Debt to Total Asset and Growth

Various theories that specify the capital structure of an organization have conclude
that there is no agreement on the anticipated relationship between a company’s
growth and the amount of debt to its total asset. Based on trade-off principle (Kraus
and Litzenberger, 1973; Scott, 1977), taking out too many loans raises the risk of
bankruptcy, that will cause a possible reduction in growth. This might lead to an
estimated unfavourable relationship.

The information failure connected with growth is beyond those related with assets. As
a result, as remaining profits are depleted, the pecking order principle (Myers, 1984;
Myers and Majluf, 1984) forecasts a selection for debt instead of exterior equity for
firms with a stronger future growth.

Creditors consider greater potential development prospects for businesses and offer
them attractive credit terms, and therefore, as per signalling theory, the anticipated
association between industry growth and debt to total asset is favourable (Ross, 1977).

Depending on the agency theory, the connection between growth and leverage can
either have a responsive ending or an unresponsive ending. For this framework,
(Stulz, 1990) highlights two categories of costs attributable to company’s future
growth:
1) costs incurred by underinvestment issues; and 2) costs incurred by overinvestment
issues; and hence, the linkage between growth and debt to total asset may be either be
unfavourable or favourable.

With regard to the first form of cost, (Myers, 1977) claims that the stockholders and
controllers of rapid growth companies have better opportunities to invest in hazardous
projects. If investment plan succeeds, all creditors and managers will earn further
dividends, but if investment programs crash, investors will bear most of the losses.
The underinvestment theory, for businesses with strong development potential, leads
to an adverse connection between growth prospects and leverage.

In respect of the issues of overinvestment, (Jensen, 1986; and Stulz, 1990) argue that
slow growing companies have an benefit of turning into leverage as a means of
disciplining the behaviour of management and decreases the expenses of available
funds, which leads to a favourable interaction between growth and debt.
Firms with strong revenue growth tend to fund development projects by retained
earnings instead of debt (Hovakimian et al., 2001). As a result of an increased
probability of altering the structure of assets in industries with good growth potential,
investors could restrict credit to this line of business.

Nonetheless, the issue of underfunding has indeed been described as a source of

empirical research that suggest a weak relation between opportunities for growth and
burden (Kim and Sorensen, 1986; Barclay et al., 1995; Rajan and Zingales, 1995;
Hovakimian et al., 2001; Fama and French, 2002; Moon and Tandon, 2007; Huang
and Ritter, 2009).