Capital Structure of Firms in Industrialized Countries

Abstract

In the present-day corporate world, the significance of capital structure can not be undermined. The capital structure decisions as to a proper mix of debt and equity components are of paramount importance for the success of the firm. Such decisions are influenced by a host of factors. The essence of this report is to critically examine the theoretical underpinnings of modern capital structure theory, appreciate the differences between the traditional view of gearing and the Modigliani- Miller versions as well as other proposed theories of capital structure. Most importantly, this report will provide an analysis of the capital structure of major firms in industrialized countries.

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Introduction

The objective of the study of capital structure is to gather knowledge on the mix of securities and other financing sources used by corporations and other business entities to finance their activities. Most of the research on the capital structure has concentrated on the ratio of debt versus equity as has been displayed by the firms in their balance sheets. There are several theories and models developed to be used for these studies. There exists no universal approach to suggest an ideal mix of debt and equity to a firm and it is not worthwhile to expect to have one. This is so because the capital requirements of each firm are unique and are determined by many internal and external factors operating on the firm. However, some theories enable the firms to formulate an idea on the capital structure required. For instance, the ‘tradeoff theory’ explains that the firms will trade off the debt content in the capital structure at levels where the tax advantage of additional borrowings would offset the cost of potential financial distress that may hinder the growth of the firm.

According to the ‘pecking order theory, the firm would prefer to induct additional debt funds instead of raising the equity if the internal cash flows of the company are not sufficient to meet the requirements of the company concerning its proposed capital expenditure plans. The quantum of debt financing, in this case, would thus reflect the need for the external funds to meet the capital expenditure proposals. There is yet another theory the ‘free cash flow theory’ – according to which the value of the firm would go up with the dangerously high level of debt financing despite the potential danger of facing financial distress by the firm. This happens when the operating cash flows of the firm are excessively higher than its investment opportunities in profitable ventures. The free cash flow theory mostly suits matured firms that tend to overinvest.

However, the financing of the firms remains a complex affair and requires consideration of various factors like the tax implications and differences in the information and agency costs. There are wide variations among the competing theories of capital structure in addressing these essential factors in deciding the capital mix. For example, the emphasis is on the tax implications in the case of trade-off theory; on the differences in the information in pecking order theory, and the agency costs in the case of free cash flow theory. In this context, this paper presents a detailed review of the different approaches to the theories of capital structure including the Modigliani and Miller approach. The paper also examines the capital structure of firms in industrialized countries.

Aims and Objectives

The overall aim of this paper is to analyze the different theories describing the capital structure of the firms. To achieve this aim the paper adopts the following objectives.

  1. To make a detailed study of the underlying principles of various theories describing the capital structure of firms
  2. To make a comparative study of the different theories and to compare them with the Modigliani and Miller approach
  3. To examine the capital structure of the major firms in the industrially advanced countries

The rest of the paper for a comprehensive presentation is organized in the following manner.

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Chapter 2 presents a detailed review of the available literature on the different theories on capital structure. Chapter 3 details the research method adopted by the research for the accomplishment of the objectives and chapter 4 presents a discussion on the collection of data and an analysis of the findings from the research. Chapter 5 makes some concluding remarks and a few recommendations for improving the capital structure of firms.

Literature Review

In this chapter, a detailed review of the available literature on the topic of the capital structure of the firms will be presented. The literature reviewed predominantly addresses the different approaches and theories to capital structure. In addition, a discussion on the various factors that affect the capital structure decisions of the firms is also presented.

Introduction

The concept of an optimal capital structure for business firms remains a cornerstone of financial economics theory since the seminal works of Modigliani and Miller (1958; 1963) that focused on tax benefits and other costs of debt. While many aspects of the corporate capital structure puzzle have been filled in, many questions remain Casey, Sumner, and Packer (2006). Many recent attempts have been made by researchers to help explain capital structure decisions made by managers in a variety of industries. Chevalier (1995) examines the relationship between capital structure and product/market competition for grocery stores. Ligon (1997) finds a positive relationship between debt/equity ratios for hospitals and the proportion of revenue generated by fee reimbursement. Staking and Babbel (1995) examine the capital structure decision in the property insurance industry and find managers making decisions in response to balancing tax benefits against the cost of potential financial distress. The preceding research indicates the ongoing interest in the capital structure topic in different industries and the different approaches to understand the decision-making process regarding debt. This makes the issue of capital structure highly important in all organizations.

Tradeoff Theory of Capital Structure

According to the trade-off theory of capital structure, the firm would find it economical to borrow up to the point where the marginal increase in the tax advantage on the interest payments is just equal to the increase in the present value of the potential cost of any financial distress the firm may face. Financial distress denotes the costs that the firm may incur towards bankruptcy or reorganization. It would also cover the agency costs that the firm may have to incur when there is a deterioration in the market credibility of the firm. It is the case that mature corporations usually do not consider the tax advantage they could get from the debt component of the capital structure. Various studies have been consistent in finding that the most successful companies in any given industry do not borrow much. In other words the lower the debt the higher is the profitability. Wald (1999) observed that the profitability of the firms is the one major determinant of the debt portion of the capital structure in many nations across the world. However, the tradeoff theory does not substantiate these findings and it is also not correct to say the managers would not pay attention to the tax advantage part of any financing decision.

Thus the tradeoff theory of optimal capital structure advocates moderate debt ratios. The theory is consistent with the fact that the firms with relatively safe and tangible assets would fund their capital structure with more debts than those companies that possess risky and intangible assets.

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The Pecking Order Theory of Capital Structure

The pecking order theory was propagated by Myers and Majluf (1984) and Myers (1984). The authors while framing the theory took into account the assets-in-pace and the growth opportunities available to the firm that need additional financing. The other assumptions include the existence of a perfect financial market but for the fact that the investors would not be able to assess the current value of the existing assets or the value that the firm could be able to generate out of the new opportunity. It, therefore, follows that the investors may not be in a position to value the securities issued by the firm to finance new capital projects. Based on these assumptions the pecking order theory suggests:

  1. The firms normally go in for internal financing as compared to external financing opportunities
  2. Dividends are considered an unreliable source of cash flow. The theory states that the changes in cash requirements should not be expected to be met out of short-run dividend changes. This implies that any change in the net cash should be met from sources of external finance
  3. If there is a requirement of external funds for capital investment, the firms will use up the safe mode of financing first. The firm would use debt first instead of security. Similarly, the firm would use any extra cash generation first to pay off the debt instead of repurchasing the already issued securities.
  4. Therefore the debt to equity ratio of any firm would largely depend on the firm’s total requirement of external financing.

Debt and the Impact of Taxes

Almost in all jurisdictions of the world, interest is considered a tax-deductible expense. Designing the capital structure with more debt financing instead of equity results in an increased after-tax return for the firm and the investors. This also enhances the value of the firm. However, in the present-day business environment this principle no more holds due to the following reasons:

  1. The tax shield on the interest payments may not always be profitable to the firms. This is doubtful because there is no guarantee that the average future tax rate would be lower than the statutory tax rate.
  2. The debt can not be considered fixed and permanent. It puts the firm and the investors in dark about the future tax shields against the interest payments. Moreover, the borrowing capacity of the firm largely depends on the future profitability of the firm. The firm may be able to enhance the borrowing in case it performs well or it may be forced to repay the debts when the going is not good. Thus the future tax shield against interest payments appears to be risky from the investors’ perspective.
  3. There is a definite tax advantage to the individual investor’s inequity as they can defer the capital gains and then pay the tax at a lower capital gains rate. This advantage will go partially offset the firm-level advantage of tax shield against interest payments.

Modigliani-Miller Propositions on Capital Structure

Another theory that is quite contrasting to the approaches of these theories has been evolved by Modigliani and Miller (1958). They have proved that neither the value of the firm nor the cost or availability of capital is materially impacted by the choice of the firm between debt and equity financing options. The basic assumption of the Modigliani and Miller approach is that there exists a perfect and frictionless capital market in which any deviation from the predicted equilibrium is being taken care of by the innovations of the financial products. There has been a wide acceptance of the theory evolved by Modigliani and Miller.

Various studies conducted on the optimal capital structure start with the proof provided by Modigliani and Miller (1958) (M&M) that in perfect capital markets the financing does not have an impact on the firm value of the cost of capital. There are other propositions of the M&M theory that add up further dimensions to the theory on capital structure. According to M&M proposition 1 value of the firm will remain constant irrespective of the proportions of debt and equity. However, proposition 1 will hold well when the assets and growth opportunities are constant on the left-hand side of the balance sheet of the firm. M&M advocate that the financial leverage represented by the proportion of debt and equity does not matter to influence the value of the firm. For example, the fact that whether the debt is short-term or long-term in nature; whether the debt is callable or call-protected; whether convertible or non-convertible do not has an impact on effecting the firm value. Proposition 1 also affirms that the cost of capital is constant irrespective of the ratio of debt to equity. Proposition 2 says the cost of equity rises with the leverage of the firm because the risk to equity rises with leverage. The M&M approach has been widely accepted as a tool for the help of the regulators and policymakers as an ideal one. Although the approach is exceptionally difficult to test directly, the innovations in the financial service products have provided evidence for the applicability of the principle of M&M relating to the cost of capital. The new financial service products make the firm use them to lower the cost of capital or increase the firm value.

Factors affecting Capital Structure Decisions

The existing large number of literature that addresses the determinants of corporate capital structure fails to deal extensively with the factors of firm-specific and institutional differences across countries that affect the capital structure of the firms. There have been some attempts in the last decade to compare the differences in the capital structure between different countries.

The study by Rajan and Zingales (1995) has found out that apart from the firm-specific factors there are country-specific factors that affect the decisions of the firms concerning the capital structure. The study has examined the capital structure of the firms in seven industrially advanced countries. Demirguc-Kunt and Maksimovic’s (1999) study report that institutional differences between the developed and developing countries are an important determinant in deciding the long-term component of the capital structure of firms. Booth et al (2001) observed that identical firm-specific factors affect the capital structure decisions both in developing and developed countries. Deesomsak et al. (2004) have identified the factors of corporate governance, legal framework, and institutional environment of the country in which the firm operates as some of the factors that affect the leverage decisions of the firms in the respective countries.

The degree of development in the banking sector, and equity and bond markets have been identified to be the other factors that influence the capital structure decisions (Fan et al 2004). Song and Phiippatos (2004) observe that the heterogeneities of the firm, industry and country-specific factors determine the deviations in the capital structure formation. Hall et al (2004) support the view that the country-specific variables largely influence the variations in the capital structure decisions of the firm. A further review of the literature indicates that the capital structure of the forms is usually affected by variables like trade-off considerations, agency consideration, and asymmetry consideration (Booth et al 2001). Other works emphasize the importance of agency costs and financial distress in fixing the proportion of the capital structure of the firms (Jensen and Meckling 1976; Myers 1977; Harris and Raviv 1990; Walsh and Ryan 1997) However, these determinants pose a serious problem for applied researchers in that there are no ways that these theoretical determinants of capital structure are not directly observable.

Conclusion

This completes the review of the literature on the theories and approaches of capital structure of the firms. The economic issues and advantages that form the elements of the theories like taxation, information, and agency costs appear to steer the finance managers to decide the optimal capital structure of the firms. However, it seems that no generalizations of the financing strategy relating to the capital structure of the firms appear to evolve from these competing theories and approaches, as it is unique for every firm.

Research methodology

Introduction

This chapter presents a detailed explanation of the methodology which will be used in conducting this research. This chapter will illustrate to the reader about research methods and the relative merits and demerits. The objective of this research will be achieved using qualitative methods. The research also follows a content analysis research and case study method to accomplish the objectives of the research.

Research Methods

Several methods of collection of data for this research were considered. It was necessary to arrive at a specific method that will be appropriate to attain the objectives of the research; which depended on the subject under study. On an analysis of the relative merits and demerits of both the techniques, it was decided that this research will use a qualitative method to gather the required data.

Qualitative Method

In contrast with the quantitative research method, the qualitative research method ‘does not rely on quantitative measurement and mathematical models, but instead uses logical deductions to decipher gathered data dealing with the human element’. The difficulty in using this research method is ‘that it is more expensive, has smaller sample sizes and is hard to measure’ In qualitative research method non-quantitative’ methods of data collection and analysis is being used (Lofland & Lofland; 1984). Qualitative research method been defined as ‘focuses on “quality” rather than quantity. While some other researchers say Qualitative method involves a subjective methodology and making the researcher as the research instrument (Adler and Adler; d1987)

Content Analysis Research Approach

The method of content research analysis enables the researcher to analyse a large volume of data and systematically evaluate them to find out the relevance and suitability of the various information and data collected during the process of exploratory study. While conducting a detailed research by adopting qualitative method, the researcher is usually provided with a large volume of data which needs to be evaluated by the researcher using his expertise and knowledge in the topic under study. The researcher has to take a clear stand on the research material he is going to use and categorize the information and data according to the degree of importance. While doing this the authenticity and importance of the source need to be considered by the researcher. In fact content analysis is an important step in completing any research.

Data Collection

Marshall and Rossman (1995) points out that the qualitative studies are based on the gathering of data and the findings and recommendations are purely based on the data already collected. Yin (1989) identified several sources that are being used in the qualitative research like archival records, direct observations, interviews, and observation of the participants. Due to the nature of the research the study has been based only on secondary sources of information.

The study relied on the internet search engine of ‘Google’ which gives the researcher the option to use subject matter, phrases, and keywords as an option to find the topic and data that is required to be explored. Other sources used were numerous journals and publications from various sources provided details in explaining and defining different viewpoints on the examination of capital structure.

Case Study

Several research studies have used case study as a research methodology. “Case study is an ideal methodology when a holistic, in-depth investigation is needed” (Feagin, Orum, & Sjoberg, 1991). “Whether the study is experimental or quasi-experimental, the data collection and analysis methods are known to hide some details (Stake, 1995)”. But the case studies on the other hand are capable of bringing out more details from different viewpoints based on a multiple source of data. Different types of case studies have been established to be used in varying circumstances. They are ‘Exploratory, Explanatory, and Descriptive’. Stake, (1995) included three others: Intrinsic – when the researcher has an interest in the case; Instrumental – when the case is used to understand more than what is obvious to the observer; Collective – when a group of cases is studied”. Case study research can not be considered as a sampling research.

Conclusion

This chapter presented a detailed account of the research method and approach that has been followed for conducting this research. It may be observed that the research uses a combination of content research analysis and the case study method to complete the study.

Discussion and Critical Reflections on the Research

Methods

This chapter details the important findings of the research followed by a case study of Edison International which is a case for a high debt company in the United States.

Discussion

The following are some of the findings of this study:

  • The study found that the particular capital structure that maximizes the value of the firm is also the one that provides the most benefit to the shareholders
  • In a world of no taxes, the famous proposition of Modigliani and Miller proves that the value of the firm is unaffected by the debt-to equity ratio. In other words, a firm’s capital structure is a matter of indifference in that world. The authors obtain their results by showing that either a high or low corporate ratio of debt to equity can be offset by homemade leverage. The result hinges on the assumption that individuals can borrow at the same rate as corporations an assumption that can be taken as very plausible. However while the work of M&M can be considered as elegant, it has to be noted that it does not explain the empirical findings on the capital structure very well. M&M imply that the capital structure decision is a matter of indifference, while the decision appears to be a weighty one in the real world. To achieve the real world applicability it is necessary to consider the corporate taxes.
  • The theories of capital structure advise the firms to structure the debt component after due consideration of tax implications. However, the firms normally create debts at a moderate level, the theories have omitted some other factors which is relevant in these decisions. This may be the costs of financial distress. The costs of financial distress normally have a large influence on the actions of the firms in the matter of issuing of corporate debts.
  • According to the pecking order theory, it is usual for the managers to indulge in more of internal financing rather than external financing. This will be the case when external financing is required to finance capital expenditure proposals. Under such circumstances the managers would select the securities which they consider a more safe such as debts. It is normal for the firms to accumulate slack to reduce the proportion of external equity.
  • In the matter of study of the capital structures in the industrially advanced countries, the study though the review of the literature observed that the presence of organized institutions in the industrially advanced countries facilitate the firms to have more sources of long-tern debts
  • The studies have found that the capital structure of the firms are being influenced by more or less identical factors both in the developed and developing countries. There are some theoretical factors the impact of which on the capital structure could not be assessed.
  • Tax-implication on the capital structure of the firm is considered as one of the most important determinant of the debt component.
  • While observing the capital structure of firms, it is important to distinguish between book values and market values. For example suppose a firm buys back its own stock and finances the purchases with a new debt. This would seem to suggest that the firm’s reliance on debt should go up and its reliance on equity should go down. After all, the firm has fewer stock outstanding after the purchase and more debt outstanding. The analysis is more complicated than it appears because the market value of the firm’s remaining shares of stock may go up and offset the effect of the increased debt.

Case Study

Edison International – A Case for High Debt

Edison International is the parent firm of Southern California Edison (SCE) and five non-utility companies. SCE is the nation’s second largest electric utility company in terms of number of customers. SCE operates in a highly regulated environment in which it has an obligation to provide electric service to customers in return for a franchise in Southern California. SCE generated about 90 percent of the operating revenue for Edison. Traditionally long-term debt has been a very prominent part of Edison’s capital structure. Its capital structure in the year 2002 on the basis of the market value is illustrated below:

2002 Million $ Percentage
Debt 14,396 69.9 %
Preferred Stock 1,358 6.6%
Market Value of Stock 4,847 23.5%
Total 20,601 100.0%

The company has grown slowly over the past several years in a regulated, non-competitive environment. The company pays out significant dividends. Most of its assets are tangible in the form of transmission, distribution, and generating systems. The company has considered the debt as a low cost source of funding and the company had significant borrowing capacity with a stable revenue stream, and high quality assets-in-place. For the firm the interest on debt is tax-deductible. Edison International is a mature, mostly regulated firm with cash flow that has not been used to keep leverage low. Instead until the recent past, the company had established a high dividend payout ratio that has given the cash flow back to the investors and kept the leverage high. This behavior is consistent with a target debt ratio and the trade off theory of capital structure. A high percentage of Edison’s assets are tangible and the state regulatory commission reduces the possibility that managers can engage in some of the selfish strategies. As a consequence the financial distress costs have been lower for firms like Edison International than non-regulated firms (Source-Ross, Westerfield, and Jaffe).

Limitations and Reflections

The study relating to the examination of the capital structure in the industrially advanced countries though interesting went rather unwieldy due to the vastness of the topic and subject under study. This has made the study to brush on all the major elements of the topic with the result that there are some important points like signaling theory and agency costs could not be included in the discussion. There were abundance of literature available for review with the result that the study has to limit itself with those resources found earlier and this has eliminated the chances of referring to some really useful research works on the topic.

Conclusions and recommendations

Conclusion

The study has utilized the content research analysis method and case study method to accomplish the objectives of the study. The major contribution of this paper has been the identification of key factors influencing the corporate debt decisions of firms in industrialized countries. While the study considered the various theories to the capital structure, it also described the famous Modigliani and Miller approach to the capital structure theory. The study further discussed the impact of taxation on the proportion of debt in the capital structure. The report has also through the case study indicated that the nature of activities and asset structure of firms have a significant impact on their debt raising capacity. It has been found out of the case study that the nature of the activities has affected the debt raising capacity of the firm. Lastly, this report has also contributed to existing knowledge on capital structures, and has raised further questions for future studies.

Recommendations

The following are few recommendations that would help the firms to have a better debt equity proportion in the capital structure;

  1. The firm should depending on the operating cash flow follow the trade-off theory of capital structure to increase or reduce the debt component. In arriving at the cash flows the firms should take care to consider only the operating cash flows and the payout of dividends
  2. The issue of Initial Public Offering can be considered as one of the important component of equity financing and depending on the existing capital structure this option can be used to alter the financial leverage of the company.

References and bibliography

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Chevalier,-J, A. (1995) Capital Structure and Product Market Competition: An Empirical Study of Supermarket LBO’s American Economic Review; 85,June, pp. 415-435.

Deesomsak, R., Paudyal, K., and Pescetto, G. (2004), “The determinants of capital structure: evidence from the Asia Pacific region”, Journal of Multinational Financial Management 14, 387-405.

Demirguc-Kunt, A. and Maksimovic, V. (1999), “Institutions, financial markets and firm debt maturity”, Journal of Financial Economics 54, 295-336.

Fan, J., Titman, S. and Twite, G. (2004), “An international comparison of capital structure and debt maturity choices”, Working paper. Web.

Hall, G., Hutchinson, P and Michaelas, N. (2004), “Determinants of the capital structures of European SMEs”, Journal of Business Finance and Accounting 31, 711-728.

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Lofland, John and Lyn H. Lofland. (1984). ‘Analyzing Social Settings: A Guide to Qualitative Observation and Analysis’ Belmont, CA: Wadsworth.

Modigliani, Franco and Merton H. Miller (1958) “The Cost of Capital, Corporate Finance, and the Theory of Investment.” American Economic Review June 48:4, pp. 261-97.

Myers, S.C. 1977. Determinants of Corporate Borrowing Journal of Financial Economics 5, 147—175.

Myers, Stewart C. (1984) “The Capital Structure Puzzle.” Journal of Finance July, 39:3, pp. 575-92.

Myers, Stewart C. and Nicholas S. Majluf (1984) “Corporate Financing and Investment De-cisions When Firms Have Information That Investors Do Not Have.” Journal ofFinancia1 Economic 13:2, pp. 187-221.

Rajan, R. and Zingales, L. (1995), “What do we know about capital structure? Some evidence from international data”, Journal of Finance 50, 1421-1460.

Ross A. Stephen, Westerfield W. Randolph, & Jaffe Jeffery ‘Corporate Finance’ Edition VII Tata McGraw Hills Publications New Delhi India.

Song, J. and Philippatos, G. (2004), “Have we resolved some critical issues related to international capital structure? Empirical evidence from the 30 OECD countries”, Working paper, University of Tennessee.

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