Literature Review: Capital Structure and Corporate Finance
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Published: Thu, 15 Mar 2018
Williamson in his article, “Corporate Finance and Corporate Governance”, analyzed the effects of tangible assets and probability of bankruptcy on the relationship between capital structure, leverage, and asset liquidity. He predicted that asset liquidity will increase optimal leverage, which means he concluded positive relationship between asset liquidity and capital structure.
Shleifer and Vishny (1992)
Shleifer and Vishny (1992) in their article, “Liquidation Values and Debt Capacity: A Market Equilibrium Approach”, discussed about asset liquidity and optimal leverage. They argue that in costs of financial distresses, asset liquidity plays an important role as a determinant. Their paper is focused on industry and economy wide determinants of liquidity.
They believe asset liquidation either through an auction or other sales will not be exactly appointed to the highest price and value users. During an industry or an economy wide recession selling assets which has just one usage can bring forth prices less than the value in best use or when buyers are prevented from bidding by rules.
They say asset liquidity limits optimal leverage levels. Holding cash flow volatility in different status like constant, cyclical and growth assets will have optimal level of debt finance and leverage in lower position. Multi department firms and specially conglomerates have higher status of optimal leverage level at the same level of cash flow.
In same industry firms are related to each other in debt level, which means a firm optimal leverage depends on the level of the leverage of the same industry firms. Even when an individual firm in an industry does not have an optimal leverage capacity, the industry might have itself. They also believe that optimal leverage levels and asset liquidity change over time. In their paper, “Liquidation Values and Debt Capacity: A Market Equilibrium Approach”, they predict that asset liquidity increases optimal leverage by analyzing the industry environment through different common ways to sell a firm assets and market equilibrium approach.
Rajan and Zingales (1995)
Rajan and Zingales (1995) analyzed Germany market to explain relationship between capital structure and its components. Their result can be an explanation of the empirical finding which firm size is negatively related to leverage in Germany. This negative effect is for German capital markets which are less developed and just large firms are traded in public.
Myers and Rajan (1998)
Myers and Rajan (1998) in their paper “The paradox of liquidity” argue that effect of asset liquidity on capital structure is negative or curvilinear. They believe a company with more liquid assets has greater value in short notice liquidity. If other components considered equal, asset liquidity are commonly seemed as increasing leverage capacity. This article is focused on the specific side of liquidity which shows greater liquidity decreases the power of borrowers to commit to their course of action. This paper examines the effects of asset liquidity fluctuation on debt level. Myers and Rajan (1998) “suggest an alternative theory of financial intermediation and disintermediation”.
They define asset liquidity the ease of selling or trading assets in the market. They believe a company with more liquid assets has greater value in short notice liquidity. If other components considered equal, asset liquidity are commonly seemed as increasing leverage capacity and in some contexts not liquid have meaningfully less value than readily tradable ones.
Myers and Rajan (1998) say that “asset liquidity is almost always a plus for nonfinancial corporations or individual investors”. However increased liquidity can be negative point for financial institutions. Although assets with more liquidity increase the ability of companies to increase cash on short notice, this also decrease the ability of management to commit reasonably to an investment and financing strategy which will protect the company’s creditors. When the company is making trading or markets for itself, this problem will become more serious.
They bring an example to show this paradox in liquidity. Consider a firm is making markets in government and corporate bonds. The firm will start activity with treasury inventory. The firm will finance its inventory with full leverage, if the securities and bonds could be unchangeably identified as collateral. Then a difficulty will come, which is unemployed inventory for trading because it is locked up.
Such a firm like this cannot perform not to sell so therefore cannot lock up the assets as collateral, because of doubt about due and default risk which is built inside the business and therefore any securities and bonds position as collateral has limitation. As a result, a nonfinancial institute, that does not need the treasuries as assets, could catch them and bring much more against them.
Companies which invest mainly on illiquid assets like financial institutes will find long-term financing and investment easier to enhance. Illiquidity will give less to creditors if they hold the assets, so it also gives more time to them to estimate interest rate and credit risk. They believe that “today’s risks would change slowly – – illiquid portfolios do not change overnight”.
Trading company creditors, with mostly liquid assets, have not any way to estimate or predict risk or values for the next step, month or year. The company will end up so liquid for its creditors when keeping assets flexible over its disposition is necessary.
Myers and Rajan (1998) believe “liquid assets give creditors greater value in liquidation, but they also give borrowers more freedom to act at creditors’ expense. While both issues have been separately recognized, their interactions arc largely unexplored”.
They show in their paper that a company with initial use of liquid core assets will be able to have a total advantage in earning external finances for projects with lower liquidity. The increasing debt level which the company will generate by accepting the less liquid project will exceed the level and capacity of the project itself. In contrast with, two company or projects which are less liquid could have less debt level and capacity combined in comparison to its stand-alone status.
They also prove that company unusually core businesses liquidity, are suitable to refer financing to other company in the industry. This will lead us to a theory of financial intermediation that is reliable with the banks rise origin. Their theory also explains why disintermediation has increased currently, and why the concentration of banks has been increased on illiquid part of the loan and borrowing.
Myers and Rajan (1998) examine the adverse shock impact on companies excessively asset liquidity. Such these firms have this ability to transform assets which this possibility leads to responds by creditors than firms with less liquid assets. A rational company will sell an asset which its liquidity is temporarily pressed down, even though its liquidity is expected to recover, and even the company asset is higher current liquidity.
Weiss and Wruck (1998)
Weiss and Wruck (1998) believe in their paper “Information problems, conflicts of interest, and asset stripping” that relationship between asset liquidity and leverage is negative. They say that distressed companies selling assets are probably to face a less liquid or illiquid market because their industry companions are also distressed. Thus companies can sell assets only at minimum price which is “fire sale”. They find that this illiquidity will decrease a company’s leverage level or debt capacity. As it is mentioned in Eastern’s case definition of asset liquidity will be “what allows value-destroying asset stripping to occur”. Less liquid assets would provide creditors with defense of such operations. “Unless a credible promise can be made not to engage in asset stripping, asset liquidity will reduce, not increase, a firm’s ability to issue debt securities”. They say that if development of capital market is continuing and provision of liquidity is increasing in a sort of asset markets, the asset stripping problem will importantly increase.
Alan A. Bevan and Jo Danbolt (2000)
The research on capital structure and leverage by Rajan and Zingales (1995) suggested that the leverage level in UK firms is positively related to firm size and tangible assets, and relation between leverage level with profitability and the growth opportunities level is negative. However, as explained by Harris and Raviv (1991), “The interpretation of results must be tempered by an awareness of the difficulties involved in measuring both leverage and the explanatory variables of interest”. In their paper, “Capital Structure and its Determinants in the UK – A Decompositional Analysis”, Alan A. Bevan and Jo Danbolt (2000) focus on the measuring leverage difficulties, and testing the Rajan and Zingales’ results sensitivity to deviations in leverage levels. They perform analysis on 822 UK firms capital structure and leverage level and find that result of Rajan and Zingales’ research to be highly dependent in definition. The determinants of leverage seem to fluctuate meaningfully, which would be depend on what component of debt is analyzed. Especially they find significant differences in the long term and short term debt determinants. On the assumption that equivalent and trade credit be on average, the results are specifically responsive to whether during measurement of leverage such debt and liability is included or not. They argue that capital structure analysis will not be complete without an examination of different forms of debt in detail.
Morellec (2001) argue in his paper, “Asset liquidity, Capital structure and Secured debt“, that affect of asset liquidity on capital structure is negative or curvilinear. This paper investigates the effect that asset liquidity has on securities valuation and the company’s financial decision makings. Morellec (2001) shows in his paper that asset liquidity will have positive relation with debt capacity only when bond conditions limit the nature of assets. He demonstrates that, using unsecured debt with greater asset liquidity will cause increase in credit spreads on debt and will decrease optimal level of leverage. At the end he concluded that bond and security conditions and asset liquidity will lead to explain leverage ratios and credit expansions.
In comparison with Weiss and Wruck (1998) that they argued asset liquidity could reduce a company’s ability for issuing debt, Morellec (2001) mentioned in his article that liquidity will increase debt capacity just at the time bond contracts enforce limitations on the assets condition.
This paper extracts simple estimation formulas when the company’s assets are liquid or divisible for debt and equity. Valuable options to decrease debt capacity will arise during economic circumstances worsen because of liquidity. In the model that Morellec (2001) demonstrates, the retained income from reduction of capacity will be used to settle debt service when the company is in trouble or to settle dividends when the company is already able to pay all debts. He concludes equity value includes the cash flow expected p-value to be earned plus a continuum of options to decrease option and the capacity for exiting the industry. Also shareholders bring capital to finance the company operation at a time the company is able to pay all debts on a stock base but it is not able on a flow base.
Morellec (2001) believes the asset liquidity net effect on company total value will be resulted from a trade-off between the reduction and increase in debt and equity value. If the operating flexibility value which is provided by asset liquidity in comparison with the reduction in debt level or value is lower, it will be optimum for the company to issue secured debt. If the reverse is true, it will be optimum for the company to issue unsecured debt. The model shows that bond contracts pledging assets as security deposit can decrease company total value by bringing about over investment in unavailing assets. This model also demonstrates that the policy of maximizing value includes mortgaging part of the company’s assets and that the optimum amount of the mortgage will depend on attributes of company and its industry.
The equity and debt value that he obtained in his paper also allow for a research of the impact of asset liquidity on optimum leverage. Higher liquidity in asset will decrease the company ability to issue debt because firm size is highly depended on the readiness of the company to sell assets. In addition, selling asset will increase the equity value while the decrease value of debt, the ratio of optimal leverage is decreased. He resulted in his model an increase of 10 to 30 percent of default spreads and simultaneously a reduction of 30 to 60 percent of optimum leverage.
Morellec (2001) analyzes the effect that asset liquidity has on the securities value and company’s financial making decisions. He demonstrated an increase in asset liquidity of the company when it is measured by liquidation of the company’s assets reduces the corporate spread and raise optimal leverage. Asset liquidity when it is calculated by selling price of the company’s asset, since the establishment of the company, decreases corporate debt value opening the space of the strategy to the borrower.
Bernadette A. Minton and Karen Hopper Wruck (2001)
Bernadette A. Minton and Karen Hopper Wruck (2001) argue in their paper, “Financial Conservatism: Evidence on Capital Structure from Low Leverage Firms”, that conservative companies have comparatively high price to book and operate comparatively often in industries to be responsive to economical distress. They believe the former attribute is coherent with a large body of earlier process documenting an opposite relationship between price to book value and leverage.
Cautious company’s strong funds flow, clear shortage of serious data problems and huge cash balances will suggest that companies’ high price to book ratios are more probably to be because of market anticipations of continued strong cash flow, instead of new technologies or products finding.
Fama and French (2002)
Amongst the rest, Fama and French (2002) defend the situation of cross-sectional leverage regressions on firm size. This and default probability interpretations have relation inasmuch, limitation on the financial structure, low volatility companies are less probably to default.
Samuel Gui Hai Huang and Frank M. Song (2002)
They employ a new database in their paper, “The Determinants of Capital Structure: Evidence from China”, that includes the accounting information and the market from more than 1000 listed companies in china burse up to the year 2000, to collecting their information of these companies to analyze capital structure. Same as the other countries in Chinese companies also leverage arises with firm size, and reduces with profitability and has mutual relation with industries. They also find that ownership structure impacts leverage. One thing that they find is different from other countries, in Chinese companies volatility raises leverage and companies incline to decrease long term debt. They also find to explain the features of Chinese firms’ capital structure is better to use static tradeoff theory instead of pecking order theory.
S Narayan Rao and Jijo Lukose P. J. (2002)
They suggest in their paper, “An Empirical Study on the Determinants of the Capital Structure of Listed Indian Firms”, that companies with high risk or companies that have high probability to default should not be much levered. They use standard deviation of company’s cash flow for five year period for the “pre liberalization” and “post liberalization” period as proxy for the company business risk and financial distress probability. Narayan Rao and Jijo Lukose P. J. (2002) argue that leverage and business risk is negatively related.
Philippe Gaud and Elion Jani and Martin Hoesli and Andre Bender (2003)
They analyze in their paper, “The Capital Structure of Swiss Companies: An Empirical Analysis using Dynamic Panel Data”, the capital structure determinants for 106 listed companies in Swiss stock exchange. They do their analysis during 1991-200. They found the companies size, the tangible assets and business risk have positive relation with leverage. Also they conclude growth and profitability have negative relationship with leverage. These relations suggest that both tradeoff theory and pecking order theory are used to describe the Swiss firms’ capital structure, in spite the fact that “more evidence exists to validate the later theory”. They shows in their analysis that Swiss companies adjust for a goal debt ratio, but the process that they have for adjustment is slower that the other countries.
Sudipto Dasgupta (2003)
While pecking order prediction of financing choice is made easier by debt level affect, then it will be difficult to differentiate experimentally trade off theory and pecking order hypothesis. Sudipto Dasgupta (2003) in his paper, “Capital Structure Theories: Some New Tests”, extends the Myers and Majluf (1984) model to extract new empirical implications of the interrelation between adverse selection and debt level restrictions. They predict in by their model that debt issuance probability will not be monotonic function of the financing shortage size, initial increasing in deficit size, after that decreasing and at last increment again. They perform their research on a panel of companies from COMPUSTAT during 1971-1998. For the smallest size group of companies, more than sixty percent of distributions are at the first range over which the likelihood of debt distribution is increasing in the shortage size, and opposed choice concerns control debt level concerns. Even for the widest size group, the likelihood of debt distribution raises monotonically in the shortage size up to eighty percent of distribution level. When companies are arranged into 3 groups based on companies’ age, also the non-monotonic model will overcome. According to the model predictions, between those two turning points (over which the likelihood of debt distribution is increasing in the shortage size, and adverse selection concerns control) will be wider for smaller and companies with younger age. It will be also wider, except the highest company in size groups, for companies with less past profitability, and companies that have higher opportunities of growth. They also result that likelihood of debt distributing is higher (lower) for companies which are below (above) an appraised ratio of target debt, and higher for companies which have higher past profitability, less price to book, and weak late performance of stock price. Therefore, their findings demonstrate that both adverse selection and Tradeoff theoretic problems will affect capital structure and debt-equity choices of companies.
Ilya A. Strebulaev (2004)
In the midst of frictions companies modify their capital structure rarely. As a result, the leverage of most companies in a dynamic economy, often, is probably different from the optimal leverage level at the new modification time. Ilya A. Strebulaev (2004) explores in his paper, “Do Tests of Capital Structure Theory Mean What They Say”, the empirical concept of their observation. An adjusted dynamic trade off theory with calibration expenses will be used for simulating company’s capital structure directions.
Especially, in the results of simulated standard cross-sectional tests on the collected data they found leverage: (1) is negatively related to profitability (Return on Asset); (2) can be highly described by stock (3) is mean-reverting. In the midst of occasional adjustment, the results of the research suggest that “cross-sectional properties of economic variables in dynamics may be fundamentally different from those derived assuming that they are always at their target levels.”
Ying Hong Chen and Klaus Hammes (2004)
Ying Hong Chen and Klaus Hammes (2004) analyze some determinants which are influencing leverage in their paper, “Capital Structure Theories and Empirical Results – a Panel Data Analysis”. They use ratios of market capital, book capital and book debt as measures of leverage. They used panel data of seven countries: Germany, Sweden, Canada, US, UK, Italy and Denmark. They found that asset tangibility has positive relation with leverage, while profitability is negatively related to leverage in all these countries. More profitable companies watch over borrowing less. They believe company size is significantly and positively related to company’s financial leverage. They conclude that the impact of the price to book ratio fluctuate in the model of the book debt ratio and demonstrate a negative and significant relationship in the model of the market leverage for all researched countries except of Denmark, which demonstrates an insignificant value. They argue that all their documents and finding are consistent with the results from related financial theories like pecking order theory and trade off theory, for example risky companies borrow less.
Alexander Kurshev and Ilya A. Strebulaev (2005)
Alexander Kurshev and Ilya A. Strebulaev (2005) empirically found in their article, ” Firm Size and Capital Structure”, that firm size strongly positively is related to capital structure. Many of sensitive explanations can be brought for this fact, but none of them has been thought over theoretically. They try in their paper to start bridging the gap by exploring ability of a dynamic capital structure model to explain the relation between firm size and leverage. That driving force which they mention is the appearance of fixed costs of external financing which guide to infrequent reorganizing and make a wedge among small and large companies. Alexander Kurshev and Ilya A. Strebulaev (2005) found four type of affection on firm size. Small companies will choose higher level of debt at the time of refinancing to pay back for lower regular rebalancing. The relation between leverage and firm size within a refinancing cycle is negative. At last, there are many companies choose no leverage. They analyzed dynamic economy to show that cross sectional relation between leverage and size is positive, therefore financing fixed cost cause to the description of the stylized leverage and firm size relation. However, when they control the appearance of unlevered companies, this relationship changes the sign.
Peter Högfeldt and Andris Oborenko (2005)
Peter Högfeldt and Andris Oborenko (2005) believe in their paper, “Does Market Timing or Enhanced Pecking Order Determine Capital Structure?”, that higher profitability which is return on assets and higher current M/B which is delayed one period are negatively related to leverage, mainly on leverage of market, like equity has much more value.
Duffie, Saita and Wang (2005)
Duffie, Saita and Wang (2005) report in their research that a 10 percent increase in value of the asset will cause reduction in the default probability of company by roughly 2 percent conditional on company’s financial arrangements.
Long Chen and Xinlei Shelly Zhao (2005)
Long Chen and Xinlei Shelly Zhao (2005) search for economic explanation for two experimental regularities in their paper “Profitability, Mean Reversion of Leverage Ratios, and Capital Structure Choices”. First of all it is prominent that companies with high profitability watch tend to have less debt level. Some new theoretical progression has used two different factors like transaction costs or dynamic tax payments to describe this phenomenon. They demonstrate that even after controlling these factors, the phenomenon will largely remain. Second of all with both empirical and theoretical descriptions, they demonstrate that leverage level can refer middle physically regardless of which theory is explaining financial decisions well. And the opposite conclusions could be drawn in the situation which financing decisions or debt level changes are analyzed. So, debt ratio changes would not be educational in recognizing the competing theories. Their results warns against the usual practice of depending on leverage ratio changes dynamics to direct results on the legitimacy of capital structure theories.
Companies with higher profitability increase less level of debt because they have enough and more inner funds to count on. They believe negative relationship between leverage ratios and profitability suggests that tax shields are in second level of concerns.
Some new expansions of the tradeoff hypothesis to a multi period, dynamic framework have opposite side that if relationship between leverage and profitability is negative, it will be actually coherent with the tradeoff hypothesis.
Laura Xiaolei Liu (2005)
Laura Xiaolei Liu (2005) in his paper, “Do Firms have Target Leverage Ratios? Evidence from Historical Market-To-Book and Past Returns”, believe there is no significantly negative relationship between the current debt level and other proxies of market timing: “the historical insider selling percentage”. This conclusion infers that the price to book ratio has negative relation with the current leverage for the reasons other than market timing.
Long Chen and Xinlei Shelly Zhao (2006)
Long Chen and Xinlei Shelly Zhao (2006) in their paper, “On the Relation Between the Market-to-Book Ratio, Growth Opportunity, and Leverage Ratio”, believe that the relationship between the price to book ratio and leverage is negative and one of the most greatly documented experimental regularities in the leverage and capital structure history. Some related researches use this negative relationship as given and argue about its economic explanation. They demonstrate that companies with more price-to-book ratios will have less debt financing costs and use more borrowing. They argue in their research that the relationship between the price to book ratio and leverage level is not monotonic and for most of the companies is positive (as they research, more than 95 percent of total market capitalization and more than 88 percent of COMPUSTAT companies). The antecedently proven negative relationship is directed by a subset of companies with high price-to-book ratios.
Jie Cai and Zhe Zhang (2006)
Many theories in finance say that structure of capital has impact on value of the firms. This prediction suggests that any change in leverage has an effect on stock return. Many literatures in finance field have been focused on the capital structure determinants. Jie Cai and Zhe Zhang (2006) used a sample of U.S. listed companies during 1975 and 2002 in their research, “Capital Structure Dynamics and Stock Returns”, and they conclude a significantly negative impact of debt level changes on standard deviation of stock returns. This negative affect stays significant after adding other determinants like ROE, price to book ratio, firm size and past returns to the analysis. They use and implement many hypotheses and theories to describe the observed effect. They conclude that the companies with higher level of leverage have stronger negative effect. This is coherent with a prediction of the pecking order theory which an increase in leverage level will cause a reduction in debt capacity of companies and will direct to lack of investment in the future. More analyses confirm this negative relation between leverage changes and investment in future.
Salma Kasbi (2007)
Salma Kasbi (2007) examines the effect of market timing and price to book ratio on capital structure in her study, “Market Timing and Capital Structure: Evidence from a Decomposition of the Market-to-Book Ratio”. He uses a decomposition of determinants of price to book ratio into misevaluation and growth opportunities, which is developed in the article of Rhodes-Kropf, Robinson and Viswanathan (2005), he demonstrates that this negative relation between the historical price to book ratio and leverage, which is argued in Baker and Wurgler (2002) sends back the constant effect of past timing efforts and therefore, may not be attributed to growth opportunities.
Antonios Antoniou, Yilmaz Guney and Krishna Paudyal (2007)
Journal of Financial and Quantitative Analysis (JFQA), Forthcoming
Antonios Antoniou, Yilmaz Guney and Krishna Paudyal (2007) investigates in their paper, “The Determinants of Capital Structure: Capital Market Oriented Versus Bank Oriented Institutions”, how companies perform in countries with capital market tendency economy like the U.K. and U.S. and countries with bank tendency economy like France, Germany and Japan, to determine their capital structure. They use panel data and a procedure of two-step system to find that the relation between leverage and asset tangibility and firm size is positive, but its relationship with profitability, growth opportunities and performance of share price in both economy types is negative. The market circumstances which company operates, affect the leverage ratio. Country’s law and financial traditions are two main factors that have impact on degree and effectiveness of capital structure determinants. The results that they find confirm that companies have target leverage ratios, French companies are the fastest in adopting their capital structure close to their goal that they have for leverage ratio, and Japanese are the slowest one in adjusting to the leverage ratio target. Generally, the economic environment and its financial markets and institutions, tax law and systems, relationship of lender and borrower, revealing to capital markets, and the protection level of investor in the country that the company is operating, have strong impact on the company capital structure.
Valeriy sibilkov (2007)
Valeriy sibilkov (2007) in his paper, “Asset Liquidity and Capital Structure”, checks different theories about the impact of asset liquidity on leverage. He used collection of data from a wide sample of U.S. listed companies and he find that leverage ratio has positive relation with asset liquidity. Further research shows that asset liquidity and secured debt have positive relationship, inasmuch as asset liquidity and unsecured debt is curvilinear. He finds in his study that financial distress and inefficient liquidation are important in this relation and they have impact on decisions of capital structure. In addition, his results are coherent with this hypothesis that increase in asset liquidity will raise managerial discretion costs.
He believes the rationale for a positive relationship between asset liquidity and leverage leans on the opinion that asset with lower liquidity will sell at higher costs, which arises the liquidation costs, debt level and probability of bankruptcy. Then less asset liquidity creates the necessity to decrease the costly default probability by reducing the leverage.
The rationale for a negative relationship between asset liquidity and leverage claim that it is more costly for directors to take away value from debtors. Therefore, less asset liquidity decreases the debt cost, and so as a conclusion, firm exploit more debt.
Sjur Westgaard and Suzan Hol and Nico Van der Wijst (2007)
Sjur Westgaard and Suzan Hol and Nico Van der Wijst (2007) address in their paper, “Capital Structure, Business Risk, and Default Probability”, the theoretical substructures of default probability, they use the capital structure neoclassical theory as a beginning point. A pattern of optimum capital structure is created and reworked into a default probability pattern. The relative static analyses demonstrate that optimum capital structure and default probability are business risk factors which are U shaped, and they are calculated by volatilit
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