External And Internal Determinants Of Capital Structure Finance Essay

External And Internal Determinants Of neat building Finance Essay1 basis1.0 IntroductionThe literature on great building surmise has make of import progress after the disposition setting publications of Modigliani and Miller in1958. After the publication of Modigliani and Miller research work, various researchers prolong developed suppositional models found on the balancing of tax effect and inefficient distribution of information. Recently, at that place be numerous models that focus on the relationship between product and market or the effect of a accompaniment ownership bodily social structure on the with child(p) pay decisions of a substantial (Bhaduri 2002). These models need been developed pertaining to legion(predicate) different sectors of frugality much(prenominal) as manufacturing by Long and Malitz (1985) and Titman and Wessels (1988). Miller and Modigliani (1966) screened these models in the background of power generating and electric companies , while Jensen and Langemeier (1996) have foc manipulationd on the agricultural sign of the zodiacs.Among the noteworthy models proposed by researchers, the tranquil trade off theory carries the primary importance. Modigliani and Miller (1958) contended that the static trade off theory is based on the assumption of friction and information-wise perfect markets. They withal proposed the irrelevance theorem which implies that the backing decisions of devoteds have nothing to do with the value of organisation and their toll of fiscal backing.Titman and Wessels (1988), Rajan and Zingales (1995) and Graham (1996) have conducted their verifiable research to investigate the important determinants of corking letter structure proposed in the theoretical models by finance commentators. In the majority of research, they found that cockeyeds decisions to achieve the mastermind crownwork structure be spontaneous. In the imperfect market, these seat proportionalitys ar not ins tantaneous and uncomplete while in perfect market, these monetary decisions ar perfect and spontaneous. It blind drunks that smasheds try to adjust their optimum great structure spontaneously as the apostrophize of outstanding varies in the market. marshland (1982), Jalilvand and Harris (1984) found that the principal(prenominal) impediments in the way of adjusting keen structure atomic number 18 the adjustments and effect cost associated to market imperfections. These imperfections arise due(p) to the inefficiencies in pecuniary market such asymmetric distribution of information and transaction cost etc.These researchers have found that the unfalterings monetary decisions normally taken in a two step process. Marsh (1982) and Jalilvand and Harris (1984) explained that in the first step, a firm judge its target swell structure and in the succeeding(a) phase, it strives to attain that target. Spies (1974), Taggart (1977), Jalilvand and Harris (1984) and Ozkan (2 001) stated that financial behaviour of a firm can be best depict by the partial adjustment model. In this partial target adjustment model, it is assumed that a firm adjusts to the target capital structure spontaneously.One customary attribute in the research is that the capital structure of a firm varies with the change in effort type. Even after the efforts of numerous researchers, no wizard universally accepted capital structure theory exists. in that respect are also a comparatively atomic topic of empirical researches conducted up till now on this topic. One manageable causality for the small number of empirical research is the intangible and conceptual nature of determinants proposed by the authors (Titman and Wessels 1988). However, the available empirical research has foc wontd on certain factors such as the size of firms profitability and volatility of net forwards engross, tax and depreciations etc. These determinants came bulge out after the studies conducte d in the developed countries such as the coupled States (USA) and the United Kingdom (UK). After the integproportionn of markets, it is be flood tide increasingly more important to study these markets to test the validity of these determinants. Because of the conflicting ideas pertaining to the financial behaviour of firms, it is important to have concrete research based on theoretical foundations to establish a valid capital structure determinant model.1.1 ObjectiveThis research news report will endeavour to determine the factors which serve as an impetuous for ever-changing the capital structure of firms crossways the different industries operating in the United States of the States (USA). The main objective of this research will be achieved investigating the relationship between following determinantsCapital structure and profitabilityCapital structure and tangibilityCapital structure and economic growth of the countryCapital structure and lay out of inflationan both(preno minal) opposite(prenominal) objective is to find and evaluate the extend to of internal forces which feed an important role in changing the capital structure of a firm.Literature Review2.0 IntroductionThis chapter attempts to establish the theoretical foundation of determinants of capital structure. First of all, the effect of different fabrication types on the capital structure has been given. Then the different capital structure theories have been described. After that, all the possible external and internal determinates of capital structure has been discussed. Lastly, the in vogue(p) instruction in the macro and micro environment, which have significant bearing on the capital structure of a film, are discussed2.1 External and Internal Determinants of Capital StructureIn this era of financial distress, where umpteen companies are facing impending failure because of the liquidity crunch and mismanagement of resources, it is imperative for financial managers to use the best mix of debt and equity in coif to drive down the cost of capital and thereby increasing the profitability of their firms.An another(prenominal) impetuous for using optimal mix is that the financial analysts, investment houses, common stock buyers and bond rating bureaus usually compare the financial leverage of a firm with industry second-rate figures before taking investment decisions (Moyer et al. 2009). Hence, it is in the in truth(prenominal) arouse of a firm to decide its optimal capital structure in order to make its financial health more contributory to further investment by yielding handsome retrieves (DeAngelo and Masulis 1980). As per definition, capital structure of a firm is the mix of the total long and short term debt plus the total get of equity (both favourite(a) and common) which is raised by a company to finance its total capital requirements (Investopedia 2009).According to Brigham and Ehrhardt (2001), there are many internal and external factors which a financial manager has to be mindful of before chalking out business plans and policies. Similarly, decisions of capital structure are the outcome of many internal and external variables (Brigham and Ehrhardt 2001). External variables rest of many macroeconomic factors such Gross Domestic Product (gross domestic product), unemployment, inflation, interest rank and tax policies etc (Besley and Brigham 2007). GDP is the accumulated market worth of finished goods and services produced within the boundaries of a country during a contingent period of time, usually one year (Investopedia 2010). Nominal GDP (inflation not adjusted) should not be composite with real GDP (inflation adjusted) as the adjoin in nominal GDP (me swear increase in prices) doesnt mean that country has made more capital during a certain period (Investopedia 2010).Inflation representation the rate of increase in the prices of goods and services all all over a period of time, usually measured by the Consumer scathe Index (CPI) and GDP deflator (a ratio of nominal and real GDP) (Investopedia 2010). just about other important variables of macro economy are the economic growth, budget deficit and poverty. These macroeconomic factors indicate the aggregate economic performance of an economy (Investopedia 2009). As these macroeconomic factors are the result of many sub factors which collectively make a very complex economic system (Campbell, McConnell and Brue 2008). These factors, by nature, are out of the control of a firms manager so he/she cannot influence the determinants. They instead have to adjust the proportion of debt and equity according to their respective costs.Some other important external variables which affect a specific capital structure are the taxation, profitability, the interest expense, the effect of say-so cost and the level of business take chances confront by the company (Moyer, McGuigan and Kretlow 2009). withal these external variables, there are many internal factors which a business manager has to consider before selecting a feature mix of debt and equity. These internal variables can be the industry specific variables such as the effect of seasonal levels of sales or these can be the internal to the firms such as the fashion and position of management. Entrepreneurial organisations, for example, have the tendency of taking bolder and ventureier business decisions as compared to bureaucratic ones which shows more happen-averse behaviour. Among the most prominent internal variables are the level of profitability, degree of risk appetence of business managers and the tangibility of determined assets etc.2.2 Effect of industry type on the capital structure of a firm in that location are a lot of variations in the capital structure of firms across the different industries all over the world (Scott and Martin 1975). Capital structure of firms varies with the change in type of industries and even within the same(p) industries (S. Titman 1984). It is seeming(a) from the Table 1 that the firms which are operating in the drugs and industrial machinery sector do not use a large amount of debt as compared to firms which are in the retail and utilities business (Brigham and Ehrhardt 2001). Some possible reasons are the uncertainties inherent in the research projects carried out by these firms or the chances of product liability police suits (Brigham and Ehrhardt 2001). Due to the low level of debt financing, these firms are also experiencing low level of financial distress (i.e. the multiplication interest earned ratios are richly) as compared to the other sectors as shown in table 1 (Brigham and Ehrhardt 2001).However, the firms which go away to the utilities sector usually rely heavily on debt financing which is evident from their common equity ratio as shown in table 1 (Brigham and Ehrhardt 2001). The major portion of total debt comprises of long term debt which they usually raise by consequence securities and mo rtgage bonds against their huge fixed assets (Brigham and Ehrhardt 2001). Another rational cigaret this phenomenon is the unchanging sales figures as compared to the other firms which have volatile sales (Brigham and Ehrhardt 2001). This factor enables these types of firms to use more debt financing because they can considerably forecast the expected level of future sales and can have an optimal business risk (Brigham and Ehrhardt 2001).2.3 Theoretical Foundations of Capital StructureFranco Modigliani and Merton Miller (famous as MM) (1958) are pioneers, having studied the rival of internal and external determinants on the capital structure of an organisation (cited in Bhaduri 2002). In the days since, there has been a large volume of research by many researchers to determine the individual effect of these environmental factors on the capital structure of a firm in different countries of the world (Al-Najjar and Taylor, 2008). Modigliani and Miller proposed that in a supposed n o-competition world, the value of a firm is independent of its capital structure (cited in Bhaduri, 2002). gain they also assumed that their theory is valid under the assumptions of perfect competition, no taxation cost, not transaction cost. They also stated that the productivity of firms is not dependent on mode of financing (cited in Bhaduri, 2002). In the above mentioned scenario, internally generated sources of funds are almost the perfect substitute of external funds (Bhaduri, 2002). Hence, companies are indifferent to the sources of financing. After the publication of their work, researchers have found some imperfections such as Kim (1978) introduced the idea of bankruptcy cost. The idea of readiness of tax cuticle was introduced by DeAngelo and Masulis (1980) and the agency cost by Jensen and Meckling (1976). All these researchers concord that the optimal capital structure is the most realistic solution to the capital structure dilemma faced by the todays firms. As the co st and benefits of leverage changes from one industry to the other, many previous researchers are of the sentiment that industry must have significant clash on the capital structure of firms (Scott and Martin 1975). Every firm tries to chase the average industry ratios (Tucker and Stoja, 2007). Ang (1976) said that firms can only have an optimal gearing ratio rather an ideal universal ratio for all in the real world scenario. Remmers et al. (1974) agreed with the Ang (1976) by stating the gearing ratio of firms varies with industries. They also said that firms that live to the same industries face same environmental conditions which crown them toward common earning and sales patterns (Remmers, Wright and Beekhuisen 1974). Scott (1972) and Scott and Martin (1975) said that most of the firms tries to choose the gearing ratio that is appropriate to their risk/return profile and their inherent business risks.Antoniou et al. (2002) found that the UK, German and French firms continuou sly adjust their debt ratios according to the target ratio, but at their own rates which is contingent to whether they belong to the manufacturing or services sector. Bradley, Jarrel and Kim (1984) said that the agency cost and bankruptcy cost are just the partial determinants of leverage. It means that these factors also have impact on the capital structure of firm but in a slight likely fashion. galore(postnominal) researchers endeavoured to tackle the recognize of optimal capital structure (Bhaduri 2002). All these works have collectively contributed in the development of financial theory (Bhaduri 2002). In spite of all these efforts, there is no one worldwide solution to the capital structure dilemma (Titman 1984). Moreover there have been very little practical evidence regarding determinants of capital structure till recently (Harris and Raviv 1991).The main reason behind this limited number of empirical research evidence on this topic is the abstract nature of determinant such as size of firms, their growth rates, intensity of capital, gross profits, volatility of future sales and salve cash flows and the impact of taxation on changes in the capital structure of a firm (Harris and Raviv 1991).Another important issue is pertaining to the geographical locations that most of the available research works have foc apply on the United States of America (USA) market (Bhaduri 2002). Less economically developed countries (LEDCs) lag behind due to the neglected role of the mystical sector in the economic development of country and the limited sources of funds for the companies belonging to the LEDCs (Bhaduri 2002).2.4 Main Factors Influencing the Capital Structure of a FirmThe chief determinants of capital structure are the attributes and factors that have very significant impact on the leverage ratio of a firm. The following is the detail of the most relevant determinants of capital structure of a company.Asset StructureAccording to the agency cost and asym metric information theories, the small-arm of tangible assets owned by a company greatly affects its capital structure (Jensen and Solberg 1992). Agency cost theory states that shareholders of a firm, which has high proportion of debt in its capital structure, have the intention to invest sub-optimally (Galai and Masulis 1976 Jensen, Solberg and Zorn 1992). A positive relationship has also been found between the collateralisable assets and debt structure of a firm. Another factor is the over consumption habit of business managers which ultimately funks the value of a firm (Bhaduri 2002).Financial DistressIf a firm is using a huge amount of debt and it has to pay heavy payments periodically, there is very high probability that it will go bankrupt in the case of falling revenues or future free cash flows (Brigham and Ehrhardt 2001). This implies that the firms, which are having volatile sales figures, usually use less debt financing in order to avoid probable financial distress (Ens en and Meckling 1976). Fear of bankruptcy forbade the firms to rely heavily on the debt financing (Bhaduri, 2002).Non-Debt Tax ShieldDeAngelo and Masulis (1980) said that one of the firms objectives of using debt financing, is to avail the benefit of a tax sieve because interest expense reduces the taxable income of a firm. So the firms which have a large non-debt tax shield are likely to use less debt financing.SizeThere are is large number of evidences that the firms which are large in size and well diversified are less likely to experience financial distress (Demsetz and Lehn 1985, Remmers, Wright and Beekhuisen 1974). This encouraged them to use relatively large amount of debt financing (Warner 1977 Ang and McConnell 1982).AgeThe age of firm is also a very pertinent factor that influences the firms decision about having a specific of capital structure (Scott 1972). Young firms are more intended to use debt financing because of the high appetite for risk taking and limited amoun t of information at hand (Scott 1972). So they find borrowing from banks a cheaper and convenient way as compared to use equity financing.GrowthFast growing firms experience a higher cost of agency problem as compared to the firms which not growing very betting. Bhaduri (2002) said that fast growing firms have more chances of adjustments in the coming years. Hence there is a negative coefficient of correlation between the longer term debt and the future growth of a firm. Myers (1977) said that the short term debt is the damages to this problem. By doing this, fast growing firms dont need to enter into long term debt contrast and can easily adjust their capital structure according to the requirements of growth and financial conditions (S. Myers 1977).ProfitabilityIf managers of a company are not capable and credible enough to convince venture capitalists to lend capital, they will preferentially rely on the internal sources of revenue (e.g. retained earnings) (Myers and Majluf 198 4). Myers and Majluf (1984) noted that profitable firms usually have more money as retimed earning in order to invest in the growth projects. Hence there must be negative relationship between debt proportion and historical profitability of the company (Myers and Majluf 1984).UniquenessIt is found that the firms which are producing unique kind of products usually have low leverage ratio (Bhaduri 2002, Antoniou, Guney and Paudyal 2002). These firms face great bar in borrowing debt from the financial institutions because in case of liquidation, their assets cant be used for some other substitute purposes (Auerbach 1985).Industry effectIt is one of the most important variables that affect the capital structure of firms (Harris and Raviv 1991). The companies which belong to those industries where there is greater degree of uncertainty in the research projects and expected future sales, they rely less on debt financing (Remmers, Wright and Beekhuisen 1974). Contrary to this, the firms wh ich have more level of certainty in their future cash flows and huge amount of fixed assets, they intended towards more debt financing (Remmers, Wright and Beekhuisen 1974). Maksimovic and Zechner (1991) said that the diversity of technologies used by firms is also the key determinant of using their capital structure. They argued that the firms which are using multiple technologies have the facility of sourcing capital from various sources of financing (Maksimovic and Zechner 1991). Where these firms can raise their funds from multiple sources, they can also reduce their risk by spreading over the wide range of technologies (Maksimovic and Zechner 1991).2.5 Most Important Capital Structure Theories2.5.1 Static trade-off theoryThis theory of capital structure assumes that company should pursue a financing mix where tax shield advantage should be equal to the interest rate expense, keeping the other factors constant such as credit crunch and probability of bankruptcy costs (Jensen and Meckling 1976). This theory in the main deals with the pros and cons of issuing fixed asset securities like debt (S. Myers 1977). It assumes that there exists an optimal height under which the value of the firm is maximized. This optimal stoppage is achieved by balancing the benefits and cost of issuing more debt (Myers 2001). One of the main advantages of issuing more debt is to take the benefit of tax deductable. This simple benefit can be more complicate when manages and owners have to pay personal tax and the issue of an absence of tax shield (Myers 2001). Debt financing also reduces the chances of agency conflict (Maksimovic and Zechner 1991). The rational is that the use of debt reduces the amount of free cash flows at the disposal of managers and there reducing the chances of conflict between managers and shareholders (Jensen and Meckling 1976).2.5.2 The Trade-Off Theory of Capital StructureThe basic idea behind this theory is that a firm normally conducts the cost-benef its analysis before taking any decision regarding its capital structure (Tucker and Stoja 2007). It means that company will just rule out the possibility of convenience in this important financial aspect as stated by the pecking order theory (Jensen and Meckling 1976). In spite of criticism by Miller (who called it a comparison of horse and rabbit), the advanced dynamic model of this theory is very robust and practical (Tucker and Stoja 2007).2.5.3 Pecking order theoryThe pecking order theory talks about the cost of asymmetric information (Myers and Majluf, 1984). It says that firms choose their sources of financing according to the rule of least(prenominal) effort or least resistance (Myers and Majluf 1984). This implies that the firms will choose the equity financing as a financing mode of finally resort (Myers and Majluf 1984). According to this theory, firms will prefer debt financing as long as it is feasible and when it is no longer possible, then they will opt for equity fi nancing (Myers and Majluf 1984).2.6 Capital Structure and Financial guessThe Financial risk of a firm is the risk associated with a lack of a sufficient amount of future free cash flows in order to meet its short term obligations (Brigham and Ehrhardt 2001). In other words, financial risk also increases as the use of fixed income securities increases like preferred stock increases in the total financing of the firm (Harris and Raviv 1991). Brigham Ehrhardt (2001) asserted that as the amount of debt increases in the overall mix of capital structure, the degree of financial leverage increases. Financial leverage means that the total amount of debt that is used in the capital structure of a firm (Harris and Raviv 1991). Another related concept is that of operating leverage which means that the portion of fixed cost used in the total cost of production of a particular product or range of products (Moyer, McGuigan and Kretlow 2009).Investors are very much concerned about the financial risk of firms because this is the kind of additional risk which they have to bear because of debt financing besides equity, in the firms total capital structure (Brigham and Ehrhardt 2001). It is the main objective before the financial managers to design the capital structure so that the value of the firm is maximized and at the same time mitigate the risk at hand (Harris and Raviv 1991).To gauge the financial risk of a firm, Times Interest Earned (TIE) ratio carries special importance in the eyeball of these investors (Besley and Brigham 2007). Times interest ratio is of immense importance to analyse the true interest cost coverage ability of a firm (Brigham and Ehrhardt 2001). TIE depends upon three important factors the amount of debt in the total capital structure, the cost of debt and the profitability of the firm (Haugen 1995). Usually the industries which are less leveraged such as Drugs and electronics etc. have a very high TIE ratio (Brigham and Ehrhardt 2001). However, t he firms which are in the business of retailing or utilities which rely more on debt financing, have low interest coverage ratios (see table1) (Brigham and Ehrhardt 2001).There are also variations in the capital structure of individual firms operating in the same industry due to the different attitude of managers and their particular risk/return profiles (S. Myers 1977). The firms where mangers are more aggressive and have high risk appetite usually use more debt financing than those firms where managers are risk-averse (Hull 2008).The tools used to find the optimal capital structure are EBIT/EPS Analysis and EPS indifference Analysis (Brigham and Ehrhardt 2001).2.6.1 EBIT/EPS AnalysisEarnings Per Share (EPS) of a firm interpolate with changes in the amount of debt in the capital structure of a firm (Warner 1977). Theoretically, as the amount of debt increases in the capital structure, the financial risk increases (Warner 1977). Because of this high financial risk, investment house s change higher interest rates for the further debt which ultimate increases the cost of capital for a firm (Brigham and Ehrhardt 2001). Surely extra amount of financial leverage increases the capability of a firm to earn higher earnings per share in the coming years (Jensen and Solberg 1992). Brigham Ehrhardt (2001), however, suggested that EBIT/EPS ratio should range from 0 to 5%. To find the exact point in this range, financial managers have to conduct an EPS indifference analysis.2.6.2 EPS indifference analysisThe purpose of this analysis is to find out the point where a firm is insouciant as to whether it uses debt or equity for the same ratio of EPS (Brigham and Ehrhardt 2001). Brigham and Ehrhardt (2001) found that a firm will report higher EPS at a low level of sales and firm is using the more equity than debt. On the other hand, an organization will experience faster increase in EPS with the increase in sales if a firm is using more debt than equity (Brigham and Ehrhardt 2 001). The point worth noting is that if business managers are confident about a certain level of sales of their firm, they should go for debt financing and vice versa (Besley and Brigham 2007).Financial risk of a firm is usually measured by interest coverage ratio, fixed charge coverage ratio and longer debt ratios (Moyer, McGuigan and Kretlow 2009). These ratios are usually compared with industry average ratios to gauge the true financial health of a firm (Moyer, McGuigan and Kretlow 2009). These ratios are also compared to the previous years ratio of the same firm to determine the trend of firms performance over a period of time (Brigham and Ehrhardt 2001). The Financial risk of a firm depends upon a number of factors such as financial leverage, direct leverage, expected future free cash flows and so on.Because of the intense competition and uncertainty in the market, it becomes necessary for the finance executives of companies to manage the risk of their organisations by either diversification, adopting an optimal capital structure, or using the innovative derivative securities (Hull 2008). An optimal capital structure is to arrange the financial structure of the firm in such a way that minimises the weighted-average cost of capital and thereby maximises the value of the firms stock (DeAngelo and Masulis 1980). The dilemma here is that when a firm is trying to maximise its EPS by increasing the amount of debt, its financial risk also increases at the same time (DeAngelo and Masulis 1980). On the other hand, if a firm tries to minimise its financial distress, it has to reduce its financial leverage which ultimately hurts the EPS of the firm (Bhaduri 2002). Hence there arises the need of an optimal financial structure which increases the EPS of a firm and reduces its overall financial distress simultaneously (Bhaduri 2002). This choice of the optimal capital structure depends upon a number of factors such as the size of firm, its growth rate, cash flow pro jections and product and industry characteristics. (Bhaduri 2002).There is a school of thought advocating that derivatives are the most useful tool to hedge financial risks at the firms level (Jalilvand, Tang and Switzer 2000). Yet there is another group who believe that there are some alternative (i.e. using less debt financing) as compared to the typical hedging techniques available which can be used to reduce the financial risk at corporate level (Berkman, Bradbury and Magan 1997). From these studies, it is evident that managing the financial risk of firms is very important for firms in order to be competitive in the market place. Some companies have made internal risk management policies as part of their corporate business strategy (Maksimovic and Zechner 1991). Smith and Stulz (1985) commented on the goal of risk management in these words The primary goal of risk management is to resist the probability of costly lower-tail outcomes those that would cause financial distress or make a company futile to carry out its investment strategy(p. 395).It is clear from the words of Smith and Stulz (1985) that the main goal of companies is to manage risk by either means.During the last decade, there has been a lot of research on the impact of industry in deciding the capital structure of firms (Booth, et al. 2001). Booth et al. (2001) studied whether the factors affecting the capital structure of firms are country specific or not. For this purpose, their study focussed on ten developing countries India, Pakistan, Thailand, Malaysia, Zimbabwe, Mexico, Brazil, Turkey, Jordan and Korea. They reported thatIn general, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates and development of capital market (Booth et al. 2001 p. 118).The institutional owners who hold large amount of shares of a firm also play a very significant role in deciding the capital structure of these firms (Al-Najjar and Taylor 2008). As these owners have the right to elect the board of directors, they can influence the mangers of their firms to adopt specific risk management policies and finance capital in a certain and specific manner (Al-Najjar and Taylor 2008).2.7 Financial market DysfunctionIn developing countries, banks and other financial institutions are main sources that provide liquidity to the economic system by advancing credit to the films (Demsetz and Lehn 1985). In repressed financial system, banks provide short and medium term loans to the young person and established entrepreneurs while fine-looking and developed financial institution provide long term loans to the big corporation (Kester 1986). These loans are mostly given to the particular sectors of national economies such as agriculture and transport and housing (Ant oniou, Guney and Paudyal 2002).Governments used to influence these commercial institutions to favour certain sectors and advance soft credit to the small industry (Leech 1987). Regularity agencies mostly restrict the banks from advancing credit to certain limits (DeAngelo and Masulis 1980). Antoniou, Guney and Paudyal (2002) said that the limitation on the financial institutions by the authorities result in the form of credit rationing. Another hu