illustrates different capital cost in per centum compared with the debt to equity ratio on the horizontal axis. The WACC line relates with the inactive theory in the Figure 2.1. Initial diminution was due to cheaper after revenue enhancement cost of debt than equity. At some point, the cheaper cost of debt is offset by the fiscal hurt cost. As the consequence, addition in debt will do addition in WACC as shown in Figure 2.2 where D*/E* is the lowest WACC degree. ( Ross S.A ( 2006 ) )

optimum % 20capital % 20structure2


Beginning: Ross S. A. , R. W. Westerfield and J. Jaffe, Corporate Finance, 7th edition, 2005, Irwin McGraw Hill.

The optimum capital construction is on occasion called the mark of the capital construction. Below is the method for ciphering the leaden mean cost of capital. ( Brealey R.A. ( 2006 ) )

WACC = Rd * ( 1-Tc ) *+ Re* Eq 2.6

2.5 The Trade-off Model

The leaden mean cost of capital by and large drops to a certain point and so swings upward at the same point where the debt increases every bit good. However, the minimal point of the WACC is the optimum capital construction and sagely utilizing the debt will increase the house ‘s value. The Trade-off theory, on the contrary, recommended that houses holding tonss of intangible assets should utilize equity support ; while those will touchable assets can utilize debt funding ( Harris and Raviv, 1990 ) . Myers said the Trade-off explains why the houses do non utilize excessively much debt. ( Myers, ( 1984 ) as bankruptcy is possible although revenue enhancement advantages on debt are acknowledged. Warner ( 1977 ) and Smith and Warner ( 1979 ) discovered that fiscal hazard and bankruptcy is lesser on bigger concern than smaller concern.

The capital construction of the Trade-off theory suggested companies keeping high hazard and intangible assets should depend chiefly on equity funding. On the other manus, companies with secure touchable assets and tonss of nonexempt income should utilize the high mark debt ratio. Situation where no accommodations on costs of capital construction occur, aim debt ratio is achieved. However, many factors that caused accommodations to the capital construction such as cost and holds, hence, analyzing the differences in existent debt ratio from those houses that have the same mark debt ratio are recommended.

2.6 The Pecking order theory

The picking order describes the manner the company prioritise the capital construction through penchant direction. The company would prefer to publish debt instead than equity if internal financess are non equal. In this theory, the beginning of finance is retained net incomes, debt ( regular and transition ) and cost ( apparatus and general ) depending on the life rhythm of the company. Retain net incomes are considered the cheapest funding while common stocks are the most expensive.

Companies would ab initio get down up with equity capital and bank loans. However, as ventures expand quickly, beginning of funding would come from ventured capitals and debut of public engagement. At the adulthood phase, many options options are used to keep the beginning of finance, although most would prefer internal investings. In the worsening phase, resources may transcend investing chances, as the consequence, repurchasing of debt or portion capital may happen.

There are many factors that may act upon the determination to taking one method of funding over the other. The undermentioned describe the most important factors:

aˆ? Assets – the companies that have a batch of tangibles assets hold more debts than those with tonss of intangibles.

aˆ? The uncertainness of runing income – companies holding ill-defined operation income tend to hold less debt in their capital construction.

aˆ? Income revenue enhancement – companies with higher income revenue enhancement would hold higher purchase ( due to revenue enhancement shield ) .

aˆ? The flexibleness needs – companies necessitating high flexibleness would keep less debt in capital construction.

In the position of Mclaney E. ( 2003 ) , the picking order theory is related to the cost of the raising financess and the handiness of investing financess. “ The maintained net income costs nil to lift, while external finance is expensive to lift. On the other manus, debt is comparatively inexpensive to lift, specifically if it is in the signifier of a term loan from a bank or similar establishment. However equity has somewhat high issue cost, peculiarly if it involves an issue to the general puting populace, but even rights issue are comparatively expensive. ” To sum up, debt funding would be the first pick of funding and equity funding would ranked last. As the consequence, the company will hold lower pitching degree but besides would do decrease on dividends as hard currency would be used to finance investings. However, revenue enhancement benefits and other factors influence the geartrain determinations. Therefore, the picking order theory may non be the best method to stay by. In add-on, through the pecking order theory created by Myers and Majluf, scholars suggest that the appropriate mark fiscal construction does non be for all companies. For case, many companies tend to increase their initial capital through militias net incomes advise the cost of operating, Myers ( 1984 ) . Past productiveness and companies ‘ net incomes constitute a strong function in the direction of capital construction.

Myers ‘s believe of increasing capital demands should be from internal beginnings where it is less dearly-won which led the company to be less in debt and more capable of bring forthing net incomes, Myers ‘s ( 1984 ) . In other words, companies with ability to bring forth net income will be given to hold lower purchase ratio as they are able capable of funding their ain investings through maintained net incomes. However, some companies tend to borrow more debt to cover with inequality and supply a better estimation. For this ground, the theory of information dissymmetry was established that attempted to explicate a given selected fiscal construction ( Ross ( 1997 ) ) .

With Pecking Order Theory, the benefits that the company could have is that it is able to derive more investing chances and growing than it usually could manage through its ain financess. In add-on, companies utilizing the Pecking Order Theory direct out a positive signal of the hereafter of the company. It shows that the company is confident that it will be able to pay back its debt duties.

2.7 The Agency Cost Theory

Myers ( 1977 ) Agency Theory discussed on the argument between stockholders and loaners on the cost benefits and involvement due to different position point. Lenders tend to give towards lower investing to guarantee ability to refund debt, nevertheless, directors are looking for high hazard investing to bring forth higher net incomes. As the consequence, this theory produces optimum fiscal combination from the clangs between the company and investors. Harmonizing to Jensen, one of the factor that drive up the capital construction degree is the bureau cost. This is because directors are more likely to demo duty in the production of hard currency in their hereafter while investors would coerce the direction of the company to utilize the capital, so more debt funding is the consequence.

Ross ( 1997 ) shows that if companies have to take resources from the holders of the company to do the best usage of investing, equity funding are non appropriate. There should be a negative relationship between future growing outlooks and the degree of long-run debt.

Again, the cost of the unit can be reduced by utilizing short-run debt alternatively of long-run debt, Myers ( 1977 ) . Therefore, developing companies tend to alter long-run loans by short-run funding. This can be translated that short-run debt ratio is correlated with growing rate.

Similarly, Jensen and Meckling ( 1976 ) show that if companies want to cut down their bureau costs, they should be flexible in debt funding. Consequently, mutable debt have positive correlativity with growing chances as good.

2.8 The Information Asymmetry Theory

Ross ( 1997 ) does non believe that a company ‘s information is to the full accessible and available in the market, hence, the writer brought up the Theory of Information Asymmetry which oppose with the guess Modigliani and Miller. Harmonizing to Ross, merely the company executives have ownership of all the activities of the company. For this ground, the determination of the Managing Director of the company can bespeak the hereafter that company. The executives ‘ determination to increase purchase means that they are confident that they will be able to For illustration, if the determination to increase purchase of its market launch will intend the direction of companies are confident that they will be able to pay for the involvements and connote their assurance in having the expected gross ( Ross, 1997 ) . At the same clip, increasing purchase will increase the value of the company. Companies with high equity investings will draw financess from their stockholders, thereby, are less likely to pay much portion capital.

Furthermore, Asymmetric Information Theory indicates that different capital construction is influenced by the size of the company. Information dissymmetry is instead serious in little companies as it is really dearly-won. To get by with these jobs, the loaner depend to the full warrants ( Ross, 1977 ) . On the other manus, Fama and French ( 1988 ) suggest that addition in the debt capital construction by and large indicate weak estimations of future net incomes and hard currency flows as less use of internal financess ( retained net incomes ) for investing there is a higher opportunity of bankruptcy. In add-on, the writer recommends that companies holding more net incomes tend to hold lower borrowing degree.

2.9 The Financial hazard and Business hazard

Normally, when puting in a concern, most investors will meet two types of hazards: the concern hazard ( hazard of operating ) and fiscal hazard.

Business hazard is the variable in net incomes before involvement and revenue enhancement of the company ‘s long-run industry.

Fiscal hazard is extra hazard due to pitching.


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