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Published by ijokostar
proposal capital structure
proposal capital structure

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Published by: ijokostar on Jul 10, 2009
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The literature on determinants of capital structure is well known of the existenceof three theories that are trade off, pecking order and free cash flow (managerial agencycosts). Each theory presents a different explanation of corporate financing. The trade off theory is concerned with the trade off between debt tax shields or tax saving, and bankruptcy costs, according to which an optimal capital structure is assumed to exist. The pecking order theory assumes hierarchal financing decisions where firms depend first oninternal sources of financing and, if these are less than the investment requirements, thefirm seeks external financing from debt as a second source, then equity as the last resort.The free cash flow theory assumes that debt presents fixed obligations such as debtinterests and principals to pay, that have to be met by the firm. These obligations areassumed to take over the firm's free cash flow (if exists), therefore prevents managersfrom over consuming the firm's financial resources.It was recognized that the three theories are "conditional" in a sense that eachworks out under its own assumptions and propositions (Myers, 2001). That is, none of thethree theories can give a complete picture of the practice of capital structure. This meansthat firms can pursue capital structure strategies that are conditional as well. That meansthat when the business conditions change, the financing decisions and strategies maychange, moving from one theory to another. This is the main reason that the literaturedoes not include one theory or one explanation on the determinants of capital structure. Infact, an interrelationship can be observed between and among the three theories of capitalstructure.1
For example, the trade off theory assumes a higher use of debt as long as the debtis associated with positive tax shields and less bankruptcy costs. This does not mean thatthe firm can reach the maximum debt ratio if, under the assumptions of the pecking order theory, the firm is profitable enough to replace debt with internal financing using theaccumulated retained earnings which is can be considered as a part of an equityfinancing. According to the free cash flow theory, it is affected by the severity of theagency costs associated with debt or equity financing. In fact, the agency theory presentsanother explanation of debt financing. That is, as long as the agency problem arises fromthe presence of information asymmetry, Ross (1977), Myers and Majluf (1984) and John(1987) have shown that under asymmetric information, firms may prefer debt to equityfinancing. Therefore, the interrelationships between and among the three theories of capital structure call for further examination.It was also found that studies on the determinants of capital structure includeselected determinants in a regression equation. This is what Fama and French (2002)referred to as the two theories of capital structure that are trade off and pecking order have share many common predictions about the determinants of leverage. In thisresearch, the study had used leverage (total debt to total asset) as dependent variable andtangibility, size, profitability, growth, volatility and non debt tax shields as independentvariables. However, Myers (2001) had stated that each theory works out under its ownassumptions. Thus, for this study, the explanatory power and significance of each theorythat are represented by independent variables will show the extent of these variables canexplain the leverage.2
Over the years numerous studies on capital structure theory have appeared.Modigliani and Miller (1958) were the first who theorized the issue by illustrate that thevaluation of a firm will be independent from its financial structure under certain keyassumptions. Internal and external funds may be regarded as perfect substitutes in a worldwhere capital markets function perfectly, where there are no transaction or bankruptcycosts and the firm cannot increase its value by changing its leverage.However, based on the previous research made by Myers (2001), he stated thateach theory applied should be based on some certain circumstances
Due to that, thetheories are not designed to be general. They are conditional theories of capital structure.Each emphasizes certain costs and benefits of alternative financing strategies. Becausethe theories are not general, testing them on a broad, heterogeneous sample of firms can be uninformative
This study comprises of certain related questions to be known:i)To what extent the three theories can give impact to the capital structuredecision on the firm’s leverage. Besides that, it also to examine whichfactors is reliably important for predicting Malaysian firms.3

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