The pecking order theory talks about the cost of asymmetric information (Myers and Majluf, 1984). It says that firms choose their sources of financing according to the rule of least effort or least resistance (Myers and Majluf 1984). This implies that the firms will choose the equity financing as a financing mode of "last resort" (Myers and Majluf 1984). According to this theory, firms will prefer debt financing as long as it is feasible and when it is no longer possible, then they will opt for equity financing (Myers and Majluf 1984).
The Trade-Off Theory of Capital Structure
The basic idea behind this theory is that a firm normally conducts the cost-benefits analysis before taking any decision regarding its capital structure (Tucker and Stoja 2007). It means that company will just rule out the possibility of convenience in this important financial aspect as stated by the pecking order theory (Jensen and Meckling 1976). In spite of criticism by Miller (who called it a comparison of horse and rabbit), the advanced dynamic model of this theory is very robust and practical (Tucker and Stoja 2007).
Static trade-off theory
This theory of capital structure assumes that company should pursue a financing mix where tax shield advantage should be equal to the interest rate expense, keeping the other factors constant such as credit crunch and probability of bankruptcy costs (Jensen and Meckling 1976). This theory mainly deals with the pros and cons of issuing fixed asset securities like debt (S. Myers 1977). It assumes that there exists an optimal point under which the value of the firm is maximized. This optimal point is achieved by balancing the benefits and cost of issuing more debt (Myers 2001). One of the main advantages of issuing more debt is to take the benefit of "tax deductable". This simple benefit can be more complicated when manages and owners have to pay personal tax and the issue of an absence of tax shield (Myers 2001). Debt financing also reduces the chances of agency conflict (Maksimovic and Zechner 1991). The rational is that the use of debt reduces the amount of free cash flows at the disposal of managers and there reducing the chances of conflict between managers and shareholders (Jensen and Meckling 1976).
EBIT/EPS Analysis
Earnings Per Share (EPS) of a firm vary with changes in the amount of debt in the capital structure of a firm (Warner 1977). Theoretically, as the amount of debt increases in the capital structure, the financial risk increases (Warner 1977). Because of this high financial risk, investment houses change higher interest rates for the further debt which ultimate increases the cost of capital for a firm (Brigham and Ehrhardt 2001). Surely extra amount of financial leverage increases the capability of a firm to earn higher earnings per share in the coming years (Jensen and Solberg 1992). Brigham & Ehrhardt (2001), however, suggested that EBIT/EPS ratio should range from 0 to 5%. To find the exact point in this range, financial managers have to conduct an EPS indifference analysis.
Capital Structure and Financial Risk
The Financial risk of a firm is the risk associated with a lack of a sufficient amount of future free cash flows in order to meet its short term obligations (Brigham and Ehrhardt 2001). In other words, financial risk also increases as the use of fixed income securities increases like preferred stock increases in the total financing of the firm (Harris and Raviv 1991). Brigham & Ehrhardt (2001) asserted that as the amount of debt increases in the overall mix of capital structure, the degree of financial leverage increases. Financial leverage means that the total amount of debt that is used in the capital structure of a firm (Harris and Raviv 1991). Another related concept is that of operating leverage which means that the portion of fixed cost used in the total cost of production of a particular product or range of products (Moyer, McGuigan and Kretlow 2009).
Investors are very much concerned about the financial risk of firms because this is the kind of additional risk which they have to bear because of debt financing besides equity, in the firm�s total capital structure (Brigham and Ehrhardt 2001). It is the main objective before the financial managers to design the capital structure so that the value of the firm is maximized and at the same time mitigate the risk at hand (Harris and Raviv 1991).
To gauge the financial risk of a firm, Times Interest Earned (TIE) ratio carries special importance in the eyes of these investors (Besley and Brigham 2007). Times interest ratio is of immense importance to analyse the true interest cost coverage ability of a firm (Brigham and Ehrhardt 2001). TIE depends upon three important factors: the amount of debt in the total capital structure, the cost of debt and the profitability of the firm (Haugen 1995). Usually the industries which are less leveraged such as Drugs and electronics etc. have a very high TIE ratio (Brigham and Ehrhardt 2001). However, the firms which are in the business of retailing or utilities which rely more on debt financing, have low interest coverage ratios (see table1) (Brigham and Ehrhardt 2001).There are also variations in the capital structure of individual firms operating in the same industry due to the different attitude of managers and their particular risk/return profiles (S. Myers 1977). The firms where mangers are more aggressive and have high risk appetite usually use more debt financing than those firms where managers are risk-averse (Hull 2008).
The tools used to find the optimal capital structure are �EBIT/EPS Analysis� and �EPS indifference Analysis� (Brigham and Ehrhardt 2001).
EPS indifference analysis
The purpose of this analysis is to find out the point where a firm is insouciant as to whether it uses debt or equity for the same ratio of EPS (Brigham and Ehrhardt 2001). Brigham and Ehrhardt (2001) found that a firm will report higher EPS at a low level of sales and firm is using the more equity than debt. On the other hand, an organization will experience faster increase in EPS with the increase in sales if a firm is using more debt than equity (Brigham and Ehrhardt 2001). The point worth noting is that if business managers are confident about a certain level of sales of their firm, they should go for debt financing and vice versa (Besley and Brigham 2007).
Financial risk of a firm is usually measured by interest coverage ratio, fixed charge coverage ratio and longer debt ratios (Moyer, McGuigan and Kretlow 2009). These ratios are usually compared with industry average ratios to gauge the true financial health of a firm (Moyer, McGuigan and Kretlow 2009). These ratios are also compared to the previous year�s ratio of the same firm to determine the trend of firm�s performance over a period of time (Brigham and Ehrhardt 2001). The Financial risk of a firm depends upon a number of factors such as financial leverage, Operating leverage, expected future free cash flows and so on.
Because of the intense competition and uncertainty in the market, it becomes essential for the finance executives of companies to manage the risk of their organisations by either diversification, adopting an optimal capital structure, or using the sophisticated derivative securities (Hull 2008). An optimal capital structure is to arrange the financial structure of the firm in such a way that minimises the weighted-average cost of capital and thereby maximises the value of the firm's stock (DeAngelo and Masulis 1980). The dilemma here is that when a firm is trying to maximise its EPS by increasing the amount of debt, its financial risk also increases at the same time (DeAngelo and Masulis 1980). On the other hand, if a firm tries to minimise its financial distress, it has to reduce its financial leverage which ultimately hurts the EPS of the firm (Bhaduri 2002). Hence there arises the need of an optimal financial structure which increases the EPS of a firm and reduces its overall financial distress simultaneously (Bhaduri 2002). This choice of the optimal capital structure depends upon a number of factors such as the size of firm, its growth rate, cash flow projections and product and industry characteristics. (Bhaduri 2002).
During the last decade, there has been a lot of research on the impact of industry in deciding the capital structure of firms (Booth, et al. 2001). Booth et al. (2001) studied whether the factors affecting the capital structure of firms are country specific or not. For this purpose, their study focussed on ten developing countries: India, Pakistan, Thailand, Malaysia, Zimbabwe, Mexico, Brazil, Turkey, Jordan and Korea. They reported that:
In general, debt ratios in developing countries seem to be affected in the same way and by the same types of variables that are significant in developed countries. However, there are systematic differences in the way these ratios are affected by country factors, such as GDP growth rates, inflation rates and development of capital market (Booth et al. 2001 p. 118).
The institutional owners who hold large amount of shares of a firm also play a very significant role in deciding the capital structure of these firms (Al-Najjar and Taylor 2008). As these owners have the right to elect the board of directors, they can influence the mangers of their firms to adopt specific risk management policies and finance capital in a certain and specific manner (Al-Najjar and Taylor 2008).
There is a school of thought advocating that derivatives are the most useful tool to hedge financial risks at the firm�s level (Jalilvand, Tang and Switzer 2000). Yet there is another group who believe that there are some alternative (i.e. using less debt financing) as compared to the typical hedging techniques available which can be used to reduce the financial risk at corporate level (Berkman, Bradbury and Magan 1997). From these studies, it is evident that managing the financial risk of firms is very important for firms in order to be competitive in the market place. Some companies have made internal risk management policies as part of their corporate business strategy (Maksimovic and Zechner 1991). Smith and Stulz (1985) commented on the goal of risk management in these words: �The primary goal of risk management is to eliminate the probability of costly lower-tail outcomes � those that would cause financial distress or make a company unable to carry out its investment strategy��(p. 395).
It is clear from the words of Smith and Stulz (1985) that the main goal of companies is to manage risk by either means.
