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Australian Academy of Accounting and
Finance Review (AAAFR)
ISSN (Online) 2205- ISSN (Print) 2205-
Theories Linking Capital Structure with Financial
Performance 2018
Abdulaziz Alghamdi, Gabriel Donleavy, Omar Al Farooque, John Anderson, Ashfaq Khan UNE Business School, University of New England, Australia and University of Jeddah, Jeddah, Saudi Arabia
1. Introduction
Maximizing firms’ shareholder wealth is an important duty of finance businesses’ managers. Scholars argue whether this goal can be reached through capital structure choices. To make this possible, firms should minimize their cost of capital and provide a return which adequately provides for the risk taken by shareholders and above the opportunity cost (Jahanzeb, 2013). Originally, Modigliani and Miller (1958) proposed that in a perfect market, capital structure is irrelevant and does not affect a firm’s value as explained in more detail in the following section. Previously, there were extensive discussions in literature on: First, the optimum capital structure choices and determinants; and second, the impact of capital structure on firms’ value and performance (Allen et al., 2013; Berger, 1995; Frank and Goyal, 2007; Myers, 1984). Following Modigliani-Miller (M&M) theory, several other theories were developed based on the assumption of the perfect market. First, trade-off theory contended that firms trade-off between the benefits and costs of using debt and equity as a source of financing when considering market imperfections, for example, taxes, bankruptcy cost, and agency cost (Luigi and Sorin, 2009). Second, pecking order theory pioneered by Myers and Majluf (1984) looked at the issue of asymmetric information between shareholders and firms’ managers. The main goal of this theory is to minimize the problem of asymmetric information using internal sources as a first choice. If internal Abstract The choice of capital structure is one of the most important and fundamental aspects of corporate finance studies. It is a controversial topic among finance scholars. In the mid-1950s when Modigliani and Miller devised their concept of “Modigliani-Miller (M&M) propositions,” the assumption was made that in a perfect market, capital structure is irrelevant and does not affect a firm’s value. Following M&M theory, finance scholars developed various theories based on the assumption of the perfect market. First, trade-off theory assumes that firms trade- off between the benefits and costs of using debt and equity as a source of financing when considering market imperfections such as taxes, bankruptcy cost, and agency cost. Second, pecking order theory examines the issue of asymmetric information between shareholders and firms’ managers. The main goal of this theory is to minimize the problem of asymmetric information using internal sources as the first choice, if internal sources are not enough to fund a business as financing requires, then external sources are resorted to be used. Third, agency cost theory argues that corporate governance comprises ownership structure and how processes are properly implemented, given that these impact on firm performance, firm value and subsequently the capital structure. Other scholars examine whether firm performance can be determined by the choices of capital structure which can be predicted by the efficiency risk and franchise value hypotheses. This study aims to shed light on the capital structure theories that have been used by scholars; various empirical studies are reviewed to clarify the capital structure theories. Keywords: Capital Structure; Leverage; Trade-off Theory; Pecking Order Theory; Agency Cost Theory
sources are not enough to fund the firm as financing requires, then external sources are employed. In addition to trade-off theory and pecking order theory, this study utilizes agency theory, which was conceived by Berle and Means (1932). They argued that corporate governance comprises ownership structure and processes which impact on a firm’s performance and its value. Reference will be made to reverse causality between capital structure and firm performance which can theoretically be predicted according to the efficiency risk and franchise value hypotheses (Berger and Di Patti, 2006). The above-mentioned hypotheses have been used by researchers as theoretical bases for assessing the impact of firm performance on the choice of capital structure. On the one hand, the efficiency risk hypothesis assumes that firms experiencing both high performance and profitability employ more debt in their financing preference choices because these firms generate more cash flow. They also are able to repay all debt obligations and interest rates (Berger and Di Patti, 2006; Margaritis and Psillaki, 2010; Yeh, 2011). As a result, the efficiency risk hypothesis asserts that firm performance positively impacts on capital structure. This is very different from the franchise value hypothesis which assumes that firms performing well use less debt in their financing sources, to protect their income and value that these firms have generated over time due to liquidity distress. This theory posits a negative relationship between firm performance and leverage (Margaritis and Psillaki, 2010; Yeh, 2011). In the following subsections, more details about these theories are provided starting with M&M theory followed by trade-off theory, pecking order theory, agency theory, and the efficiency risk, and franchise value hypotheses.
1.1. Capital structure definition
Capital structure is defined as the financing sources that firms use to finance their assets, operations and future growth, particularly the proportions of debt (leverage) and equity (Jensen, 1986). As well, capital or financial leverage refers to the degree to which a company’s total capital comprises debt (Arnold, 2014). The terms leverage and gearing can be used interchangeably. However, leverage is used more frequently in the United States and while gearing is applicable to the United Kingdom. In terms of banks’ capital structure, Greenbaum et al. (2016) defined bank capital structure as a mix of equity, subordinated debt, and deposits that banks use to finance their assets, operations, and future growth. Leverage ratio serves as the capital structure indicator and is basically defined as the firm’s debt/total assets. Diamond and Rajan (2000) state that banks’ capital structure is almost similar to that in non-finance firms. However, they also found that the main differences are due to variations in the role of capital, range of industries that firms operate in, and how the economy works. Diamond and Rajan - according to their model - contend that non-finance firms benefit more from using banks’ funding and liquidity offering, while finance firms do not have that access due to capital regulations. As a result, they built a new model based on banks’ capital structure to better understand all the relevant issues concerning this capital structure. Furthermore, according to Diamond and Rajan (2000), banks’ operations in the form of liquidity- creation and credit-creation are influenced by banks’ capital structure. From this perspective, they started examining whether banks could finance their operations from customers’ deposits or should use other sources such as debt or equity. Diamond and Rajan (2000) indicated that banks could not fund borrowers with only deposits because depositors are not negotiable and no specific period is set aside for depositors to use their money. Consequently, they suggested that banks should use different sources of finance such as debt and equity to protect themselves against depositors’ shocks. Sorokina (2014) asserted that the capital structure of financial institutions differs from the capital structure of non- finance firms, in at least two respects. First, banks heavily depend on deposits to finance their primary operations. Second, finance firms - and particularly their capital structure - are subject to government legislation and regulations.
2. Capital Structure Theories
The M&M theory comprises two versions: (i) M&M without tax and (ii) M&M with tax. In the following subsections, these two versions are explained in more detail.
2.2. M&M with tax
In 1963, Modigliani and Miller updated their proposition by adding a firm’s tax to their previous propositions. They examined the effect of corporate taxes on both a firm’s value and cost of equity. Basically, tax shield benefit is the tax saving achieved by a business from interest expenses (Arnold, 2014). On the one hand, the leveraged firm will benefit from a tax deduction because it will only be taxed after interest expenses. On the other hand, the unleveraged firm which does not have interest expenses will be taxed on its total earnings. For this reason, leveraged firms pay less tax because interest expenses are deducted. It implies that a leveraged firm has greater cash flow than an unleveraged firm which is made possible by the tax shield benefit. Consequently, M&M assumed that the firm’s value increases as long as the firm’s cash flow increases. M&M proposition 1 (with tax): The value of the leveraged firm is equal to the value of the unleveraged firm plus the present value of interest tax shield VL = VU+TcD (4) Where: VL = the value of leveraged firm; VU = the value of unleveraged firm; Tc = the firm’s tax rate; and D = the firm’s debt. M&M examined the effect of leverage on the firm’s cost of equity. In a world of no tax, M&M stated that leverage increases the firm’s risk which results in higher cost of equity which shareholders demand. This suggests that a positive relationship exists between cost of equity and leverage. In a world where there is a tax, M&M expect the same conclusion; however, they added the amount of tax shield benefit to be added to the equity. As a result, the tax shield benefit will reduce the total firm’s cost of capital. M&M proposition 2 (with tax): The cost of equity rises with leverage because risk to equity rises with leverage Figure 1: The cost of debt, equity, and weighted average cost of capital and firm value under the Modigliani-Miller proposition (no tax) Arnold (2014)
Based on M&M proposition II (with tax), the firm’s cost of equity can be expressed as:
E A c^ (^ A D )
D
r = r + (1- T ) r - r
E
Where: rE = the cost of equity; rD = the cost of debt; rA = the required rate of return of firm’s assets (WACC); D = the value of the firm’s debt; E = the value of the firm’s equity; and Tc = firm’s tax rate. Furthermore, WACC can be expressed as:
D^ (^ c ) E
D E
WACC = × r 1- T + ×r
V V
From the previous analysis, we can see that the M&M propositions (with tax) suggest firms should, in the absence of bankruptcy costs, use 100% as debt because there are tax shield benefits that businesses can exploit. Figure 2 summarizes the M&M proposition (with tax). It illustrates the relationship between cost of equity, cost of debt after tax, and WACC. It can be clearly seen that WACC declines and debt/ equity increases which mean the more debt used the less WACC is obtained. We can see clearly that the WACC is declining as long as the firm uses debt because certain tax shield benefits enable the firm’s value to increase. Remarkably, the less WACC, the higher firm value will be (Arnold, 2014).
2.3. Trade-off theory
This theory emerged following Modigliani and Miller (1963) added tax shield benefits to their original M&M propositions. Since M&M theory suggests using debt to obtain tax shield benefits, this will lead to 100% debt financing, which obviously results in a high level of risk. For this reason, Kraus and Litzenberger (1973) added bankruptcy cost to M&M theory, stating that since bankruptcy cost “risk” Figure 2: The cost of debt, equity, and weighted average cost of capital and firm value under the Modigliani-Miller tax model Arnold (2014)
profitability which is negatively related to leverage (Frank and Goyal, 2007). However, the theory does not take into consideration the agency cost since it implies giving more power to managers to control cash flow, which was inconsistent with the normative thrust of agency theory proposed by Jensen and Meckling (1976) [Figures 4 and 5].
2.5. Agency theory
Agency theory was originally developed by Berle and Means (1932), who argued that corporate governance comprising ownership structure had an important role to play and impacted on firm performance and firm value. Berle and Means (1932) stated that the separation between ownership and control will reduce the agency problem which will result in maximizing firm value. It does this by encouraging managers to act more in the business owners’ interests. Extending this, Jensen and Meckling (1976), stated there are three different agency conflicts: First, between managers and shareholders; second, between debt holders and equity holders; and third, between majority shareholders and minority shareholders. These conflicts lead to rising agency cost which can seriously undermine firm value. Jensen (1986) explained that agency cost must be minimized to increase firm value and increase shareholders’ wealth. Agency cost can be decreased through several mechanisms and one of these is debt. It has long been debated that debt could be used as a monitoring mechanism to mitigate agency cost. While the conflict between managers and shareholders can be reduced through debt, using debt to finance firms’ operations will reduce agency cost because it decreases free cash flow which can be exploited by managers to serve their own interests and not those of shareholders. Debt obligations and interest payments encourage managers to do their best to meet all a company’s debt obligations; otherwise, firms will become bankrupt due to the strong relationship between debt and bankruptcy cost. Therefore, if firms fail to pay back their debt obligations, firms will be under threat of default, and hence, all managers are at great risk of losing their positions and reputations. The conflict between majority shareholders and minority shareholders is another assumption of agency theory in regard to ownership structure and its impact on firm value and performance. The majority of shareholders have strong monitoring and controlling power due to their voting rights, especially if managers are the majority shareholders. Therefore, leverage can mitigate the opportunistic behavior of managers. In this scenario, managers and directors with engage in less opportunistic behavior and will do their best to repay all debt and interest obligations. Consequently, all efforts by majority shareholders especially if they are managers will lead to minority shareholders benefiting in the long-term. It can Figure 3: The cost of capital and firm value with taxes and financial distress as leverage increases Arnold (2014)
be clearly seen that agency theory suggests that firm should use more debt to mitigate agency conflict between managers and shareholders. Doing so will minimize the agency problem and increase firm value. However, using more debt will lead to an increase in a firm’s risk and bankruptcy costs. In turn, the conflict between debt holders and equity holders will sharpen due to the risk of default that firms are subject to, which significantly impacts on firm value. Conflicts between equity holders and debt holders derive from issues concerning underinvestment. This problem happens because firms take into account the cost of debt (serves debt holders), more than benefits (serves equity shareholders). Stulz (1990) argues that debt payment can positively help shareholders because it forces managers to pay the interest obligation, which reduces the overinvestment problem. In contrast, debt could negatively influence shareholders because high-interest payments will lead to the likelihood of projects not being profitable, thus resulting in the underinvestment problem. Therefore, firms must take into account that debt should be determined by the trade-off between cost of debt and benefits. According to Myers (1984), when a firm experiences a high level of bankruptcy, even if it has the available cash flow and better NPV projects, equity investors will make no effort to invest in such a firm because the value obtained by it will largely go to the debt holders. It is clearly evident that agency theory suggests firms should use more debt to mitigate agency conflict between managers and shareholders to enhance firm value. In contrast, to mitigate conflict between debt holders and equity investors, firms should use less debt because not doing so will increase the risk of default, which is due to the underinvestment problem. Utilizing debt should be determined by the trade-off between cost of debt and tax shield benefits (Stulz, 1990). Driffield et al. (2007) investigated the impact of ownership structure on capital structure and firm performance for the period 1994–1998 in four Asian countries, i.e. Indonesia, South Korea, Malaysia, and Thailand. In their study, the sampling is divided into two groups - family and non- family firms. Their results show that ownership concentration positively affects leverage in family firms but negatively impacts on leverage in non-family firms. In addition, the influence of managerial opportunism or moral hazard (measured by the separation of control and cash flow rights) on capital structure and firm performance has been examined. The results show that managerial opportunism has a significant positive impact on leverage and firm performance in family firms while it has an insignificant relationship in non-family firms. Another empirical study by Margaritis and Psillaki (2007) looked at the relationship between capital structure and firm performance and considered the impact of reverse causality of firm performance on Figure 4: Pecking order theory (researchers) Retained earnings Debt Equity Internal source External sources
2.6. The efficiency risk and franchise value hypotheses
The main theories regarding capital structure mainly interpret the relationship between capital structure and firm performance, mainly in terms of the impact of the former on the latter. With regard to the reverse causality between capital structure and firm performance which can be theoretically predicted by the efficiency risk and franchise value hypotheses (Berger and Di Patti, 2006), these hypotheses have been used by researchers to evaluate the impact of firm performance on the choice of capital structure. The efficiency risk hypothesis assumes that firms enjoying high performance and high profitability employ more debt in their financing preference choices because these firms generate more cash flow and can repay all debt and interest obligations (Berger and Di Patti, 2006; Yeh, 2011). Consequently, the efficiency risk hypothesis posits that firm performance positively impacts on capital structure. Meanwhile, the franchise value hypothesis contends that high performing firms use less debt in their financing sources to protect their operating income and value that such businesses have generated over time due to liquidity distress. The franchise value hypothesis posits a negative relationship between firm performance and leverage (Margaritis and Psillaki, 2010; Yeh, 2011). Empirically, many researchers have investigated the impact of capital structure on firm performance. However, only a few studies - Berger and Di Patti (2006) in the US, Margaritis and Psillaki (2010) in France, Yeh (2011) in Taiwan, and Driffield et al. (2007) in Asia - examine reverse causality between firm performance and capital structure utilizing the efficiency risk and franchise value hypotheses. Berger and Di Patti (2006) examined the relationship between capital structure and 7320 US banks’ performance, documenting the significant and positive impact of leverage on their performance. It emerged that higher leverage or lower equity capital ratio resulted in the ability to make more profits, which indicated a positive relationship between leverage and performance. This finding confirms the assumption of the efficiency risk hypothesis. Furthermore, Driffield et al. (2007) examined the simultaneous relationship between firms’ capital structure and their valuation. They detected a negative association between firm value and level of leverage. This outcome is in line with the franchise value hypothesis. Other empirical studies by Margaritis and Psillaki (2007) and Margaritis and Psillaki (2010) utilized the quantile regression method to examine reverse causality from firm performance to leverage, observing that firm performance plays a significant role in capital structure decisions and choices. Specifically, both studies stated that firm performance positively impacted on leverage when a firm has low to middling levels of leverage; however, this relationship becomes much more negative if a firm has a high level of leverage. This result is in line with both the efficiency risk and franchise value hypotheses. This finding supports the efficiency risk hypothesis where high performing firms tend to use more debt because they can meet their debt obligations. Therefore, it is revealed that firms with high levels of performance tend to use more debt; however, applying more debt may increase bankruptcy costs and overall risk, thus subjecting companies to more financial distress and possible default. Furthermore, emphasized here is the fact that the negative relationship between firm performance and leverage was observed for these firms who already applied high levels of leverage. This is also explained by the franchise value hypothesis which posits that high performing firms tend to successfully minimize their debt levels to avoid bankruptcy and financial distress.
3. Conclusion
Capital structure theories have existed for many decades, but they still constitute a major puzzle in the literature. The optimum capital structure for firms cannot be generalized to all other firms which make the choices of capital structure difficult for managers and scholars. Since the development of M&M which was originally proposed in the 1950S and deemed capital structure to be irrelevant to firm value, trade-off theory, pecking order theory, and agency cost theory have sort to clarify the relationship between capital structure and firm value and performance. This paper found that in recent times scholars have tested whether capital structure choices can be affected by bank performance using a reverse causality approach, utilizing the efficiency risk, and franchise value hypotheses. The efficiency risk hypothesis found firms which performed well and enjoyed high profits employed more debt in their financing preference choices because they can generate higher cash flows and are able to repay all debt and interest obligations. In contrast, the franchise value hypothesis assumed that such high performing
firms employ less debt in their financing sources to protect their operation incomes and value. While the theories described here to some extent can explain the capital structure choices and optimum capital structure, it is still debatable what the outcomes will be due to these hypotheses’ different predictions.
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