Factors Affecting Capital Structure, Trade-Off and Pecking Order Theories - Coursework Example

Student Name: Tutor: Course: Date Q2.Factors Affecting Capital Structure, Trade-Off and Pecking Order Theories Corporate and personal taxes are not the only factors that affect the financial mix. Capital structure refers to a way in which a company or a firm finances its assets through the combination of equity and debt assets or the hybrid securities (Brealey et al., 2012). The company may decide on whether to finance its activities by either a mixture of debts and equity from the share and investors or debt-equity by loans. Capital structure involves making these two decisions of the type of securities to be used or the capital gearing in the cost of capital. A financial mix is affected by the following factors. Trade on equity which is the ownership of the firm. This element takes advantage of equity capital over the borrowed funds on the cost of capital. It is the additional revenue that the equity owners or the shareholders earn due to the issue of the bonds such as debentures and preference shares (Frank & Goyal, 1-37). If the rate of return on preference share capital and interest on loanable capital is small than the firm’s revenue, then the shareholders have an advantage. Secondly, the degree of control, effects in such that if the company is made up of elected shareholders on equity. The members have maximum rights to decide on the capital structure. Since the preference shareholders have fewer rights regarding voting; However, the capital structure is affected because it is made of debentures holders and loans and not equity shareholder. It is in such that the debentures holders have no rights in voting. Thirdly, the financial plan flexibility. It depends on the financing plan used if it is debentures and loans they can be payable at any time while the equity capital is not refunded at any time which provides rigidity in the financial plan. The size of a company affects the capital structure in such that if a business is a small sized its capital structure will consist of loans from the banks and retained profits. The large sized company’s capital structure may consist of good will, debentures, and issuance of stock. As well as borrowings from big financial institutions (Bessler et al., 137- 150) Obviously, The larger the firm, the greater the capitalization. The period of financing also is a major factor since if the businesses in a shorter time then loans are best while if it is in the long-term, the company may opt for the issuing of shares and debentures. Taxes also affect the capital structure by changing the decisions on financial assets to capitalize (Mackinlay, 1-52) The taxes absorb more risks it brings subsidy to debt finance and restricts securities for tax purposes. Naturally, the cost of capital reduces the debt in structure increases. Thus, this appears there will be no equity at all. The firm's value increases by the PV of the tax shield. However, it is so difficult to build up a financial mix by the personal tax differences. There is a big gap between the capital structure theories according to Graham. The tradeoff theory of a financial mix is a useful idea in a firm that chooses how much debt and equity finances to use (Graham & Harvey 187- 243) It is by balancing the costs and benefits. Kraus Litzenberger advocated between the dead weight of being bankrupt and the savings on tax debt. The agency costs are inclusive of the balance. The theory also states that the company should borrow as long as the benefits from the tax shield outweigh the cost of the balance. It outlines the use of an optimal debt to equity ratio in which that the weighted average cost of capital is minimized and the firm's value maximization. The primary objective of the tradeoff theory is to show that many of the companies are financed by both owing’s and equity capital. The cost of funding the capital include the cost of being bankrupt on debts and non-bankruptcy costs in costs such as the payments terms. The relevance of the tradeoff has been questioned over the years; Miller suggests that there is uncertainty when taxes are significant while the bankruptcy is rare and has little dead-weight costs (Modigliani et al., 261-297) The theory states the debt to equity ratio above the optimal level brings about the effect of the loss of distress in removing the tax benefits, increases weighted average cost of capital, and it also decreases the firm's value. Obviously, a company with a bigger size, more profitable and more tangible assets the company the more borrows. Trade-off theory has different limitation such as not all businesses have a targeted debt to equity ratio since some of the companies may use targeted credit ratings, (Murray & Goyal, 135-200). It does not clearly explain how to find the optimal level, and the theory fails in explaining why high profitable companies take fewer debts. Trade-off theory is affected by various factors which include the expected bankruptcy and debts in which that the higher the expected bankruptcy cost it is of more advantageous to the equity. The bigger firms have more debts since they are diversified, and the default risk is low. The tangible assets undergo a minimal loss in their value when the company is in adversity. The more the wealth, the higher the leverage. Through this, the tradeoff theory brings a negative correlation between growth and leverage (Frank &Goyal, 217-248). Taxes and debts is a major factor in the tradeoff theory. The reasoning being that the higher the taxes the significant tax advantage there is. If an entity has high tax rates consecutively, the debt ratios are high in comparison to business with low taxes. Thus, this affects the capital structure of how small or big an entity is. According to the survey, it concludes that the tax is a major player in determining the capital structures decisions, (Graham & Harvey 2001). The theory also predicts that marginal tax benefit of debt should be equal to the marginal expected bankruptcy cost (Miglo, 1-27). Empirically it shows that the leverage of a given entity is inversely related to the expected bankruptcy costs and each company adjust their financial mix according to the target ratios. However, the negative relation between the debt and profitability is not supportive of the theory. Pecking order theory is also known as the pecking order model. The design insinuates that the cost of financing a given entity increases as the information becomes asymmetrical, (Hiller et al., 2013) A major company source of financing comes from the debt, equity and the internal funds. Apparently, the company has to prioritize their sources of a financial mix by preferring the internal funding followed by debts and lastly capital. The theory tries to show that most of the entities observe the prioritization of sources of capital structure and prefer more the internal funds. Pecking theory explains more on the relationship between the profitability and debt ratio which is inverse. It is because internal funding is most preferred, the dividend payout ratio to investment is targeted ad adapted so as to avoid sudden changes (Miglo, 1-27). There sticky revenue policies and uncertain fluctuations in their investment and profits. Pecking order theory outlines that the managers know much about the company which is right then the investors thus providing asymmetry of information and this affects the choice in the decision of capital structure on internal versus external financing and debt over the equity. It favors the debt over the equity funding since the managers are much confident in it. In this model, the small sized companies are much on capital dominance than the internal funding dominated by big entities. Much more the equity is overpowered by debts. Empirically if the announcement on equity issues made, there is a significant negative stock price. It is because the statements generate weak market reactions (Antweiler & Frank, 2006). There is a negative relationship between debt and profitability which is affecting the capital structure due to the size of the firm. The model there is a decrease in equity incentives if the information asymmetry is high. The pecking order model should include since it allows to the dynamics of the firm which enables it to dictate the optimal capital structure which makes it superior. Bearing in mind that the managers should use the bonds in financing the operations since they are less risky to the share prices. It explains variances on the debt ratio rather than the adjustment model based on the trade-off. The pecking model is known to work well in the firms that are investing in intangible assets In conclusion, capital structure is affected by taxes, the size of the business, trade on equity and financial flexibility among others. Trade-off Theory is more convenient in explaining the corporate debt which is affected by bankruptcy and debts while the pecking order theory considers managerial motivations and is superior in explaining the capital structure changes. Pecking theory is more efficient in the investment of intangible assets rather than Trade-off theory. References Antweiler, Werner, and Murray Z. Frank. Do U.S. Stock Markets Typically Overreact to Corporate News Stories? Working Paper, the University of British Columbia and the University of Minnesota. (2006) Andrew Mackinlay 2012 How do taxes affect capital structure? 1-52 Brealey, Myers, and Allen. Principles of Corporate Finance 12th edition McGraw-Hill edition (2017) Frank Murray Z. Goyal Vidan. K. Tradeoff and pecking order theories of debts handbook of empirical corporate financial: Empirical corporate finance Elsevier 2011. Pp 135-200 Frank M. Z Goyal V. K. Testing of the pecking order theory of capital structure. Journal of financial economics. (2003)67(2) 217- 248 Frank, Murray and Vidhan Goyal. “Capital structure decisions: Which factors are reliably important?”, working Paper, University of Minnesota and HKUST. (2007) 1-37 Graham, J. R. & Harvey, C. R. The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics (2001) 60 (2-3), 187-243. Hiller D., Westerfield, R., Jaffe, J and Jordan, B. Corporate Finance 2nd European edition, Berkshire: McGraw-Hill Education. (2013) Modigliani, Franco, and Merton H. Miller. The Cost of Capital, Corporate Finance and the Theory of Investment, American Economic Review (1958). 48(3), 261-297. Murray Z Frank, Vidan K Goyal. Journal of corporate finance: capital structure decisions: factors affecting capital structure. (2009) 38 (1) 1-37 Miglo, A. Trade-off, pecking order, signaling and market timing models. Ch. 10 In Capital Structure and Corporate Financing Decisions, Ed. Baker K., and G. Martin. Wiley. (2011) Read More