The Relationship Between The Capital Structure

Published Date: 02 Nov 2017

CHAPTER 2

Introduction

Within the area of corporate finance, the investigation of ‘ideal’, optimal and actual capital structures is a mature research field. Over fifty years ago, Durand (1952) asserted that the choice of capital structure of a firm could be influenced by the relative costs of debt and equity, and therefore the value of a firm could be affected by the net balance of relative cots of debt and equity in the chosen structure of capital. Durand’s ‘relevance theory’ was based on only a number of hypothetical scenarios. Later in the same decade, Modigliani and Miller (1958) developed a formal theory of capital structure. Using theoretical models, they presented their ‘irrelevance theory’, that is the capital structure of a firm does not affect the value of a firm under perfect market conditions.

The study of capital structure was pioneered by financial researchers in the 1950. It focused on an examination of relationship between capital structure and the value of a firm. The key research issue in the financial literature focuses on the debate between the traditional ‘relevance theory’ of Durand (1952) and the modern ‘irrelevance theory’ of Modigliani and Miller (1958).

2.1 Theories of Capital Structure

2.1.1. Durand’s Relevance Theory

According to Durand’s (1952) traditional theory of capital structure, the value of firm can be affected by its capital structure. This theory is based on three key points:

Net Income Approach: Debt is normally cheaper than equity, therefore, when more debt is mixed with equity; the weighted average of the cost of total funds including both debt and equity becomes lower, thereby increasing the value of a firm.

Net Operating Income Approach: When more debt is used, the cost of equity is increased because shareholders demand risk premium for higher debt financing. As a result, the weighted average of the cost of total funds including both debt and equity becomes higher, thus decreasing the value of a firm. The benefits of lower cost in debt funding can partially or totally offset the increased cost of equity, thereby impacting on the value of a firm.

Optimal Capital Structure Approach: The impact of capital structure on the value of a firm depends on net balance between the benefits of debt financing (cost reduction) and the increased cost of equity (risk reduction). The result of the hypothetical analysis is that there may be an optimal capital structure where the value of firm can be maximized, or the cost of capital minimized by adjusting the ratios of debt to equity.

The traditional approach, therefore, focuses mainly on the relative costs of debt and equity and their associated impact of capital structures on the value of a firm. Durand’s (1952) research pioneered the study of capital structure; however it provides only a hypothetical framework of various scenarios, with the focus on the right hand-side of company’s balance sheet or on the cost difference between different financing instruments; that is, debt and equity.

2.1.2. Modigliani and Miller’s Irrelevance Theory

In their seminal paper, Modigliani and Miller (1958) demonstrated that under perfect market conditions, capital structure (debt-equity ratio) has no effect on the value of a firm, and that the value of a firm is mainly determined by the return of assets regardless of the mix of capital structure. Their arguments were based on the following famous propositions in perfect market conditions (Modigliani and Miller model, or MM model).

The market value of a firm is determined by capitalizing the firm’s expected return appropriate to the risk class of assets independent of the firm’s capital structure. (Modigliani and Miller, 1958, p.268)

The price per dollar worth of expected return must be the same for all shares of any given class (Modigliani & Miller, 1958, p. 267); and

The average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream in its risk class of assets (Modigliani and Miller 1958, p268)

According to the MM model, it is the return on assets (the left-hand side of a firm’s balance sheet) that determines the value of a firm not the capital structure or mix of funding (the right-hand side of a firm’s balance sheet). Therefore, the market value of a firm is independent of its capital structure. As a result, the value of a firm with debt and the value of a firm without debt must be the same. If they are not the same, arbitrage between these two firms will take place through a home-made leverage process which will result in the same value for both firms. The MM model of capital structure was established on the basis of the analysis of two financial behaviors: (1) the arbitrage behavior of investors in the face of different values of firms in the same risk class to prove that the values of leverage and un-leveraged firms cannot be dissimilar; and (2) the risk-averse behavior of investors in the face of different risks of debt and equity to prove that the cost of equity will be increasing along with the debt ratio.

2.1.3. Trade-Off Theory (TOT)

The theory of irrelevant capital structure together with the empirical inconsistencies directed the scientific discussion toward more thorough examination of debt financing.

The MM model, based on perfect market conditions, was relaxed initially by one condition is tax. Debt has benefits in increasing the value of a firm due to the tax deductibility of debt interest. Modigliani and Miller (1963) introduced the corporate income tax effect into their model and demonstrated that, in the event of tax, the capital structure has a positive impact on the value of a firm after taking into account the interest costs being tax-deducted. In a further refinement, Miller (1977) incorporated the personal income tax rate into this equation and found that the corporate tax benefit of debt could be reduced or offset by this tax rate. In another study, impact of non-debt tax shield such as depreciation, investment tax credits and depletion allowance and argued that the corporate tax benefit of debt could be increased or expanded as a result of these non-debt tax shields. These three kind of study focus on the examination of tax benefits of debt.

Most scholars agree that debt has benefits and, more importantly, also agree that tax benefits are not inexhaustible. Otherwise, it would be beneficial to finance company operations 100% by debt (Swanson, et al.,2003, p. 158). However, debt has costs as well. The inclusion by bankruptcy costs in a study of capital structure by Baron (1974, p178) produced the bankruptcy theory of capital structure. Bankruptcy theory argues that the more debt is issued, the greater the risk to equity (higher cost of equity), but also the greater the likelihood of bankruptcy and the higher the costs of bankruptcy (Baxter 1967). Bankruptcy costs include both direct in indirect costs. Direct costs of bankruptcy include the legal and administrative costs of liquidation and reorganization. According some empirical studies, this costs is on average 1% of market value of the company seven years before bankruptcy, and 2.5% of the market value of the company three years before bankruptcy. Indirect costs of bankruptcy include the impaired ability to conduct business and the tendency to under-invest. According to Altman (1984), both direct and indirect bankruptcy cost could be as high as 11% to 17% of the total value of the firm up to three years prior to bankruptcy. Some empirical studies suggest that large companies tend to have higher debt because their bankruptcy costs are relatively lower than small companies.

Trade-off theory (TOT) hypothesizes that some factors representing debt benefits have positive impact on debt level and other factors representing debt costs have a negative impact on debt level. According to TOT, the choice of capital structure depends on the net impact of positive factors offsetting negative factors (see Table A1 on p61 of the Appendix). Tot argues for the existence of the optimal capital structure where a firm’s value is maximized by developing a balance between the present value of both debt tax shields and non-debt tax shield and the present value of bankruptcy costs arising from financial distress.

2.1.4. Pecking Order Theory (POT)

Pecking order theory (POT) is based on the hypothesized existence of information asymmetry between shareholders, managers and creditors when either debt or equity is used. POT (Myers and Majlut, 1984) assumes that insiders (either managers or existing shareholders) are privately and better informed about the future returns and investment opportunities than outside investors and/or than creditors. Considering the information asymmetry between inside and outside investors and between creditors and shareholders, POT reject the existence of an optimal capital structure and argues that firms normally follow a pecking order in corporate finance; that is, preferring internal funding instead of external funding and preferring debt funding instead of equity funding.

Myers (1984) explained that this pecking order is due to the fact that information is not symmetrical when it comes to the arrangement of debt and/or equity. Creditors are not necessarily well-informed on how managers are working in their best interests. When contracting with an agent who has superior information, a uniformed agent faces the consequences of adverse selection because he does not know if the relevant characteristics of the informed agent are good or bad.

Myers and Majluf (1984) further explained that the issuing of equity could be a negative signal to investors. The under-investment occurs when equity is used in the event of information asymmetry due to serve underpricing and possible rejection of projects with high net present value. They argued, therefore, that the issuing of debt could be a positive signal to investors, and using internal funds or debt avoids the underinvestment problem (Harris and Raviv, p 306-311). According to Ross (1977), the use of debt provides a signal (information) to outside investors on the perceived good performance by that company. POT differs from TOT in the interpretation of the impact of a firm’s profit, size and growth on capital structure. TOT states that profit, size and growth are positively related to capital structure because they are all proxies for high debt-related tax benefits or low debt-related bankruptcy costs. However POT argues that the same characteristics can be negatively related to capital structure due to the existence of information asymmetry.

The financial approach on the basis of TOT and POT has made many contributions to the study of capital structure, but it has a number of limitations. The some people pointed out that most of the financial statement numbers move together over time, and there will be multi-linearity because the accounting equation (assets= liabilities + equity) will naturally result in variables explaining each other. Another concern is that capital structure adjustment to achieve the optimum capital structure can be very costly in imperfect markets, particularly so in a dynamic trade-off situation. This approach restricts the analysis to the impact of financial determinants on capital structure and ignores the implications of non-financial factors business strategies in objective, values and goals of firm’s decision makers (owner, creditor and manager) on a firm’s capital structure, as well as the impact of a conflict of interest between and among shareholders, managers and creditors on a firm’s capital structure. Real business context indicates to us that the choice of debt or equity cannot and should not be made simply by balancing debt benefits and debt costs without doing this in the various environments of the firm’s business strategies and corporate governance arrangements.

2.1.5. Corporate Governance Approach: The Impact of Agency Costs

On Capital

In the 1970s, the research on financial determinants extended to include the rapidly growing area of corporate governance (Jensen and Meckling, 1976). Corporate governance is concerned with the establishment of mechanisms to align different interests of shareholders and minimize the conflict of interest between and among shareholders. The conflict of interest or principal-agent problem is the key issue in corporate governance theory. This classical agency theory problem was originally by Jensen who observed that, in a large corporation, ownership and control were often separated, and this separation is subject to moral hazard, adverse selection and agency cost.

Agency Cost Theory (ACT)

The corporate governance approach is based on agency cost theory (ACT). Jensen and Meckling (1976) were the first to examine capital structure form the agency cost perspective. The essence of the agency theory is based on the assumption that agent may not always act in the interests of principals thus leading to misalignment between the interests of argents with those of principals and resulting in the loss in return to the principals. ACT considers the impact of agency costs on capital structure in the corporate governance context of various interest conflicts between shareholders and managers and between shareholders and creditors when either debt or equity is used. Jensen and Meckling (1976, p.308) defined the agency cost as including (1) the monitoring expenditures of the principal (2) the bonding expenditures of the agent, and (3) the residual loss. Some studies explained the agency cost in more detail as including the total cost of creating and structuring contracts, including monitoring costs, bonding costs, and the residual loss of opportunities that may have been beneficial in the absence of conflict of interest between shareholders and managers due to separation of ownership form management. On other hand argued that these agency costs are mainly ex ante costs such as the maladaptive costs incurred when transactions drift out alignment should be included. All these agency costs are reflected in the cost imposed on the company through monetary demands of the principals.

Agency Cost of Equity

Agency cost of equity arises from the conflict of interest between shareholders and managers. When managers of a listed company decide to raise capital for an investment project from equity finance, shareholders supply equity finance to companies with the expectation of a return. The managers of the company are the agents in relation to the shareholders who are the principals. The principals (the shareholders) are supposed to receive the expected return, and their agent (the managers) is supposed to deliver these returns. Whether are agents act fully in the interest of the principals emerges as a question according to agency cost theory. Managers know that the benefit of equity financing goes entirely to shareholders if a business goes well, but the cost of achieving a maximum return is high and is borne entirely by managers if a business goes bad.

Managers may misuse the funds from new shareholders for non-pecuniary consumption, with the expectation that these costs would be shared by new shareholders. When managers do not manage firms in the interest of shareholders, the returns to shareholders will be discounted, and the loss of profit is the agency cost of equity. the cost of effort to prevent the loss of profit from happening such as management compensation and or management ownership is also part of the agency cost. When shareholders as principals are aware of these agency problems associated with managers as their agents for their investment, they can push up the prices of equity to compensate for the agency costs. Increases in equity prices are additional costs of equity finance. This is described as the agency costs of equity to the company. Shareholders may use the threat of exit make sure that the agency cost in minimized. A number of interest-alignment measures, such as buy-out, share option, external directors, and so on, can be used to minimize the agency cost. These corporate governance instruments are not discussed directly in this thesis. Jensen and Meckling (1976) also found that there is an agency problem between the existing owner-managers and the new owners in relation to equity finance. In equity finance, the existing owner-managers dilute their ownership by issuing outside equity, they may be induced to pursue greater non-pecuniary benefits so that they can share the cost with the new owners. This is described as the effects of incentive dilution from issuing new equity, or the agency cost of equity financing. As new owners become aware of the agency problem, they demand a higher return to investment, thus pushing up the equity cost. There is an inverse relationship between the capital structure and the costs for equity including the agency cost of equity, that is, the lower the debt-equity ratio, the higher is the cost of equity. When this inverse relationship exists, there is an equity agency cost.

Jensen (1986) also demonstrated that, in the case of an agency problem associated with new equity finance, debt could be used as a governance device to reduce agency cost in equity financing (Jensen and Meckling 1976). This is because, under the debt arrangement, managers are obliged to make repayments out of available cash flow to creditors. More importantly, the bankruptcy threat by the lenders would normally prevent manager’s form undertaking wasteful action, thus reducing the agency cost of equity finance. If they spend the free cash on wasteful expenditures, the repayment schedule may be unlikely to be met. In the case of default, debt-holder may take the firm to bankruptcy court and obtain a claim over its assets.

Agency Cost of Debt

Agency cost of debt arises from the conflict of interest between shareholders and creditors. When shareholders of a listed company decide to raise capital for an investment project from debt financing, the creditors supply funds to the company with the expectation of a return. The shareholders of the company are agents, in relation to the creditors who are the principals. The principals (creditors) are supposed to achieve the expected return and their agents (shareholders) are supposed to deliver these returns. Shareholders know that the benefit of debt financing goes entirely to shareholders if the business goes well, but the cost of achieving a maximum return is high and is fully borne by creditors if a business goes bad. Also, shareholders know that debt-financing can be a mechanism to discipline managers. Shareholders may wish to undertake more debt by taking on riskier project; however, managers dislike taking more debt and tend to take on less risky project. When shareholders do not behave in the interest of creditors, the returns to creditors will be discounted as a result of bankruptcy to debtors. The cost of effort in preventing this loss is also part of the agency cost of debt. Unless the interests of share-holders are aligned with the interests of debtors, shareholders will not maximize the return to debt in the creditors interests. The loss of profit or underperformance of a loan is the direct agency cost debt. In order to prevent shareholders from behaving in this way, an indirect agency cost occurs.

When creditors as principals are aware of these agency problem associated with shareholders as agent for their investment, they can push up the prices of debt to compensate for these agency costs. Increase in debt prices are the additional costs to the company in debt finance. These are the agency costs of debt to the company. There is a positive relationship between capital structure and the cost of debt including the agency cost of debt; that is, the higher the debt-equity ratio, the higher is the cost of debt. When this positive relationship exists, there is a debt agency cost. Debt-holders may use the threat of declaring the bankruptcy of a firm to make sure that the agency cost is minimized.

The Trade-Off between Agency costs of Equity and Debt

The important argument behind the corporate governance approach is that the capital structure decision is not only a financial decision but also a choice of corporate governance arrangement to minimize the agency costs or the conflicts of interest between stakeholders: mainly shareholders, managers and creditors. In the case of a debt agency cost problem, equity could be used as a governance device to reduce agency cost in debt financing. This is because under the equity arrangement, shareholders will bear and share more and more of the cost failure with creditors. Creditors may be at ease with their loans. In the case an equity agency cost problem, debt could be used as a governance device to reduce equity agency cost. This is because under the debt arrangement, managers will be disciplined to comply with the debt repayment.

The balance between the agency costs of equity and debt is the key to deciding the desired level of capital structure (Jensen and Meckling 1976). A firm tends to use more debt when the debt agency cost is lower than the equity agency cost. However, when more debt is used, the debt agency cost may rise to match the equity agency cost. A firm tends to use less debt when the debt agency cost is higher than the equity agency cost. When more equity is used, the equity agency cost may rise to match the debt agency cost. The adjustment between debt finance and equity finance according to the changing relative agency costs between debt and equity can influence a firm’s capital structure (see Table A2, on p62 of the Appendix).

2.2 Overview of Corporate strategy and policy literature

Management theorists in order to identify and conceptualize the differences in approach in managing firms across these levels of company hierarchy have defined the levels of strategy, i.e. corporate level, business level, and functional level. Corporate level strategies focus on what businesses should the company invest in, in order to satisfy the interests of the stakeholders and to maximize the value of stockholders investment. The focus here is no issues pertaining to firm growth and liquidity (e.g. Kim Mayer), which influence stockholders satisfaction. On the other hand, business level strategies entail ways in which a company would seek to attain competitive advantage through effective positioning. It should be noted that these positioning strategies of companies would vary depending on the industry setting (Hill and Jones 1995). In corporate finance, although business level strategies are not defines as positioning strategies, the objectives of these strategies and their effect are considered within the diversification and liquidity concepts of corporate strategies.

The objective of functional level strategies is so achieve competitive advantage through "strategies directed at improving the effectiveness of functional operations within a company" (Hill and Jones 1995; p12). Note that in corporate fiancé the functional level strategies are considered as aggregates reported as part of the financial statements of individual business units, which are then analyzed in connection to the corporate strategies. It should also be noted that the business and functional strategies are impacted by the way in which corporate strategies are formulated. Although it may be argued that a bottom-up approach of defining functional level and business level strategies will not entail the effects of corporate strategies on functional and business level strategies, in reality firms define their resource allocation strategies first by taking into consideration the effect of these strategies on overall corporate performance. Once the resource allocation decisions are formulated at the corporate level, managers at the business level can then identify the appropriate strategies to meet the objectives laid out by managers at the corporate level.

Management theorists have suggested that in order to achieve competitive advantage, the firm should achieve a fit between the environments, strategy, structure and controls (Jennings and Lumpkin 1992). Effective strategy formulation and implementation lead to the attainment of performance objectives identified by the stake holders of the firm. Whereas the concept of fit between the environment and strategy is important in order to achieve competitive success, who suggested that strategic intent is key to achieving success as compared to strategic fit, the paradigm that most management theorists followed until the late eighties. The authors suggest that strategic that strategic intent is about building new resources and competencies to tap future opportunities as opposed to the strategic fit perspective of achieving a fit between existing company resources and current environment opportunities.

In corporate finance, the strategic intent perspective is studied under the concepts of how future risk impacts the firm and how firms should allocate resources to manage risk on the long-term. The alignment between environment risk, strategies, structure, and performance can therefore be validated by considering the lag effects of risk on resource allocation decisions. The allocation of resources studied under corporate strategies affect the capital structure of firms (Barton and Gordon, 1987, 1988;). And firms that perform better are able to manage the above process, vis-a- vis resource allocation and decisions related to the firm’s capital structure, in a better way that lead to value addition (Barton and Gordon; 1987, 1988).

The performance of firms becomes the single most important construct that has been studied by management researchers, hospitality strategy researchers, as well as corporate finance researchers. Since performance objectives are what firms wish to accomplish, this construct will be scrutinized to reveal the key variables that represent it. The overall objective of a firm’s existence is to continue to survive through the crests and troughs of the industry life cycle. And in order to do so, firms need to insure that the performance objectives are met consistently. Researchers have emphasized on various performance measures that range from stockholder satisfaction measures, via return on equity and earnings per share to operational performance measures, i.e. return on sales and gross operating profit. These measures also vary from accounting measures to market-based measures. In this study, we will identify various performance measures by examining the work of researchers who have advocated the use of key performance variables, both accounting and market measures, which represent the outcome variables of a firm.

2.2.1 Strategy - Definitional Issues

Strategy has been defined very distinctly in strategic management theory. For instance, according to Chandler (1962), strategy is the determination of basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals. Hofer & Shendel (1978) defined strategy as the match among organizational purposes, resources, skills, environment opportunities and risks. Similarly, Thompson & Strickland (1978) defined strategy as the manner in which an organization accomplishes its objectives through the formulation of means, matching and allocating resources, and directing its effort to produce results. On the other hand, Bourgeois (1980) defined strategy in terms of a firm’s relationship with the environment to achieve its objectives, while Mintzberg (1978) defined the term as a pattern in a stream of decisions or actions.

These definitions are important for the literature as it defines the domain of strategy in terms of its literal meaning as well as the direction of research efforts that it influences. Although the above definitions of strategy may differ in literal meaning, the underlying theme common to all is the ability of the organization to meet its objectives by directing its efforts in a resourceful manner, aligning them to the developments in the external environment. Having identified this theme in the definition of strategy, it becomes essential to identify whether each individual research domain within the field is a proponent of this ideology professed by eminent researchers. To do so, it is essential to pinpoint the orientations of the sub-domains in the field of strategy.

2.2.2 Sub-domains of Strategy

The strategic management model suggests that intended strategy is an outcome of certain distinct actions taken by firms. These actions can be categorized as the product of a firm’s external analysis and internal analysis (Hill & Jones, 1995). The external analysis is about understanding the firm’s external environment to identify opportunities and threats. This analysis includes analyzing the firm’s remote environment domain, task environment domain, and industry environment domain in order to identify the forces driving change and their impact on the organization during a given time period (Olsen et al., 1998). On the other hand, the internal analysis entails pinpointing what the strengths and weaknesses of the firm are in order to identify the quantity and quality of resources available to the organization (Hill & Jones, 1995). The concept that entails analyzing the firm’s external and internal environment and subsequently identifying the appropriate strategy comes under the strategy formulation sub-domain of strategy research. Another way, the sub-domain that deals with designing organizational systems and structures in order to put the strategy into action is termed as strategy implementation.

Strategy choice is a component of strategy formulation that entails identifying the strategic alternatives in tandem with the firm’s strengths and weaknesses. Since strategy is about identifying the appropriate courses of action, these alternatives vary depending on the hierarchical levels of the organization confirmed by, for instance, Hofer & Shendel (1978), who point out that strategy content varies with the level of organizational hierarchy. The hierarchical levels identified by various management theorists in the strategy domain are functional level, business level, and corporate level strategies (Hill & Jones, 1995) and are discussed in the following section.

2.2.3 Hierarchical Levels of Strategy

Corporate Level Strategy

The corporate level strategy entails decisions made by corporate managers to insure that company stakeholders are satisfied at all times. With this as the goal, the managers at the corporate level of company hierarchy decide to invest in business (es) that result in long-term profit maximization and increased returns to the firm’s stockholders. Corporate strategies entail two distinct dimensions that include measures pertaining to growth (Zook & Rogers, 2001) and liquidity (Kim et al., 1998). Corporate managers decide what businesses to invest in and how liquid the assets of the firm should be to maximize the value of the firm, both in the short and long term scenario. Two dimensions in detail will be presented in the following of this chapter.

Business Level Strategy

Business level strategy applies to the unit level of the organization and is referred to as those strategies that are applied at the strategic business unit (SBU) level. SBU level strategy is formulated and implemented by business level managers, who are also referred to as unit level managers or general managers. While this may be the case in the manufacturing industries, the hospitality industry general manager does not necessarily formulate these strategies rather they are instrumental in the implementation of the strategy. The formulation of business level strategies is entailed in the corporate strategy when the corporate managers define the positioning of the firm. Since business level strategy is a result of market segmentation and positioning strategies, the generic strategies of cost leadership, differentiation, and focus (Porter, 1980) result from the way corporate managers conceive the orientation and positioning of the product during the time of its inception.

This logic also applies to the Miles & Snow’s typology of prospector, defender, analyzer, and reactor. These generic typologies are a result of the corporate level manager’s positioning strategies, and the budget allocated to the units to pursue that strategy. Attention, the hospitality industry is different from the manufacturing industry in terms of the distinction between the three levels of strategy. There is an overlap in the decisions made at the three levels, with the corporate level influencing the decisions of the unit level and the functional level. This may not be apparent by scrutinizing the organizational structure; rather, this results from the job responsibilities that are entrusted to the different levels of management hierarchy, especially the business and functional level.

Functional Level Strategy

Functional level strategies are those strategies that are initiated by the profit/support centers of an organization. These centers are individual functions that result when activities that are similar in their characteristics and objectives are grouped under a given function. Each separate function should have its own goal and objective, and functional managers formulate strategies to attain those goals and objectives. To be competitively superior to other firms, functional level managers strategize to attain superior efficiency, superior quality, superior customer responsiveness, and superior innovation (Hill & Jones, 1995). Although hospitality researchers have posited that manufacturing based strategy theory may not be applicable to the hospitality industry (Murthy, 1994), it can be argued that strategies professed by management theorists have been generalized to apply to any given industry.

2.3. The Firm Performance Construct

Various research efforts in the economic and management fields have tried to capture the performance construct that defines the outcome of the action taken by firms in comparison to competing firms or the industry. Since the primary objective of a business entity is to make profits, performance has been the most important construct studied over the past thirty-five years of strategy and corporate finance research. The important issue that needs to be addressed in research that tries to establish the relationship between environment, strategy, structure, and firm performance pertains to the identification of variable that represent the firm performance construct. A firm’s performance can be measured in terms of its profitability and market performance. Typically, profitability is measured in terms of return on the capital invested in the business or return on the revenues generated during a given period. On the other hand, market performance is measured in terms of market indicators such as share price and dividend yield ratio. The objective of this study will be to operationalize those measures of performance that have been tested in past studies to have a significant relationship with the environment, corporate strategy, and capital structure of the firm. Studies on performance measures include Beard and Dess (1981), and Hall and Weiss (1969). Beard and Dess (1981) used to the test the relationship between corporate level strategies and firm performance using regression analysis. Result revealed that corporate level strategies influenced firm performance. Hall and Weiss (1967) used "Return on Assets" as the performance measure to test the relationship between firm size and profitability. Correlation analysis was used as the statistical method and result indicate that a negative correlation exists between firm size and profitability. These returns represent the profitability measures to assess the firm performance. Market performance measures are corporate performance indicators and therefore result from the aggregation of SBU performance within a given corporation. The profitability of a firm can be measured to include the effect on two stakeholders, i.e. bondholders and stockholders. Since these two groups of investors have different perspectives on a firm’s performance, it is essential to pinpoint which group will be benefited because of external environment effect, corporate strategy and capital structure decision. Therefore, the performance construct will be operationalized to include measures that are a barometer of stakeholder satisfaction, categorized as two distinct types, i.e. accounting measures and cash flow measures. Indicators such as return on equity and return on assets are accounting measures which reflect stockholder satisfaction, and indicators such as free cash flow per share are finance related ratios that may indicate bondholder’s willingness to invest in the firm.

2.4. Relationship between Capital Structure and Financial

Performance

Hutchinson, (1995) in his scholarly works argued that, financial leverage had a positive effect on the firm’s return on equity provided that earnings’ power of the firm’s assets exceeds the average interest cost of debt to the firm. Taub (1975) also found significantly positive relationship between debt ratio and measures of profitability. Nerlove (1968), Baker (1973), and Petersen and Rajan (1994) also identified positive association between debt and profitability but for industries. In their study of leveraged buyouts, Roden and Lewellen (1995) established a significantly positive relation between profitability and total debt as a percentage of the total buyout-financing package. However, some studies have shown that debt has a negative effect on firm profitability. Fama and French (1998), for instance argue that the use of excessive debt creates agency problems among shareholders and creditors and that could result in negative relationship between leverage and profitability. Majumdar and Chhibber (1999) found in their Indian study that leverage has a negative effect on performance. Gleason et al., (2000) support a negative impact of leverage on the profitability of the firm. In a polish study, Hammes (1998) also found a negative relationship between debt and firm’s profitability. In another study, Hammes (2003) examined the relation between capital structure and performance by comparing Polish and Hungarian firms to a large sample of firms in industrialized countries. He used panel data analysis to investigate the relation between total debt and performance as well as between different sources of debt namely, bank loans, and trade credits and firms’ performance measured by profitability. His results show a significant and negative effect for most countries. He found that the type of debt, bank loans or trade credit is not of major importance, what matters is debt in general.

Mesquita and Lara (2003), in their study found that the relationship between rates of return and debt indicates a negative relationship for long-term financing. They however, found a positive relationship for short-term financing and equity. Abor, (2007) in his scholarly works on debt policy and performance of Medium Sized Enterprises found the effect of short-term debt to be significantly and negatively associated with gross profit margin for both Ghana and South African firms. This indicated that increasing the amount of short-term debt would result in a decrease in the profitability of the firms.

Concluding Remarks

This chapter has reviewed the capital structure literature and emphasized that study of capital structure needs to examine the financial characteristics of firms in their associated environment of business strategy and corporate governance. Five capital structure theories: Relevance theory, irrelevance (MM model), theory trade-off theory (TOT), pecking order theory (POT), agency cost theory (ACT) have been discussed in relation to their implied capital structure determinants. On the basis of both theoretical predictions and empirical studies, summaries are represented to illustrate that the choice of capital structure may be related to the factors affecting the following:

Relative benefits and costs between debt and equity (TOT) and relative information asymmetry between debt and equity (POT) in the financial approach;

Different corporate governance environments of ownership structure and ownership concentration (ACT) in the corporate governance approach,

The theoretical framework outlined in this chapter is that shareholders, managers and creditors interact with one another in relation to their influences on the capital structure decision by considering the costs and benefits of debt and equity, their business strategies and perceived risks, and their conflicts of interest and its mitigation of the conflict. The impact of these factors on capital structure is subject to the variations in the market and institutional conditions between countries.