In regard to firm-level determinants of leverage, three main theoretical method are specifically important: the trade-off, the agency and the pecking order hypotheses.
We analyze five firm-level determinants of capital structure: growth opportunities, profitability, distance from bankruptcy, size and tangibility.
According to Myers and Majluf (1984), managers tend to issue new shares when prices are overestimated, thus benefiting old shareholders. Aware of this possibility, new shareholders might demand a discount on the stock price in order to get it. So, managers avoid issuing new shares, although this decision can make firms ignore profitable investments.
Myers (1984), therefore, suggests that companies seeking to decrease the costs of asymmetric information have a preference of funding resources. In this sense, companies would prefer using retained earnings in first place, then low-risk debt, high-risk debt and, as the last resource, new equity. Consequently, companies that have good investment opportunities but lack internal cash flow could turn to debt to fund their projects first, thereby affording such companies high leverage. In contrast, Autore and Kovacs (2010) show that company may issue new equity even in conditions of high asymmetric information, since such asymmetry is lower than the recent past.
Titman and Wessels (1988) suggest that firm profitability is a significant capital structure determinant since it reflects the amount of earnings that may be possible to firm retain. Thus, Fama and French (2002) suggest that in a simple pecking order model, by holding the investment level fixed, leverage would correlate negatively with profitability. Debt will grow as investment needs is higher than retained earnings. While profitability is regularly treated as a capital structure determinant,
The firm size is also a very common determinant in capital structure studies. Titman and Wessels (1988) state that larger firms may be more diversified, thereby making them less prone to insolvency risk. Also as a function of size, larger firms may have a greater debt capacity. Moreover, larger companies, being in general more transparent, tend to have larger debt levels and can issue larger amounts of debt, so allowing them to spread the issuing costs (Byoun, 2008).
Finally, tangibility plays a significant role on capital structure, as the collateral perspective of assets in place tend to increase leverage. As Titman and Wessels (1988) suggest, since tangible assets can be used as collateral for a given debt, the borrower is forced to use the resources in a pre-determined project, so curtailing the motivating to assume high risks. tangibility is determined as the ratio of fixed assets to total assets.
Capital Structure Among Latin American Companies
by Raj Aggarwal, Professor of Finance, 1 he University of Toledo, and, G. Baliga, The University of Delaware
The capital structure of a company is a significant influence on its profitability and stability. While a high symmetry of debt may make a company very profitable as it is growing, it also increases the probability of insolvency and destruction particularly if that growth slows down or temporarily becomes negative.
The capital structure of a company refers to the merge of longterm financing used by a firm. Such sources can be classified into two major categories, debt, or borrowed capital, and equity, or the capital supplied by owners in exchange for stock or as earnings retained and reinvested in the business. Borrowed capital obligates the company to meet a fixed schedule of debt service payments that must be met irrespectively of the level of sales or profits or any other circumstances regarding the operations of the company. Default in meeting debt service obligations exposes the company to the danger of insolvency and liquidation of its assets. The use of equity or owner's capital posture no such risks. So, a higher symmetry of debt in a firm's capital structure will, ceterus paribus, lead to higher levels of risk of insolvency for the company.
In contrast, because of the tax deductibility of interest payments and the associate safety enjoyed by the providers of debt capital, debt is a much cheaper form of capital for a firm than is equity. So, the use of a high symmetry of debt capital can increase the profitability of a company when its sales are rising and when its assets can earn a higher rate of return than the cost of its debt. On the other hand, because debt service payments are a fixed cost, a company's losses can also be increase with a high debt ratio if its sales are declining or if its assets are earning less than the cost of a debt. This means that the proportion of debt in a firm's capital, or the degree of its financial leverage, influences the level and variability of a firm's earnings and the probability of its survival. Therefore, a firm should have the maximum amount of debt that can be serviced even under adverse conditions without the
firm going bankrupt. In determining its debt capacity, a firm, therefore, must determine the stability and minimum level of the cash flows available to service its debt, see, for example, (Donaldson, 1962). For example a company with stable sales such as a utility can afford a higher debt ratio than a company that manufactures consumer durables (such as appliances) and has highly cyclical sales.
