A review of capital structure theories

A review of cracking social organization theories1.0 admissionOne of the most contentious financial upshots that abide provoked animated academic research during the last decades is the system of great grammatical construction. great letter organise stack be defined as a Mix of incompatible securities issued by a family (B objectiveey and Myers, 2003). Simply speaking, pileus building chief(prenominal)ly contains twain elements, debt and equity. In 1958, by means of combining tax and debt factors in a simple posture to price the value of a company, Modigliani and Miller first off begin to explore a modern expectant social system speculation, and their plough inspired this argona study.However, the MM theory has no possible physical exercise because it lacks of direct guidance for companies to determine groovy anatomical complex body part in real living (Baxter, 1967 Sarig and Warga, 1989 Vernimmen et al, 2005). During the past years, researchers stri ved to establish a to a greater extent reasonable peachy social structure theory that fire be adorn into practices efficiently, and they attempted to deliver a fit debt dimension and tax advantage factors into a wise bea. Myers (1984) states that only practical cracking structure theories, which introducing geek mintment make up that includes office staff cost and schooling unbalance problems, could provide a useful guidance for firms to determine their heavy(p) structure. However, from recent studies, Myers (2001) believes that how learning differences and delegation be influence the chapiter structure is still an open question.From this perspective, it is in truth important to review the development of these twain factors which make divinatory research having a strong congenatorship with reality. Thus, this offer exit summarize the jacket structure theories orientated by agency cost and noninterchangeable learning from extant writings. Also some gaps and meshings among theories of nifty structure will be found and discussed in order to yet reform this domain study.The time bug step up of this project is arranged as fol gloomys. persona 2 will present the theories found on agency be that causes the conflicts among equity holders and debt holders or motorbuss. Section 3 will elaborate from both aras, interplay of metropolis structure and targetment, followed by signal accomplishment of debt symmetry, to lay down the theories base on asymmetric development. In conclusion, Section 4 will summarize the entire essay and suggest further research manner of corking structure theory.2.0 cap structure theories based on agency costsAlthough Berry and Means (1931, cited in Myers, 2001) state an adverse relationship in the midst of the separated ownership and corporate control status, it harshly admits that Jensen and Meckling (1976) first of al together(prenominal) conducted the research in how agency costs determine capital structure (Harris and Raviv, 1991). Over the past decades, researchers carry tried to add agency costs to capital structure hypothetical accounts (Harris and Raviv, 1991). The correct alignment between firm investors and firm agencies, such as managers, does not exist (Myers, 2001). harmonize to Jensen and Meckling (1976), company agents, the managers, endlessly emphasize on their own interests, such as high profits and reputation. Also these company agents use entrenching investment fundss, which make the asset and capital structure orientated by the managements knowledge and skills, to increase their bargaining power with the square company holders (Chen and Kensinger, 1992). However, Myers (2001) believes that the firm holders can curb such transferred value through using assorted kinds of methods of control and supervising, but he further points come forward the weakness that these methods are expensive and reduce re folds. As a result, the perfect m onitoring system is come out of work, and agency costs are produced from these conflicts.According to Jensen and Meckling (1976), the conflicts between investors and agencies are gener aloney divided into two types. The first conflict occurs between debt holders and equity holders, and the second conflict is from between equity holders and managers. Consequently, all the capital structure theories based on agency costs can be also classified based on these two conflicts. In the rest of this section, each individual conflict will be separately discussed.2.1 Conflicts between Debt holders and Equity holdersJensen and Meckling (1976) point out that agency costs problems feel in determining the structure of a firms capital when the conflict between debt holders and equity holders is caused by debt contracts. Similar to Jensen and Mecklings conclusion, Myers (1977) observes that since equity holders bear the only cost of the investment and debt holders get the main destiny of the pr ofits from the investment, equity holders may nurse no interest in investing in value-increasing businesses when companies are likely to face bankruptcy in the short term future. Thus, if debt occupies a large part of firms capital, it will data track to the rejection of investing in more value-increased business projects. However, in 1991, Harris and Raviv cast a contrasting opinion to ad except the capital structure theory based on this conflict. They point out that most debt contracts give equity holders a push power to invest sub-optimally investment project. If the investment fails, collectable to limited liability, debt holders bear the consequences of a make up of the debt value, but equity holders get most of yields if the investment could generate returns in a higher place the debt par value. In order to prevent debt holders from receiving unfair treatment, equity holders unremarkably get less for the debt than original expectation from debt holders. Thus, the agenc y costs are created by equity holders who issue the debt rather than debt holders reason (Harris and Raviv, 1991).Tradeoff capital structure theory has a basic and strong relationship with this type of agency costs. However, different researchers hold various(a) explanations of the relationship. Myers (1977) points out the debt cost reason, potassium (1984) announces that convertible bonds can reduce the asset substitution problem which comes from the employmentoff theory, Stulz and Johnson (1985) consider about collateral effect. In the end, only Diamond model (1989) is widely accepted. If Equity holders do not consider reputational reason, they are voluntary to trade relatively safe projects, but this activity will lead to less debt support (Diamond, 1989 microphone et al, 1997). Diamond model (1989) assumes two tradeoffs, unsteady and risk- indigent, to show that the debt repayment should consider two possible investment plans. Furthermore, Mike et al (1997) use empirical evidence to indicate how to use debt to trade off these two optional investment plans. Moreover, in 1991, Harris and Raviv expanded Diamonds model to three investment fillings. They point out that one choice of investment can only contain the risk- cease project, one option can invest in risk project and the last option connect both risk-free and risk projects. In fact, since the reputation factor is zippy for a manager, managers are willing to choose risk-free investment projects that score more possibility of success. Consequently, the amount of debt is much reduced by managers.2.2 Conflicts between Managers and Equity holdersJensen and Meckling (1976) also states that conflicts naturally arise between managers and equity holders since managers just hold parts of the whole firms capital. Consequently, firm mangers only benefit from part of the profit generated by their business activities, but they simultaneously bear the whole cost of these actions. However, Myer (2001) cast s a different opinion about the reason of the conflict and claims that in fact, managers never bear the full costs of the business activities unless the manager is also the firms investor. He further maintains that the real cause of the conflict is due to an imperfect observable reward system between investors and managers, because both parties move over different standpoints to measure their own interest, especially the rewards.There are two dominant models, the Harris and Raviv model and the Stulz model, to explain this area. Although both models have a common assumption that labor contracts cannot address the conflict between managers and equity holders, both models hold different opinions about debt release and the problem in the drawbacks of debt in the capital structure. According to Harris and Raviv model (1990), managers are designed to want to draw out the companys online opeproportionns all the time even if equity holders pick the liquidation of the company. However, i n Stulz model (1990), managers are keen to invest all available bullion even if the equity holders can benefit from compensable out cash. Moreover, Harris and Raviv (1990) point out that debt alleviates the agency costs and the conflict results from self-aggrandizing equity holders the chance to speed up liquidation when cash flows are hard to predict. In contrast, Stulz (1990) based on Jenson model (1986) concludes that debt payments reduce free cash flow. He further maintains that the debt costs reduce the available funds of a profitable project, since the costs result from debt payment that more than exhausts free cash flow. As a result, capital structure can be firm by trading off debt advantages against debt costs.3.0 Capital structure theories based on asymmetric informationThe development of information modeling provides a possible approach to explain capital structure. In these capital structure theories, company insiders, such as managers, are assumed to obtain all orp hic information about the investment opportunities or investment return. whatever theories try to find out how the allocation of capital structure passes the insiders information of a firm to outsiders. Meanwhile, in other theories, the purpose of the capital structure is to improve efficiencies in the companys investment activities infra asymmetric information (Vernimmen et al, 2005). The rest of this section will be divided into two subsections based on both sets of theories mentioned above.3.1 Interplay of capital structure and investment This area of research begins with two vital academic radicals, Myers and Majluf (1984) and Myers (1984). According to Myers and Majluf (1984), the firms equity will be mispriced by the market when investors obtain less information of one firms assets value than the firms current insiders. Moreover, they further point out that if firms issue equity to absorb capital for a rude(a) investment, mispricing may make a net red to the firms current shareholders. In Myers second paper (1984), he formally defines this as a pecking order capital structure theory. In this theory, a firms capital structure is determined by the purpose of the company to pay new investment.Furthermore, with the development of the Myers pecking order theory, researchers find some vital empirical implications of this theory. Krasker (1986) confirms the results of Myers theory (1984) and also shows that the larger the equity issue, the worse the asymmetric information problem and the firm with worse asymmetric information problems will often have a more down the stairs price problem. Ebsen (1986) finds that if managers could trade their firms new equity, the down the stairs price problem caused by asymmetric information will be reduced. Then Dierkens (1991) argues that the beneath price problem can be work out by information releases such as annual financial mastery reports. However, some economists cast a doubt on the pecking order theory. These theoretical researches have a common feature that they all put investment situations under the pecking order theory but provide more finance choices for a firm. Brennan and Kraus (1987) state that it is not necessary for a firm to have a preference for financing through debt over equity and the under price problem can be addressed through various financing options and simple capital structure rather than solving asymmetry information problem. Their findings are also confirmed by Noe (1988). Moreover, in 1993, Nachman and Noe put Brennan and Kraus theory into practice and also come to the same conclusion.3.2 Signal effect of debt ratioAfter discussing models which investigate the interplay of capital structure and investment, it is vital to turn to models in which investment is a fixed factor and only capital structure is regarded as a private information signal.The investigation of this area starts with the work of Ross (1977). According to Rosss capital structure theory, only fir ms insiders, such as managers, can get full information of the firms return distribution, but investors cannot. The main empirical implication of Ross theory is that there is a positive relation between firm value and debt ratio. However, further research combines debt and dividend policy together to show an opposite opinion that a firm value is determined by dividend and debt ratio rather than a single factor of debt ratio (Vernimem et al, 2005). Furthermore, in 1982, Heinkel improve Ross model. His model is similar to Ross but does not have the same assumption. Instead, high market value firms are assumed to have high total value but low quality debt, thus high market value firms has high equity value. This finding has been reconciled with further capital structure theoretical research (Franke, 1987 John, 1987).Another debt ratio signal model is built by Poitevin (1989). He firstly points out the potential competition between an entrant and an incumbent under the asymmetric info rmation. According to Poitevin model (1989), the marginal costs of entrant are private information obtained only by the entrant, and in a stable situation, the capital of high cost entrants does not issue any debt while low cost entrants never issue equity. However, Glazer and Israel (1990) cast a different conclusion against Poitevin. They maintain that low cost entrants are willing to issue equity since they can much easier use this finance approach to reduce marginal production costs than the high cost entrants. Nevertheless, Harris and Raviv (1991) point out the weakness of the Glazer and Israel model is that they ignore the dividends finance factor which has the same signal effect as debt. Normally, a capital structure theory should combine various basic finance factors together. In the end, Glazer and Israel cognize this weakness and claim that their results cannot be considered as a capital structure theory.4.0 Summary and ConclusionTo sum up, this literature review of capit al structure theories is element arranged. The set of theories based on agency costs and the set of theories based on asymmetric information are separately presented in the passage. Moreover, each set of theories can also be divided into some(prenominal) subsections. Agency costs cause two types of conflicts among stakeholders, and these conflicts affect a firms choice of capital structure. Moreover, capital structure theories show that under an asymmetric information situation, capital structure has a strong reaction with investment activities and debt ratio has a mansion utility for the determination of capital structure.The range of the selected paper is from 1958 to 2005. These papers cover majority parts of the study including agency costs, interplay of capital structure and investment, imperfect information situations and debt signal effect. Also these papers are all from core financial journals, e.g. ledger of Finance, daybook of Financial sparings, journal of Financial Management, American Economic Review and Review of Financial Studies. Thus, this literature review can be considered to be efficient and thorough.This essay covers a considerable number of literatures which can present modern theoretical findings of capital structure. However, it should be noticed that the blooming period of capital structure theory is between 1970s-1980s. After 1990, the theoretical research seems to have developed very slowly, and the majority of papers in this field just review author findings since few new theories of capital structure come out.The direction of the theoretical research of capital structure should incline to be more practical. The future study should be extended in two areas. (1) Add psychosocial conditions and assumptions to improve extant capital structure theories. It is important to acknowledge that most capital structure theories cannot be used by companies in real life since these theories lacks of more reality factors. Thus, behavior fina nce could provide a new approach to extant theories. (2)Combine agency costs and asymmetric information problems together in one capital structure theory. Currently, both problems are discussed separately. However, companies often suffer from these two problems at the same time when they determine their capital structure. Consequently, it is necessary to set up a new theory based on both problems. Bibliography1. Baxter, N. (1967) Leverage, risk of ruin, and the cost of capital, ledger of Finance, 22, pp. 395-403.2. Brealey, R. A. and Myers, S. C. (2003) Principles of Corporate Finance. seventh edn. New York The McGraw-Hill Company.3. Brennan, M. and Alan, K. (1987) Efficient financing under asymmetric information, daybook of Finance, 42, pp 1225-1243.4. Chen, A. H. and Kensinger, J. (1992) comical Equity, Journal of Applied Corporate Finance, 5(1), pp. 36-43.5. Diamond, D. W. (1989) Reputation acquisition in debt markets, Journal of Political Economy, 97, pp. 828-862. 6. Dierkens , N. (1991) Information Asymmetry and Equity Issues. Journal of Financial and numeric Analysis, 26(2), pp.181-199. 7. Ebsen, E. (1986) The Valuation Effects of Corporate Debt Offerings, Journal of Financial Economics. 15(1), pp. 119-152. 8. Franke, G. (1987) Costless house in financial markets, Journal of Finance, 42, pp.809-822.9. Glazer, and Israel, R. (1990) Managerial incentives and financial signaling in product market competition, International Journal of Industrial Economics, 8, pp. 271-280. 10. Green, R.C. (1984) Investment incentives, debt, and warrants, Journal of Financial Economics, 13, pp. 115-136.11. Harris, M. and Raviv, A. 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