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This paper provides new insights into the way in which capital structure and market power and capital structure and profitability are related. Capital structure and market power, as measured by Tobin's Q, are shown to have a cubic relationship, due to the complex interaction of market conditions, agency problems and bankruptcy costs. The study finds a saucer-shaped relation between capital structure and profitability, due to the interplay of agency costs, costs of external financing and debt tax shield.
INTRODUCTION
In corporate finance, the academic contribution of Modigliani and Miller (1958, 1963) about capital structure irrelevance and the tax shield advantage paved the way for the development of alternative theories and a series of empirical research initiatives on capital structure. The alternative theories include the tradeoff theory, the pecking order/asymmetric information theory and the agency theory. All these theories have been subjected to extensive empirical testing in the context of developed countries, particularly the United States (US) (see Harris & Raviv 1991 for a review). A few studies report on international comparisons of capital structure determinants (Rajan & Zingales 1995; Wald 1999); and there are some studies that provide evidence on the capital structure determinants from the emerging markets of South-East Asia (Annuar & Shamsher 1993; Ariff 1998; Pandey, Chotigeat & Ranjit 2000; Pandey 2001). The recent focus of corporate finance empirical literature has been to identify some 'stylised' factors that determine capital structure.
With relatively little evidence available on the interaction between capital structure and product market structure, some researchers have recently started investigating this relationship. Brander and Lewis (1986), Maksimovic (1988), Ravid (1988) and Bolton and Scharfstein (1990) variously offer a theoretical framework for the linkage between capital structure and market structure. On a broader front, Harris and Raviv (1991) and Phillips (1995) provide surveys of both the theoretical and empirical research on the relationship between capital structure and market structure, while studies in the US by Krishnaswamy, Mangia and Rathinasamy (1992), Chevalier (1993) and Phillips (1995) investigate the empirical relationship between capital structure and market structure. In a recent study, Rathinasamy, Krishnaswamy and Mantripragada (2000) examine this issue in an international context using data from forty-seven countries. All these studies establish a linear relationship, either positive or negative, between capital structure...