Capital structure theory benefits people to understand

Capital structure theory defines as the combinationof the owned capital such as the reserves, equity, and surplus and borrowedcapital such as loans from banks, financial institutions and so on.

The capitalstructure theory benefits people to understand about the factors in therelationship between capital structure and the value of the company. The theoryis beginning from Modigliani-Miller theorem. It is a theorem that haveexplained about the capital structure and it is as a basis of modern thinkingon capital structure. In 1958, this theorem came out by Franco Modigliani, anItalian economist, a professor at Carnegie Mellon University and MIT SloanSchool of Management and also with Merton Howard Miller who is an American economist.Although it is a nice structure theorem, but it is irrelevant in a perfectmarket because it must have some imperfections which exist in the real world.

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So, there are four types of theories that can help to overcome theimperfections. There are trade-off theory, pecking order theory, agency costtheory and signaling theory.            Firstof all, one of the main capital structure theories is trade-off theory. It isabout the formulation of capital structure and it is optimal capital structuresby trading off the benefits and cost of debt and equity. It is a primary theorythat had come out by Modigliani and Miller in 1963. As the result inintroduction, there are some imperfections in perfect market today.

Danso &Adomako (2014) stated that Trade-off theory recommended the modified MM propositionstress out that the benefit of tax shield are offset by the firm costs offinancial distress and agency cost.  So,trade off theory had took part in the categories of the interest tax shields(benefits), cost of financial distress and the firm value. The formula below shows the use of trade-off theory:V (firm) = V + PV(interest tax shields) – PV (costs of financial distress)            Theformula above explains that the value of firm is equal to the value of firmplus present value of interest tax shields and minus present value of the costsof financial distress. Based on Sheikh & Wang (2010), the trade-off theoryneed to choose a capital structure that can help to minimize the costs ofprevailing market imperfections so that it can maximize the firm value. Moreover, trade-offtheory is also named as tax based theory and bankruptcy costs. Based on Awan& Amin (2014), it expected every sources of money have their own costs andreturns. These are the connections between the earning capacity of firm and thebusiness or failure risks. So, the firm get more tax advantages will increasetheir debt to their financed business operation.

Therefore, the cost offinancial distress always in the balance condition with the benefits frominterest tax shield (Chen, 2011). Next, bankruptcy cost is about the distresscost which is a type of cost suffer when the shareholders or investors estimatethat the firm will going to be terminate. Actually, the debt can benefit thefirms too. Debt is a type of valuable signal for firms. According to Ross(1977), the leverage will increases firm’s value because enhancing leverage isrelated to the market’s realization of value.

Next, equity will also bediminish by debt which related with agency costs. Secondly, it turns forthe pecking order theory. The 2nd International Conference inManagement and Muamalah 2015 (2nd ICoMM) on 16th and 17thof November 2015 had come out an argument which is Trade Off theory did notreflect the irregularity of information. So, Pecking Order theory had used tointroduce about it. Pecking Order theory is a theory about the conflict betweenthe insider and outsider due to the asymmetry of information. So, it is notarget capital structure in this theory.

Based on Schoubben & Hulle (2004),this theory also consider signaling effect. Pecking Order Theory isa theory that suggested by Myers and Majluf in 1984 and Mostafa and Boregowdain 2014. Mostafa and Boregowda (2014) have stated the supply and demand factorsis the main factor which determining the level of debt ratios. However, most ofthe decisions of sources in financing is depends on the preference. Myers and Majluf haveargued the asymmetry of reality information between managers who act asinsiders and investors who act as outsiders. By following the argument, themanagers have more confidential information compare to the investors and theywill benefits more for their old shareholders. Danso & Adomako (2014) havedetailed the financial cost determined the hierarchy that have involved in thecorporate financing decision. It is because the companies should minimize theadditional cost and maximize their value.

If a company’s funds are not enoughto finance investment opportunities, the firm should choose to get an externalfinancing or finance a new investments that is more cheaply available sources. Myers& Majluf (1984) have argues about it because if managers more take care fortheir old shareholders, the managers will not send out a new shares that isundervalued. A firm will only emanate new stock in equilibrium during themarket down price (Mostafa & Boregowda, 2014), mentioned by Myers (1984).

Furthermore, Kim andStulz (1988) have mentioned that the announcement of debt declaration increasewill cause the share price rise too. Therefore, when managers declare theequity or release the equity to enable it as an alternative of riskless debt,the firm’s share price will fall because it normally will be markdown by theoutsiders. So, managers prefer to avoid the declaration of equity as possible(Luigi & Sorin, 2009). On the other hand, Myers and Majluf (1984) alsoargued that if firms maintain the investment opportunities by using itsretained earnings without issue new security, the asymmetric of information canbe overcome. This indicates that the problem of equity will become worse becausethe asymmetric information of insiders and outsiders increase.

Moreover, the peckingorder theory consider the market-to-book ratio as a measure of investmentopportunities (Baker & Wurgler, 2002). According to this theory, itexplained that the higher profitability of firms, the less debt will be issues.Then, that firm can finance their company’s activities with their internalfunds possiblely. Hence, the small firms that have more growth opportunitiesshould dispute more debt than equity (Mostafa & Boregowda, 2014). As aresult, the firm should collect benefits from satisfying the financial stagnantfor supplying the equity when information asymmetry is less.

It will enable thedebt with more elastic. Accordingly, the debtcapability point is almost same to the target debt ratio which has explained intrade-off theory. Based on the explanation above, we can identify that whetherfirm use all internal sources at the time of IPO check or not, if company do sofor investing in new plan, then the pecking order theory will be carry out forthe next. Thirdly, according toAkerlof and Arrow, signaling theory defined as a first studied in the contextof job and product markets. 7 Spence (1973) had described that it was developedinto signal equilibrium theory. 7 Spence (1973) also said that a good firm candiscriminate itself from a bad firm by transferring the reliable signal aboutits quality to capital markets. Debt as a signal can beused to separate the good from the bad firms. Signals from firms are as a vitalroles to get the financial resources under the asymmetry information betweeninsiders and outsiders.

Ross also mentioned that the insider smart indistribution of firm returns but outsiders do not. The firms with high quality havesignaling higher debt level. In contrast, the lower quality of firms will havelower debt level.

By the ways, the low quality firms will not try to attractscrutiny because they do not want to be find out. Next, there are two types ofsignaling through information have been proposed. Spence (1973), Leland andPyle (1977), Ross (1977) and Talmor (1981) have discussed about the costlysignaling equilibrium. However, Bhattacharya and Heinkel (1982), Rennan andKraus (1984) have discussed about the costless signaling equilibrium.

Besidesthat, the debt can be used to be a signal to discriminate the potential ofthose fresh and new firms (Poitevin, 1989).  Fourthly, agency costsare a type of costs that must be paid to agent as a behalf of capital. Whenthere are some conflicts of interest between shareholders and managers, thesecosts will arise. It is because the shareholders prefer to benefit in theirshareholders’ value. However, managers wish to maximize their personal benefitscompare to the interests of shareholders. Agency costs are the sum ofmonitoring expendirtures by the principal, the bonding expendituresby theagents and the residual loss. Agencycosts = Monitoring Expenditures + Bonding Expenditures + Residual LossProfessor MichealJensen who was from Harvard Business School and Professor William Meckling whowas from Simon School of Business, University of Rochester have wrote “Theoryof the Firm: Managerial Behavior, Agency Costs and Ownership Structure”.

Bothof them focus on the analysis of agency costs that had generated by the contractualarrangements between the owners and top management of the corporation.Agency relationship hasbeen explained as “a contract under which oneor more persons (the principal) engage another person (the agent), to performsome service on their behalf which involves delegating some decision makingauthority to the agent” (Jensen and Meckling, 1976).Basedon their thought, if both utility of insiders and outsiders are maximize, thenthere will be believe that the agent will not always act in the best interestsof the capital. Besides that, they competed that the firms can limit thediversities of principal from the interest by giving the appropriate incentivesto their agents and leading the monitoring costs consist of monetary andnon-monetary.             In addition, the bonding costs will be paid to the agentfor expanding the resources and it can avoid the agents take certain actions toharm the principal. However, Jensen and Meckling (1976) argued that the agencycost is the costs that cannot be avoid since it is accepted by the owner. Theowner just can suggest to hope the costs be minimizes so that the decisions ofagents would maximize the welfare of the principal.

The dollar equivalent ofthe reduction in welfare experienced by the principal as a result of thisdivergence is also a cost of the agency relationship, and we refer to this lattercost as the “residual loss” (Jesen and Meckling, 1976). When there iscooperative efforts involve it, the agency costs will arise although there isno clear principal and agents relationship (Alchian and Demsetz , 1972). As aresult, it is clear that the definition of agency costs has a bit of different viewswith the importance of theory that came out by Alchian and Demsetz (1972).

The agency cost thatgenerated in the corporate form was introduced by Jensen and Meckling (1976)which leads to an ownership structure theory of the firm. Jensen and Meckling(1976) just focus a general problem in their journal, that was the analysis ofagency costs which generated by the contractual arrangements between the shareholdersand managers of the corporation. “We focus almost entirely on the positiveaspects of the theory.

That is, we assume individuals solve these normativeproblems, and given that only stocks and bonds can be issued as claims, weinvestigate the incentives faced by each of the parties and the elementsentering into the determination of the equilibrium contractual formcharacterizing the relationship between the manager (i.e., agent) of the firmand the outside equity and debt holders (i.e., principals)” written by Jensenand Meckling (1976).As a conclusion, thecapital structure theories can be used in the long-term financing of company.It provides a unique blend of financial sources to the whole company.

Theequity and debt are the important characters in these theories. As a result, wecan know that debt equity ratio reveal the stability, internal and externalthreats and opportunities of company. The higher the leverage of firm will haveless risk compare to those companies which within high debt. The combination ofcompany’s’ debt and equity, the total value of the company is not really becauseof the capital structure.

However, it still has some effects and it isregarding to the irrelevance of capital structure. So, we should use in rightways in right situations and problems.


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