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Sustainable and actionable business outcomes
Edited by Robert Rugimbana
Introduction
A fundamental issue in corporate finance involves understanding how firms choose their capital structure. There is no unique view that explains the capital structure decision of the firm. The literature on capital structure has focused on four main theories such as trade-off theory, pecking order theory, market-timing theory and inertia theory to explain corporate leverage ratios. The trade-off theory of corporate capital structure assumes that firms strive to maintain an optimal capital structure that balances the costs and benefits associated with varying degrees of financial leverage. This optimal level is achieved by making trade-off between the gains from debt or equity to loss from them. Benefits include interest tax shield and the costs include bankruptcy costs, agency costs, etc. It suggests that every firm has an optimal debt ratio defined by a point where benefits of interest tax shield gets offset by costs of financial distress. This often leads to "target adjusted" mean reverting behaviour in debt ratios in time ([27] Myers, 1984). The pecking order theory argues that a firm's security issue is based upon the information asymmetry between the managers and external equity holders. This theory predicts that under information asymmetries between firms' managers and the markets, projects are first financed with internally generated funds followed by safe and risky debt, and finally by equity. [2] Baker and Wurgler (2002) posit the market-timing theory of capital structure, whereby a firm's observed capital structure is a cumulative reflection of its past capital raising choices and that managers make these choices to benefit current shareholders. Under the market-timing theory a firm's issuance decision is based upon capital market conditions at the time funds are being raised. Both pecking order and market-timing theories do not predict an optimal capital structure for the firm, and hence provide no implications regarding the rebalancing of a firm's capital structure.
[31] Welch (2004) proposes that managerial inertia leads to persistence in firm capital structure and that past changes in equity prices is the single most important factor in explaining leverage ratios for firms. The dynamic trade-off theory of capital structure has argued that every firm has target leverage and there is always a difference between the observed and target...