Asset Tangibility Of The Firm

Published Date: 02 Nov 2017

Capital structure

In this paper I will talk about the definition of capital structure and some determinants (factor) of capital structure and hypothesis to each determinants to support it .

Definition:-

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage.[citation needed] In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.

Some determinants (factor) of capital structure :

Asset tangibility of the firm (Tangibility)

The size of the firm (size)

Market to book ratio (MB)

Non-debt tax shield (NDTS)

Profitability (Profit)

Tangibility

On the relationship between tangibility and capital structure, theories generally state that tangibility is positively related to leverage. In their pioneering paper on agency cost, ownership and capital structure, Jensen and Meckling (1976) point out that the agency cost of debt exists as the firm may shift to riskier investment after the issuance of debt, and transfer wealth from creditors to shareholders to exploit to the option nature of equity. If a firm’s tangible assets are high, then these assets can be used as collateral, diminishing the lender’s risk of suffering such agency costs of debt. Hence, a high fraction of tangible assets is expected to be associated with high leverage. Also, the value of tangible assets should be higher than intangible assets in case of bankruptcy.

Hypotheses

There is appositive relationship between capital structure and tangibility because tangible assets are easy to collateralise for debt.

Size

A number of authors have suggested that leverage ratios may be related to firm size. Warner [41] and Ang, Chua, and McConnell [I] provide evidence that suggests that direct bankruptcy costs appear to constitute a larger proportion of a firm's value as that value decreases. It is also the case that relatively large firms tend to be more diversified and less prone to bankruptcy. These arguments

suggest that large firms should be more highly leveraged.

The cost of issuing debt and equity securities is also related to firm size. In

particular, small firms pay much more than large firms to issue new equity (see

Smith [34]) and also somewhat more to issue long-term debt. This suggests that

small firms may be more leveraged than large firms and may prefer to borrow

short term (through bank loans) rather than issue long-term debt because of the

lower fixed costs associated with this alternative.

Hypotheses

There is appositive relationship between size of the firm and capital structure , since larger firms have been shown to have

lower bankruptcy risk and relatively lower bankruptcy cost.

Non-Debt Tax Shields

DeAngelo and Masulis [12] present a model of optimal capital structure that incorporates the impact of corporate taxes, personal taxes, and non-debt-related corporate tax shields. They argue that tax deductions for depreciation and investment tax credits are substitutes for the tax benefits of debt financing. As a result, firms with large non-debt tax shields relative to their expected cash flow include less debt in their capital structures.

Indicators of non-debt tax shields include the ratios of investment tax credits over total assets (ITC/TA), depreciation over total assets (D/TA), and a direct estimate of non-debt tax shields over total assets (NDT/TA). The latter measure is calculated from observed federal income tax payments (T), operating income (OI), interest payments (i), and the corporate tax rate during our sample period (48%), using the following equation>

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Hypotheses

There is a negative relationship between Non-Debt Tax Shields NDTS and the capital structure .

Profitability

Myers [27] cites evidence from Donaldson [13] and Brealey and Myers [7] that

suggests that firms prefer raising capital, first from retained earnings, second

from debt, and third from issuing new equity. He suggests that this behavior may

be due to the costs of issuing new equity. These can be the costs discussed in

Myers and Majluf [28] that arise because of asymmetric information, or they can

be transaction costs. In either case, the past profitability of a firm, and hence

the amount of earnings available to be retained, should be an important determinant of its current capital structure.

Hypothesis

There is appositive relationship between profitability and capital structure, when affirm has high capital structure it mean that it has high rate of profitability.

And there is the negative relationship between profitability

and debt.

Market to book ratio :

It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

Hypothesis

I think there is a negative relationship between market to book value ratio and capital structure .

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