Capital Structure Theories Of Capital Structure

Published Date: 02 Nov 2017

Introduction

The review of literature is in three main parts: the theoretical review, empirical review and conceptual framework. The theoretical review presents perspectives on propositions and ideas of some earlier researchers, authors and educators on the theories of capital structure and financial performance measures. The research methodology, findings and recommendations of some researchers in relation to capital structure and financial performance are reviewed under the empirical review. Apart from these two main sections, the section also deals with a conceptual perspective of the researcher. This is where the researcher tries to narrow down the theories reviewed and develops a framework of which it is intended to be met after the research.

For the purpose of the empirical review, four main related literatures in Ghana have been reviewed. These include the works carried out by Abor (2005) on the profitability of listed firms in Ghana; Abor and Biekpe’s (2005) on what determines the capital structure of Ghanaian firms; Amidu’s (2007) determinants of capital structure of banks in Ghana and Gatsi and Akoto’s (2010) on capital structure and profitability of banks in Ghana. In addition to these article other articles that relate to the insurance industry such as the determinants of performance in the life insurance sector of Pakistan by Naveed, Zulfqar and Usman (2011), determinants of capital structure in the Life Insurance Sector of Pakistan by Naveed, Zulfqar and Usman (2010) and other literature that directly relate to the subject matter but are carried out in selected developed countries.

Theoretical review

The theoretical review delves predominantly on the definitions provided by writers on capital structure, theories of capital structure and financial performance.

The concept capital structure

The term capital structure is a widely known terms in the finance world, many scholars have given their own version in terms of definitions since the earlier work of Modigliani and Miller (1958). Some of these definitions are reviewed below;

Capital structure is the specific mix of debt and equity that a firm uses to finance its operations (Abor, 2005). This brief definition lends its self for review considering the fact that it emphasis on specific proportion of debt and equity used for financing organisations. Abor (2005), then added that, the concept is actually a mixture of different securities and that a firm can choose among many alternative sources of capital such as the issue of large amount of debt or very little debt; arrangement of lease financing; use warrants; issue convertible bonds; sign forward contracts or trade bond swaps; and issue of dozens of distinct securities in countless combinations. In summary, the definition provided by Abor (2005) did not consider the fact that the sources of capital could occur from time horizons.

In relations to the definition provided by Abor, (2005), Naveed, Zulfquar and Ishfad (2010), recognised the draw backs and defined the capital structure concept as the relationship between the various forms of finance thus long term and short term making mention of debentures, bonds, bank and trade credits, commercial papers, preference share capital and equity capital. The writers further added that, the term then signifies the relationship between equity and debt capital that are ascertain in a target proportion to attain the objectives of the firm. Neveed et al (2010) provided a clear understanding of the concept but they did not clearly explain the proportion preposition of the capital structure concept.

Hence, Ross, Westerfield, Jeff and Jordan, (2011) provided a definition which relates to the proportion prepositions by defining the term as the proportion of a firms finance from current liabilities, long – term debt and equity. Ross et al, (2011) also indicated that capital Structure is a firm’s choice of how much debt it should have relative to equity and presented the pie model which considered the value of the firm finance as a pie which can be divided among the various providers of funds. Ross et al (2011) further indicated that such a choice is a strategic one which has many implications for the firm for that matter capital structure should be a matter of policy by the directors in order to serve the ultimate interest of the shareholder and other stakeholders of the company.

To add to literature on the subject matter, Saad (2010) as cited in Abu-Rub (2012), opined that capital structure basically mean the manner in which a firm finance its assets through the combination of equity, debt, or hybrid of securities. The researcher views this definition as a contemporary one which has not just highlighted the proportion issue but has also added a new dimension of a hybrid security been part of the fray. Abu-Rub (2012) therefore indicated that the firm can issue different securities in countless combinations but it attempts to find the particular combination that maximizes market value and will also lend itself to a lower cost.

From the plethora of definitions, the researcher considers capital structure from a triangular perspective to mean a situation where it consist of the proportion of finance the company receives from both short and long term debt, equity and hybrid capital.

Theories of capital structure

Several theories have been developed to analyse alternative capital structure and explained by academic scholars and researchers in corporate finance. These include the irrelevance optimal capital theory of (Modigliani and Miller 1958). This has come to stay as the "M& M theory" and also the static trade off theory.

The trade off theory suggests that there are optimal capital structures by trading off the benefits and cost of debt and equity. The main benefit of debt is tax deductibility of interest and the costs are bankruptcy cost (Kim, 1978) and agency cost (Jesen and Meckling, 1976; Myers, 1977). However, recent studies have shown a focus shift from the trade off theory to pecking order theory (Quan, 2002; Mazur, 2007) hence the necessity of reviewing other theories as the pecking order theory, asymmetric information; tax benefits associated with debt use; bankruptcy cost; agency cost; market timing theory and signalling theory. All the above theories have been reviewed below for the purpose of this study.

Irrelevance Modigliani and Miller Theory (M &M Theory)

Modigliani and Miller (1958) cannot be left out when the discussion of capital structure is in force. In corporate finance literature, these two scholars are credited as the originators of the capital structure theories. In their contribution to theories on capital structure, they came out with two main propositions namely M and M proposition I and M and M proposition II.

M and M proposition I

The first preposition put forward by Modigliani and Miller (1958), states that a firms cost of capital which is represented by weighted average cost of capital remains stable at all levels of leverage, the import of this is that, there is no optimal capital structure for a particular company and for that matter an industry. Their notion was that, it is completely irrelevant how a firm chooses to arrange its finance. In other words, the value of the firm is independent of its capital structure. In drawing this conclusion, the following assumptions were made;

An individual can borrow at the same rate and conditions as corporations, such that if individuals can borrow at a higher rate, one can easily show that corporations can increase firm value by borrowing.

Secondly that the capital markets were perfect, this assumption was central to means that, bankruptcy risk could be ignored so that distressed companies could always raise additional finance in a perfect market. The notion of the perfect capital market is also defined by; the stocks of different companies are homogenous and there can serve as perfect substitute, Investors are in a consensus about the expected future returns for all shares and all securities are traded under perfect market conditions

In sum according to the theory the way in which a firm arrange its assets can have no impact on the value of the firm. The value of a firm is derived from the net present value of investments the firm has committed its current resources into.

M & M proposition II

Modigliani and Miller (1963) amended their model in their second paper and the result was the proposition II. The amendment according to Watson and Head (2010) was done in relation to their acknowledgement of the existence of corporate tax and the tax deductibility of interest payment. This means that as the firm increases its leverage, by replacing equity with debt, it shields more and more of its profits from tax. However they indicated that, although varying capital structure of the firm may not change the firms’ total value; it does cause important changes in the firms’ debt and equity.

M&M II demonstrated that, as the firm raises its gearing proportion, the increase in leverage raises the risk of the equity and therefore the required return, or cost of equity (KE). Modigliani and Miller (1963), Proposition II indicated that the cost of equity depends on three things: the required rate of return on the firm’s assets; the firm’s cost of debts and the firm’s debt-equity ratio.

Modigliani and Miller (1963), proposition II therefore states that, a firm’s cost of equity capital has a positive linear relationship with its capital structure. Modigliani and Miller therefore concluded from figure 4 that the cost of capital or the required rate of return on the firm’s assets (KA) does not depend on the debt-equity ratio; it is the same no matter what the debt-equity ratio is. The import of this is that the firm’s overall cost of capital is unaffected by its capital structure.

Hence, the fact that the cost of debt is lower than the cost of equity means that, the benefit of cheaper debt capital is exactly offset by the increase in the cost of equity from borrowing as a result of the increment in financial risk exposed to the equity holders of the company. In other words, the change in the weight of debts and equity in the capital structure of a particular firm is exactly offset by the change in the cost of equity (RE), so the cost of capital of the company stays the same.

Gatsi and Akoto (2010) recognised that, the fundamental theoretical model of capital structure centres on some key assumptions which include; the idea that firms have information that investors do not have, and that the interest of managers, equity – holders and debt holders may not coincide. The writers also found that though the theories have also recognized the benefits of financial leverage in firm financing while avoiding friction and bankruptcy costs of financial distress arises the need to review friction and bankruptcy cost.

Modigliani and Miller having proved the irrelevance theory of capital structure, has left the finance world into what the researcher can describe as the capital structure puzzle since the arguments put forward by other scholars on the relevancy of the term has been found to be the reality after proving that the assumptions put forward by those great scholars does not hold in the real world. It is in the face of this that, other theories have also sprung in corporate finance over the years.

These recognitions have led to two dominating theoretical models, namely the Static Trade – Off model and the pecking order theory. Enshrined in these two models are additional ones but the study considers six other theories that explain the capital structure decisions. These models are based on asymmetric information, tax benefits associated with debt use, bankruptcy cost, agency cost, market timing theory and signalling theory (Naveed et al ,2011). The information asymmetry, market timing theory and signalling theory, as noted by Abu -Rub (2012), are rooted in the pecking order theory frame work, while bankruptcy cost, agency cost, and the benefits of tax savings can be considered in terms of the static trade – off choice.

Agency cost

Jensen and Meckling (1976) identified the existence of an agency relationship which emanated from the principal – agency relationship in an organisation. This result from the nexus of contracts that exist between the following; shareholder – managers’ relationship, debt holders- shareholders relationship, managers – employee relationship and debt holders – managers relationship. They assumed that there could be an agency problem between these parties as the agent might not work in the optimum interest of the principal.

Harris and Raviv (1990) stated that the conflict between shareholders and managers arises because managers hold less than 100% of the residual claim. As a result, they do not capture the entire gain from their profit enhancing activities but they do bear the entire cost of these activities. So for this problem to be rectified, there arises the need to implement policies that will ensure that the interest of the principal are ultimately adhered to and as a result the cost involved in these policy implementation are referred to as the agency cost.

According Chen, Jung and Chen (2010) the agency cost arises as a result of the relationships between shareholders and managers, and those between debt – holders and shareholders. Jensen and Meckling (1976) proposed that there are two kinds of agency costs - agency costs of equity and that of debt. The conflicts between managers and shareholders leads to agency costs of equity, and the conflicts between shareholders and debt-holders leads to agency costs of debt.

Usually, managers are interested in accomplishing their own targets mostly as a result of greed which may differ from the ultimate goal of shareholders maximisation. The owners may try to monitor and control the managers’ actions and decisions. These monitoring and control actions results in agency costs of equity. When a lender provides money to a firm, the interest rate is based on the risk of the firm. Manager may tempt to transfer value from creditors to shareholders (Watson and Head 2010). These monitoring and control actions results in agency cost of debt

As already noted, conflict usually occurs when the agent decides not to maximize the principals’ wealth. The whole concept is about separation of ownership and control. This may result in managers exerting insufficient work, indulging in perquisites, and choosing inputs and outputs that suit their own preferences. Another issue is that managers may invest in projects that reduce the value of the firm but enhance their control over its resources and also increase short term focused profitability of the firm without considering the long term survival of the companies.

Harris and Raviv (1990) noted that there may be a situation where all efforts by the owners to liquidate the firm may be voted against by the directors with the reassurance of a future for the company and thus indicated that managers have an incentive to continue a firm’s current operations even if shareholders prefer liquidation. Abor (2008), supported the idea and indicated an instance where it may be optimal for the investors to liquidate the firm and managers may choose to continue operations to enhance their position. Abor (2008) further stated that the conflict between debt-holders and shareholders is due to moral hazard.

Chittenden, Hall and Hutchinson (1996), opined that agency theory suggests that information asymmetry and moral hazard will be greater for smaller firms. Jenson and Meckling (1976) however noted that the conflict between debt- holders and equity – holders arises because debt control gives equity – holders’ incentive to invest sub optimally. According to Abor (2008), in the event of an investment yielding large returns, equity – holders receive the majority of the benefits. He further indicated that in the case of the investment failing, because of limited liability, debt-holders bear the majority of the consequences.

The agency problems associated with information asymmetry, managerial risk incentives and forgone growth opportunities can be resolved by means of the maturity structure and call provision of debt (Barnea, Haugen and Snebet, 1980). They further pointed out that, shortening the maturity structure of the debt and the ability to call the bond before the expiration date can help reduce the agency costs of underinvestment and risk-shifting. They also demonstrated that both features of the corporate debt serve identical purposes in solving agency problems.

Abor (2008) argued that the agency costs of debt can be resolved by the entire structure of the financial claim. As a result, to effectively reduce agency problems, there is a need to change the capital structure of the firm. Bernea et al (1980) also contend that this provision would inevitably allow debts to be withdrawn between their maturity, an act which is capable of changing the capital structure of the firm by reducing the debt levels and reducing the agency costs.

From the above discussion, it can be concluded that firms with higher agency costs due to conflict between the firm and the debt-holders should have lower levels of debt in their capital structure to maximize the wealth of the shareholder. That is to say, to be able to entirely minimise the agency problems, there arises the need to entirely change the capital structure of the firm. This according to Arshadi (1989) can be done by sending a binding signal to debt- holders by incorporating call provisions into the debt contracts among others. Bernea et al (1980) were in consensus with Arhadi (1989) that, this provision would inevitably make way for debt to be withdrawn before their maturity, an act which is capable of changing the capital structure of the firm through the reduction of agency cost as well as debt levels.

Information asymmetry cost

Jensen and Meckling (1976), did not lose focus of the fact that, information asymmetry is a cause of the agency problem, in view of this, Klein, O’Brien and Peter (2002) indicated that in corporate finance, information asymmetry refers to the idea that insiders of a firm, for example managers have superior knowledge than other market participants on the value of their firms’ assets and investment opportunities. Information asymmetry usually creates an avenue for market participants to price firms’ claims incorrectly, thus providing a positive rate for corporate financing decisions.

Myers (1984) and Myers and Majluf (1984) also contend that the concept of optimal capital structure is based on the notion of asymmetric information. Abor (2008) explained that the existence of information asymmetries between the firm and the firms finance providers causes the relative costs of finance to vary among different sources of finance.

In that regard, Myers and Majluf (1984) further opined that an internal source of finance thus where funds provider is the firm or funds are internally generated by the companies, will have more information about the firm than new equity holders, thus these new equity holders will expect a higher rate of returns on their investments. This means it will cost the firm more to issue fresh equity shares than to use internal funds. Similarly, this argument could be provided between internal finance and new debt holders.

Gatsi and Akoto (2010) also added that the presence of this information gap between managers and investors has led to the formulation of two distinct but related theories of financial decisions, namely: market timing theory and signally theory. These are reviewed and discussed within the "pecking order" model.

The pecking order theory

The theory as cited in Watson and Head (2010), Donaldson (1961) came against the idea of companies having a unique combination of debt and equity finance which can minimise its cost of capital but explains how a firms can use internally generated funds to initially finance their operations instead of external borrowings. The initial explanation of the theory according to the writers, involves issue costs and the ease with which source of finance are accessed.

Myers and Majluf (1984) noted that according to the pecking order theory firms do not have a well defined target debt to equity ratio and each firm’s observed debt ratio simply reflects the firm’s cumulative requirement for external finance over an extended period. In a related literature, Gatsi and Akoto (2010) stating their opinion on the model, argued that raising external finance is costly because insiders have more information about the firms’ prospects than outside investors, and outside investors know this and would thus demand higher returns on their investments. Hence from the point of view of outside investors, equity is riskier than debt and therefore demands a higher result premium for equity than for debt. Thus, insiders perceive debt to be a better source of funding than equity, and internal funding is even better.

Titman and Wessels (1988), discovered that transaction cost may be a significant determinant of capital structure choice; this reflected in the short term debt ratios which are negatively related to firm size. This view was supported by Leary and Roberts (2010), were of the view that although the fundamental basis of the pecking order theory is on adverse selection, based on information asymmetry, it is not necessary for information asymmetry to exist for a financing hierarchy to arise, other factors such as the expensive of issuing various classes of securities and incentive conflicts can create their own order for capital.

Myers and Majluf (1984) therefore opined that firms prefer retained earnings to debt and would only issue equity as a last resort. Abor (2008) supported this by saying that debt financing will only be used when there is an inadequate amount of internal funding available, and equity will only be used as a last resort. However, Ryen et al,(1997) were of the opinion that even if pecking order exists, companies may at times choose to ignore it in order to maintain a spare debt capacity or to retain internal funding in favour of debt if they believe that it will be required to fund attractive future investment opportunities.

In support of this Zenner (2005) stated that the reason that companies may choose to maintain spare debt capacity is to maintain their credit rating since it can take several years to recover from a downgrade. Retain internal funding in favour of debt improves the company’s ability to withstand a period of poor performance and allows it to execute a recovery plan

Implications of the pecking order theory

Barclay and Smith (2005) indicated that companies that identify small investment opportunities and substantial free cash flow will have low (or even negative) debt ratios because the cash will be used to pay down the debt. It therefore suggests that firms with high-growth prospects with lower operating cash flow will have high debt ratios because of their reluctance to raise new equity. It should be emphasised that where information asymmetry does not clearly manifests itself, the firm will then turn to debt if additional funds are needed, and eventually issue equity to cover any remaining capital requirements. It is clear at this point that, firms would prefer internal sources to costly external finance.

Thus, import of the pecking order theory is that, firms that are profitable and therefore generate high earnings are expected to use less debt capital than those that do not generate high earnings.

The static trade-off theory

Frydenberg (2004) explained that, the theory shows how a firm’s optimal debt ratio is determined by a trade-off between the benefits and obligations of borrowing, holding the firm’s assets and investment plans constant. The firm can use debt in place of equity, or equity for debt until the firm ultimately maximised the value of the firm. The benefit of debt according to Frydenberg (2004) is primarily the tax-shield effect, which emanates from the fact that interest on debt is deductible on the profit and loss account.

The costs of debt is directly and indirectly associated to bankruptcy costs such that as the firm increase it’s gearing level the inability to pay the obligations attached to the debt also increases enhancing the probability of bankruptcy of firm. In the more general trade - off theory several other arguments are used for why firms might try to adjust their capital structure to some target. Leverage also depends on restrictive covenants in the debt-contracts, takeover possibilities and the reputation of management. In view of this, Harris and Raviv (1990) proposed a negative correlation between debt and monitoring costs.

The theory according to Ross et al (2011), states that firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased profitability of financial distress. Ross et al (2011) further noted that the static theory is called static theory because it assumes that the firm is fixed in terms of its assets and operations and it only considers possible chances in the debt – equity ratio. They also stated that the model is not capable of identifying a precise optimal capital structure, but it does point out two of the more relevant factors, namely taxes and financial distress.

The trade off theory indicates the exposure of the firm to bankruptcy and agency cost against tax benefits associated with debt use. Bankruptcy cost is a cost directly incurred when the perceived probability that the firm will default on financing is greater than zero. One of the bankruptcy costs is liquidation cost, which represents the loss of value as a result of liquidating the net assets of the firm. Another bankruptcy cost is distress cost, which is the cost a firm incurs if stakeholders believe that the firm will discontinue.

The static trade – off theory has been critised by many authors, including Miller (1977), who argued that the static trade – off model implies that firms should be highly leveraged than they really are, as the tax savings of debt seem large while the costs of financial distress seem minor.

Implications of the static trade-off theory

The tax benefit from leverage include; the fact that debt is a factor of the ownership structure that disciplines manager; debt is a useful signalling tool that is used to inform the investors about a message of the firms level of excellence and Debt also reduces the excessive consumption of perquisites because creditors demand annual payments on the outstanding loans (Naveed et al 2011).

Debt from the static trade-off model, therefore, implies that debt is obviously important to the firms that are in a tax – paying position (Abor 2008). Because of this, firms with substantial accumulated losses will get less value from the interest tax shield (Abu- Rub 2012). Again, firms that have a sizeable amount of tax shields from other sources, such as depreciation, will get less benefit from leverage (Ross et al, 2011). It should further be noted that not all firms have the same tax rate. The higher the tax rate the greater the incentive to borrow (Ross et al, 2011).

The static trade-off model also implies that firms with a greater risk of experiencing financial distress will borrow less than firms with a lower risk of financial distress. For example, all things being equal the greater the volatility in earnings before interest and tax, the less a firm should borrow. It should also be noted that financial distress is more costly for some firms than for others. The cost of financial distress depends primarily on the firm’s assets. In particular, financial distress costs will be determined by how easily ownership of those assets can be transferred.

Market timing theory

The market timing theory states that if managers critically observe the funds market and take advantage of the information gap, they would only issue new shares when they believe those shares are overvalued by investors. Abor and Amidu (2007) further explain that pertinent problems within the firm may not be known immediately to outside investors unless the market is in the strong form market hypothesis or else would not reflect in the share prices of the companies. This assumption is true because in the real world, capital market is not efficient.

As a result, companies that have profitable uses for more capital but believe their shares are undervalued will generally choose to issue debt rather than equity to avoid diluting the value of existing shareholders claim (Barclay and Smith 2005). Myers (1984), Myers and Majluf (1984), also indicated that in the real world efficient firms will always use the cheapest source of funding to influence their operations. This is based on the assumption that managers would act in accordance to the objective of the firm from the finance perspective of maximising the wealth of the shareholders.

Gatsi and Akoto (2010) stating their stand on the performance of the firm, emphasised that investors are well aware of the future prospects of the firm than mangers and they also understand management’s motivation to issue overpriced shares and to avoid issuing undervalued ones. As a result, the shares issued may be relatively expensive all things being equal, and manages would reasonably avoid them and rather use internally generated funds. Thus, by choosing the timing of new share, managers have the advantage of controlling to some level the informational disadvantage of the market.

Most authors have suggested that firms should issue shares to invest in growth opportunities to avoid the cost of financial distress some of which include but not limited to (Lucas and McDonald, 1990) and (Korajezyk, Lucas and McDonald, 1992). Hence the declaration by other literature that astute manager would prefer to use internally generated funds rather than issuing new shares. The same notion, according to them would also inform debt – holders to demand higher returns in these investments to pay-off. As a result, internally generated funds become a cheaper source of funding companies’ debt.

Therefore, the reason to recognise the necessity to note that firms may not necessarily issue new equity as they believed it is overvalued or use internal funds because their existing shares are undervalued. Hence it explains why information asymmetry can be costly to firms as investors may misinterpret manager behaviour and charge them unfairly.

From the fore – going discussion it evident and provides validity for a conclusion that firms can optimized it’s worth by gradually choosing to finance new investments with the cheapest available source of funds. It can also be recognised that managers would prefer internally generated funds or retain earnings to external fund and, if outside funds are needed, they prefer debt to equity because of the lower information costs associated with debt issues.

Signalling theory

The signalling theory is based on the conception that managers have more superior information than outside investors when it comes to the financial performance and non financial performance of the firm, and would thus send some form of message through this potential information to investors by increasing leverage. Barclay and Smith (2005) in a contrast view to the market timing theory mentioned that, securities often are seen as an attempt to raise capital with the minimum cost, the signalling model assumes that financing decisions are designed basically to convey future prospects to outside investors. This is usually done to raise the value of shares when managers think they are undervalued.

Gatsi (2012), argued that debt obligates firms to make a fixed cash payment to debt-holders over the term of the debt security. They also mentioned that firms could be forced into bankruptcy and liquidity, if they default in honouring their debt obligations, and would ultimately affect the managers as they could lose their jobs. Managers may be aware of this and do everything possible to maintain their positions, all things being equal.

Barclay and Smith (2005) contend that, dividend payments are not obligatory and managers have more judgment over their payments and can omit them in times of financial difficulty. Ross et al (2011) indicated that adding more debt to the company’s capital structure can show as a credible signal of higher expected future cash flows as it shows that the firm has a credible reputation been able to redeem their credit responsibilities on time. In view of this, increasing gearing has been suggested one of the potentially effective signalling tools.

Two other signalling models are described by Heinkel in 1982 and Blazenko in 1987. The Heinkel model is focused on debt signalling information to the investors about the average and variability of the returns. In that model he assumed that positive relationship between the average and the degree of variability facilitates signalling equilibrium in which higher value firms signals their quality with higher debt levels while the Blazenko model observes that managers that are prone to the mean variance criterion would shift risky positive net present value investments opportunities thus reducing the value of the firm.

From the fore-going discussion, it evident that higher – value firms would use more debt in their capital structure to signal this value relative to their low – value counterpart and this is based on the premise that inefficient firms cannot manage debt and any attempt to use more debt would jeopardize the financial health of the firm due to bankruptcy and its associated costs.

Capital structure and the issue of tax benefits

Capital structure of the firm can also be explained in terms of the tax benefits associated with the use of debt, since debt from one of the components of the capital of a firm. Tax can generally be said to be a payment to support the government in undertaking of the developmental activities of the company or it can also be seen as a compulsory payment from households and firms to government to enable government to finance its projects and programmes because of this, tax policy usually have significant effect on the capital requirements decisions of firms. According to Ross et al (2011) the benefits associated with tax is called tax shield.

Modigliani and Miller (1963) explained that, corporate tax laws allow firms to deduct interest payments but not dividends in computing taxable profits. According to them, this suggests that tax advantages derived from the introduction of debt into a firm would lower the firm’s expected tax burden and thereby increase its after-tax cash flow.

Brownlee, Ferris, and Haskins (2001) who were of the notion that when managers are tasked to make corporate business decisions, they tried to minimize taxes within the confines of the tax laws of that country , stated that every major business decision is affected in one way or other by taxes. Modigliani and Miller (1963) and Miller (1977) mentioned that a tax benefit is created, as the interest payments associated with debt are tax deductible, while payments associated with equity, such as dividends are not tax deductible. Therefore, this tax effects encourage debt use by the firm, as more debt increases the after tax proceeds to the owners to be used as retained earnings which is relatively cheaper when used as capital than the other capitals.

Abor (2008) further mentioned that while there is corporate tax advantage resulting from deductibility of interest payments on debt investors receive this interest as income. He again added that the interest income received by the investors is also taxable on their personal accounts, and the percentage income tax effect is negative. Gatsi and Akoto (2010) also opined that holders of debt and equity must pay taxes on the intended income and the dividend/capital gain that they receive respectively. However, debt-holders do know that they pay higher taxes than equity holders thus debt-holders being rational will therefore demand high returns on their investments relative to equity holders. This is meant to compensate for the risk that debts –holders take.

Barclay and Smith (2005) stated that it is the equity holders that bear all the tax costs of the firm’s operations, whether the company pays the taxes directly in the form of corporate income tax or it pays it indirectly in the form of required returns on the debt it sells. Miller (1977) and Myers (2001) argues that as the supply of debt from all corporations expands, investors with higher and higher tax brackets have to be enticed to hold corporate debt and to receive more of their income in the form of interest rather than capital gains.

However Abu-Rub (2012) argue that this proposition must not deceive managers into introducing very high levels of debt into their operations because of the associated benefits. The researchers further cautioned that the premise that the tax advantage has an eminent possibility of being dashed away by the higher tax that debt-holders pay on their interest income compared to what equity- holder pay on their dividends and capital gains. It should be noted that investors in general, and debt – holders in particular being interested in their after tax profits would incorporate the loss value in their expected returns to pay off this making the ultimate cost of debt higher than equity.

The import therefore is that, firms that can derive maximum benefit from debt usage are those whose managers can accurately determine the point where the advantages of interest tax shield ends and where the costs of financial distress starts.

Bankruptcy cost

Bankruptcy cost are the costs incurred when the perceived probability that the firm will default on financing is greater than zero (Abor; 2008).Ross et al (2011) also explained that, bankruptcy cost means the cost that a firm incurs when a firm fails to honour its debts obligation and stands on the possibility of being closed down. According to them, the cost of bankruptcy may be both direct and indirect. Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy process while the loss in profits incurred by the firm as a result of the unwillingness of stakeholders to do business with them is an example of indirect bankruptcy costs.

Warner (1977) opined that the direct costs are often small in relation to corporate market value whiles indirect costs are substantial. Titman (1984) also added that customer dependency on a firm’s goods and services and the high probability of bankruptcy affect the solvency of firms. Abor (2008) also had this to say: "if a business is perceived to be close to bankruptcy, customers may be less willing to buy its goods and services because of the risk that the firm may not be able to meet its warranty obligations" and further explained that employees might be less inclined to work for the business and suppliers are less likely to extend trade credit.

Kim, Heshmati and Aoun (2006) stated that such restrictions or limitations can affect a firm’s value and its performance, because it may eventually have to forge attractive investment opportunities leading to underinvestment. This could adversely impact on the profitability and existence of the firm.

Modigliani and Miller (1963) contend that firms may be unable to pay their debts if they over-borrow and become financially distressed. Nevertheless, it is reasonable for firms to increase value because of tax deductibility of debt. It should be noted that bankruptcy cost increases with increased debt use thus reducing the value of the firm (Warner, 1977). As a result, managers of financially distressed firms would advocate for less debt in their capital structure relative to their low-debt counterparts so as to safeguard against underinvestment and associated problems.

In conclusion, Grossman and Hart (1982) contend that if bankruptcy is costly to managers, perhaps because they would lose benefits of control or reputation then debt finance should rather create incentives for managers to work harder, consume fewer prerequisites and make better investment decisions.

Firm performance

Firm performance assessment has several dimensions. Performance measures could be financial or non-financial performance, market or accounting performance. Kaplan and Norton (1992) introduced a multi-dimensional approach to performance measurement called the balanced score card approach. The objective of this research is to assess the effect of corporate governance mechanisms on two basic performance measures (market performance and accounting performance). Indeed, the market performance measure is expected to encapsulate the effects of all the four dimensions in Kaplan and Norton’s (1992) balance scorecard. The dynamics of accounting performance and market performance measures are discussed next.

Financial performance measures

Rose et al (2011) suggested two broad measures of financial performance- absolute measure and relative measure. The absolute measure assesses performance based on the absolute quantum of profit. "Profit- equivalent" connotes varied forms of profit (profit before tax, profit after tax, Residual income and Economic value added). One weakness of the absolute measure is its inability to relate the profit to the resources used to generate profit. Absolute measure may not provide quality information for performance comparison decisions.

Relative performance measures are much useful for inter and intra firm comparisons because they relate profit with resources used in generating such profits. Desai and Dharmapala (2007), Inger (2012) and several researchers used relative performance measures. Pervasive in literature is net profit margin (NPM), return on Equity (ROE), and return on assets (ROA). The appropriateness of each of the measures, according to Gupta and Newberry (1997), depends on the focus of the research in question. NPM has featured in most capital structure research. This can be explained by the fact that most of the researchers conduct the study by relating capital structure on statement of financial position items rather than on income statement item (sales). Naveed et al (2011), chose ROA as performance measure over ROE because the latter does not capture the entirety of performance from both debt and equity perspective.

It is important to discuss the relationship between profit and ROA as well as how capital structure is likely to affect this relationship from a theoretical perspective. All things being equal, high profit should translate into high return on asset. This proposition is valid if increased profit is as a result of increase in efficiency level. Put differently, return on asset will only improved if the rate increase in profit is more than the rate of increase in capital structure used in generating profit.

As discussed earlier, capital structure has the potential of affecting total income, hence affect the expenditure and ultimately, increase profit after interest and tax. It is expected that the effective and efficient use of capital available will reflect as higher ROA, ROE and NPM. This thinking is however, illusive if the capital sources trigger a disproportionate increase in capital used. For instance, it is possible to achieve increase in financial performance with the used of more retain earnings and not necessarily through acquisition of more debt capital.

It becomes imperative to juxtapose ROA, ROE and NPM –capital structure relationship with Naveed et al (2011) observation that in contemporary times, management compensation is tied to effective use of capital at its disposal. If the self-interest seeking proposition of agency theory is something to go by, then it is possible for management to pursue after tax profit maximisation objective to the detriment of ROA. Indeed, this is where capital structure mechanisms play a role in the financial performance relationship. The dynamics of this role is what this research seeks to establish.

Empirical review

The empirical review section cover issues relating to the relationship that literature have establish between the financial performance of a firm and the capital structure of those firms. While some studies seems to be consistent with the pecking order theory assertion, most studies have establish a relationship between the two variables but as others find a positive relationship, others establish a negative relationship but so far no literature has concluded on the fact that there could be a neutral relationship such that the level of capital structure does influence the financial performance of a firm thus disproving the assertion of Modiglani and Miller a (1956) as reviewed in the theoretical frame work above. However, the empirical perspectives established by other writers have been reviewed below.

Empirical evidence in relation to the pecking order theory

Within the framework of pecking order theory which explains that firms would prefer retain earnings to finance their operational activities and if not enough would prefer debt capital because it is cheaper than equity capital as well as it inability to dilute control before finally resulting to equity capital, Titman and Wessels (1988) established that firms with high financial performance which is measured in terms of return on asset and equity, all other factors holding constant, would maintain relatively lower debt levels since they can realise such funds from internal sources.

Rajan and Zingales (1995) also confirm a significantly negative correlation between profitability and leverage in their work meaning that, as firms make more profits, they would like to retain it to finance its operational activities hence affirming the assertion of the work of Titman and Wessels in 1988. Taking the issue from this angle, Fama and French (1998), indicated that debt usage does not necessarily grant tax benefits; high leverage may rather lead to agency problems among shareholders and debt holders that predict negative relationships between leverage and profitability therefore concluding on the fact that, it is better to use internally generated fund before the use of other source of finance by the firm.

Graham (2000) after considering the size of the firm argued in his work that large scale companies which persistently earn high profit mostly operate with low debt levels indicating that they would rather retain their profit for both expansion and operational activities. However in the banking sector which belongs to the financial industry just as the insurance sector, Cassa and Holmes (2003) and Hall et al. (2004) who all work on the banking industry established that a negative relationship between profitability and both long-term debt and short-term debt ratios.

In relation to the economy of Ghana, Amidu (2007) devised a research to investigate the determinants of capital structure of banks in Ghana which in conjunction with the insurance sector forms the financial industry in Ghana and found a significantly negative relation between total debt and profitability. Amidu (2007), work affirmed earlier literature on the fact that the pecking order theory forms a basis for decision making by firms when deciding on the constitution of their capital. The import of the above empirical results is that, profitable firms use less debt in funding their operations therefore affirming the pecking order theory discussed in the theoretical framework.

However, Murray and Vidhan (2009), in their study on profit and Capital structure found a rather opposing results to the literature reviewed above, the paper showed that previous literature has misinterpreted the evidence as a result of the wide spread use of familiar but empirically misleading gearing ratios, more profitable firms experience an increase in both book equity and market value of equity, empirically, they react as in the trade- off theory.

Again their finding mentioned that highly profitable firms typically issue debt and repurchase equity, while low profit firms typically reduce debt and issue equity, firm size matters that large firms make more active use of debt, while small firms make more active use of equity and in a trade – off model, financing decision depend on market conditions. Empirically, poor market conditions result in reduced use of external finance. The impact is particularly strong on small and low profit firms.

The study of Murray and Vidhan (2009), lend itself to credibility because of the wide range of factor of which some include the size of the firm and other economic fact as well as using the market values of equity in the computation of the leverage ratios but the study did not specify the population used for the study though the study used regression methodology in analysing the data which were constructed from the usual compustat and CRSP data bases making the study a complex to grasp what they are really researching into.

Although the studies reviewed above empirically shows the support for the pecking order theory, other writer are of different opinion such that most of them have found either a positive relationship or a negative relationship to exist among the capital structure and financial performance of the companies, the researcher reviews these findings and the frameworks that established these opposing views below.

Empirical review based on the financial performance and the capital structure of firms

In examining the association between capital structure and firm financial performance, numerous studies have been conducted by researchers that indicate a negative relationship between the two variables by inculcating a controlling variable. These include; the study by Fu (1997), who studied on the relationship between capital structure and profitability using a cross sectional study on the Malaysian firms, the study was aimed at solving the dearth of research on effect that the capital structure has on the profitability of the firms in Malaysia.

In view of that the researcher, took a total of 267 firms listed on the Kuala Lumpur Stock Exchange for a period of ten years from 1985 to 1994. Two major sets of variables were used in the study to indicate capital structure, these are Debt to Equity Ratio that was decomposed into Debt Ratio, Financial Leverage Ratio, Funded Capital Ratio, Funded Debt Ratio, Current Debt Ratio, Funded Assets Ratio; and, profitability which was measured by Return On Equity, Earnings Per Share, Return On Investment, Profit Before Tax, Net Income. Using the time-series cross-sectional methodology the data was analysed and in order to generate empirical evidence, the Pearson Product-Moment Correlation, mean and bar chart analysis were employed.

Fu (1997) results implied that profitability is significantly related to capital structure. Specifically, profitability was inversely or negatively related to the amount of liability in a company’s capital structure. Hence, the gearing of the company turns to increase whenever the firms’ profitability level reduces. His study also found evidence of the existence of an optimal capital structure among listed companies and that firms of different sectors were found to adjust their capital structure regularly in order to achieve an optimal combination of debt and equity.

Confirming the study by Fu (1997), Lara and Mesquita (2002), who researched into the capital structure and profitability in the case of the Brazilian economy, asserts that the determination of capital structure for a company is a challenging one that involves several factors, such as risk and profitability. Further in the study Lara and Mesquita (2002) emphasised that the capital structure decision becomes even more difficult, in an economy with volatile macroeconomic environment.

Therefore, the choice among the ideal proportion of debt and equity can affect the financial performance of the company, as much as the return rates. In the study, data were collected from about 70 companies for a period of seven years. Having indicated the influence of the macro economic factors, the study factored inflation, exchange rate and other economic variable as a controlling variable and therefore used ordinary least Squares (OLS) method in the estimation of a function relating the return on the equity (ROE) with the indexes of long and short-run debts, and also with the total of owner’s equity. The results indicated that the return rates present a positive correlation with short-term debt and equity, and an inverse correlation with long-term debt.

The study conducted by Lara and Mesquita (2002), recognised the influence of macroeconomic variable in the choice of capital structure as well as the profitability of the firm. This recognition gives credibility to their work because they expanded the discussion to the entire environment unlike what other writers. But the data point in the work as well as the data analysis thus the ordinary least square (OLS) used may not entirely reveal the true situation on the ground.

Cheng,Liu and Chien (2010), in their study, using a panel threshold regression analysis on the capital structure and firm value in china which is different from Fu (1997), cross sectional methodology approach found an increase in gearing does not improve firm value in the same proportion. This conclusion was ascertained by applying an advanced panel threshold regression model to test the panel threshold effect of debt ratio on firm value among 650 A-shares of Chinese listed firms from 2001 to 2006. The results confirm that a triple-threshold effect does exist and showed an inverted-U correlation between leverage and firm value.

Attention must be drawn to the fact that, their study did not consider the financial institutions, banking, finance, and insurance firms since they assert that the balance sheet of those firms has a striking different structure from those of nonfinancial firms. Though their work did not consider the insurance sector, their study is a significant literature to review because of the panel threshold methodology that was employed by them as the current study has adapted the panel data methodology.

Moreover, Graf (2010) revealed that, the relationship between the capital structure and risk-adjusted profitability of European and US banks is positive. Risk adjusted performance was measured by accounting figures and also by market prices. By using a dynamic panel regression and controlling for several bank characteristics such as loan portfolio quality, liquidity endowment and size. The study found that the bank performance is inversely 'u'-shaped related to the leverage ratio. The leverage ratio for the purpose of the study was defined as total assets over book equity.

For the purpose of the study Graf (2010) analysis was based on banks' balance sheets and income statements between 1994 and 2008 of European and the US banks. A total of 920 data were collected from a sample of about 175 US banks and about 820 observations for 205 European banks. This shows how reliable the study is with reference to the American and the European economies but would have been more generalised if it hand included a sample of financial institutions in both the Asian and the African continent.

In the analysis, the study was analysed with the use of a two-way dynamic panel regression model to relate bank performance to the capital structure and the control variables. This meant that the dummy variable for each bank and a dummy variable for each year were appropriately appreciated. That notwithstanding the study also revealed that, but assumption was that the impact of the leverage ratio and the other independent variables on the bank performance is the same across banks and over time.

Furthermore, Dreyer (2010) conducted a research that set out to determine whether there is a relationship between the observed leverage levels of South African companies, their profitability, earnings volatility and the probability of financial distress. The study considered the impact of the 2007 and 2008 global financial crisis in the leverage and the earrings volatility and found a negative correlation between the variables which suggests that firms that earn most of their revenue through either imports or exports are subjected to the vicissitude of the South African currency as well as the commodity price cycles. The findings of the study supported both the capital structure theory and the pecking order theory.

The result were obtained after taking a population of companies listed on the Johannesburg stock exchange over a period of ten year showing how significant the companies understudy will impact on the findings made. The cross-sectional, longitudinal and panel data methodology was used to analyse the data that was dominated by a secondary data without the consideration of a primary data.

Narrowing the issue down to the insurance industry, Naveed, Zulfquar and Ishfaq (2010), researched into the determinates of capital structure taking the life insurance sector of Pakistan as a case aimed at investigating the impact of firm level characteristics on capital structure of life insurance companies of Pakistan so that future studies can understand the factors that influence capital structure of the insurance companies.

For the purpose of the study, leverage was taken as dependent variable while profitability, size, growth, age, risk, tangibility of assets and liquidity are selected as independent variables. The result after using the ordinary least square (OLS) regression model to analyse the data indicated that size, profitability, risk, liquidity and age are important determinants of capital structure of life insurance companies and In addition, life insurance companies follow Pecking Order pattern in terms of profitability, liquidity and age as well as leverage has a negative relationship with profitability, liquidity and age while positive relationship between leverage and size shows consistency with the Trade-off theory.

As cited in Naveed, Zulfquar and Ishfaq (2010), one reason that necessitates the usage of less debt ratio is that when firm survives in business for a long time then it accumulates more funds for the day-to –day operations of the business and subsequently keeps away the firm to go for debt financing (Nivorozhkin, 2005). In addition, positive relationship between leverage and age is not likely to apply in transition economies because experience or maturity of the firms before economic reforms is likely to be limited (Al - Bashs and Sentic, 2008).

Their study is consistent with work of Abor (2008) on the issue of determinates of the capital structure of firms in Ghana. Therefore, the reason why the researcher has indicated the usage of these variables in the hypothesis formulated for the work. What was not considered by the writers was the factor that would probably affect the performance of the insurance companies

But Naveed et al (2011) resolved the issue of the determinants of performance of insurance companies by conducting a research on the topic again, discussing it from the perspective of the life insurance sector of Pakistan. The study examined the impact of firm level characteristics such as size, leverage, tangibility, risk, growth, liquidity and age on performance of listed life insurance companies of Pakistan over seven years from 2001 to 2007.

The results after conducting an Ordinary Least Square (OLS) regression analysis indicated that the size, risk and leverage are important determinants of performance of life insurance companies of Pakistan while ROA has statistically insignificant relationship with growth, profitability, age and liquidity. It must be noted that their findings was consistent with the study conducted by the Sufian, et al (2009) and Hakim and Neaime (2005) to investigate the determinants of profitability by selecting the non-commercial banks financial institutions.

Building on the foundation laid by Naveed et al (2010 and 2011), Petrov and Najjar (2011), conducted a study on the capital structure of insurance companies in Bahrain and found a strong relationship between firm characteristics, such as Tangibility of Assets, Profitability, Firm Size, Revenue Growth, and Liquidity, and observed capital structure, as represented by the Debt Ratio, although Profitability and Revenue Growth are not statistically significant and require further research.

The study that derived the findings of Petrov and Najjar (2011) was based on 150 of insurance companies in Bahrain, most of them are privately held and their financial information is considered confidential and impossible to obtain and for most of them, the integrity of their accounting data cannot be verified due to lack of proper independent auditing.

Therefore, the researchers limited the study to all publicly-traded insurance companies listed on the Bahrain Stock Exchange, for a period of 2005 - 2009 because they publish reliable audited statements. Which is quit a short period for a decision to be undertaken, that notwithstanding, their model was based on a standard multiple linear regression analysis using the debt ratios as the dependent variables and tangibility of asset, profitability, firm size, revenue growth and liquidity as the independent variable. Though their work is referred as the ground breaking for studies into the capital structure of insurance companies, their profitability was measured with only return on asset without any giving any justification for that action.

In relation to the Ghanaian context, Amidu (2007) study on determinants of the capital structure of banks in Ghana; Abor’s (2005) on the effect of capital structure on the profitability of listed firms in Ghana. Amidu (2007) found an inverse relationship between short-term debt and firm profitability. Abor (2005), found an inverse relationship between company profitability and long-term debt. Graham (2004) concluded that there is an inverse relationship between total debt and profitability. He further indicated that large and profitable companies present low debt levels.

Furthermore Gatsi and Akoto (2010), entered into the financial industry of Ghana by conducting a study of the capital structure and profitability in Ghanaian banks using panel data methodology. The study covered banks listed on the Ghana stock exchange and covered a period ten years and was observed that 87% of the total capital of banks in Ghana is made up of debt. Of which, 65% constitute short-term debts while the remaining is made up of long-term debts.

Their findings however, confirmed that banks are highly levered institutions and also highlights the significance of short term debts over long-term debts in bank financing in Ghana. Their finding was in consonance with previous studies in Ghana by Abor (2005) and Amidu (2007) in stressing the importance of short term debt in firm financing in Ghana. Gatsi and Akoto (2010) also, revealed a significant negative relationship between bank size and profitability and made the suggestion that larger banks tend to exhibit lower margins and is consistent with models that emphasize the negative role of size from scale inefficiencies.

Gatsi and Akoto (2010) also revealed a significantly negative association between short-term debts and net interest margin. This means that as deposits increase in the banking sector, net interest margin falls. In their study, long-term debts was negative but insignificant in determining net interest margin in the banking sector

Regarding total debts, it was significant and negatively related to net interest margin. Finally their study revealed that bank size was significantly and negatively related to both returns on equity and net interest margin in the banking sector. However there was a positive and statistically significant relationship between sales growth and both returns on equity and net interest margin in the banking sector.

Gatsi and Akoto (2010)