Capital Structure Generally the Capital Term Paper

  • Length: 7 pages
  • Subject: Economics
  • Type: Term Paper
  • Paper: #55511809

Excerpt from Term Paper :

All theories of capital structure are considered supplementary. As Myers pointed out it is a 'kind of puzzle and every new theory fills a small gap'. (Does Capital Structure really matter?)

Evaluating the tradeoff and pecking order theory Shyam-Sunder and Myers by analyzing the debt patterns through time they could find out that under the pecking order model, "a regression of debt financing on the firms deficit of funds should yield a slope with efficiency close to unity." (Do changes in a firm's capital structure signal information to shareholders?) They were not able to discard such hypothesis on their test for 157 U.S. firms from the years 1971 to 1989. They then strived to experiment the efficacy of their test to discriminate against the static tradeoff model. It is the faith of Shyam-Sunder and Myers that the data supports the pecking order model. According to Chirinko and Singha, however the test devised by Shyam Sunder and Myers appear to create misleading inferences when examining plausible styles of external levels of financing. Alternative tests are essential that can identify the deciding factors of capital structure and can differentiate among competing hypotheses. Mayer and Sussman model formulated during 2002 utilizes a filtering technique to detect large investment spikes. They could reveal that the spikes are largely financed with debt by large farms and in terms of equity by small firms. This entails that in the short to medium terms firms appear to function a pecking order for the purpose of financing large investments. But in the long run they target an optimal capital structure. (Do changes in a firm's capital structure signal information to shareholders?)

The capital structure of a company is influenced by several factors. The multinational companies operating across the national boundaries sometimes in many diverse nations exhibiting varying economic, market, financial, tax and legal structures are prone to confront business, political and currency risks not confronted by the domestic companies. The choices regarding the capital structure of their foreign associates must represent the local conditions along with the parent company necessities with regard to the capital structure and the necessity to maximize the overall company value. The MNCs take into account the role of internal capital markets in this decision making process. They also take advantages of the international differentiations in tax structures and come across high financing costs for affiliates in countries with weak creditor rights and less developed capital markets. Moreover, the multinationals also adhere to the local capital structure principles. (Internal Capital Markets and Capital Structure Choices of U.S. Multinationals' Affiliates)

Modigliani and Miller taking assumption of an efficient market environment with no taxes and bankruptcy costs reveal that the value of a firm is quite invariant to its capital structure. Such theory of irrelevance has since been altered and expanded so that capital structure is influenced with the deviations from perfect markets like taxes and bankruptcy costs and the real world costs connected to agency problems, asymmetric information and hazards relating to moral issues. The modern theories of capital structure therefore, takes into account such real world costs and frictions and incorporate the theories like tradeoff theory, agency cost theory, pecking order theory and asymmetric information theory etc. The empirical analysis made by Titman and Wessels, Harris and Raviv and Frank and Goyal affirm the significance of such firm deciding level of capital structure. The general evidence is seen that a firm's leverage level is linked to its "size, investment facilities, profitability, fixed assets, tax rates, bankruptcy probability, dividend policy, and the industry average leverage." (Internal Capital Markets and Capital Structure Choices of U.S. Multinationals' Affiliates)

It has also been regarded pertinent to visualize that the institutional differences like "tax code, bankruptcy laws, the state of development of bond markets, and pattern of ownership" which are also liable for differences in aggregate corporate capital structure in different nations. The prevailing empirical literature on international capital structure variations, establish that taxes have no explanatory power. However, such derivations may appear to be unwarranted when the personal taxes are also taken into account along with the corporate taxes. The explanatory power of the taxes, moreover, is highly responsive to the hypothesis about the marginal investor's tax rate. (What Do We Know about Capital Structure? Some Evidence from International Data)

Harris and Raviv regard the bankruptcy law as a crucial part of the debt contract. The G-7 nations differ significantly in their bankruptcy procedures particularly the extent to which liquidation is stressed upon over renegotiation of claims and the level to which management has control over the bankruptcy process. The bankruptcy law has several impacts like strict enforcement of creditor rights increases ex-ante contractibility. Moreover, it assures the creditors to penalize the management if the firm creeps into financial distress thus providing the management powerful incentives to dissuade away from it. Contrary to this the profitable enterprise finds it worthwhile to continue and entail the managers the right incentives post-bankruptcy when the rights of creditors are infringed in bankruptcy. The nations differ in the magnitude to which they control this trade-off in enforcing creditor rights. (What Do We Know about Capital Structure? Some Evidence from International Data)

The studies made in the sphere of determination of the relationship of taxes and corporate financing decisions particularly with reference to the Italian Tax Reform of 1997 reveal that there exists a close relationship between corporate income tax and corporate financing decisions. The Italian Tax Reform of 1997 entails a specified sphere of analysis to test varied explanatory theories for at least two factors, firstly, it influences each company in the country according the chance to examine the interactions between taxes and financing decisions in a regulated environment and secondly, it permits to experiment with alternative hypotheses about capital structure decisions outside the purview of the U.S. The study reveals that the companies have remarkably reduced their levels of financial leverage during the period of operation of the Italian Tax Reform of 1997, confirming to the fact that taxes have a profound part in capital structure decisions. (Taxes and Capital structure: Evidence from the Italian Tax reform of 1997)

During the period they appear to have enhanced the equity as aimed by Tax Reforms. Further the variations of taxes paid by companies is statistically important in providing an explanation with regard to the debt variation even before the Tax Reform takes effect, while it is not remarkable or significant in providing an explanation for the debt policy after the Tax Reform. During the period wherein the post tax reform took place, the companies have also represented a negative relation between capital expenditure and leverage variation which is statistically important. And this is most likely as a result of the impact or the major influences of DIT that provides opportunities for allowing tax advantages for the new equity-financed investments. Moreover it also needs to be understood that there are several empirical findings that larger companies have declined or brought about a reduction in their leverage even more. This could be due to the fact that bigger companies could have the facility to exploit the sources of tax advantage which are stemming from DIT even more. Large companies have more added avenues of opportunities for the purpose of accessing equity capital. Finally, the smaller companies deploy more varieties of hybrid sources of financing including the bond hold by shareholders, trilateral or triangular financing. (Taxes and Capital structure: Evidence from the Italian Tax reform of 1997)

References

Aggarwal, Raj; Aung Kyaw, NyoNyo. 2004. Internal Capital Markets and Capital Structure Choices of U.S. Multinationals' Affiliates. December. Retrieved at http://www.fma.org/Chicago/Papers/SubCapStrFMA.pdf#search='Capital%20structure%20theories%20of%20companyAccessed 18 August, 2005

O'Sullivan. Karen. Do changes in a firm's capital structure signal information to shareholders. Retrieved at http://www.csn.ul.ie/~karen/Articles/Maynooth%20Thesis/Thesis%20Interim%20Report.doc. Accessed 18 August, 2005

Pauwels, J.L. 2001.Does Capital Structure really matter? January. Retrieved at http://www-econo.gelso.unitn.it/cgilbert/fin2rapport.doc. Accessed 18 August, 2005

Prasad, Sanjiva; Green, Christopher J; Murinde, Victor. 2001. Company Financing, Capital Structure, and Ownership: A Survey, and Implications for Developing Economies. February. Retrieved at http://idpm.man.ac.uk/publications/archive/fd/fdwp27.pdf#search='Capital%20structure%20theories%20of%20companyAccessed 18 August, 2005

Previtero, Alessandro. Taxes and Capital structure: Evidence from the Italian Tax reform of 1997. Retrieved at http://www.efmaefm.org/AcceptedPapers2003/PreviteroAlessandro/PreviteroAlessandro.pdf#search='Capital%20structure%20theories%20of%20companyAccessed 18 August, 2005

Rajan, Raghuram G; Zingales, Luigi. What Do We Know about Capital Structure? Some Evidence from International Data. Retrieved at http://gsbwww.uchicago.edu/fac/raghuram.rajan/research/paper4.pdf#search='Capital%20structure%20theories%20of%20companiesAccessed 18 August, 2005

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