Theory Of Optimal Capital Structure Research Articles

Debt Capacity and Financial Performance of Quoted Firms in Nigeria

Introduction: The field of research treating debt capacity can be comprehended as a unique piece of a lot more extensive capital structure hypothesis. This started with the paper of Modigliani/Miller in 1958. There has been a continuous and serious hypothetical dialog about the ideal capital structure of an organization. One generally new piece of the related discussion is debt capacity and potential connection to the capital structure of an organization.
 Purpose: The purpose of the study was to examine the effect of debt capacity and financial performance of quoted firms in Nigeria. This study expected that debt capacity can be a way to characterize and deal with the capital structure of an organization.
 Methodology: The study formulated 3 hypotheses and the least square multiple regression was used for hypothesis testing empirical results based on 2014 to 2018 accounting and marketing data for 20 quoted firms in Nigeria lend some support to the pecking order and static tradeoff theories of optimal capital structure. Data were sourced from the Nigeria Stock Exchange, Security and Exchange Commission, and other relevant data sources. This study investigated, experimentally, if there might be a significant relationship between the debt capacity of organizations and their financial and market performance. 
 Findings: A firm’s debt capacity was found to have a significant impact on the firm’s accounting performance measure. Debt capacity measures have a positive and significant relationship with the market performance measure (Tobin’s Q). A fascinating finding is that all the influence estimates have a positive and exceptionally critical association with the market execution measure (Tobin’s Q), which could somewhat bolster Myers, (1977)’s contention that organizations with high transient obligation to add up to resources have a high development rate and superior.
 Unique contribution to theory, practice and policy: The consequences of this result further affirm some earlier discoveries by different researchers and prior analysts and the exploration work has had the option to discover answers to the examination addresses prior brought up in the basic part in the accompanying ways. It was therefore recommended that Companies can finance themselves with debt and equity capital. By increasing the amount of debt capital relative to its equity capital, a company can increase its return on equity. Also, in transition, the economic environment is more volatile and riskier than in developed markets. Therefore, a management scheme of capital structure that provides for flexibility in financing is preferable.

No-fault default, chapter 11 bankruptcy, and financial institutions

This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.

No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions

This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization

Building on the trade-off between agency costs and monitoring costs, we develop a dynamic theory of optimal capital structure with financial distress and reorganization. Costly monitoring eliminates the agency friction and thus the risk of inefficient liquidation. Our key assumption is that monitoring cannot be applied instantaneously. Rather, transitions between agency and monitoring are subject to search frictions. In the optimal contract, the firm seeks a monitoring opportunity whenever it is financially distressed, i.e., when the risk of liquidation is high. If a monitoring opportunity arrives in time, the manager is dismissed, the capital structure is reorganized as in Chapter 11 bankruptcy, and the search for a new manager begins. In agency, an optimal capital structure consists of equity, long-term debt, contingent long-term debt, and a credit line with performance pricing. In financial distress, coupon payments to contingent debt are suspended but the interest rate on the credit line is stepped-up, which gives the firm simultaneously debt relief and a steep incentive to improve its financial position. An episode of distress can end with financial recovery, transition to bankruptcy reorganization, or liquidation.

The relationship between business cycles and capital structure choice: The case of the international shipping industry

Research on capital structure choice depicts firm size, profitability, and asset tangibility as the main determinants of capital structure. The trade-off and pecking order theories of optimal capital structure predict contradictory relationships between each of these determinants and firm leverage. We attempt to reconcile the conflicting results in the literature by incorporating the impact of different phases of the economic cycle upon the choice of capital structure in a concentrated ownership setting. Studying 117 internationally listed shipping companies (about 60% of the entire population), we explore potential determinants of capital structure choice in periods of expansion (2003Q4), peak (2007Q4), trough (2008Q4), and sideways movement (2010Q4). Our finding that size, tangibility, and corporate performance constitute the main determinants of capital structure in the shipping sector is consistent with the literature. We employ the Generalized Method of Moments (GMM) to estimate the interaction between capital structure choice, corporate profitability and structure of ownership. Our model asserts bidirectional positive relationships between leverage and profitability and leverage and concentrated ownership in the peak period of 2007, but bidirectional negative relationships amongst these variables in all other periods. We conclude that the sentiment of the ship-owner during different phases of the business cycle, along with ownership concentration are key elements in explaining the relationship between profitability and leverage in the shipping sector.

Taxation and leverage in international banking

This paper explores how corporate taxes affect the capital structure of multinational banks. Guided by a theory of optimal capital structure, it tests whether (i) corporate tax rates induce subsidiary banks to raise leverage in light of traditional debt bias; and (ii) cross-country corporate tax differences affect a subsidiary’s leverage through international debt shifting. Using a novel data set for 756 commercial bank subsidiaries of 91 largest multinational banks in the world, we find that taxes matter significantly through both channels.

Optimization of Resources of the Company

This article helps to understand that there is no theory of optimal capital structure of the company in a perfect market where there are no transaction costs, costs of bankruptcy and tax and where information is perfect. It recalls that the consideration by some authors of market imperfection factors implies that there is an optimal capital structure of the company corresponding to its maximum value. It reviews the financial conditions of the capital increase by companies. It shows that the demand of optimal debt to a debtor is based on his expectation of credit and the conditions for granting the credit, requested in terms of interest rate and repayment periods, offered by the creditor. It proposes a model for determining the optimal rent for a rental investment operation by a company.

Does Financial Leverage Influence Investment Decisions? The Case of Pharmaceutical Firms in India

The theory of capital structure irrelevance developed by Modigliani and Miller (1958 & 1963) paved a path to the development of various theories. Although Modigliani and Miller (1958) proposed the theory of irrelevance by arguing that investors do not give considerable attention to financial leverage under the perfect market condition since financial risk could be diversified away by the marginal investors. Further, Miller (1977) modified the theory by introducing the same level of personal as well as corporate taxes into the model. In 1980, Deangelo and Masulis extended Miller’s work by examining the effect of tax shields other than interest payments on debts. In 1977, Ross has done research on the signalling role of debt. Another equilibrium theory of optimal capital structure is agency theory proposed by Jenson and Meckling (1976). Myers (1984) proposed pecking order theory i.e. consequence of asymmetric information. These theories motivated the researchers to do further research on this domain. Numerous studies have investigated the relationship between financial leverage and investment decisions by using various approaches in different geographical contexts and at different points in time. The results of these studies are inconclusive. The inconclusive results motivated the author to undertake a study on the relationship between financial leverage and investment decisions in Indian pharmaceuticals firms and the extent to which this relationship is explained by these theories.A quantitative analysis has been carried out over a panel data sample of 95 listed pharmaceutical companies of BSE for the period of 2000-2012. To understand the relationships proposed above, this study used five measures namely financial leverage, sales, cash flows, Tobin Q ratio, net investment to fixed assets ratio and net sales to fixed assets. These variables were used by McConnell and Servaes (1995); Lang et al (1996); Aivazian et al (2005); and Serrasqueiro, Mendes, and Nunes (2008). This study has adopted the same variables to test the theory of relevance and irrelevance of companies’ non-observable individual effects. Financial leverage is measured using two proxies. The first proxy of financial leverage is calculated by dividing the total long term borrowings by the total assets. The ratio emphasises the dominant role of long-term borrowings (Aivazian et al, 2005). The second proxy of financial leverage could be calculated by dividing the total liabilities by the total assets. Similarly, two proxies were also used for growth opportunities. First proxy for growth opportunities is Tobin’s Q which refers to the market value of total debt and equity of a company divided by the book value of debt and equity. The second proxy is sales growth which is defined as net sales deflated by net fixed assets. Cash flow is measured as the profit before extraordinary items and all non-cash items.The study employed panel data regression with pooled, fixed or random effect regression. Among the three methodologies, this study found that fixed effect model is more appropriate to understand the proposed relationships in relation to pharmaceutical firms over the sample period. This study found that pooled regression is not the best way to estimate the investment-financial leverage relationship as it fails to consider the relevance of cross section effects i.e. companies’ non-observable individual effects. The relationship between financial leverage and investments was negative as expected by agency theory and statistically significant at 10 per cent level. The cash flow was positively related to investment However, this study found that there is a change in estimated coefficients of parameters in terms of magnitude and statistical significance while performing fixed effect model with AR (1). It suggests that it is important to consider the impact of previous period for investment in the current period.

Taxation and Leverage in International Banking

This paper explores how corporate taxes affect the financial structure of multinational banks. Guided by a simple theory of optimal capital structure it tests (i) whether corporate taxes induce subsidiary banks to raise their debt-asset ratio in light of the traditional debt bias; and (ii) whether international corporate tax differentials vis-a-vis foreign subsidiary banks affect the intra-bank capital structure through international debt shifting. Using a novel subsidiary-level dataset for 558 commercial bank subsidiaries of the 86 largest multinational banks in the world, we find that taxes matter significantly, through both the traditional debt bias channel and the international debt shifting that is due to the international tax differentials. The latter channel is more robust and tends to be quantitatively more important. Our results imply that taxation causes significant international debt spillovers through multinational banks, which has potentially important implications for tax policy.

Stochastic modelling and prediction of contractor default risk

The purpose of this paper is to describe a systematic framework of stochastic modelling and prediction of financial default risk of construction contractors. Net-worth-to-asset ratio is identified as an index for default process modelling. The default condition is defined as when the ratio becomes negative the first time. A mean-reverting dynamic model for the contractor default process is found by statistical analysis and is justified by using the theory of optimal capital structure. The stochastic modelling of default uses the time to default as the fundamental random variable. A discrete time trinomial Markov chain model is developed to assess default risk in terms of a cumulative default probability function, a default probability function, and the mean and variance of time to default. Practical examples are given to illustrate the stochastic methods. A default discriminant study on a group of contractors and publicly traded companies validates the methods, and indicates a high predictability of events of default and declines of credit rating.

Financial market-product market interactions in industry equilibrium: Implications for information acquisition decisions

With few exceptions, theories of optimal capital structure have been derived for single firms in isolation. ’ This approach does not model the effect of a capital structure decision on other firms in the industry and can therefore not take into account industry equilibrium conditions. Recently, first steps towards an analysis of capital structure decisions in an industry equilibrium have been made. These contributions demonstrate that in this setting some standard results of single firm capital structure theories may be reversed. Modelling the decisions of other firms is particularly important when analysing the effect of capital structure on product market decisions since the product market effects depend crucially on a firm’s competitive environment. The emerging literature on financial market-product market interactions in industry equilibrium can be classified into a strand of literature which uses capital structure as a commitment device and one in which capital structure does not play such a role. The former models rely on the fact that rival firms can observe the choice of capital structure and rationally anticipate its effects on subsequent investment and production decisions. The latter models do not require a commitment effect of capital structure. In these contributions, firms have no incentive to alter their capital structures in equilibrium, even if capital structure renegotiations were unobservable.

A time-series approach to exploring aggregate optimal capital structure: cointegration analysis

Although there are a substantive number of corporate capital structure models which postulate the existence of an optimal capital structure, only Miller's model (1977) explicitly addresses the issue of an optimal aggregate capital structure. To date, there is very little empirical evidence to substantiate or refute the existence of an aggregate optimal capital structure. Johansen's procedure for cointegration testing is employed to test Miller's hypothesis, along with other theories of optimal capital structure. The cointegration approach is advantageous in that it allows for the testing of long-run equilibrium relationships between series which are non-stationary. The Johansen's procedure utilizes tests which have well-defined limiting distributions unlike those employed in the Engle and Granger procedure. Additionally, this methodology allows us to explicitly define the number of cointegrating vectors and, therefore, the number of common stochastic trends. The results indicate that there is an equilibri...

Merton H. Miller's Contributions to Financial Economics

It is an honor to review Merton Miller's contributions to financial economics. His work with Franco Modigliani built the framework, and much of the fabric of modern corporate finance. This report is organized in five sections: (i) corporate finance and financial economics; (ii) the Modigliani-Miller (MM) theory of optimal capital structure; (iii) the MM theory of dividend policy; (iv) MM and the normative theory of corporate finance; and (v) conclusions.

Explaining differences in corporate capital structure: Theory and new evidence

This paper tests a theory of optimal capital structure based on three simple imperfections: (i) personal and corporate taxes; (ii) bankruptcy related costs; and (iii) transfer of wealth from unprotected creditors. In contrast to other empirical tests (most of which rely on comparative statics to devise a linear regression), we derive a testable equation explicitly from the firm's value-maximizing first order condition. Our cross-sectional tests confirm earlier findings by Warner (1977) and Ang et al. (1982) that the fixed (explicit) costs of bankruptcy are not statistically significant.However, we find strong explanatory power in the marginal (implicit) costs of bankruptcy. These costs have two components. First, the data suggest that firms with high fixed-asset intensity carry heavier debt loads because of the floor that these assets create for potential bankruptcy costs to be borne by security-holders. This result explains inter-industry differences in debt-ratios found by Schwartz and Aronson (1967) and Scott (1972). It also explains some anomalies in recent tests by Bradley et al. (1984) who find a positive relationship between debt ratios and depreciation when their model predicted a negative relation. In our view, depreciation acts more asa proxy for fixed asset and less as a proxy for non-debt tax shield which Bradley et al. were analyzing. Secondly, our tests suggest that an unprotected creditor or wealth transfereffect provides additional stimulus to issuance of debt and that this stimulus is stronger than the net tax effect. Schwartz (1981) finds such distributional explanations to be both economically meaningful and worthy of further empirical research because of its potential for initiating legal reform. We modestly claim that our finding in this regard is an important first step in this research and is similar to the wealth-transfer effect from bondholders to stockholders studied by Masulis (1980, 1983).

The Determinants of Capital Structure Choice

ABSTRACTThis paper analyzes the explanatory power of some of the recent theories of optimal capital structure. The study extends empirical work on capital structure theory in three ways. First, it examines a much broader set of capital structure theories, many of which have not previously been analyzed empirically. Second, since the theories have different empirical implications in regard to different types of debt instruments, the authors analyze measures of short‐term, long‐term, and convertible debt rather than an aggregate measure of total debt. Third, the study uses a factor‐analytic technique that mitigates the measurement problems encountered when working with proxy variables.

Bankruptcy and Agency Costs: Their Significance to the Theory of Optimal Capital Structure

We support and generalize our original results (1978) in light of potential impediments to a pure market solution to agency problems and potential causal links between liquidation and bankruptcy. In the case of bankruptcy costs, market impediments are easily eliminated through the inclusion of simple provisions in corporate charters and bond indentures. Further, we demonstrate that recent attempts to link liquidation costs to capital structure are without merit. If the firm is to be liquidated on the basis of a rule other than one that maximizes the total value of all the claimants, arbitrage profits arise, and informal reorganization will discipline management to follow the liquidation rule that is optimal for existing securityholders. Also, we find that the pure market solution is not readily generalizable to other classes of agency problems, particularly the risk incentive problem. However, the alternative solution of the risk incentive problem through complex financing contracting may be useful in explaining complexities in contemporary financial contracts.

Optimal capital structure and project financing

We examine the financing and incorporation modes for new projects. There are two objectives. The first is to provide a theory of optimal capital structure that links risk, leverage, and value and is particularly applicable to large firms. Counter to conventional wisdom, we show riskier firms acquire more debt, pay higher interest rates, and have higher values in equilibrium. Second, we provide an economic rationale for project financing which entails organizing a new project legally distinct from the firm's other assets. We explain why project financing involves higher leverage than conventional financing and why highly risky assets are project-financed.

On the Existence of an Optimal Capital Structure: Theory and Evidence

ONE OF THE MOST contentious issues in the theory of finance during the past quarter century has been the theory of capital structure. The geneses of this controversy were the seminal contributions by Modigliani and Miller [18, 19]. The general academic view by the mid-1970s, although not a consensus, was that the optimal capital structure involves balancing the tax advantage of debt against the present value of bankruptcy costs. No sooner did this general view become prevalent in the profession than Miller [16] presented a new challenge by showing that under certain conditions the tax advantage of debt financing at the firm level is exactly offset by the tax disadvantage of debt at the personal level. Since then there has developed a burgeoning theoretical literature attempting to reconcile Miller's model with the balancing theory of optimal capital structure [e.g., DeAngelo and Masulis [5], Kim [12], and Modigliani [17]. The general result of this work is that if there are significant "leverage-related" costs, such as bankruptcy costs, agency costs of debt, and loss of non-debt tax shields, and if the income from equity is untaxed, then the marginal bondholder's tax rate will be less than the corporate rate and there will be a positive net tax advantage to corporate debt financing. The firm's optimal capital structure will involve the trade off between the tax advantage of debt and various leverage-related costs. The upshot of these extensions of Miller's model is the recognition that the existence of an optimal capital structure is essentially an empirical issue as to whether or not the various leverage-related costs are economically significant enough to influence the costs of corporate borrowing. The Miller model and its theoretical extensions have inspired several timeseries studies which provide evidence on the existence of leverage-related costs. Trczinka [28] reports that from examining differences in average yields between taxable corporate bonds and tax-exempt municipal bonds, one cannot reject the Miller hypothesis that the marginal bondholder's tax rate is not different from the corporate tax rate. However, Trczinka is careful to point out that this finding does not necessarily imply that there is no tax advantage of corporate debt if the personal tax rate on equity is positive. Indeed, Buser and Hess [1], using a longer time series of data and more sophisticated econometric techniques, estimate that the average effective personal tax rate on equity is statistically positive and is not of a trivial magnitude. More importantly, they document evidence that is consistent with the existence of significant leverage-related costs in the economy.

On the Asset Substitution Problem

In their seminal paper, Modigliani and Miller [11], [12] demonstrate that if capital markets are perfect and investment policy is held constant, the market value of the firm is independent of its financial decisions. Furthermore, if capital markets are perfect, stockholders have incentive to choose the investment policy which maximizes the market value of the firm (see [6]). Motivated by this assumption, the firm has been viewed as a “black box;” namely, as one homogeneous unit whose clear objective is to maximize its market value. However, in a growing body of recent literature (see [1], [2], [7], [9], [13], and [14]), researchers recognize that the firm in an “imperfect” capital market is a collection of groups whose interests can, and do, conflict. Jensen and Meckling [9] study the roles of three important groups—the owner-manager, the stockholders, and the bondholders—focusing on the potential costs resulting from divergence of interests among them. They provide a theory of optimal capital structure in terms of reducing the costs of these conflicts.

The Impact of Capital Structure Change on Firm Value: Some Estimates

This study develops a model based on current corporate finance theories which explains stock returns associated with the announcement of issuer exchange offers. The major independent variables are changes in leverage multiplied by senior security claims outstanding and changes in debt tax shields. Parameter estimates are statistically significant and consistent in sign and relative magnitude with model predictions. Overall, 55 percent of the variance in stock announcement period returns is explained. The evidence is consistent with tax‐based theories of optimal capital structure, a positive debt level information effect, and leverage‐induced wealth transfers across security classes.