Capital Structure of a Firm

Does the capital structure of a firm really matter? If so, how and why does it matter? Practitioners and scholars of corporate finance have debated these questions for several years and have found it difficult to come up with definitive answers. The classical work of Modigliani and Miller (1958) provided the impetus for what is now, orthodox corporate finance theory on the optimal capital structure of firms. They postulated that, in a perfect or frictionless capital market, the choice between debt and equity financing has no material effect on the value of the firm. Stern and Chew (2003) noted that following the Modigliani-Miller propositions, academic researchers in the 1960s and 1970s turned their attention to market imperfections that might make firm value depend on capital structure. They further noted that the main suspects were a tax code that encourages debt by making interest payments but not dividends tax-deductible and expected costs of financial distress that rise with increasing amount of debt. Towards the end of the 1970s, they noted, there was also discussion of signalling effects, such as the tendency for stock prices to fall significantly on the announcement of new equity issues and to rise on the news of stock buyouts. These effects seemed to confirm the existence of large information cost that could influence financing choices in the predictable ways.Myers (1984), however, noted that there is a conflict which has existed among the different theories and referred to is as the “capital structure puzzle.” Barclay and Smith (2005) noted that it has been the difficulty of coming up with conclusive tests of the competing theories. Firstly, they noted that model on capital structure typically are less precise than...

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...there may some problems. They noted that in such estimation technique, some of the variables in the equation were likely to be simultaneously determined with the dependent variable or the other explanatory variables. They recommend that Instrumental Variables (IV) techniques be used to carry out studies of this nature. This study will compare the results of the traditional panel data techniques with those of the instrumental variable techniques. The remainder of this paper will be organized as follows: Chapter 2 introduces the review of both the theoretical and empirical literature. Chapter 3 explains and develops the method which is employed in this study. Chapter 4 gives an analysis of the data used in this study and the empirical results. Finally, in Chapter 5, the conclusions of this study are presented along with policy recommendation on firm financing.