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Capital Structure Theories
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  Capital Structure Relevancy Theories According to Buferna et al (2005), in the literature of capital structure, three important and popular but conflicting capital structure relevancy theories have been developed, whichincludes the Static tradeoff theory, !ec ing order theory and Agency costs theory# $hesetheories are e%plained below& 2.3.2.1. Static Trade-of Theory  $he Static tradeoff theory (S$$) came as a reaction on the 'iller and 'odigliani theory, presenting the benefits of debt financing via debt related ta% shields# oubts were raisedover the fact that there was no offsetting cost to debt# $herefore, a discussion followedsaying that the optimal leverage should be found where a tradeoff between ta% shield benefits of debt and costs of financial distress was found (ShyamSunder and 'yers, ***)#ebt enables the possibility to deduct interest charges raising incentive for higher leveragein order to ma%imi+e the ta% shield# By doing this the firm value increases with the value of the ta% shield (raham, 2000)# amodaran (200) stretches the increased financial disciplinefor managers as a conse-uence of higher debt levels# .owever there have been raisedconcerns on increasing ris s of ban ruptcy with increasing debt levels and li elihood of raising agency costs occurring between owners and managers# An underlying reason for thisis a conflict of interests generated by debt ('yers, */)# $herefore, according to the tradeoff theory, an optimal debt level which ma%imi+es the value of the firm does e%ist, whenattaining a trade off as balancing the benefits of debt against the cost of financial distress#As indicated in raph 2#, the straight line AB shows the value of a firm under alle-uityfinancing# 1hen a firm underta es debt it has to pay interest# nterest payments aregenerally ta% deductible, thus when a firm ta es debt3 it is able to increase its value# $his iscalled the interest ta% shield of debt# ebt almost literally shields the firm from paying outmore in ta%es# $herefore, as curve A4 shows, initially as the firm underta es more debt, thevalue of the firm increases# .owever, after a certain level (the optimum level) of debt, thevalue of the firm starts falling as shown by the falling portion of curve A4# After a certainlevel of debt, the costs of debt start outweighing the benefits of debt# $his is illustrated bythe curve A, which shows that the costs of financial distress rise significantly at higher levels of debt# At higher levels of debt, firms have to pay more interest and if they areunable to repay the debt and interest, then they are li ely to go ban rupt# As costs of  / financial distress rise, firms would prefer to stic to a reasonable6 level of debt# $his isillustrated in the diagram above where the optimum mar et value of the firm is achievedwhere the present value of the interest ta% shield is at a ma%imum# $he tradeoff modelassumes that companies have an optimal capital structure and they aim to attain this througha target debt level# $his is the reason why the $radeoff $heory is often referred to as theStatic $radeoff $heory6 in the literature# Graph 2.1: The Static Trade-off Theory of Capital Structure Source: Myers, 1984 pp 577  ebt has the disadvantage that it increases the probability of firms becoming financiallydistressed# $he costs of debt include potential ban ruptcy costs# 7epayment of interest ondebt is an obligation that a firm has to fulfill whatever its financial state# .ence, if a firm isunable to underta e its debt obligation it will obviously face ban ruptcy#Another cost of debt is the agency conflicts that can arise between stoc holders8shareholdersand bondholders8debt holders (9ama and 9rench, 2002)# $his can be e%plained by the fact  that if an investment pays off e-uity holders are the ones to benefit as they are entitled to theresidual profits after interest on debt has been repaid# 7is y investments are the ones thatnormally have higher returns and therefore e-uity holders will prefer these types of investment# ebt holders on the other hand, are only concerned with their interest payments#$hey would prefer firms to choose less profitable but safe investments# $his e%plains theconflict that may arise between stoc holders and bondholders# * $he benefits of debt include the ta% deductibility of interest payments (Benito (200:)# Asargued by Benito firms use debt as a means of limiting the interest of managers which maydiverge from the interests of shareholders# n fact, debt reduces free cash flow problems ase%cess cash is used to repay debt, rather than managers using it to consume bonuses (9amaand 9rench, 20023 .arris and 7aviv, **)# 2.3.2.2. Pecking Order Theory  9irm managers or insiders are assumed to possess private information about thecharacteristics of firm6s returns and the investment opportunities available to them (.arrisand 7aviv, **)# ;arious theories have been developed that have attempted to e%plicitlymodel this private information which has conse-uently given rise to theories other than the$radeoff $heory# $he !ec ing <rder $heory (!<$) is one such theory that attempts toe%plain capital structure decisions by formally ta ing into account the inherent informationasymmetry that e%ists between different parties# $he pioneers that have e%plicitly accountedfor asymmetric information in their wor have been 7oss (*==) and >eland and !yle(*==)# .owever, the first ones to actually ta e into account asymmetric information in thearea of capital structure have been 'yers (*/) and 'yers and 'a?luf (*/)# $heyshowed that the choice of capital structure mitigates inefficiencies in the firm6s investmentdecisions that are caused by information symmetry#According to the !ec ing <rder theory, firms have a strong preference for internal finance('yers, */) as it is believed to have a cost advantage over new debt and e-uity# f e%ternalfinance is re-uired, firms first issue debt and when all other @safe options are e%hausted3they issue e-uity as a last option# $he literature regarding the !ec ing <rder theory has beendormant since its inception in the early */06s when it was first proposed by 'yers (*/)and 'yers and 'a?luf (*/)#$he !ec ing <rder $heory proposed by 'yers (*/), prescribes a strict ordering or hierarchy of finance& firms use internal finance first then debt and only when such optionsare e%hausted, e-uity finance is used# $his is e%plained by the fact that internal and e%ternalfinance are not perfect substitutes# 20 Figure 2.1: Pecking Order of Financial Hierarchy Source: Henrik and Sandra, 2004 pp 5  $he !ec ing <rder $heory is diagrammatically illustrated above# $he hierarchy shown in9igure 2# above can be e%plained by number of factors# $hese factors include the costsassociated with each form of finance which are related to the degree of informationasymmetry, the @safeness of each form of finance or the signal that the issuance of someform of finance gives to the mar et# nternal finance is believed to be the cheapest source of finance followed by debt and e-uity# $he availability of internal funds allows firms tounderta e investment without having to resort to e%ternal finance which is relatively moree%pensive due a number of factors#  Additionally, 'yers (*/), e%plains this hierarchy by the fact that firms follow the rule of @issue debt when investors undervalue the firm and issue e-uity or some other security whenthey overvalue it# nvestors are aware of this and do not buy securities unless they areconvinced that the firm has e%hausted its @debt capacity# .ence, investors typically ensurethat firms follow a pec ing order#Also the issuance of debt or e-uity can cause agency problems to arise# $he issuance of debtcan cause conflicts to arise between managers and debt holders while the issuance of e-uitycan cause conflicts to arise between debt holders and e-uity holders# 9urthermore, theissuance of e%ternal finance namely debt, involves repayment of capital and interest whichthe firm has to pay whatever its financial state# $his increases the ris of financial distress#All these factors e%plain why a firm would prefer internal finance over e%ternal finance# 2 Another e%planation for the pec ing order is provided by 'yers and 'a?luf (*/) thatdraws from an asymmetric information framewor # $he management is assumed to nowmore about the firm6s value than the potential investors# <nly insiders now the -uality of afirm or its investment pro?ects# $herefore outsiders re-uire a premium if they are as ed tofund these pro?ects# $he degree of information asymmetry regarding e-uity is higher whencompared to debt# 9inancial intermediaries are able to monitor the firm and gain access toinformation that outside investors cannot get# <utsiders are normally not able to monitor firms and thus re-uire a much higher premium on e-uity finance than debt since they are inthe dar regarding the growth prospects of firms#Asymmetric information increases the cost of debt but, on the other hand, ta% advantageshave an opposing effect, which reduce the cost of debt relative to e-uity issues ('yers,*/)# $he most e%pensive source of finance is believed to be e-uity finance due to variouscosts associated with new e-uity issues# $hese costs include underwriting discounts,registration fees, ta%es and selling and administrative e%penses# Also, firms tend to issuesafe6 securities first, namely in the form of debt rather than e-uity# .ere safe6 implies thatthe terms are not affected by managers inside information (Shyam Sunder and 'yers,***)# ebt cannot be regarded as a safe6 security as there are costs of financial distressassociated with it, but it is still considered safer6 than e-uity# 2.3.2.3. gency Costs Theory  $he ne%t important theory mentioned in the literature is the agency cost theory# $his theorywas developed by ensen and 'ec ling in their *=C publications# $his theory considereddebt to be a necessary factor that creates conflict between e-uity holders and managers# Bothscholars used this theory to argue that the probability distribution of cash flows provided bythe firm is not independent of its ownership structure and that this fact may be used toe%plain optimal capital structure# ensen and 'ec ling recommended that, given increasingagency costs with both the e-uityholders and debtholders, there would be an optimumcombination of outside debt and e-uity to reduce total agency costs#
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