Capital structure Theories


Chapter 2 Literature Review

2.1 Introduction

Nowadays, most of corporations must answer two question. The first one is deal with what investment should the company do . Thus, to run a successful company , financial manager will focus on the project with a positive net present value in order to create the wealth for the shareholder. Once the project has been approved the next step is to consider how companies should raise finance. Therefore they need to consider the mixture of debt and equity which is known as capital structure. It can be seen that capital structure is one of the key elements in corporate finance.

Basically there are several ways to choose for raising finance. The company can meet the potential sources of finance such as debenture , bonds , bank loans , leasing, stocks and convertible form as hybrids that have the option to change the form of instrument from debt to equity and vice versa.

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However the basic and widely used instruments are bonds and stocks . The overall objective for operating the business is to minimize the cost of capital and maximize the market value of the company in order to create wealth for the owner of business. Whilst, it is crucial to understand and examine whether the organization achieve the optimal capital structure.

The main theory of capital structure of Modigliani and Miller in 1958 which has been discussed and debated until now was made assumption under the perfect capital market. In this article MM stated that the choice of mixture between debt or equity is irrelevant to the capital structure.

In 1963 Modigliani and Miller published another article to modify their model by introducing the corporation tax because the interest on tax payment is deductible. Based on this theory the firm should use the 100% of debt. However, in the real world it is unlikely for the perfect capital market will exist.

In a practical way none of the theoretical capital structure gives us the accurate and complete picture because each theory has different assumption and preposition and can apply and varies to condition change, company' policy financial decision and so on.

According to learning from theories, it is better for us to comprehend the interrelationship between them and capital structure so that we will understand why one concept of theory is better than the others.

2.2 Capital structure Theories

2.2.1 Modigliani and Miller Theory

It can be stated that one of the most famous theory of capital structure is Modigliani and Miller Theory which was first published in 1958 and was known as proposition 1. This proposition represented that the market value of the firm cannot change by the way to use any combination of debt and equity. In contrast, the firm's value is ascertained by the assets including tangible assets for example machinery, equipment, factories and intangible such as patents, trademarks and technical expertise and so on.

Therefore under the viewpoint of Modigliani and Miller firms which are running in the similar business and having the same operating risk will tend to have the same total value and also independent to their capital structure.

Brigham and Ehrhardt (2001) demonstrated that the value of the company will be indifferent regardless to the way of financing from internal and external forms but future cash flow arise from the level of risk will determine solely of the firm's value. Hence, an optimal capital structure would not appear because of the irrelevance capital structure.

However, The Modigliani and Miller theory in 1958 has been modified, Stiglitz(1969) argued that under the perfect of capital market condition is unlikely to happen because when the firm raise more debts reflect to increasing in the rate of interest and firms pay interest rate vary form firm to firm. In contrast to the perfect market is supposed to be no tax and transaction cost. All of information is freely available without incurred any cost in the market.

According to a great number of criticisms, Modigliani and Miller issued another article in 1963 to relax their Modigliani and Miller (1958) because in the world of uncertainty there are no perfect capital market is likely to happen so the corporation tax was included. The most important thing should not be ignored is the tax deductible on interest payment. As a result, the overall cost of debt to the firm is lower than the one in Modigliani and Miller theory (1958) without tax.

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To summarize Modigliani and Miller review in 1963 ,Brigham and Ehrhardt (2001) stated that the tax subsidy was caused the market value of the firm rise. The firm's value is totally increased reflect to their debt -equity ratio changed.

Previously Modigliani and Miller 1958 distorted the fact that the corporate taxes allow tax relief on interest payments whereas the dividend payments to shareholder are not deductible. This is the main reason to encourage the firm to raise debt as much as possible or use 100% of debt financing in order to increase the total firm's value and the optimal capital structure will exist. Miller 1977 developed the irrelevance of capital proposition by introducing both personal and corporate tax. He presented the expecting value of a levered firm in a situation with tax system. In practice, it is rarely to find any firm totally fund for debt financing because high gearing level lead to bankruptcy risk, the problem of agency cost, financial distress and so on.

Modigliani and Miller (1958) argued that firms which differ from their method of financing would have the same value of the corporation. The reason due to the size of the company and the financial decision and operating determine the firm's value and the mixture of debt and equity ratio is irrelevant. They approved that if the capital structure does matter ,there will be an opportunity for arbitrage which is not appropriated in the real world.

Enter the proposition 1

The famous proposition 1 of Modigliani and Miller is a statement of the law of one price. It stated that the market value of the firm is unaffected by the financial decision. Brealey and Myers(2008) explained by made assumption for two firms that have the same operating of business and differ solely in capital structure. Firm U is unlevered and firm L is levered. As a result the value for the both firms will be the same as:


or Value of the levered firm = Value of unlevered firm

Brealey and Myers (2008) concluded that “All would agree that the value of the unlevered firm U must be equal to the value of the levered firm L . As long as investors can borrow or lend on their own account on the same terms as the firm, they can undo the effect of any change in the firm's capital structure. This is the basis for MM's famous proposition 1”

Proposition 2

Brealey,Myers and Allen (2008) stated that” the MM's proposition 2 present the expected rate of return on the common stock of a levered firm increase in proportion to the debt-equity ratio (D/E), expressed in market value; the rate of increase depends on the spread between rA,the expected rate of return on a portfolio of a firm's securities, and rD , the expected return on the debt”.

According to the proposition 2 bring us to the question is there any opportunity to rise the stockholder by changing the gearing ratio? As we learn in the earlier that when the debt-equity ratio increase will effect the higher require expected return on equity for the investors to compensate that increasing risk.

The relationship between the equity ratio (D/E) and the weighted average cost of capital (WACC)

The key objective of financial management is to create the stockholder's wealth by maximize the firm' value and minimize the overall cost of capital. Thus, financial manager is seeking for profitability by trying to obtain the efficiency combination of debt and equity is one of strategies to reduce the cost of capital. The basic concept to raise the market value can be achieved by decreasing the WACC and the shareholder wealth also increase.

Figure 1 shows the traditional view of capital structure. Taxation has been excluded from this point of view. When the risk is stable at the certain level of low gearing, the rising of debt will bring down the WACC. In contrast to higher level of gearing, the equity holders are insecure because of the financial risk due to the interest payment on debt must to be paid first. Therefore the WACC begin to increase. Finally uncertainty such as financial risk , bankruptcy and so on are likely to happen at very high level of gearing , both equity and debt holder push up the WACC further.

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However an optimal capital structure does exist at point P where the cost of capital is lowest and market value of the firm will be maximized.

The implication on proposition 1

Brealey and Myers (2008) defined “the weighted average cost of capital is the expected rate of return on the market value of all firm's securities”. At the level of operating income unchanged, If the firm's value increase , the WACC will tend to fall down.

Modigliani and Miller also stated that “as investors are rational ,the required return of equity is directly proportional to the increase in gearing. There is thus a linear relationship between cost of equity and gearing. The increase in cost of equity exactly offsets the benefit of the cheaper debt finance and therefore the WACC remains unchanged”.

Because of irrelevance capital structure theory so the WACC and the firm's value is unchanged from the debt to equity ratio. The firm is totally free to choose any mix of fund.

The implication on proposition 2

There have been a large number of theoretical and empirical developed from the proposition 1. The main discussion is solely depended on the tax system. Therefore MM (1963) applied the corporation tax which gives tax subsidies on interest payments. Due to the fact that debt is the cheaper source of finance . It is more attractive to investors and reduces the total cost of capital by borrowing more unless the shareholder demand a higher expected rate of return.

MM(1963) adjusted that “debt interest is tax deductible so the overall cost of debt to the company is lower than in MM (1958). Lower debt costs less volatility in returns for the same level of gearing lower increase in cost of equity. Moreover the increase in cost of equity does not offset the benefit of the cheaper debt finance and therefore the WACC falls as gearing increases”.

When the firm has geared up may cause the WACC falls and raise the firm's value. The appropriate capital structure should be 100% debt finance. The advantage of geared company over ungeared company for example has lower WACC, a higher of market value and can pay less tax.

2.2.2 Debt and Taxes

According to perceive the tax features that effect on the capital structure, the main component that influence is the tax subsidy on interest payment. In MM ‘s proposition 2 highlighted that the firm's value is higher because using of cheaper debt cause interest payment can be deducted from taxable corporate income. However it is rarely to find firm go for a huge of debt because high debt means high risk of bankruptcy and other direct and indirect costs. As Brealey, Myers and Allen(2008) argued MM(1963) that it is overstated the value of the firm because there is inaccurately predicting that debt is stable in the same level and perpetual. On the other hand, debts always change at a point in time as the profits and value of the firm change. It is better organize to use non debt tax shield when it is likely that the firm will have future income to shield but unforeseen circumstances can happen all the time.

Titman and Wessels(1988) had done the empirical research for determinants of capital structure and found out that firms with specialize products and services will tend to use lessen equity to debt ratio because of their uniqueness related to the research and development expenditures, selling expenses and so on. The large firm with profitable tends to use less amount of debt to the proportion of market value of equity. They also discovered that the smaller firm is willing to use short term of debt than the bigger firm.

Brennan (1970) argued that the MM (1963) is still imperfect because they neglected the personal income tax which is relevant to the theory of valuation. He pointed out that MM (1963) ignored the fact that personal tax is allowed to be deductible on interest payment as same as corporation tax and dividends and capital gains receiving in the form of asymmetric distribution of tax deduction are difficult to introduce because of the personal tax nature that give an effect to marginal tax rate to vary from investor to investor with different level of incomes. Moreover he applied personal tax into CAPM because in the world of uncertainty, there are different investors with marginal tax rate and risk averse who are concerned with selecting portfolios to hold over the same single period horizon.

The problem arises as substituting debt for equity in order to taking the benefit of tax shield, the firm can get more surpluses to payout higher return to the investor but what happen if the firm issue the equity finance and how the firm can deal with corporation tax. Here,Miller (1977) introduced personal taxation and highlighted that the firms should increase the level of debt to equity ratio so that the firms would have higher after tax income. As a result, firms have better returns to payout bondholders and stockholders and the value of the firm is irrelevant. Miller added that to encourage taxable investor the interest rate on the bond need to be worth enough to invest so the investor can compensate interest income on the personal tax. The disadvantage on raising debt finance incur when tax on interest payment has been rise than on equity returns.

De Angelo and Masulis (1980) extended Miller's analysis as they perceived that his theory is sensitive especially when corporate tax code apply and more sensitive with the non debt tax shield such as accounting depreciation , investment tax credit and so on. The market price will capitalize personal and corporate tax and will determine the firm to consider whether to be leveraged and enjoy tax benefit comparing to the risk of bankruptcy as trade off. In contrast to the MM theory in 1963 which summarize that the optimal capital structure arise when the firm issue full of debt financing. Moreover they point out that non debt tax shields are effective to the optimal capital structure because they will reduce the tax benefit when the firm raises debt finance. Therefore the firm with great amount of non debt tax shield tends to issue less debt financing for their capital structure and vice versa for the firm with small amount of non debt tax shield.

2.2.3 The Trade off theory of capital structure

Basically choices of the firm to choose between debt and equity raising finance is important because the price of stocks are varies depend on the announcement of financial decision which can be attractive investors.

Myers (1984) pointed out that whereas Modigliani and Miller (1963) suggested that company should go for debt financing 100% but in the real world we know very little about capital structure and it is hard to find out what type of securities that company should issue the debt ,equity or hybrid.

Trade off theory can be classified into two categories. One is static trade off theory which Myers (1984) explained that is the way of firm will be setting target debt ratio and then moving gradually toward it as the same way as adjust dividend and moving toward a target payout ratio. Another one is dynamic trade off theory perceive that leverage firms when face with the situation that their ratio is not match with the target. Here ,the firm will adjust capital structure after compare the benefit for obtaining optimal capital structure to the cost of adjusting it whether it is worthwhile. It is costly to issue and repurchase the debt in their point of view.

Thus ,it is the main duty for the financial manager to revise frequently the firm's debt-equity decision by considering the trade off between costs and benefits of borrowing. Myers (1984) concentrate on the balancing between interest tax shields and the costs of financial distress include the legal and administrative cost of bankruptcy as well as the subtler agency moral hazard,monitoring and contracting costs which are erode firm value even if formal default is avoided. The firm is supposed to substitute debt for equity, or equity for debt,until the value of the firm is maximized.

The graph shows in figure.. below represent that a firm's value is determined by the trade off of the cost and benefit of borrowing ,holding the firm assets and investment plans constant (Myers 1984)

Because of raising debt finance is interest deductible so giving the tax shield benefit and lead to more earning and the firm's value also increase. Therefore in theoretical concept the firm tends to use more debt financing rather than equity financing. Using more debt increase the level of gearing and will cause higher financial risks. Therefore in order to compensate those risks the firm will expect the higher rate of return either.

Nevertheless, most of company would not issue only debt finance but will raising the combination of debt and equity financing because it is less risky and less opportunity of cost of bankruptcy , cost of financial distress, tax exhaustion and so on.

Hence, the table below shows advantages and disadvantages for using debt. The firm must consider the main factors can be affected for example using debt totally cheaper than equity because debt finance is normally tax deductible and more flexible in contrast to equity but bring the risk of having to meet regular repayments of interest and principal of loans. The firm can end up with liquidation if face up with the difficulties in repayment.

Advantages of Borrowing

Disadvantages of borrowing

Tax Benefit:

Higher tax rates-> Higher tax benefit

Bankruptcy Cost

Higher business risk-> Higher Cost

Added Discipline:

Greater separation between managers and stockholders-> Greater benefit

Agency Cost:

Greater separation between stockholders and lender-> Higher cost

Loss of future financing flexibility:

Greater uncertainty about future financing needs -> Higher cost

Table 2 Source: Domodaran 1999

Brealey et al (2008) summarized that ”target debt ratios may vary from firm to firm. Companies with safe,tangible assets and plenty of taxable income to shield ought to have high target ratios. Unprofitable companies with risky,intangible assets ought to rely primarily on equity financing”.

2.2.4 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”.

It can be seen that the pecking order theory try to answer the question why firms using debt or equity. The more profitable firm borrow less because they don't need outside money in contrast to the less profitable one which normally will first raise debt finance because they don't have enough internally generated funds. Base on the theory does not focus mainly on tax shield topic as the trade off theory does. If firms choose to raise finance as the pecking order theory suggested, then firm can obtain benefit saving from using internal funds which have the lowest issue costs and the degree of issue cost is moderated in issue debt and become most expensive by raising equity.

Myers (1984) highlighted that asymmetric information is one concept that related to financial decision because the managers are acting as the insider so before an announcement of the share price all information has been passed through managers and finally through investors. That is the main reason why asymmetric information does affect the choice of financing even internal or external sources. Once again, financial manager will give priority to internally funds first, the second one is debt because it is cheaper and lower risk and consider equity finance as the last resort. Myers and Majluf (1984) demonstrated that the cost from issuing securities may be associated according to manager can access better information than the stockholder. Firms can escape this cost by raising debt using secured by property with know value.

2.2.5 The agency cost theory

Basically the idea of separate ownership and management has clear advantage because the firm can change stockholders without disrupting the operating of business. However it also brings the problem when the objective between shareholder and manager are different.

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”.

As a result the conflict of interest occur because the shareholder who acts as the principal does not trust in manager who act as an agent for the firm that he is performing on the best interest. Therefore the agency costs exist when the manager is not acting in the way to maximize the firm's value and the firm has to meet the cost of controlling and monitoring them.

Eisenhardt (1985) Stated that agency problems is focused on resolving the relationship between principals and agents ,he recognized that the problem incur when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing. The second problem is dealing with the sharing of risk which is appear when the principal and agent have different attitudes towards risk. Base on theoretical theory to reduce the agency problem, he concern with the term of governance machanisms. Eisenhardt (1985) assumed two proposition the fist one is outcome based contracts which is believed that cause an managerial opportunism

“Proposition 1 : when the contract between the principal and agent is outcome based, the agent is more likely to behave in the interests of the principal”

The second proposition has been linked to the information systems control the agent opportunism. There, the principals can check what the agents has been doing through the information system so it is not easy to deceive them.

“Proposition2 : When the principal has information to verify agent behavior ,the agent is more likely to behave in the interests of the principal”.

Eisenhardt (1985) presented elements and descriptions for the agency theory in the table..below

Key Idea

Principal-agent relationships should reflect efficient organizational of information and risk-bearing costs

Unit of analysis

Contract between principal and agent

Human assumptions

Self interest

Bounded rationality

Risk aversion

Organizational assumptions

Partial goal conflict among participants

Efficiency as the effectiveness criterion

Information asymmetry between principal and agent

Informational assumption

Information as a purchasable commodity

Contracting problems

Agency (moral hazard and adverse selection)

Risk sharing

Problem domain

Relationships in which the principal and agent have partly differing goals and risk preferences(e.g. compensation,regulation,leadership,impression management,whistle blowing,vertical integration,transfer pricing)

Source: Eisenhardt (1985)

Eisenhardt (1985) summarized that two agency problems incurred among the uncertainty and incomplete information which are adverse selection and moral hazard. Adverse selection does exist when the principal can not examine the ability or skill of the agent immediately or while he or she is working whereas the moral hazard refers to the lack of effort for the agent. Here, the principals must verify that their agent devote all effort for work.

Diamond(1989) give suggestion to predict the outcome of the borrower by looking at their reputation which can find by looking at their old payment record and old credit rating. Firms with good reputation have greater capacity to borrow more because their backgrounds are likely to be transparent and there are little chances to destroy their value by investing in unprofitable project or negative net present value project.

Jensen and Meckling (1976) argued the first agent problem between equity holders and debt holders. The problem incurs due to the different characteristics for equity holder and debt holders have different cash flow claims on the firm. Normally equity holders are willing to take risk because they can obtain the surplus. Thus these actions do affect the debt holders as they can receive only fixed claim on the cash flows and will not receive their promised payments. Moreover if the companies face with liquidation problems, the equity holders will get hurt minimal due to the concept of separate legal entity and limited liabilities. Titman (1984) argued that under liquidation condition, the bondholders will receive the highest priority claim and lowest to the stockholders therefore the bondholders is totally desire to liquidate when the firm is bankruptcy. This is another main conflict refer to different in objective between both parties.

Moreover, bank and bondholder are normally lend the firm money and they have the same propose to see company running successfully as same as company would like to be, but when the firm get trouble their union can be convert as the lender just want to get the money back and is hardly to support the firm to take more risks. These conflicts between them lead to agency cost problem.

Jensen and Meckling (1976) introduced other agency problem between equity holders and managers. Here, the agency cost exist when the manager act on their own interest rather than the best interest of the firm. There are three type of the agency costs. The first one is the cost of monitoring for the managerial activities, it is the cost that principals need to pay for monitoring and controlling the agents such as audit cost. The second one is the expenses that use for restrict the undesirable managerial behavior for example the expenditure for recruit the member of the board from external. The last one is opportunity loss due to the power of the manager is restricted by not allow to make decision in the situation that may affect the shareholder wealth.

The main point that distract the manager to act on their own self interest is because of asymmetric information as manager is know everything better than shareholder. It will give the best solution if everyone had the same information. But under the uncertainty condition, it is unlikely to happen. Therefore to encourage managers to be part of owner of the company by giving them the share price so they will not act in an undesirable way. However care need to be taken if managers own a great number of shares because they will tend to borrow more debt for bring the agency cost from external down.

The other device to resolve the conflict between managers and equity holders by issuing more debts in order to reduce free cash flow because raising debt finance force the company to pay the interest payment and the principal frequently.

It can be stated that good governance is really helpful for resolve the problems. Fama and Jensen(1983) recommended to use board as a device for monitoring the agent to assure that they act on the best interest for the firm. Eisenhardt (1985) supported that richer information systems control the opportunism managerial and the top executive managers are likely to perform in the best interest due to frequently monitoring and controlling from the board as a result less risk of greenmail and golden parachutes which the performance to benefit manager rather than the shareholder will not happen.

2.2.6 The bankruptcy cost

In the perfect market , it is unlikely that the cost of bankruptcy will incur but in the real world the market is still far from perfect and the firm's management must consider the trade off between issue debt financing in order to lower the cost of capital and the risk of bankruptcy exist. The more debt financing the firm issue result in high level of gearing, the higher chance the firm is likely to end up with bankruptcy cost. Haugen and Senbet(1978) refer the term of bankruptcy costs do arise when the fix obligation to the creditor can not be met. Therefore the cost of bankruptcy can be grouped into two direct and indirect bankruptcy cost. The cost of transfer the ownership to creditor cause the former one such as legal, accounting fees and trustee fees and so on whereas Warner (1977) refers indirect costs include lost profit, lost sale and such a way that firm lose credit and can not issue anymore securities.

Baxter (1967) pointed out that risk of ruin is not likely to affect partly on debt but will affect to the level of leverage for example suppose the firm to be low leveraged, an increasing the level of debt is not directly reliance to the probability of bankruptcy in the capital structure. On the other hand,it will cause greatly effect to the cost of capital. Thus the risk of ruin is sensitive to the level of leverage and therefore with the low leveraged firm the interest payment on debt has been raised slowly but when the capital structure is more risky will cause the interest rate increase immediately. He also added that net operating income is also influence to capacity of the firm to tolerate leverage. Firms with stable income tend to have more debt financing whereas firms with risky income has limited ability to bear the fixed cost on interest payment and they might find that the cost of capital also increase because of leverage.

Kraus and Litzenberger (1973) argue that implication of tax system, direct and indirect costs will incur in the imperfect of capital market. Tax saving reduce the payment form tax liabilities and also increase the profit after tax. However issuing debt do force firm to pay fixed amount of interest payment and if this cannot be met cause the firm go to bankruptcy. Here, Kraus and Litzenberger determine the choice of financing by trade off between tax saving advantage and bankruptcy penalties. Titman (1984) point out that the decision on firm's liquidation affect to bankruptcy risk and introduce indirect bankruptcy costs which are influence to the non financial stakeholder such as customers and suppliers as they can impose the probability of liquidation. He stated that when firm issue higher level of debt result in higher risk of bankruptcy and trade is become worse.

Based on Warner (1977)'empirical research, he studied the relationship between capital structure and direct bankruptcy costs by obtaining evidences from 11 railroad firms because he perceive that indirect bankruptcy cost is an opportunity lost and hardly predictable. Moreover he found out that the market value of the firm is irrelevance to the length of time spending in bankruptcy process. Hence, firms with high market value will not end up simply with bankruptcy comparing to the lower market value firm. Titman and Wessels (1988) support that large firm tends to more diversify in order to reduce the risk and opportunity loss and bankruptcy and recommend firm should be diversified in high level.

2.3 Empirical Studies

2.3.1 The Determination of Optimal Capital structure: The Effect of Firm and Industry Debt Ratios on Market Value

In order to prove their research topic above, the writers had studied key variables such as debt to equity ratio, industry average and market value by using a sample of 183 debt issue announcement over 4 years between 1982-1986. According to theories of De Angelo and Masulis (1980) and Masulis (1983) demonstrated that firm is seeking for optimal capital structure by changing the level of gearing until moving toward or below the industry average, the writers try to examine the correlation between debt level of the firm and it's industry average do affect the firm's market value. Here, the writers found that there are no significant relationships supported these theories. They compare the debt-equity ratios to industry averages. Here, the industry average can be measure by Value Line Investment Survey and another one is COMPUSTAT tapes.

Under Value Line Investment Survey method, the writers investigate 55 industries and formulate leverage ratio by using long term debt over net worth, then compare the outcome to industry average whether the firm's debt-equity ratio below or above industry average. If the firm's leverage ratio above industry average, that firm is classed as high debt firm and vice versa to the firm below industry average. Measuring by COMPUSTAT tapes, the writers calculate leverage ratio by used formula total debt over market value of equity instead but still use the same standard for evaluating in the term of high or low debt firm.

Moreover to writers had tested the theory of Jensen and Meckling(1976) and Jensen (1986) that when low growth firm raising debt financing, opportunity arise as obtaining device for controlling and monitoring manager because reflect to capital market with different growth rates. Hence, the writers compare sale growth rate from year -5 to year -1 to the anticipate sale growth rate from year 0- year 5. The firm is referred to high growth firm when the prior sale growth rate is lower than the current one and in opposite to the low growth firm.

The writers summarize that they can not find the relationship between capital structure and firm industry as the market value is unaffected to the leverage ratio and the industrial average so that their finding do support the irrelevance capital structure of MM' 1958 which point out that the firm can issue any mix of fund regardless to the market value.

2.3.2 Capital structure and Profitability: The Brazilian case

The authors perceive that it is very hard for the firm to make financial decision regarding capital structure because there are numerous variables such as risk and profitability determine the choices. Moreover the authors try to investigate any effect on capital structure of 70 Brazilian companies over past seven years. In order to examine the relationship between debt and profitability, the authors formulate the function as follow:


Table 3 shows that the writers use regression model to estimate the influence of capital structure on profitability.

Table 3 Regression Model among the financial indexes of selected Brazilian companies 1995-2001)




t test



























F test






Mesquita and Lara.' Capital structure and Profitability: The Brazilian case' ;

The coefficient is 67.6% related to the variances of ROE were indicated by various variables. The significant of 1% assume that they should be adjusted so that ELP which is long run debt to total liability is excluded from this analysis. LP/PL represent the reason between the long term debt and equity has significant biggest for the test and negative figure shows the inverse relationship that means the higher level of debt cause the lower of profitability. ECP refers to short term of debt over total liability plays an important role as gives most significant of 2%. The result shows that short term of debt is widely use among profitable firms and because of the instability of Brazilian economic, most firms need fund to use in working capital. It is likely that this form of debt is easiest and more flexible to issue in the viewpoint of financial institution. PL is calculated by index equity over total liability gives the positive outcome and present the relationship to the same direction to profitability. It can be stated that this is the main source of financing in Brazilian company.

The authors summarize that their finding is contrast to the theory of MM'1958 which affirm that the value of the company is unaffected to the capital structure and also give the inverse result comparing to MM'1963 which stated that firm choose use debt as much as possible because the outcome is the lower of debt can bring more profit. However their result would supported by several theories such as Fama and French (1998) demonstrate that higher level of leverage would cause the agency problem between stockholder and creditors, then give negative correlation between capital structure and profitability. Miller(1977) conclude that there are no benefit from issuing debt financing because the personal taxation will set against. Therefore based on authors' result firms can make profitability under raising short term debt and equity but profit will not be applicable if firm go for long term debt financing.

2.3.3 Profit Margin And Capital Structure: An Empirical Relationship

The authors tried to investigate the correlation between borrowwed capital and profitability of the firm by used data based on different 53 firms across industries during 1995-1996. Therefore they are mainly focused on the level of investment in debt-equity ratio and the degree of market power. The authors had studied the linear relationship and created the equation following to Hay and Morris (1991) and Martin (1994) as :

PMit = а0+а1 CRt+a2 Fit+a3 Iit+ut

The authors explained that PM defined as the margin profit of the firm and formulated by profit to sale ratio. CR referred to the four firm concentrate ratio and was calculated by four firm sale over total industry sale. F was stranded for debt to equity ratio include both firm with high or low debt-equity ratio in order to give the result more accurate. I measured the level of investment for the firm. The coefficient a2sign represented how effectiveness for the firm using borrowed capital. The а1 sign showed that with positive coefficient the firm tended to has cooperation whereas with negative sign the firm would compete to each other.

After completed data by equation then the authors moved on to parameter of total model which were the fixed effect and random effect models which gave the result as the table…

Table …

Total Model

Fixed effect model

Random effect model








































SER = Standard error of the regression

n = Number of observations

t = Values in parentheses


Eriotis et al. ‘Profit Margin And Capital Structure: An Empirical Relationship';

The authors found the negative relationship between debt to equity ratio and firm's profitability which indicated that firms used their internal funds such as retained earning would earn more profitable than firms which mainly rely on the borrowed capital and they also pointed out that fixed asset can be one variable to use as a strategy to achieve profitability. They highlighted others inverse relationship affected firm's profitability , which was firm took account to complete rather than cooperate.


Eriotis, N.P., Frangouli, Z. and Ventoura-Neokosmides, Z. (2002). ‘Profit Margin And Capital Structure: An Empirical Relationship', The Journal of Applied Business Research, 18 (2), pp.85-88. Available from: (Acessed: 8 December 2009)