Week 10 Capital Structure

A firm's basic capital resource comes from the stream of cash flow produced by its assets. Once there is a gap between internal equity and the cash that the firm need, the firm must finance this gap by issuing equity, debt or hybrid securities. The term capital structure referss to the mix of different types of securities ( long-term debt, common stock, preferred stock, convertible debt, etc) issued by a company to finance its assets ( Song, 2005). There is always a question: How do firms choose their capital structure? A lot of theories have been developed to answer this puzzling question.

Many factors have been identified as the important determinant of capital structure: leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size, and decreases with volatility, advertising expenditure, and the probability of bankruptcy, profitability and uniqueness of the product.

The financial literature offers two comppeting models of financial deisions: static trade-off and pecking order theory. In the trade-off model, firm identify their optimal leverage by weighting the costs of financial distress and the tax benefits. At the optimal leverage level, the benefit of the last unit of debt just offsets the cost. In contrast, pecking order theory arises due to the existence of asymmetric information and transaction costs. In this theory, firms raise funds in a particular sequence and follow two rules. Firstly, corporations prefer internal financing than external ones. Secondly, firms always issue the safest securities first.

It seems that one is competing the other one and they seem both reasonable to some extent. Scholars always try to run a between them in order to find the circumstances in which one is superior to another (Fama and French 2002). They find that pecking order works best for large, mature companies that have access to public bond markets. These firms rarely raise equity and they prefer internal financing to external ones, yet turn to debt markets rather than equity when external financing is needed. This is not consistent with smaller, younger, growth firms, which are mmore likely to rely on equity instead of debt. Here, the pecking order theory stumbles(Frank and Goyal 2003). The trade-off theory still retains some explanatory power once pecking order motives are accounted for. The theory is particularly helpful in explaining inter-industry differences and works best for those companies with tangible assets. It suggests that the debt ratio is lower in volatile industries where value depends on intangible assets and growth opportunities.

Nevertheless, it has to be noted that many scholars have proved that there is in fact no conflict between these two theories. Rajan and Zingales (1995) constructed a study of debt versus equity choice by large firms and they find that large firms tend to have higher debt ratios; firms with high propositions of fixed assets to total assets have higher debt ratios; more profitable firms have lower debt ratios and firms with higher ratios of market-to-book value have lower debt levels. These results interpret evidences for both the trade-off and pecking order theories. Fama and Frech (2002) stated that though motivated by different forces, the two models share many predictions about dividends and leverage. Confirmed predictions shared by the trade-off and pecking order models are that more profitable firms and firms with fewer investments have higher dividend pay outs.

To sum up, it is always too simplistic to say one is superior to another. Either one is good at explaining certain issues and has obtained a number of empirical supports. More appropriately speaking, pecking order theory is offered as a complement to rather than a substitution for the traditional trade-off model.