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Capital structure


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Does capital structure affect firm value?


H0 : There is no a significant relationship between capital structure and their total market value in the stock exchange Thailand.

H1: There is a significant relationship between capital structure and their total market value in the stock exchange Thailand.

Research question

Are there any optimal capital structure of firms in stock exchange Thailand and to examine for the relationship between capital structure and company value.

Does capital structure affect firm value? An empirical analysis of firms listed in energy and utilities sector in stock exchange Thailand (SET)


1.1 Background of study

Capital structure plays an important role in financial management of the company. Every firms can mix of debt and equity in different way in order to increase the wealth of ordinary shareholder. There are several type of debt and equity such as common share, preference share ,hybrids ,convertible bonds and so on. Therefore the firms can raise debt and equity finance in countless combination because they need to find the best combination that minimize the weigh average cost of capital and to achieve the objective of management is to maximize the firm value.

Basically better management can increase the shareholder's wealth by considering the investment project with optimal gearing ratio. From that point of view nevertheless the positive investment project increase the wealth of shareholder , the financial decision is also the key to prospect company future.

Groth and Anderson (1997)stated that “understanding capital structure and its practical implications is important to the professional manager regardless of functional area of expertise. The seminal work in the area of capital structure earned the researchers Nobel Prizes”.

Therefore the financial managers would have a duty to determine which debt and equity are used in the capital structure could increase wealth. Typically each company is seeking for profitability by use any strategies that can bring down low cost and gain the company return and value for the operating side. In additional to the financial side is to get the efficiency combination of debt and equity because it reduces the cost of capital.

However there are several debates for which capital structure do effect the company value. Is it possible to increase shareholder wealth by changing the gearing ratio or level? How can we find an optimal capital structure? Hence, in this paper will mostly discuss the literature reviews and the research methodology for answering that question.

1.2 Statement of problem

Over the past decades, there have been a large number of theoretical and empirical studies appeared. The first famous theory that has been issued by Modigliani and Millers in 1958 was known as proposition 1mention that where the firms are running in the same type of business at the same particular operating risks their capital structure is irrelevant to shareholder wealth. Therefore the firm must have the same total value and they can issue any mix of fund.

However the proposition 1 is based on the perfection of capital market and ignore tax , the costs of bankruptancy, financial distress and so on but in the real situation the market is seem to be imperfect. Myer(2001) argued that capital structure theory depend on some circumstances . Each theory can give us the different result regard the cost and benefits from financial strategies.

This study will therefore answer the question to what extend different theories of capital structure can identify the impact on the company value in stock exchange Thailand market and are there any relationship between the capital structure and the financial performance of the company.

2. Literature Review

2.1 Modiglini and Miler Theory of capital structure

Nowadays most of literature review and article have examined and expanded from the famous theory of Modiglini and Miller theory of capital structure. Start with the theory published in 1958 under assumption that in a perfect market the value of the firm is unaffected by its choice of capital structure. Therefore the total value of the firm is stable regardless of debt to equity ratio. To give support under this assumption imagine that two firm with the same operation of business but different in capital structure. Where firm U is unlevered ,the total value of its equity (EU) is the same as the total value of the firm (VU) . Additionally where the firm L is levered, thus the total value of the firm L is equal to the value of the debt less value of the equity of the firm L. As a result the total value for both company will be the same.

Because Modiglini and Miler (1958) believe that when there are no taxes and capital markets function well , it makes no different whether the firm should borrow or individual shareholders should borrow . The market value of a company does not depend on its capital structure. They proved the assumption by represent that the arbitrage opportunity would emerge if the total value of the firm relevant to capital structure. The arbitrage should not be in the practical and real situation.

The proposition 1 can be illustrated as VL = VU

or Value of the levered firm = Value of unlevered firm

In order to prove that their proposition (1958) was viable , They make assumption that there are no tax and transaction cost exist in the market. Individual and corporation can borrow at the same rate. However there are a large number of articles argued with his article because it seems to be unrealistic.

Thus, in 1963 Modiglini and Miller published second literature which is known as preposition 2 to modify and fix proposition 1 by considering the corporation tax. It stated that the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio. While proposition 1 says that financial leverage has no effect on shareholder wealth. In contrast to proposition 2 says that the expected rate of return increases as the firm's debt to equity ration increases. This means that when the debt-equity ratio increases the risk is also increases and therefore shareholders expect the high rate of return according to the level of risk they face.

Hence, the firm can take benefit as levered firm rather than keep the status as unlevered firm because the corporation can deduct interest payment as an expense but dividend payment are non deductible. As Modiglini and Miller theory stated that the optimal capital structure will exist where the cost of capital or weigh average cost of capital (WACC) minimize and the total market value of the firm maximize.

Modiglini and Miller theory with tax illustrated that gearing up by raising debt finance rather than equity finance reduces the WACC and the value of the firm rise. Finally an optimal capital structure does exist at point where debt is 100%

The proposition 2 can formulate as:

Value of levered firm = Value of un-levered firm + Value of tax saving

It is used under assumptions that there is corporation tax in the market but without transaction cost exists. The individual and corporation can still borrow money at the same rate. Therefore the best of capital structure should be 100% debt finance because of tax deductible on interest. Under criticism of theory there are a great amount of articles expanded due to can not used in the real world.

2.2 Trade off Theory of capital structure

The trade off theory explains the idea how the firm chooses to raise equity and debt finance by balancing the costs and benefits. Brealey and Myer (2008) presented that each firm should set their own target debt ratio which is vary from firm to firm. The firms with safe tangible asset and plenty of taxable income to shield ought to have high target ratio. Unprofitable companies with risky intangible assets ought to rely primarily on equity financing.

Trade off theory has been used widely for study corporate of capital structure because it justify the fact that to raise part of debt finance the company obtain benefit from tax saving nevertheless the firm face with the cost of capital such as cost of financial distress including bankruptcy cost and financial distress without bankruptcy mostly related to customers and suppliers because they are extra cautious about for the firm that may not be around for long. Potential employee leaving or difficult to recruit is also costly for financial distress.

In addition to the firm increase gearing result in an increased level of financial risk. So that the shareholder require higher expected return in order to compensate that financial risk.

However there are several articles has been question about the relevance of trade off theory.

Brealey and Myer (2008) stated that the trade off theory of capital structure can explain how company actually behave because this theory successfully explains many industry differences in capital structure. High technology growth companies whose asset are risky and mostly intangible normally use relatively little debt. Graham and Harvey(2001) pointed out that Airlines can and do borrow heavily because their assets are tangible and relatively safe.

There is some evidence that in contrast to the trade off theory of capital structure in real life that the most profitable companies commonly borrow the least (Ward ,1999). Because under this theory it stated that high profits should mean more debt capacity and more tax saving as a result give a higher target debt ratio.

2.3 Bankruptcy cost

Corporate bankruptcies concept does exist when stock holders exercise their right to default. Where the firm is coping with the problem but the limited liabilities allows stockholders to diminish and leaving all trouble to their creditor. The former creditors then become the new stockholders and the previous stockholder left with nothing (Brealey and Myer 2008)

Warner (1977) classify two type of bankruptcy costs which are direct and indirect. Direct costs include lawyer's fee , accountants' fee and the value of the managerial time spent in administering the bankruptcy cost. Indirect costs include lost sales, lost profits and possibly the inability of the firm to obtain credit or to issue securities except under especially onerous terms. He did the research by investigate 11 railroads to seek the relationship between bankruptcy costs and the market value of the firm. The evidence shows that while the higher market value railroads generally did incur higher bankruptcy cost, the cost do not appear to be directly proportional to market value.

While Warner supported the direct bankruptcy cost, Baxter(1967) introduced the indirect bankruptcy cost. He developed optimal capital structure models which incorporated bankruptcy cost. These model show that the value of a firm is maximized by increasing the level of debt financing to a point where the marginal present value benefit of the tax shied equal the marginal present value of the cost of bankruptcy.

Extentions of the Modigliani-Miller theory have been provided by many researchers. Titman(1984) refers the idea of indirect bankruptcy cost . He argues that stakeholders not represented at the bankruptcy bargaining table, such as customers, can suffer material costs resulting from the bankruptcy. He shows that the bankruptcy status may occur according to the firm ‘s liquidation decision. He pointed out that the firms end up with the cost that can impose on their customers, suppliers and workers by liquidating are relevant to their capital structure decision.

Titman and Wassels (1988) refer there are plenty of authors have suggested that leverage ratio may be related to the firm size. They proved that direct bankruptcy costs seem to constitute a larger proportion of a firm's value as that value decreases. The large firm tends to be more diversified and less prone to bankruptcy. As a result , large firm should be more highly leverages

2.4 The Pecking order Theory

There is an argument that there is not necessary to find an optimal capital structure through the theory. Therefore the pecking order Theory refer to the idea that the investment is financed first with internal funds, reinvested earnings primarily and then by new issues of debt and finally with new issues of equity. New equity issue are a last resort when the company runs out of debt capacity. (Brealey and Myer 2008)

In contrast to the static trade off theory Myers(1984) summarizes the concept of pecking order theory as follow:

1. Firms prefer internal finance.

2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends.

3. Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities mean that internally generated cash flow may be more or less than investment outlay . If it is less,the firm first draw down the cash balance or marketable securities.

4. If external finance is required, firms issue the safest security first. That is ,they start with debt,then possibly hybrid securities such as convertible bonds,then perhaps equity as a last resort.

Base on the theory,there is no well-defined target debt-equity mix because there are two kinds of equity,internal and external,one at the top of pecking order and one at the bottom. Each firm's observed debt ratio reflects its cumulative requirements for external finance.

Brealey and Myer (2008) explain why the most profitable firms generally borrow less not because they have low target debt ratios but they don't need outside money. In the opposite way ,less profitable firms issue debt because they do not have internal sufficient fund for investment and debt financing is first resort for external financing following to the pecking order theory

2.5 The agency cost

Previously Modiglini and Miller theory(1958) ignored taxation. Since then 1963 they amended the model by implication corporation tax. From that point it is suggested that the higher the level of taxation, the lower the combined cost of capital. That means if the firm use higher level of the gearing ,the higher the value of the company. The company financial strategy should choose a 99.9% gearing level

However in practice most of the firm can not go for high levels of gearing because according to Modiglini and Miller theory is still far from perfect. They distort the problems which can occur from raising high level of gearing such as bankruptcy risk. There is the possibility of bankruptcy as gearing increase result in increase the WACC and the value of the share price reduce.

Agency cost is also the main problem does not exist in Modiglini and Miller theory. Jensen and Meckling (1976) argued that the combination of debt and equity does affect the cost such as agency cost, bankruptcy cost and so on. The benefit of tax saving of raising debt produces an optimal capital structure less than a 100% because the benefit form tax is traded off offset the likelihood of incurring the costs.

Jensen and Meckling(1976) define an agency relationship as a contract under which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involve delegation some decision making authority to the agent. If both parties to the relationship are utility maximizes, there is good reason to believe that the agent will not always act in the best interest of the principal.

In addition, they identify and examine the concept of agency costs by generating the existence of debt and outside equity. They found that bondholders' agency cost move in reverse direction. It is falling when the level of debt increase. Thus,it follows that at some point the minimum cost of agency will exist by combined the firm's debt and equity securities.

3. Research objective

The main objective for the corporate finance to study capital structure is to review the literature of capital structure in different theories according to their effect on company value and test the implication of theories that seek to justify an optimal capital structure

Since 1958 Modigliani and Miller model stated that the value of the company is irrespective to the capital structure. Based on that model MM make assumption for the perfect market so they ignore the tax issue , losses from bankruptcy cost , the agency cost and so on. As a result there are several literatures have been expanded from Modigliani and Miller model.

Thus, this study paper is seeking for investigation and gives the explanation for the existence of optimal capital structure and the financial performance. The aim of this research is to answer the question whether the relationship between the capital structure and the value of the firm.

4.Research Methodology

In order to answer the question of the project . It is necessary to set up the hypotheses then answer them. The hypotheses to be tested for this project are as follow:

HO : There is no a significant relationship between capital structure and their total market value in the Stock Exchange Thailand (SET)

H1 : There is a significant relationship between capital structure and their total market value in the Stock Exchange Thailand (SET)

Sampling Method

Additionally, this study also gain the data from sampling method. It is very practical and to prove that the project is reliable by identify the group of data which is the listed firms of energy and utilities sector in the stock exchange Thailand (SET). The project represents 25 listed companies ,the total amount of the share is 287,181,000 and the market value is 8,551,158,000 baht. It can be stated that the market value of the share for group representative is significantly more than half of the whole total market value(19,130,000,000baht). Therefore they can be good sample of the project.

Explanatory Variables

It is important to justify the variables that do affect the company value In this study there are as follow:

1.Earning per share (EPS)

Earning per share is widely used to measure company success therefore it is the basic tool to indicate the company performance.

Earning per share = profit after interest, after tax and after preference dividends/number of ordinary share in issue

2. Gearing

Gearing is used to measure of risks. High gearing mean high risk .

Gearing = Total Debt/shareholder equity

3. Dividend per share (DPS)

The dividend per share is calculated to show the shareholder how much of the overall dividend payout they are entitle to

Dividend per share = total ordinary dividend/total number/total number of share issued

4.Return on equity (ROE)

Return on equity measures how much profit a company generates for its ordinary shareholders with the money they have invested in the company.

ROE = Profit after tax and preference dividends/Ordinary share capital plus reserve×100%

5.Data collection Methods

Research design mainly focuses on data collection and sources. Therefore to research for this project will use the quantitative analysis by use the secondary data that has already been researched because of limited resources. The second data can collect from the journal of finance Economics, Journal of Banking and Finance, textbook from library, the stock market data, the financial annual report and so on. Most of the source of data such as financial statement , dividend payout ,the data from stock market to use calculate the variables is mainly available from website http://www.setsmart.com. It is the source of data open public for the investor who interested to buy the share in stock exchange Thailand (SET). However to acquire the information must have the username and password.

6. Project Planning








Revised literature review


Data analysis procedures customization




Development of the detailed methodology




Secondary data collecting




Secondary data analysis and interpretation



Preparing questionnaire for interviews



Carrying out interviews


Transcribing interviews


Chapters writing and coordinating with supervisor




Summarized analysis of findings



Draft Conclusions


Draft Recommendations


Final conclusions, recommendations


Project Final submission


7. Bibliography and References

Brealey,R.A.and Myers,S.C.and Allen,F.(2008) ‘Principle of Corporate Finance'.9th edition.Boston:Mcgraw-Hill/Irwin

Graham,J. and Harvey, C.' The theory and practice of corporate finance : evidence from the field'.Journal of Financial Economics 60 (May/June2001),pp.187-244.

Groth, J. and Anderson, R.(1997), capital Structure: Perspectives for Managers,Management Decision

Jensen,M.C.and Meckling,W.H.(1976)' Theory of the firm: Managerial Behavior, Agency Costs and Ownership Structure'. Journal of Financial Economics, Vol. 3, No. 4,(July 1, 1976).Available at SSRN:http://ssrn.com/abstract=94043 10.2139/ssrn.94043.(accessed:24/08/09)

Modigliani, F.; Miller, M. (1958). ‘The Cost of Capital, Corporation Finance and the Theory of Investment'. American Economic Review 48 (3): 261-297. Available at http://www.jstor.org/stable/1809766.(accessed:21/08/09)

Modigliani, F.; Miller, M. (1963). ‘Corporate income taxes and the cost of capital: a correction'. American Economic Review 53 (3): 433-443. Available at http://www.jstor.org/stable/1809167. (accessed:22/08/09)

Myers, S.C., 1984, The Capital Structure Puzzle, The Journal of Finance, Vol. 39, No. 3, Papers and Proceedings, Forty-Second Annual Meeting, American Finance Association, July, pp. 575-592

Myers,S.C.(1984)'The capital Structure Puzzle'. The journal of finance,Vol.39,No.3,(July 1984),pp575-592. Available at http://www.jstor.org/stable/2327916.(accessed:23/08/09)

Oscar,B.'U shaped cost of equity function? Digging into Modigliani-Miller(1958)Mistake'(September2006). Available at SSRN:http://ssrn.com/abstract=934550(accessed:21/08/09)

Titman,S.(1984).'The effect of capital structure on a firm's liquidation decision'.The Journal of finance Economics 13 (March 1984),pp.137-151.

Titman,S.and Wessels,R.(1988) ‘The Determinants of capital structure choice'.The Journal of finance Economics43 (March 1988),pp1-19. Available at http://www.jstor.org/stable/2328319?seq=6.(accessed:23/08/09)

Wald,J.K.,'How firm characteristics after capital structure : An International comparison'.Journal of Financial Resarch22 ( Summer1999),pp.161-187.

Warner,J.B.(1977)'Bankruptcy Costs:Some evidence'. The Journal of Finance,Vol32,Issue2, (May,1977),pp337-347.

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