[The Journal of Online Education, New York, January 2009]
Capital Structure and Ownership Structure:
A Review of Literature
ASc Finance, BBA (Hons) Finance, BSc (Hons) Banking & International Finance
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There have always been controversies among
Capital Structure is a mix of debt and
finance scholars when it comes to the subject of
equity capital maintained by a firm. Capital
capital structure. So far, researchers have not yet
structure is also referred as financial structure of
reached a consensus on the optimal capital
a firm. The capital structure of a firm is very
structure of firms by simultaneously dealing with
important since it related to the ability of the firm
the agency problem. This paper provides a brief
to meet the needs of its stakeholders. Modigliani
review of literature and evidence on the
and Miller (1958) were the first ones to landmark
relationship between capital structure and
the topic of capital structure and they argued that
ownership structure. The paper also provides
capital structure was irrelevant in determining the
theoretical support to the factors (determinants)
firm’s value and its future performance. On the
which affects the capital structure.
other hand, Lubatkin and Chatterjee (1994) as
well as many other studies have proved that there
Capital Structure ; Ownership Structure ; Agency
exists a relationship between capital structure and
Theory ; Leverage ; Corporate Finance
firm value. Modigliani and Miller (1963)
ABOUT THE AUTHOR
showed that their model is no more effective if
tax was taken into consideration since tax
Roshan Boodhoo is interested in
researching a wide range of economic,
subsidies on debt interest payments will cause a
finance and business-related topics.
He is currently completing a Master
rise in firm value when equity is traded for debt.
of Arts in Finance and Investment at
the University of Nottingham as well
In more recent literatures, authors have
as an Executive Master of Business
Administration at the Institute of
showed that they are less interested on how
Business Management Studies.
capital structure affects the firm value. Instead
they lay more emphasis on how capital structure
of the firm. Modigliani and Miller (1963) argued
impacts on the ownership/governance structure
that the capital structure of a firm should
thereby influencing top management of the firms
compose entirely of debt due to tax deductions
to make strategic decisions (Hitt, Hoskisson and
on interest payments. However, Brigham and
Harrison, 1991). These decisions will in turn
Gapenski (1996) said that, in theory, the
impact on the overall performance of the firm
Modigliani-Miller (MM) model is valid. But, in
(Jensen, 1986). Nowadays, the main issue for
practice, bankruptcy costs exist and these costs
capital structure is how to resolve the conflict on
are directly proportional to the debt level of the
the firms’ resources between managers and
firm. Hence, an increase in debt level causes an
owners (Jensen, 1989). This paper is review of
increase in bankruptcy costs. Therefore, they
literature on the various theories related to capital
argue that that an optimal capital structure can
structure and ownership structure of firms.
only be attained if the tax sheltering benefits
provided an increase in debt level is equal to the
Value and Corporate Performance of Firms
bankruptcy costs. In this case, managers of the
Capital structure is very important
firms should be able to identify when this
decision for firms so that they can maximize
optimal capital structure is attained and try to
returns to their various stakeholders. Moreover
maintain it at the same level. This is the only
an appropriate capital structure is also important
way that the financing costs and the weighted
to firm as it will help in dealing with the
average cost of capital (WACC) are minimised
competitive environment within which the firm
thereby increasing firm value and corporate
operates. Modigliani and Miller (1958) argued
that an ‘optimal’ capital structure exists when the
risks of going bankrupt is offset by the tax
management of firms are able to calculate the
savings of debt. Once this optimal capital
optimal capital structure but in real world
structure is established, a firm would be able to
situations, many researchers found that most
maximise returns to its stakeholders and these
firms do not have an optimal capital structure
returns would be higher than returns obtained
(Simerly and Li, 2000). The reason underlying
from a firm whose capital is made up of equity
this argument is that, in general, the performance
only (all equity firm).
of a firm is not related to the compensation of the
It can be argued that leverage is used to
managers of the firm. Accordingly, managers
discipline mangers but it can lead to the demise
prefer to surround themselves with all sorts of
luxury and amenities rather than sharing the
consideration as a key factor to determine the
firms’ profits (paying out dividend) with its
performance of the firm. Jensen and Meckling
shareholders. Hence, the main problem that
(1976, p. 308) states that “An agency relationship
shareholders face is to make sure that managers
is a contract under which one or more persons
work with the objective of increasing the firm’s
(the principal[s]) engage another person (the
value instead of wasting the resources. In other
agent) to perform some service on their behalf
words, shareholders have to find a way to deal
which involves delegating some decision-making
with the principal-agent problem.
authority to the agent”. The problem is that the
interest of managers and shareholders is not
The Agency Theory
always the same and in this case, the manager
who is responsible of running the firm tend to
developed the agency theory and they argued that
there is an increase in the gap between ownership
maximising returns to the shareholders. This
and control of large organisations arising from a
means that managers will use the excess free
decrease in equity ownership. This particular
cash flow available to fulfil his personal interests
situation provides a platform for managers to
instead of increasing returns to the shareholders
pursue their own interest instead of maximising
(Jensen and Ruback, 1983). Hence, the main
returns to the shareholders.
problem that shareholders face is to make sure
In theory, shareholders of a company of
that managers do not use up the free cash flow by
the only owners and the duty of top management
investing in unprofitable or negative net present
should be solely to ensure that shareholders
value (NPV) projects. Instead these cash flows
interests’ are met. In other words, the duty of top
should be returned to the shareholders, for
managers is to manage the company in such a
example though dividend payouts (Jensen, 1986).
way that returns to shareholders are maximised
The costs of monitoring the managers so that
thereby increasing the profit figures and cash
they act in the interests of the shareholders are
flows (Elliot, 2002). However, Jensen and
referred as Agency Costs. The higher the need to
Meckling (1976) explained that managers do not
monitor the managers, the higher the agency
always run the firm to maximise returns to the
costs will be.
shareholders. Their agency theory was
Pinegar and Wilbricht (1989) discovered
developed from this explanation and the
that principal-agent problem can be dealt with to
some extent through the capital structure by
increasing the debt level and without causing any
have a key role in the governance structure of the
radical increase in agency costs. Similarly,
firm which means that these debt-holders will
Lubatkin and Chatterjee (1994) argue that
have an upper hand in the decision-making of the
increasing the debt to equity ratio will help firms
firm with regards to the strategies and to be
ensure that managers are running the business
adopted. However, this might lead to a conflict
more efficiently. Hence, managers will return
between shareholders and debt-holders at they do
excess cash flow to the shareholders rather than
not share the same ideas. Debt-holders will
investing in negative NPV projects since the
ensure that the firm makes enough profit to be
managers will have to make sure that the debt
able to meet its debt obligations. On the
obligations of the firm are repaid. Hence, with
contrary, shareholders are more interested in
an increase ion debt level, the lenders and
returns that they should obtain. However, if the
shareholders become the main parties in the
profit the firm has made is just enough to cover
corporate governance structure. Thus, managers
its debt obligations, then will not be any excess
that are not able to meet the debt obligations can
cash flow left to be paid out as dividend because
be replaced by more efficient managers who can
debt-holders have the priority over shareholders.
better serve the shareholders. This mean that
In this case, shareholders will guide the
leverages firms are better for shareholders as debt
management to invest in projects with higher
level can be used for monitoring the managers.
expected returns which entails a higher risk level
In this case, it can be said that debt
so that they can get a return. It is here that the
financed firms are more appropriate for investors
conflict of interest arises since debt holders will
but with a high debt levels increases the cost of
impose certain restrictions so that the firm can
capital as well as bankruptcy costs. Moreover,
repay their debt obligations by preventing them
there is more risks in investing in firms with high
from making risky investments (Florackis, 2008).
debt levels as these firms tend to have a bad or
Hence, there are the managers, shareholders and
low rating by rating agencies. Obviously a low
debt-holders try to impose different strategies
rating will in most cases not attract investors.
this might render the governance structure of the
firm becomes constrained. It can be argued that
Governance Structure and Bankruptcy Costs
if debt-holders exercise too much pressure on the
resulting from High Debt Levels
management of the firm, this can lead to a drop
Obviously, with an increase in debt level
in performance since the debt-holders will prefer
of a firm, debt holders (for example, lenders)
that the firms invest in less risky projects to meet
the debt obligations and prevent the firms to
Jensen (1986) defines free cash flow as
invest in projects that can ensure long term return
the amount of money left after the firm has
and comprising of a higher level of risk.
invested in all projects with a positive NPV and
Warner (1977) argues that the potential
states that calculating the free cash flow of a firm
bankruptcy costs a firm might face are reflected
is difficult since it is impossible to determine the
in its share price and this is taken into
exact number of possible investments of a firm.
consideration by investors when they make
Lang, Stulz and Walking (1991) uses the Tobin’s
investment decisions. Bankruptcy costs refer to
q as a proxy to determine the quality of
the costs associated with declining credit terms
investment. Firms with a high ‘q’ showed that
with customers and suppliers. It can be argued
firms were using their free cash flows to invest in
that suppliers would not be willing to give long
positive NPV projects whereas firms with low
term credit terms to the firm as the latter faces
‘q’ showed that firms were investing in negative
the risk of default and similarly, customers would
NPV projects and therefore, the free cash flows
avoid buying products and services from a firm
should instead be paid out dividends to the
facing a high risk of default since warranties and
shareholders. As a whole, this study is in line
other after sales services will be void or at risk.
with the free cash theory and was considered as
very reliable among economists. We can
The Free Cash Flow Theory
conclude that using free cash flows to invest in
Jensen (1989) states that when free cash
negative NPV projects leads to an increase in
flows are available to top managers, they tend
invest in negative NPV projects instead of paying
out dividends to shareholders. He argues that the
Announcements of Capital Expenditures
compensation of managers with an increase in
The free cash flow theory argues that
the firm’s turnover. Hence the objective of the
there should be a reduction in the free cash flow
company is to increase the size of the firm by
of firms with poor investments so that managers
investing in all sorts of projects even if these
do not waste the firm’s resources by investing in
projects have a negative NPV. Dorff (2007)
negative NPV projects. Hence reducing the free
argued that compensation of managers tend to
cash flow is advantageous but on the other hand,
increase when there is an increase in the firm’s
shareholders or potential investors get a bad
image of the firm when the latter is cancelling or
delaying investment opportunities. Vermaelen
(1981) and other studies discuss the effects of
(2002) showed that the profitability of firms
announcements of capital expenditures on the
increase considerably when managers are given
market value of the firm but their results are very
shares of the company. This is because the
unclear and in contradiction to each other;
managers will work in the interest of the
meaning that there is no real proof of the above
shareholders since the managers themselves own
mentioned relationship. However, McConnell
shares of the firm.
and Muscarella (1985) found that announcements
of future capital expenditures do have an impact
structure to management can solve the principal-
on the value of firms operating in the industrial
agent problem. This is in line with Smith (1990)
who carried a study on 58 Management Buyouts
of public companies during the period of 1977 to
Equity Financing and Firm Performance
1986. His findings revealed that there exists a
We have observed from the previous
chapter in this paper that managers uses excess
ownership and the performance of the firm. This
free cash flow to pursue their personal interests
study also provide empirical evidence that
instead of paying out dividends to shareholders.
increase in operating profits result from the
Lambert and Larcker (1986) argued that
decrease in operating costs and the proper
managers of firms financed mostly with equity
management of working capital of the firms. This
(where there are a large number of shareholders
is in line with Lichtenberg and Siegel (1990).
with very small shareholding power) tend to have
this behaviour. In this case, since it will be
difficult to regroup all the shareholders to
This paper is a review of the literatures on
pressure and control the management and as a
capital structure and provides empirical evidence
result, the shareholders prefer to sell their stocks
that here exists a relationship between the capital
instead of incurring agency costs to solve this
structure and ownership structure of the firm.
Economists have not yet reached a consensus on
On the other hand, companies with a
how to determine the optimal capital structure
small number of shareholders with large
(debt to equity ratio) that will enable firms to
shareholding can more easily regroup themselves
maximise performance by simultaneously dealing
to pressure and control the management on how
with the principal-agent problem. Taking into
to run the firm. The study of Dolmat-Connel
consideration the shortcomings of both equity
and debt financing, it can be argued that debt
Therefore, the coefficient β2 is expected to be
financing is better as it allows tax deductibility
negative and in this case, it will support the idea
on interest payments and also provides a
that agency costs can be reduced by giving shares
mechanism to control the activities of managers.
of the firm to its managers.
We have observed that there are many
Capex is the Capital Expenditure of the
factors which can be used to determine the
firm. Jensen (1989) argues that the more free
capital structure of a firm. The estimated model
cash available, the more the managers will invest
below is more or less similar as the model used
irrespective of whether the investment is good or
in Damodaran (1999) except that some of the
bad and this eventually leads to an increase in the
independent variables are different as this model
leverage. Hence, we can expect the coefficient β3
is based on the different theories discussed in this
to be negative as with an increase in leverage, the
firm will have more interest payment to make
and therefore less free cash available.
DE = β0 + β1Tax + β2Insider + β3Capex + ε
The estimated model is very limited since
it only includes variables which have been
discussed in the brief literature review of this
DE is the Debt to Equity ratio (Capital
paper. In reality, it is much more complex to
Structure) or Leverage (Dependent variable).
determine the optimal capital structure of a firm.
Tax is the Tax Rate of the industry.
Modigliani and Miller (1963) argued that with a
empirical evidence regarding the relationship
higher debt level, a firm benefits with more tax
between capital and ownership structure.
deductibility. In this case, we could expect the
1 to be positive.
Insider is the Insider Holding of the
Berle, A.A. and Means, G.C. (1932). The
company which is the percentage of shares that
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managers own. This variable takes into account
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