Theoretical and Practical Review of Capital Structure and its Determinants
Capital structure is the mixture of debt and equity financing. Its choice and determinants related to many different factors. This thesis firstly present several traditional theories discussed on capital structure, such as trade-off theory, agency cost theory and theory of pecking-order. Then the paper concluded seven determined factors from practical aspects and discussed on the correlations among these factors and the choice of capital structure. The capital structure of a firm describes the way in which a firm raised capital needed to establish and expand its business activities. It is a mixture of various types of equity and debt capital a firm maintained resulting from the firm's financing decisions. More than four decades ago the modern theory of capital structure established after the publication of the celebrated paper of Modigliani and Miller (1958). Capital structure choice has inspired and fascinated many researchers. Countless studies investigated into the explanations of firms' capital structure choice, both theoretical studies and empirical ones. There still remains no clear answer to Myers 20 years old question (1984, p575) "How do firms choose their capital structure?" Different theories answer this question from different point of view. For instance, traditional trade-off theory postulates the existing of an optimal capital structure, which indicates the optimal choice of capital structure by firms is a balance of corporate tax shield against the bankruptcy cost and agency cost. However pecking order theory throws doubt on the existence of target capital structure, suggesting that firms use debt only when the internal financing is not available. Previous studies concluded that firms' leverage ratio closely related to firm-level characteristics. For an instance, Harris and Raviv (1991) summarize that "leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size and decreases with volatility, advertising expenditure, the probability of bankruptcy, profitability and uniqueness of the product." Most of previous empirical evidences were based on US firms with few notable exceptions. However, the experience of a single country may cover the effects of different financial system and economic tradition on capital structure choice. Cross-country comparisons are essential for the understanding of the difference in leverage choices across countries. And also cross-country comparison can be used to suggest linkages between institutional differences and empirical results about capital structure. Among the notable exceptions, Rajan and Zingales (1995) investigated the leverage ratios and capital structure determinants in G-7 countries. They found that although belonging to different financial systems, the firms are levered similarly across G-7 countries at the aggregate level with only U.K and Germany being less levered. And the factors related to leverage identified by studies in the United States seems similarly related to the leverage choice in G-7 countries as well. The variation in the results suggests that the institutional differences contribute to the capital structure choice of the firms. 2. Theory Review of Capital Structure and its Determinants