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Financing Capital Structure And Financing Of Small Companies Finance Essay

The capital structure of business is mix of type of debt and equity the company has on its balance sheet. The capital or owner ship of a business can be evaluated by knowing how much of ownership is in debt and how much in equity. The company debt might include short and long term debt(such as mortgage) and equity include common stock,prefferd share and retained earning.

Debt equity ratio some time called leverage ratio it is measure of how much of company’s assets are funded through borrowing or financing(debt)and how much through equity.

Calculation of debt to equity is usually express as

Long Term debt

Share holder equity

IF the Debt-to-Equity Ratio is larger than 1 the assets of company are purchased mostly through financing/borrowing. A business with a high debt-to-equity ratio is supposed to be “highly leveraged” the debt-to-equity ratio of a business is for a while referred to as business capital structure.

In simple a firm could choose many alternative way of capital structure. It can issue huge amount of debts or small. It can arranges lease financing, use warrant, issue changeable bond and can sing forward contract or trade bond swap. It issue dozens of isolated securities in immeasurable combination however this attempts to find the particular arrangement that maximizes its overall market valu.The point is that their attempts to set capital structure that maximize their market value, firm do different with regards to their capital structure.That,s why there are different theories of capital structure that explain cross sectional difference. These theories check the purpose the capital structure from different aspect and conclude in dissimilar outcomes as far as the option of the purpose of level of financial leverage is concerned .for the time being experimental evidence has sometime confirmed to be not consistent to particular theory that is examine.

The most important case is that of experimental testing of pecking order theory where different researcher have conclude in diverse inconsistent . I check the factor that determine the point of financial leverage of Pakistan firm during 2006 to 2009. Small firm occupy important place in Pakistan's economy. They account for 81% of industrial labour power and of the 28% value added in manufacturing sector. They contribute 5.10 of GDP compare to 12.80% of large scale industry.

Literature Review

Capital Structure is a mix of debt and equity capital maintained by a firm. Capital

structure is also referred as financial structure o fa firm. The capital structure of a firm is very important since it related to the ability of the firm to meet the needs of its stakeholders. Modigliani and Miller (1958) were the first ones to landmark the topic of capital structure and they argued that capital structure was irrelevant in determining the firm’s value and its future performance. On the other hand, Lubatkin and Chatterjee (1994) as well as many other studies have proved that there exists a relationship between capital structure and firm value. Modigliani and Miller (1963)

showed that their model is no more effective if tax was taken into consideration since tax subsidies on debt interest payments will cause arise in firm value when equity is traded for debt .In more recent literatures, authors have showed that they are less interested on how capital structure affects the firm value. Instead they lay more emphasis on how capital structure impacts on the ownership/governance structure thereby influencing top management of the firms to make strategic decisions(Hitt, Hoskisson and Harrison, 1991). These decisions will in turn impact on the overall performance of the firm(Jensen, 1986). Nowadays, the main issue for capital structure is how to resolve the conflict on the firms’ resources between managers and owners (Jensen, 1989). This paper is review of literature on the various theories related to capital structure and ownership structure of firms.

Chapter 3 Capital structure

Suppose a perfect capital market no transaction or bankruptcy costs perfect information firm and individual can borrow at the same interest rate no taxes and investment decisions aren't affected by financing decisions. Modigliani and Miller made two finding under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm plus an added premium for financial risk. That is leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created.

Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all

Modigliani. Miller theory

The Modigliani–Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a company’s value is unaffected by how it is financed, regardless of whether the company’s capital consists of equities or debt, or a combination of these, or what the dividend policy is. The theorem is also known as the capital structure irrelevance principle .A number of principles underlies the theorem, which holds under the assumption of both taxation and no taxation. The two most important principles are that, first, if there are no taxes, increasing leverage brings no benefits in terms of value creation, and second, that where there are taxes, such benefits, by way of an interest tax shield, accrue when leverage is introduced and/or increased. The theorem compares two companies—one unlevered (i.e. financed purely by equity) and the other levered (i.e. financed partly by equity and partly by debt)—and states that if they are identical in every other way the value of the two companies is the same. As an illustration of why this must be true, suppose that an investor is considering buying one of either an unlevered company or a levered company. The investor could purchase the shares of the levered company, or purchase the shares of the unleveled company and borrow an equivalent sum of money to that borrowed by the levered company. In either case, the return on investment would be identical. Thus, the price of the levered company must be the same as the price of the unlevered company minus the borrowed sum of money, which is the value of the levered company’s debt. There is an implicit assumption that the investor’s cost of borrowing money is the same as that of the levered company, which is not necessarily true in the

Presence of asymmetric information or in the absence of efficient markets. For a company that has risky debt, as the ratio of debt to equity increases the weighted average cost of capital remains constant, but there is a higher required return on equity because of the higher risk involved for equity-holders in a company with debt.


• In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is that capital structure is important because one or more of the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure.


• Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratio

Jensen and Meckling

Jensen and Meckling state that the owner have to bear cost due to the separation of possession and management in the corporation shape of business. The shareholder have to provide incentive to the managers for the efficient working and increased productivity. The cost which is paid by owner to managers or agent, is known as agency cost.

If the firm take loan then the manager have to act as the agent of owner as well as to the debt provider. Therefore, agency cost theory of capital structure state that the most favorable capital structure is that point where the agency cost of all the interested party is at the minimum level (Jensen and Meckling, 1976)

Capital structure in real word

If capital structure is irrelevant in a perfect market then imperfection which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfection by relaxing assumption made in the M&M model.

Static Trade –Off Theory

The static trade off theory of optimal capital structure assumes that firm balance the marginal present values of interest tax shields against the costs of financial distress .the tax advantages of borrowed money and the costs of financial distress when the firm finds that it has borrowed too much. The static trade-off theory states that the value of the leveraged and un-leveraged firm is not same. In the case of debt financing the firm can save the amount of interest payments on the debts from the tax purposes.

However, at the same time due to debt finance the cost of financial distress and the agency cost of the debt financing of the firm increases. This theory further states that the optimal capital structure is that where the tax benefit on the interest payments for the firm, the financial distress and the agency cost of the debt financing balanced with each other. This theory focus on the three point’s tax advantage, financial distress costs, and the agency cost. This theory states that the firm save tax on the interest payments of the debt finance.

As suggested by MM (1963), that value of the firm is only depend on the capital structure due to the fact that interest expenses on the debts are tax deducible but the same is not applicable on the dividend payments. The second point is financial distress costs. As the firm increases its leverage position the chances of bankruptcy increases as suggested by Jensen and Meckling (1976). Therefore, due to continue inclusion of debt financing the bankruptcy cost is also increases for the firm. As discussed in the agency cost of capital structure that the owners have to pay incentives to their agents (managers) in the corporation form of business. If the corporation also financed by debts then these agents (managers) have to work as the agents of the debt providers so it increases the agency cost of capital structure. Jensen and Meckling (1976) suggest that the optimal capital structure is that point where the tax advantage on interest payments must balanced out with the cost of bankruptcy and agency cost of capital struct

Agency cost Theory

Jensen and Meckling (1976) point out that agency costs occur due to incomplete alignment of the agent’s and the owner’s interests. The separation of ownership and control may generate agency costs. Two types of agency costs are identified in the paper by Jensen and Meckling (1976): agency costs derived from conflicts between outside equity holders and owner-managers, and conflicts between equity holders and debt holders. From then on, a great amount of research has been devoted to demonstrate the interaction between agency costs and financial decisions, governance decisions, dividend policy, and capital structure decisions.

Much empirical evidence collected by researchers, for example, Ang et al. (2000), and Fleming et al. (2005), shows that agency costs generated from the conflicts between outside equity holders and owner-manager could be reduced by increasing the owner-managers’ proportion in equity, i.e., agency costs vary inversely with the manager’s ownership. However, the conflicts between equity holders and debt holders would be more complicated. Theoretically, Jensen and Meckling (1976) argue that there should be an optimal capital structure, under which the lowest agency costs of a firm can be deduced from an independent variable --- “the ratio of outside equity to the whole outside financing”. The locus of agency costs, which is equal to agency costs of outside equity and the ones of debt, would be a convex curve. This implies that agency costs should not be monotonic any more.

Some researchers such as Grossman and Hart (1982); Williams (1987), argue that high leverage reduces agency costs and increases firm value by encouraging managers to act more in the interests of equity holders. This argument is known as the agency costs hypothesis. Higher leverage may reduce agency costs through the monitoring activities by debt holders (Ang et al., 2000), the threat of liquidation which may cause managers to lose reputation, salaries, etc. (William, 1987), pressure to generate cash flow for the payment of interest expenses (Jensen 1986), and curtailment of overinvestment (Harvey et al., 2004).

Signaling theory

The Modigliani-Miller theorem on the irrelevancy of financial structure implicitly assumes that the market possesses full information about the activities of firms. If managers possess inside information, however, then the choice of a managerial incentive schedule and of a financial structure signals information to the market, and in competitive equilibrium the inferences drawn from the signals will be vali-dated. One empirical implication of this theory is that in a cross section, the values of firms will rise with leverage, since increasing leverage increases the market's perception of value.

Stephan a Ross (1977), explains that debt is considered as a way to highlight investor’s trust in the company. If a company issues the debt it provides a signal to the markets that the firm is expecting positive cash flows in the future, as the principal and interest payments on debt are a fixed contractual obligation which a firm has to pay out of its cash flows. Thus the higher level of debt shows the manager’s confidence in future cash flows. Another impact of the signaling factor, as we have already discussed it in the pecking order theory, is the problem of the under pricing of equity. If firm issues equity instead of debt for financing its new projects, investors will interpret the signal negatively since managers have superior information about the firm than investors, they might issue equity when it is overpriced.Among other explanations about a firm’s behavior in choosing its capital structure is the agency theory.

Jensen and Meckling (1976) identify the possible conflict between shareholders and a manager’s interests because the manager’s share is less than 100% in the firm. Furthermore, acting as an agent to shareholders, the manager tries to appropriate wealth from bondholders to shareholders by incurring more debt and investing in risky projects.

This is consistent with the work of Myers (1977) who argues that, due to information asymmetries, companies with high gearing would have a tendency to pass up positive NPV (net present value) investment opportunities (under investment problems). Therefore argues that companies with large amounts of investment opportunities (also known as growth options) would tend to have low gearing ratio

A manager having a less than 100% stake in the business may try to use these free cash flows sub-optimally or use it to their own advantage rather than use it to increase the value of the firm. Jensen (1976) suggests that this problem can be somehow controlled by increasing the stake of the manager in the business or by increasing debt in the capital structure, thereby reducing the amount of “free” cash available to managers to engage in their own pursuits (Jensen, 1976, Stultz, 1990). Here the reduction in the cash flow because of debt financing is considered to be a benefit.

Stultz (1990) suggests that the agency problem can be solved to some extent if the management stake is increased or the proportion of debt in the capital structure is increased.

However, as the proportion of debt in the capital structure increases beyond a certain point, the opposite effect of leverage on agency costs may occur (Altman, 1984 and Titman, 1984). When leverage becomes relatively high, further increases may generate significant agency costs. Three reasons are identified in the literature which can cause this opposite effect: first reason is the increase of bankruptcy costs (Titman 1984). Second reason is that managers may reduce their effort to control risk which result in higher expected costs of financial distress, bankruptcy, or liquidation (Berger and Bonaccorsdi Patti, 2005). Finally, inefficient use of excessive cash used by managers for empire building would also increase agency costs (Jensen, 1986)..

Peaking order theory

The pecking order theory of capital structure is among the most influential theories of corporate leverage. According to Myers (1984), due to adverse selection, firms prefer internal to external finance. When outside funds are necessary, firms prefer debt to equity because of lower information costs associated with debt issues. Equity is rarely issued. These ideas were refined into a key testable prediction by Shyam-Sunder and Myers (1999). The financing deficit should normally be matched dollar-for-dollar by a change in corporate debt. As a result, if firms follow the pecking order, then in a regression of net debt issues on the financing deficit, a slope coefficient of one is observed.

Shyam-Sunder and Myers (1999) find strong support for this prediction in a sample of 157 firms that had traded continuously over the period 1971 to 1989. This is an attractive and influential result. The pecking order is offered as a highly parsimonious empirical model of corporate leverage that is descriptively reasonable. Of course, 157 firms is a relatively small sample from the set of all publicly traded American firms. It is therefore important to understand whether the pecking order theory is broadly applicable. In this paper, we study the extent to which the pecking order theory of capital structure provides a satisfactory account of the financing behavior of publicly traded American firms over the 1971 to 1998 period. Our analysis has three elements. First, we provide evidence about the broad patterns of financing activity. This provides the empirical context for the more formal regression tests. It also serves as a check on the significance of external finance and equity issues. Second, we examine a number of implications of the pecking order in the context of Shyam- Sunder and Myers’ (1999) regression tests. Finally, we check to see whether the pecking order theory receives greater support among firms that face particularly severe adverse selection problems.

The pecking order theory derives much of its influence from a view that it fits naturally with a number of facts about how companies use external finance.1 Myers (2001) reports that external finance covers only a small proportion of capital formation and that equity issues are minor, with the bulk of external finance being debt. These key claims do not match the evidence for publicly traded American firms, particularly during the 1980s and 1990s. External finance is much more significant than is usually recognized in that it often exceeds investments. Equity finance is a significant component of external finance. On average, net equity issues commonly exceed net debt issues. Particularly striking is the fact that net equity issues track the financing deficit much more closely than do net debt issues.

Shyam-Sunder and Myers (1999) focus on a regression test of the pecking order. In this test one needs to construct the financing deficit from information in the corporate accounts. The financing deficit is constructed from an aggregation of dividends, investment, change in working capital and internal cash flows. If the pecking order theory is correct, then the construction of the financing deficit variable is a justified aggregation. Under the pecking order, each component of financing deficit should have the predicted dollar-for-dollar impact on corporate debt. The evidence does not support this hypothesis. Even if a theory is not strictly correct, when compared to other theories it might still do a better job of organizing the available evidence. The pecking order is a competitor to other mainstream empirical models of corporate leverage. Major empirical alternatives such as the model tested by Rajan and Zingales (1995) use a different information set to account for corporate leverage. It is therefore of interest to see how the financing deficit performs in a nested model that also includes conventional factors. The pecking order theory implies that the financing deficit ought to wipe out the effects of other variables. If the financing deficit is simply one factor among many that firms tradeoff, then what is left is a generalized version of the tradeoff theory.

We find that the financing deficit does not wipe out the effects of conventional variables. The information in the financing deficit appears to be factored in along with many other things that firms take into account. This is true across firm sizes and across time periods.

Since the pecking order does not explain broad patterns of corporate finance, it is natural to examine narrower sets of firms. According to the pecking order theory, financing behavior is driven by adverse selection costs. The theory should perform best among firms that face particularly severe adverse selection problems. Small high-growth firms are often thought of as firms with large information asymmetries. Contrary to this hypothesis, small high-growth firms do not behave according to the pecking order theory. In fact, the pecking order works best in samples of large firms that continuously existed during the 1970s and the 1980s. Large firms with long uninterrupted trading records are not usually considered to be firms that suffer the most acute adverse selection problems.

To understand the evidence it is important to recognize the changing population of public firms. Compared to the 1970s and 1980s, many more small and unprofitable firms became publicly traded during the 1990s. Since small firms generally do not behave according to the pecking order, this accounts for part of the reason that the pecking order theory is rejected. But the time period has a stronger effect than just this. For firms of all sizes, the financing deficit plays a declining role over time. Previous literature provides other evidence pertinent to a general assessment of the pecking order theory. The pecking order theory predicts that high-growth firms, typically with large financing needs, will end up with high debt ratios because of a manager’s reluctance to issue equity. Smith and Watts (1992) and Barclay, Morellec, and Smith (2001) suggest precisely the opposite. High-growth firms consistently use less debt in their capital structure.

The pecking order theory makes predictions about the maturity and priority structure of debt. Securities with the lowest information costs should be issued first, before the firm issues securities with higher information costs. This suggests that short-term debt should be exhausted before the firm issues long-term debt. Capitalized leases and secured debt should be issued before any unsecured debt is issued. Barclay and Smith (1995a, 1995b) find that 50% of their firm-year observations have no debt issued with less than one-year maturity, 23% have no secured debt, and 54% have no capital leases. It seems difficult to understand this evidence within a pure pecking order point of view. Chirinko and Singha (2000) question the interpretation of the Shyam-Sunder and Myers (1999) regression test. Chirinko and Singha show that equity issues can create a degree of negative bias in the Shyam-Sunder and Myers test.

Suppose that firms actually follow the pecking order theory, but that these firms issue an empirically observed amount of equity. In that case, they show that the predicted regression coefficient is actually 0.74 rather than one. This amount of bias is not trivial, but it still leaves the coefficient very far from the magnitudes of slope coefficients that are observed. Chirinko and Singha also point out that if, contrary to the pecking order, firms follow a policy of using debt and equity in fixed proportions, then the Shyam-Sunder and Myers regression will identify this ratio. As a result, finding a coefficient near one would not disprove the tradeoff theory. Chirinko and Singha’s cautionary note reinforces an important 5 methodological point. Most empirical tests have various weaknesses. It is therefore important to examine the predictions of a theory from a number of points of view rather than relying solely on a single test.

The theory of irrelevance of capital structure

The modern work on capital structure theory began by Modigliani and Miller (1958). The theory proves that the value of the firm is independent from its capital structure. They proof their hypothesis based on different assumptions. These assumptions are not applicable in the real world so as the literature, their work considered best but it cannot be applicable in the practical life.

M&M further published the correction for their previous work in 1963 as “A Correction”. In that study, they have described that the value of the firm is independent from its capital structure but the interest expenses on the debt create the difference. They further explained that point by sayings that as the interest expenses are tax deductible due to the income tax law prevailing in different countries so the firms working in these countries decreases the tax liability and increases the after tax cash flows. On the other hand, dividend payments are not tax deductible; firms have to pay the tax on all their incomes and this procedure make equity a costly source of financing. Therefore, this differential treatment encourages corporations to use debt in their capital structures. Their work provides the basis for other researchers for further research. As a result different other theories of capital structure developed by other researchers like static trade-off theory, pecking order theory and agency cost theory.

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