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1. Introduction
Capital structure represents the mix of debt and equity. The ideal mix of debt and equity for a firm is the one that maximizes the value of the firm and minimizes the overall cost of capital. The debt irrelevance proposition of Modigliani and Miller (1958) suggests that when capital markets are perfect (i.e. no asymmetric information, no taxes, no transaction costs and no bankruptcy and agency costs, etc.), there is no ideal mixture. In other words, the choice between debt and equity is simply irrelevant. However, if corporate taxes exist, capital structure matters a great deal because of the fact that interest is a tax deductible expense and generates a valuable tax shield (Modigliani and Miller, 1963). Therefore, financing with debt instead of equity not only increases the total after tax return to debt and equity investors but also increases the value of the firm. However, considering the risks and consequent costs of higher debt, the trade-off theory states that firms can determine an optimal capital structure by weighing the costs and benefits of an additional dollar of debt. The benefits of debt include the tax deductibility of interest expense and reduction of the free cash problem. The costs of debt include potential bankruptcy costs and agency conflicts between shareholders and debt holders (Fama and French, 2002). Alternatively, pecking order theory says that firm will borrow, rather than issuing equity, when internal funds are insufficient to finance the capital expenditure program (Myers and Majluf, 1984). Free cash flow theory suggests that high debt levels can increase the firm value despite the threat of financial distress when a firm’s operating cash flow significantly exceeds its profitable investment opportunities (Jensen, 1986). In sum, different conditional theories of capital structure suggest different debt levels because of the fact that each theory is based on different assumptions. For instance, trade-off theory is based on costs and benefits of an additional dollar of debt; pecking order theory is based on asymmetric information; and free cash flow theory emphasizes agency costs.
Several researchers have explored the impact of firm-specific factors on capital structure and tested the predictions of different capital structure models (Titman and Wessels, 1988; Rajan and Zingales, 1995; Wald, 1999; Booth et al., 2001; Fama and...