External And Internal Determinants Of Capital Structure Finance Essay

foreign And Internal De edgeinants Of crownwork social building Finance Essay1 macrocosm1.0 IntroductionThe literature on with child(p) construction surmisal has made fundamental progress after the trend setting issuings of Modigliani and Miller in1958. After the publication of Modigliani and Miller look work, various researchers learn developed theoretical models based on the balancing of valuate effect and inefficient distribution of information. Recently, t present be numerous models that focus on the relationship between product and market or the effect of a particular ownership organise on the metropolis financing decisions of a wet (Bhaduri 2002). These models support been developed pertaining to many different sectors of economy much(prenominal) as manufacturing by Long and Malitz (1985) and Titman and Wessels (1988). Miller and Modigliani (1966) tested these models in the context of power generating and electric companies, while Jensen and Langemeier (1996 ) fall in foc employ on the agricultural solids.Among the n angiotensin converting enzymeworthy models proposed by researchers, the static trade off theory carries the un hassleatic importance. Modigliani and Miller (1958) contended that the static trade off theory is based on the assumption of friction and information-wise perfect markets. They too proposed the irrelevance theorem which implies that the financing decisions of upstandings have vigor to do with the value of organisation and their cost of financing.Titman and Wessels (1988), Rajan and Zingales (1995) and Graham (1996) have conducted their empirical research to investigate the important determinants of bang-up building proposed in the theoretical models by finance commentators. In the majority of research, they effect that truehearteds decisions to achieve the target great structure atomic number 18 spontaneous. In the imperfect market, these target ratios argon not fast and incomplete while in perfect ma rket, these monetary decisions are perfect and spontaneous. It means that firms try to adjust their optimal ceiling structure spontaneously as the cost of working slap-up varies in the market. Marsh (1982), Jalilvand and Harris (1984) found that the briny impediments in the way of adjusting superior structure are the adjustments and transaction cost associated to market imperfections. These imperfections lift due to the inefficiencies in financial market much(prenominal) asymmetric distribution of information and transaction cost etc.These researchers have found that the firms financial decisions unremarkably taken in a two step process. Marsh (1982) and Jalilvand and Harris (1984) explained that in the first step, a firm decide its target capital structure and in the next phase, it strives to attain that target. Spies (1974), Taggart (1977), Jalilvand and Harris (1984) and Ozkan (2001) stated that financial behaviour of a firm potbelly be best described by the partial adj ustment model. In this partial target adjustment model, it is assumed that a firm adjusts to the target capital structure spontaneously.One common attribute in the research is that the capital structure of a firm varies with the change in industry type. Even after the efforts of numerous researchers, no single univers e real(prenominal)y accepted capital structure theory exists. There are in like manner a comparatively small number of empirical researches conducted up public treasury now on this topic. One affirmable reason for the small number of empirical research is the intangible and conceptual nature of determinants proposed by the authors (Titman and Wessels 1988). However, the available empirical research has foc apply on current factors much(prenominal) as the size of it of firms profitability and volatility of earnings forrader touch, revenue enhancement and depreciations etc. These determinants came out after the studies conducted in the developed countries such a s the fall in States (USA) and the unite Kingdom (UK). After the integration of markets, it is becoming increasingly to a greater extent important to field of operation these markets to test the validity of these determinants. Because of the conflicting ideas pertaining to the financial behaviour of firms, it is important to have practical research based on theoretical mental homes to establish a valid capital structure determinant model.1.1 ObjectiveThis research paper will endeavour to determine the factors which serve as an impetuous for changing the capital structure of firms across the different industries operating in the United States of America (USA). The main objective of this research will be achieved investigating the relationship between following determinantsCapital structure and profitabilityCapital structure and tangibilityCapital structure and economic growth of the countryCapital structure and rate of inflationAn other(a) objective is to find and evaluate the force of internal forces which play an important role in changing the capital structure of a firm.Literature Review2.0 IntroductionThis chapter attempts to establish the theoretical foundation of determinants of capital structure. First of all, the effect of different industry types on the capital structure has been given. Then the different capital structure theories have been described. After that, all the possible external and internal determinates of capital structure has been discussed. Lastly, the latest outgrowth in the macro and micro environment, which have significant bearing on the capital structure of a film, are discussed2.1 External and Internal Determinants of Capital StructureIn this time of financial distress, where many companies are facing impending interruptcy because of the liquidity crunch and misman advancement of resources, it is imperative for financial managers to use the optimal mix of debt and comeliness in order to drive down the cost of capital and thereby increasing the profitability of their firms.Another impetuous for victimization optimal mix is that the financial analysts, investment houses, common stock buyers and bond rating bureaus unremarkably compare the financial leverage of a firm with industry average figures before taking investment decisions (Moyer et al. 2009). Hence, it is in the very interest of a firm to decide its optimal capital structure in order to make its financial health much conducive to further investment by submissive hand around returns (DeAngelo and Masulis 1980). As per definition, capital structure of a firm is the mix of the occur long and short term debt plus the total amount of rectitude (both preferred and common) which is raised by a ships company to finance its total capital requirements (Investopedia 2009).According to Brigham and Ehrhardt (2001), there are many internal and external factors which a financial manager has to be mindful of before chalking out business plans and polic ies. Similarly, decisions of capital structure are the outcome of many internal and external variables (Brigham and Ehrhardt 2001). External variables consist of many macroeconomic factors such Gross Domestic Product (GDP), unemployment, inflation, interest grade and tax policies etc (Besley and Brigham 2007). GDP is the accumulated market worth of stainless goods and services produced within the boundaries of a country during a particular period of time, usually angiotensin converting enzyme year (Investopedia 2010). Nominal GDP (inflation not adjusted) should not be confused with real GDP (inflation adjusted) as the increase in nominal GDP (merely increase in prices) doesnt mean that country has made more bullion during a certain period (Investopedia 2010).Inflation means the rate of increase in the prices of goods and services over a period of time, usually measured by the Consumer Price Index (CPI) and GDP deflator (a ratio of nominal and real GDP) (Investopedia 2010). Some other important variables of macro economy are the economic growth, budget famine and poverty. These macroeconomic factors indicate the aggregate economic performance of an economy (Investopedia 2009). As these macroeconomic factors are the result of many sub factors which collectively make a very complex economic system (Campbell, McConnell and Brue 2008). These factors, by nature, are out of the control of a firms manager so he/she cannot influence the determinants. They instead have to adjust the proportion of debt and candor according to their respective costs.Some other important external variables which affect a specific capital structure are the taxation, profitability, the interest expense, the effect of agency cost and the level of business take chances faced by the company (Moyer, McGuigan and Kretlow 2009).Besides these external variables, there are many internal factors which a business manager has to consider before selecting a particular mix of debt and equity. Thes e internal variables can be the industry specific variables such as the effect of seasonal levels of gross gross gross sales or these can be the internal to the firms such as the style and attitude of solicitude. Entrepreneurial organisations, for example, have the design of taking bolder and encounterier business decisions as compared to bureaucratic ones which shows more risk-averse behaviour. Among the most prominent internal variables are the level of profitability, degree of risk appetite of business managers and the tangibility of fixed assets etc.2.2 Effect of industry type on the capital structure of a firmThere are a lot of variations in the capital structure of firms across the different industries all over the world (Scott and Martin 1975). Capital structure of firms varies with the change in type of industries and even within the uniform industries (S. Titman 1984). It is evident from the Table 1 that the firms which are operating in the drugs and industrial machi nery sector do not use a large amount of debt as compared to firms which are in the retail and utilities business (Brigham and Ehrhardt 2001). Some possible reasons are the uncertainties inherent in the research projects carried out by these firms or the chances of product liability law suits (Brigham and Ehrhardt 2001). Due to the low level of debt financing, these firms are overly experiencing low level of financial distress (i.e. the times interest earned ratios are high) as compared to the other sectors as shown in table 1 (Brigham and Ehrhardt 2001).However, the firms which belong to the utilities sector usually rely heavily on debt financing which is evident from their common equity ratio as shown in table 1 (Brigham and Ehrhardt 2001). The major portion of total debt comprises of long term debt which they usually raise by issuing securities and owe bonds against their huge fixed assets (Brigham and Ehrhardt 2001). Another rational behind this phenomenon is the stable sales figures as compared to the other firms which have volatile sales (Brigham and Ehrhardt 2001). This factor enables these types of firms to use more debt financing because they can easily forecast the expected level of prox sales and can have an optimal business risk (Brigham and Ehrhardt 2001).2.3 Theoretical Foundations of Capital StructureFranco Modigliani and Merton Miller (famous as MM) (1958) are pioneers, having studied the force of internal and external determinants on the capital structure of an organisation (cited in Bhaduri 2002). In the geezerhood since, there has been a large volume of research by many researchers to determine the individual effect of these environmental factors on the capital structure of a firm in different countries of the world (Al-Najjar and Taylor, 2008). Modigliani and Miller proposed that in a supposed no-competition world, the value of a firm is independent of its capital structure (cited in Bhaduri, 2002). Further they also assumed that thei r theory is valid under the assumptions of perfect competition, no taxation cost, not transaction cost. They also stated that the productivity of firms is not dependent on mode of financing (cited in Bhaduri, 2002). In the above mentioned scenario, internally generated sources of monetary resource are almost the perfect substitute of external funds (Bhaduri, 2002). Hence, companies are indifferent to the sources of financing. After the publication of their work, researchers have found some imperfections such as Kim (1978) introduced the idea of bankruptcy cost. The idea of facility of tax sort was introduced by DeAngelo and Masulis (1980) and the agency cost by Jensen and Meckling (1976). All these researchers agreed that the optimal capital structure is the most realistic solution to the capital structure dilemma faced by the todays firms. As the cost and benefits of leverage changes from one industry to the other, many anterior researchers are of the opinion that industry ess ential have significant impact on the capital structure of firms (Scott and Martin 1975). Every firm tries to chase the average industry ratios (Tucker and Stoja, 2007). Ang (1976) say that firms can only have an optimal caravan ratio rather an ideal universal ratio for all in the real world scenario. Remmers et al. (1974) agreed with the Ang (1976) by stating the gearing ratio of firms varies with industries. They also said that firms that belong to the same industries face same environmental conditions which lead them toward common earning and sales patterns (Remmers, Wright and Beekhuisen 1974). Scott (1972) and Scott and Martin (1975) said that most of the firms tries to choose the gearing ratio that is appropriate to their risk/return profile and their inherent business risks.Antoniou et al. (2002) found that the UK, German and French firms continuously adjust their debt ratios according to the target ratio, but at their own rates which is contingent to whether they belong to the manufacturing or services sector. Bradley, Jarrel and Kim (1984) said that the agency cost and bankruptcy cost are just the partial determinants of leverage. It means that these factors also have impact on the capital structure of firm but in a less same(p)ly fashion.Many researchers endeavoured to tackle the issue of optimal capital structure (Bhaduri 2002). All these works have collectively contributed in the development of financial theory (Bhaduri 2002). In spite of all these efforts, there is no one comprehensive solution to the capital structure dilemma (Titman 1984). Moreover there have been very little practical evidence regarding determinants of capital structure till recently (Harris and Raviv 1991).The main reason behind this limited number of empirical research evidence on this topic is the abstract nature of determinant such as size of firms, their growth rates, intensity of capital, gross profits, volatility of future sales and free cash flows and the impact of t axation on changes in the capital structure of a firm (Harris and Raviv 1991).Another important issue is pertaining to the geographical locations that most of the available research works have focused on the United States of America (USA) market (Bhaduri 2002). Less economically developed countries (LEDCs) lag behind due to the neglected role of the private sector in the economic development of country and the limited sources of funds for the companies belonging to the LEDCs (Bhaduri 2002).2.4 Main Factors Influencing the Capital Structure of a FirmThe chief determinants of capital structure are the attributes and factors that have very significant impact on the leverage ratio of a firm. The following is the detail of the most relevant determinants of capital structure of a company.Asset StructureAccording to the agency cost and asymmetric information theories, the composition of tangible assets owned by a company greatly affects its capital structure (Jensen and Solberg 1992). sel f-assurance cost theory states that shareholders of a firm, which has high proportion of debt in its capital structure, have the intention to invest sub-optimally (Galai and Masulis 1976 Jensen, Solberg and Zorn 1992). A positive relationship has also been found between the collateralisable assets and debt structure of a firm. Another factor is the over consumption habit of business managers which ultimately reduces the value of a firm (Bhaduri 2002).Financial harmIf a firm is using a huge amount of debt and it has to pay heavy payments periodically, there is very high probability that it will go bankrupt in the case of falling revenues or future free cash flows (Brigham and Ehrhardt 2001). This implies that the firms, which are having volatile sales figures, usually use less debt financing in order to avoid probable financial distress (Ensen and Meckling 1976). Fear of bankruptcy forbade the firms to rely heavily on the debt financing (Bhaduri, 2002).Non-Debt Tax ShieldDeAngelo an d Masulis (1980) said that one of the firms objectives of using debt financing, is to avail the benefit of a tax shield because interest expense reduces the taxable income of a firm. So the firms which have a large non-debt tax shield are likely to use less debt financing.SizeThere are is large number of evidences that the firms which are large in size and hearty diversified are less likely to experience financial distress (Demsetz and Lehn 1985, Remmers, Wright and Beekhuisen 1974). This encouraged them to use relatively large amount of debt financing (Warner 1977 Ang and McConnell 1982).AgeThe age of firm is also a very pertinent factor that influences the firms decision some having a specific of capital structure (Scott 1972). Young firms are more intended to use debt financing because of the high appetite for risk taking and limited amount of information at hand (Scott 1972). So they find acquire from banks a cheaper and convenient way as compared to use equity financing.Grow thFast growing firms experience a higher cost of agency problem as compared to the firms which not growing very fast. Bhaduri (2002) said that fast growing firms have more chances of adjustments in the coming years. Hence there is a proscribe correlation between the longer term debt and the future growth of a firm. Myers (1977) said that the short term debt is the remedy to this problem. By doing this, fast growing firms dont take aim to enter into long term debt contrast and can easily adjust their capital structure according to the requirements of growth and financial conditions (S. Myers 1977).ProfitabilityIf managers of a company are not capable and credible enough to convince venture capitalists to lend capital, they will preferentially rely on the internal sources of revenue (e.g. carry earnings) (Myers and Majluf 1984). Myers and Majluf (1984) noted that profitable firms usually have more money as retimed earning in order to invest in the growth projects. Hence there must be negative relationship between debt proportion and historical profitability of the company (Myers and Majluf 1984).UniquenessIt is found that the firms which are producing unique kind of products usually have low leverage ratio (Bhaduri 2002, Antoniou, Guney and Paudyal 2002). These firms face great difficulty in borrowing debt from the financial institutions because in case of liquidation, their assets cant be used for some other substitute purposes (Auerbach 1985).Industry effectIt is one of the most important variables that affect the capital structure of firms (Harris and Raviv 1991). The companies which belong to those industries where there is greater degree of precariousness in the research projects and expected future sales, they rely less on debt financing (Remmers, Wright and Beekhuisen 1974). Contrary to this, the firms which have more level of certainty in their future cash flows and huge amount of fixed assets, they intended towards more debt financing (Remmers, Wrig ht and Beekhuisen 1974). Maksimovic and Zechner (1991) said that the diversity of technologies used by firms is also the key determinant of using their capital structure. They argued that the firms which are using multiple technologies have the facility of sourcing capital from various sources of financing (Maksimovic and Zechner 1991). Where these firms can raise their funds from multiple sources, they can also reduce their risk by spreading over the wide range of technologies (Maksimovic and Zechner 1991).2.5 Most Important Capital Structure Theories2.5.1 Static trade-off theoryThis theory of capital structure assumes that company should pursue a financing mix where tax shield advantage should be equal to the interest rate expense, keeping the other factors constant such as credit crunch and probability of bankruptcy costs (Jensen and Meckling 1976). This theory mainly deals with the pros and cons of issuing fixed asset securities like debt (S. Myers 1977). It assumes that there exists an optimal point under which the value of the firm is maximized. This optimal point is achieved by balancing the benefits and cost of issuing more debt (Myers 2001). One of the main advantages of issuing more debt is to take the benefit of tax deductable. This simple benefit can be more complicated when manages and owners have to pay personal tax and the issue of an absence of tax shield (Myers 2001). Debt financing also reduces the chances of agency conflict (Maksimovic and Zechner 1991). The rational is that the use of debt reduces the amount of free cash flows at the temperament of managers and there reducing the chances of conflict between managers and shareholders (Jensen and Meckling 1976).2.5.2 The Trade-Off Theory of Capital StructureThe basic idea behind this theory is that a firm ordinarily conducts the cost-benefits analysis before taking any decision regarding its capital structure (Tucker and Stoja 2007). It means that company will just rule out the possibility of thingamabob in this important financial aspect as stated by the pecking order theory (Jensen and Meckling 1976). In spite of criticism by Miller (who called it a comparison of horse and rabbit), the advanced dynamic model of this theory is very robust and practical (Tucker and Stoja 2007).2.5.3 Pecking order theoryThe pecking order theory talks about the cost of asymmetric information (Myers and Majluf, 1984). It says that firms choose their sources of financing according to the rule of least effort or least resistance (Myers and Majluf 1984). This implies that the firms will choose the equity financing as a financing mode of last resort (Myers and Majluf 1984). According to this theory, firms will prefer debt financing as long as it is workable and when it is no longer possible, then they will opt for equity financing (Myers and Majluf 1984).2.6 Capital Structure and Financial RiskThe Financial risk of a firm is the risk associated with a lack of a sufficient amount of future free cash flows in order to meet its short term obligations (Brigham and Ehrhardt 2001). In other words, financial risk also increases as the use of fixed income securities increases like preferred stock increases in the total financing of the firm (Harris and Raviv 1991). Brigham Ehrhardt (2001) assert that as the amount of debt increases in the overall mix of capital structure, the degree of financial leverage increases. Financial leverage means that the total amount of debt that is used in the capital structure of a firm (Harris and Raviv 1991). Another related concept is that of operating leverage which means that the portion of fixed cost used in the total cost of production of a particular product or range of products (Moyer, McGuigan and Kretlow 2009).Investors are very much concerned about the financial risk of firms because this is the kind of additional risk which they have to bear because of debt financing besides equity, in the firms total capital structure (Brigham and Ehrhardt 2001). It is the main objective before the financial managers to design the capital structure so that the value of the firm is maximized and at the same time mitigate the risk at hand (Harris and Raviv 1991).To cipher the financial risk of a firm, Times Interest Earned ( compel) ratio carries special importance in the eyes of these investors (Besley and Brigham 2007). Times interest ratio is of huge importance to analyse the true interest cost reporting ability of a firm (Brigham and Ehrhardt 2001). TIE depends upon three important factors the amount of debt in the total capital structure, the cost of debt and the profitability of the firm (Haugen 1995). Usually the industries which are less leveraged such as Drugs and electronics etc. have a very high TIE ratio (Brigham and Ehrhardt 2001). However, the firms which are in the business of retailing or utilities which rely more on debt financing, have low interest coverage ratios (see table1) (Brigham and Ehrhardt 2001).T here are also variations in the capital structure of individual firms operating in the same industry due to the different attitude of managers and their particular risk/return profiles (S. Myers 1977). The firms where mangers are more aggressive and have high risk appetite usually use more debt financing than those firms where managers are risk-averse (Hull 2008).The tools used to find the optimal capital structure are EBIT/EPS Analysis and EPS indifference Analysis (Brigham and Ehrhardt 2001).2.6.1 EBIT/EPS AnalysisEarnings Per Share (EPS) of a firm vary with changes in the amount of debt in the capital structure of a firm (Warner 1977). Theoretically, as the amount of debt increases in the capital structure, the financial risk increases (Warner 1977). Because of this high financial risk, investment houses change higher interest rates for the further debt which ultimate increases the cost of capital for a firm (Brigham and Ehrhardt 2001). Surely extra amount of financial leverage i ncreases the capability of a firm to earn higher earnings per share in the coming years (Jensen and Solberg 1992). Brigham Ehrhardt (2001), however, suggested that EBIT/EPS ratio should range from 0 to 5%. To find the exact point in this range, financial managers have to conduct an EPS indifference analysis.2.6.2 EPS indifference analysisThe purpose of this analysis is to find out the point where a firm is insouciant as to whether it uses debt or equity for the same ratio of EPS (Brigham and Ehrhardt 2001). Brigham and Ehrhardt (2001) found that a firm will report higher EPS at a low level of sales and firm is using the more equity than debt. On the other hand, an organization will experience faster increase in EPS with the increase in sales if a firm is using more debt than equity (Brigham and Ehrhardt 2001). The point worth noting is that if business managers are confident about a certain level of sales of their firm, they should go for debt financing and vice versa (Besley and B righam 2007).Financial risk of a firm is usually measured by interest coverage ratio, fixed charge coverage ratio and longer debt ratios (Moyer, McGuigan and Kretlow 2009). These ratios are usually compared with industry average ratios to gauge the true financial health of a firm (Moyer, McGuigan and Kretlow 2009). These ratios are also compared to the previous years ratio of the same firm to determine the trend of firms performance over a period of time (Brigham and Ehrhardt 2001). The Financial risk of a firm depends upon a number of factors such as financial leverage, Operating leverage, expected future free cash flows and so on.Because of the intense competition and uncertainty in the market, it becomes essential for the finance executives of companies to manage the risk of their organisations by either diversification, adopting an optimal capital structure, or using the sophisticated derivative securities (Hull 2008). An optimal capital structure is to arrange the financial str ucture of the firm in such a way that minimises the weighted-average cost of capital and thereby maximises the value of the firms stock (DeAngelo and Masulis 1980). The dilemma here is that when a firm is trying to maximise its EPS by increasing the amount of debt, its financial risk also increases at the same time (DeAngelo and Masulis 1980). On the other hand, if a firm tries to minimise its financial distress, it has to reduce its financial leverage which ultimately hurts the EPS of the firm (Bhaduri 2002). Hence there arises the need of an optimal financial structure which increases the EPS of a firm and reduces its overall financial distress simultaneously (Bhaduri 2002). This choice of the optimal capital structure depends upon a number of factors such as the size of firm, its growth rate, cash flow projections and product and industry characteristics. (Bhaduri 2002).There is a school of thought advocating that derivatives are the most useful tool to hedge financial risks at t he firms level (Jalilvand, Tang and Switzer 2000). Yet there is another group who believe that there are some alternative (i.e. using less debt financing) as compared to the typical hedging techniques available which can be used to reduce the financial risk at corporate level (Berkman, Bradbury and Magan 1997). From these studies, it is evident that managing the financial risk of firms is very important for firms in order to be competitive in the market place. Some companies have made internal risk management policies as part of their corporate business strategy (Maksimovic and Zechner 1991). Smith and Stulz (1985) commented on the goal of risk management in these words The primary goal of risk management is to eliminate the probability of costly lower-tail outcomes those that would cause financial distress or make a company unable to carry out its investment strategy(p. 395).It is make from the words of Smith and Stulz (1985) that the main goal of companies is to manage risk by e ither means.During the last decade, there has been a lot of research on the impact of industry in deciding the capital structure of firms (Booth, et al. 2001). Booth et al. (2001) studied whether the factors affecting the capital structure of firms are country specific or not. For this purpose, their study focussed on ten developing countries India, Pakistan, Thailand, Malaysia, Zimbabwe, Mexico, Brazil, Turkey, Jordan and Korea. They reported thatIn general, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates and development of capital market (Booth et al. 2001 p. 118).The institutional owners who hold large amount of shares of a firm also play a very significant role in deciding the capital structure of these firms (Al-Najjar and Taylor 2008). As these owners have the right to elect the board of directors, they can influence the mangers of their firms to adopt specific risk management policies and finance capital in a certain and specific manner (Al-Najjar and Taylor 2008).2.7 Financial market dysfunctionIn developing countries, banks and other financial institutions are main sources that provide liquidity to the economic system by advancing credit to the films (Demsetz and Lehn 1985). In keep down financial system, banks provide short and medium term loans to the young and established entrepreneurs while big and developed financial institution provide long term loans to the big corporation (Kester 1986). These loans are mostly given to the particular sectors of national economies such as agriculture and transport and housing (Antoniou, Guney and Paudyal 2002).Governments used to influence these commercial institutions to favour certain sectors and advance soft credit to the small industry (Leech 1987). Regularity agenc ies mostly restrict the banks from advancing credit to certain limits (DeAngelo and Masulis 1980). Antoniou, Guney and Paudyal (2002) said that the demarcation on the financial institutions by the authorities result in the form of credit rationing. Another hu