Definition and significance of capital structure decisions
Capital structure is exceptionally essential, and its decisions have a vital role in firm financial management. Moradi and Paulet (2019) made a valuable contribution to capital structure decisions. The author stated that most firms used their capital structure to maximize their market value during the Euro crisis. They used the concept of cost minimization to survive in the Euro crisis. Capital structure can minimize a firm’s cost of financing and costs of capital. When they determine the proper mix of finance sources, they can maintain the overall capital costs to the lowest during a recession or financial crisis. The firm’s capital structure depends upon several factors such as trading or leverage on equity, company’s growth, size and nature of business, investors’ requirements, floatation costs for modern securities, and the flexibility of capital structure legal requirements and corporate tax rates. Further, the decision to create a balanced capital structure is essential for the overall health of a firm. Excessive use or overexploitation of any component in the capital mix will not favor the organization. For instance, Li and Islam (2019) stated that an organization could not excessively depend on debts because it is more expensive than equity. Therefore, an ideal capital structure should assist the firm in decreasing the costs of capital, provide needed flexibilities, minimize business-related risks and the firm’s value, and give control to the owner (Li and Islam, 2019). If these assumptions were to hold in all situations, then the decision of whether to finance a company by either equity or debts for sustaining capital structure would perhaps not need to pre-occupy diverse corporate stakeholders, including theoreticians, managers, and shareholders. Kumar et al. (2017) noted that despite the logic of Ramli et al. (2019) results, financing still matters due to factors like agency costs and taxes.
Furthermore, Khémiri and Noubbigh (2018) approached the importance of financial structure decisions using evidence and data from sub-Saharan African organizations. The authors considered variables like economic risks, non-debt tax shield, age, and size of firms, including growth and profitability, that were regressed against leverage. Their results proved that these variables have a negative coefficient of correlation with debts to equity ratio. This implies that capital structure explains the relationship between long-term debts and equity in a firm’s capital. The capital structure explains the debt-to-equity ratio that tells organizations the number of risks associated with the nature of its capital structure. Li and Islam (2019) demonstrated that a firm could also increase its profit in the form of higher return to equity shareholders through a sound capital structure. It is undeniable because they can increase earnings per share by trading on equity and increasing the proportion of debt capital in the capital structure, which provides the cheapest form of money.
Theories of Capital Structure
The theories of the pecking order, trade-off, and signaling are well presented. There are sentential studies on the capital structure determinants based on each approach, which are again founded on diverse research results of numerous researchers. Capital structure theories were initiated by Modigliani and Miller (1958). The authors hypothesized that when an organization has no taxes, the current market will be more efficient. The value of a company does not rely on the number of debts taken by the organization. Modigliani and Miller’s (1958) theories have been broadened by Moradi and Paulet (2019). The proposed that organizations depend on internal funds at the start of the business.
Pecking order theory
This theory was initially proposed by Donaldson (1961), who concluded that organizations prefer to finance investments using retained earnings rather than external finances, regardless of the firm’s size. Khémiri and Noubbigh (2018) expanded Donaldson’s (1961) idea on their research. According to Khémiri and Noubbigh (2018), pecking theory assumes there is no optimal debt-equity ratios. A firm utilizes all available internal funds before choosing external finances, especially external equity, to avoid dilutions of control of the firm. Moradi and Paulet’s (2019) empirical analysis of organizations during the Euro crisis suggested that more profitable companies that stood had higher target debt ratios. It means higher profitability companies lowered the probability of bankruptcy, higher taxes savings from debts, and higher overinvestments. Li and Islam (2019) stressed that trade-offs between bankruptcy costs and tax advantages of borrowing influence the optimal debt ratio of a company. However, these effects can be insignificant due to a non-debt tax shield.
Pecking theory has no target debt ratio, whereas trade-off theory defines an optimal capital existence structure. Ramli et al. (2019) argued that an optimal capital structure is identified by substituting equity for debts and vise versa until the firm maximizes its values. Organizations usually set a target debts ratio and shift towards attaining it. While pecking order theory does not consider the target debt ratio, the trade-off theory implies that more profitable companies have higher target debts ratios. They usually ensure a lower probability of bankruptcy (Moradi and Paulet, 2019). Additionally, Li and Islam (2019) popularize the dynamics of trade-off theory. The author stated that the approach deviates debt ratio from targets in situations where costs of adjusting debts ratios are higher compared to the cost of maintaining a sub-optimal capital structure. Moradi and Paulet (2019) developed a hypothesis that determined the negative relationship between leverage and profitability, explaining the trade-off theory. It is because organizations reflexively accumulate losses and profits and allow debt ratio to deviate from the target
Li and Islam (2019) illustrated that signaling theory determines the optimal capital structure, and choices of leverage ratios are significant factors in determining a firm’s financial system. I agree with the authors’ argument because the signal theory was created based on the perspective that the capital structure of an organization signal information from the company to outside investors. Signaling theory assumes that, unlike an outsider, an insider, like a general manager, understands the company’s state. Thus, they prefer equity over debts because excessive usage of debts may cause job loss if the firm becomes insolvent or goes into liquidation. Khémiri and Noubbigh (2018) studied the impact of signaling theory in small firms in sub-Saharan African nations and that it had little effect on small organizations. Small firms are not publicly listed on a stock exchange and cannot quickly signal information to investors in the modern capital market. However, it still provides asymmetric information between investors and owner-manager, which drives the signaling game where the number of debts and timing of new concerns are perceived as signs of organizational performance (Khémiri and Noubbigh, 2018). Despite an in-depth discussion of capital structure theories and their significance on the firm’s capital structure, some research highlighted different findings. For instance, Khémiri and Noubbigh (2018) found that signaling theory appeared to be unimportant in determining leverage.
Empirical results from the literature concerning different determinants of capital structure
Through a review of the identified studies on determinants of capital structure, this section summarizes four main determinants based on signaling theory pecking-order and trade-off theories of capital structure. They entail profitability, firm size, and growth opportunities.
The pecking-order theory suggested by Khémiri and Noubbigh (2018) implies that a firm that needs to raise capital prefers to choose internal financing and then advance to external funding. They start by issuing debts and new money in the final stages. This means that profitable organizations have more internal finances to support the process and lower debt ratios to minimize leverage. Moradi and Paulet (2019) argue that creditors prefer to offer loans to high cash flow organizations in their empirical analysis. The proxies for profitability are operating incomes scaled by all assets. Li and Islam (2019) investigated the Australian market and found significant negative associations between leverage and profitability in the modern market. This evidence is consistent with the predictions of the pecking order theory.
Size of the firm
Khémiri and Noubbigh (2018) suggest that the leverage ratio relates to firm size. They argued that large firms are more diversified and fail or close less often. The size implies an inverse proxy for bankruptcy profitability. Li and Islam (2019) also stated that the direct cost of bankruptcy reduces with firm size. The size of a company is also linked costs of issuing equity and debts securities.
The potential growth of organizations influences their capital structure of preference. Kumar et al. (2017) highlight that the possibility of shareholders undertaking an action is severe for companies with valuable future investment chances. It will not be easy for such organizations to borrow funds. A growing firm finds it challenging to take debts. Growth changes also imply conflicts between equity and debts interest. The prediction is based on trade-off theory. Li and Islam (2019) supported this concept by finding empirical evidence on the negative association between leverage and growth opportunities. However, short-term debts have positive relationships with growth opportunities, while long-term obligations have an inverse relationship. The signaling theory illustrated by Li and Islam (2019) explains that high-value organizations can use more debts financing since debts have their dead-weight cost, making it less valuable for the firms to fall to bankruptcy.
Moradi, A., & Paulet, E. (2019). The firm-specific determinants of capital structure–An empirical analysis of firms before and during the Euro Crisis. Research in International Business and Finance, 47, 150-161.
Khémiri, W., & Noubbigh, H. (2018). Determinants of capital structure: Evidence from sub-Saharan African firms. The Quarterly Review of Economics and Finance, 70, 150-159.
Kumar, S., Colombage, S., & Rao, P. (2017). Research on capital structure determinants: a review and future directions. International Journal of Managerial Finance.
Li, L., & Islam, S. Z. (2019). Firm and industry specific determinants of capital structure: Evidence from the Australian market. International Review of Economics & Finance, 59, 425-437.
Ramli, N. A., Latan, H., & Solovida, G. T. (2019). Determinants of capital structure and firm financial performance—A PLS-SEM approach: Evidence from Malaysia and Indonesia. The Quarterly Review of Economics and Finance, 71, 148-160.