Honours Financial Economics Lectures Notes1 2017

Lecturer: Tendai Gwatidzo, PhD.

Topic: Capital Structure Theory

Recommended Readings
1. Modigliani F., and Miller, M. H. (1958). The cost of capital, corporation finance
and the theory of investment. American Economic Review XLVIII, 261-297.
2. Modigliani F., and Miller, M. H. (1963). Corporate income taxes and the cost of
capital: A correction. American Economic Review 53 (3): 433 – 443.

3. Myers, S. C., and Nicholas S. Majluf, N., S. (1984), Corporate financing and
investment decisions when firms have information that investors do not have.
Journal of Financial Economics 13 (2), 187 – 221.

Introduction
Capital structure is defined as the mixture of debt and equity that a firm uses to finance
its activities. A decision to start a business or expand the operations of an already existing
firm involves an implicit decision to raise capital. How does the firm raise funds to
finance growth? Does it use debt or equity? Would the firm’s value be affected by such a
choice? There are three main sources of funds namely; equity financing, debt financing
and the use of internal funds (e.g., retained earnings). Examples of debt include; bank
loans, leases, commercial paper, corporate bonds. Examples of equity include; common
stock/equity. If a firm’s capital structure includes a significant amount of debt, then the
firm is said to be highly leveraged. The financing decision involves the determination of
the optimal mix of the various sources of funds required for financing the assets of the
firm.

The major difference between debt and equity is that debt holders have a contract
specifying that their claims must be paid in full before the firm can make any payments to

1
Please note that I cannot guarantee that these notes are error free. You can bring to my attention any errors that you may come across
as you read.

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the equity holders. In this regard debt holders are senior claimants. A second distinction
between debt and equity is that payments to debt-holders are generally viewed as a tax-
deductible expense of the firm. In contrast the dividends on an equity instrument are
viewed as a payout of profits and they are not a tax-deductible expense.

Debt and Equity as Contingent Claims

Since the cash flow generated by the firm is stochastic, the payoffs for debt holders and
equity holders depend on the future state of the firm. Consider a firm with a capital
structure made up of equity & a single zero coupon bond. The bond promises to pay
R200 when it matures. At the end of a given period the cash flow (CF) generated by the
firm is shared among the claimants (in this case the shareholders and debtholders).
Debtholders are senior claimants so they get what is due to them first (R200), with the
shareholders (being residual claimants) getting whatever may be left. For example, if the
firm generates a cash flow amounting to R50 then the whole amount will be claimed by
the debtholders, with the shareholders getting nothing. If the firm generates R100 as CF
again the whole amount will be claimed by the debt holders, with the shareholders gain
getting nothing. So, as long as the amount generated by the firm is smaller than the
amount due to debtholders the shareholders will get nothing and debtholders will claim
100% of the cash flow. If the CF generated by the firm is R250 the debtholders will get
R200 and the shareholders will get the remainder (R50). Figure 1 below shows the payoff
diagram for debtholders and shareholders.

Figure 1: Debt and Equity as Contingent Claims

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Measures of Leverage
Leverage Definition Formula Reference
Total debt to firm value ratio (book Total debt divided by sum of total debt and book Rajan and Zingales
value) value of equity (1995)
Short term debt to firm value ratio Short term debt divided by sum of total debt and Booth et al (2001)
book value of equity
Long term debt to total debt plus market Long term divided by sum of total debt and market Mutenheri (2003)
value of equity value of equity
Total debt to book value of equity Total Debt divided by book value of equity Mutenheri (2003)

Sources of Finance

Finance
Sources

Debt Equity

Private Public External Retained

Debt Debt Equity Earnings

Bank Debt Non-Bank Private Public

Debt Equity Equity

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The starting point of any study of capital structure is the Modigliani and Miller
propositions I and II. In their 1958 and 1963 papers Modigliani and Miller explained or
promulgated what have come to be known as Modigliani and Miller Propositions I and II.

Modigliani and Miller Proposition 1 (MM1)

Proposition I states that, in the absence of taxes and other market frictions like transaction
costs and bankruptcy costs, the market value of a firm is independent of its capital
structure. This means that management cannot change the market value of the firm by
merely altering the firm’s capital structure.

If equity is not sufficient to finance additional investment, management can use debt and
this should not affect the value of the firm. MM1 - can be interpreted as implying that the
size of a pie does not depend on how it is sliced.

What is market value of the firm?

Market value of the firm in this context is equal to the market values of all claims on its
cash flows. So market value of an unlevered firm is equal to the sum of total market
values of the firm’s equity shares. The market value of a levered firm is equal to the sum
of total market values of debt and equity securities.

That is, Value of unleveled firm: VU  EU

Value of levered: VL  D  EL
Where: VU is the market value of the unlevered firm (that is the firm with no debt).
EU is the market value of the equity of the unlevered firm.
VL is the market value of the levered firm.
D is the value of debt
EL is the value of the equity of the levered firm.

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Proof of Proposition I
Consider two firms that are identical in all respects except for their capital structure. One
firm, call it L, is levered and the other firm, call it U, is unlevered. The firms produce the
same cash flows.

Company U: Company U has no debt so its cash flows are split among its shareholders.
Thus the current value of company U (i.e., VU) is the same as the value of its equity. That
is, VU = EU.

Company L: Company L is levered so its cash flows must be split among its debtholders
and shareholders. The value of L is thus equal to the value of debt and equity securities
(i.e., D + EL). According to the Modigliani and Miller proposition 1:
VU = VL or VU = D + EL
If this were not so there would be an opportunity to earn arbitrage profits.

Proof
Suppose both firms generate cash flows equal to X. Suppose an investor invests in two
portfolios by purchasing a% of the levered firm and a% of unlevered firm.

Investor Costs and Payoffs

Portfolios
Current Cost Future Payoff
Portfolio 1 Buy α% shares of U αE = αVU αX
Buy α% bonds of L aDL arDL
Portfolio 2 Buy a% shares of L aEU a(X - rDL)
aDL+aEU=a(DL+EU)=aVL arDL + a(X - rDL) = αX
Total

The two portfolios have the same payoff (aX). Therefore, if there are no arbitrage
opportunities, their current cost must be the same so that:
aVL = aVU
Thus, VU = VL
Hence the value of the firm does not depend on whether it is levered or not.

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Consider the case where VU > VL : Any investor can simply purchase a fraction a% of
the under-priced firm at a cost of aVL and short-sell a fraction a% of firm U realizing
proceeds equal to aVL. The investor would thus realize an arbitrage profit equal to
aVU - aVL > 0.

Consider the case where VU < VL

In this case there is also an opportunity to earn arbitrage profits. An investor would in this
case purchase a fraction a% of the under-priced firm at a cost of aVU and short sell a
fraction a% of firm L realizing proceeds equal to aVL. The investor would thus realize an
arbitrage profit equal to aVL - aVU > 0.

In either of these cases all investors would attempt to perform the indicated arbitrage and
their collective trading activities would alter market values of the firms until any
arbitrage profit is eliminated at equilibrium such that the equilibrium would be
maintained when the values of both the levered and unlevered are equalized.

Alternative Proof of MM1

Assume two firms that are identical in all respects except for their capital structures.
Suppose that these two firms exist for one year, produce identical pretax cash flows (X)
at the end of that year, and then liquidate. The firms are financed differently: company U
is unleveraged (it has no debt) and company L is leveraged (it has some debt in its capital
structure).

The following table shows the cash-flows of the two companies. Company U has no debt
so its cash flows are split among its shareholders. Thus the current value of company U is
the same as the value of its equity. Company L has debt so its cash flows must be split
between the shareholders and debt-holders. So after one year the firm has a debt
obligation equal to D + RDD = (1+RD)D. So at the end of the year the debt-holders will
receive (1+RD)D and the shareholders, being residual claimants, will receive X-
(1+RD)D. The current value of firm L is the current value of its outstanding debt and
equity (VL=D+EL).

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Now, since firms U and L are generating the same cash flows their current value must
also be the same.

That is, VU = VL = D+EL

Thus whether a firm is leveraged or not does not affect the value of the firm.
Company U Company L
Future Cash Current Future Cash Current
Flows Value Flows Value
Debt 0 0 (1+RD)D D
Equity X VU X-(1+rD)D EL
Total X VU X VL = D + EL

What is short selling?

To short sell is to sell securities that you do not currently own. To short sell shares the
investor must borrow the shares from someone who owns them. To close out the short
position the investor buys the shares back and returns them to the original owner.

Impact of taxes on capital structure in the context of the MM proposition

In the above Modigliani and Miller framework the capital markets were perfect and there
were frictions. Once we introduce taxes in the MM framework, it is optimal to have a
firm financed by 100% debt. In a follow-up to their 1958 article, Modigliani and Miller
(1963) introduced corporate taxes and their conclusion was that to maximize its value, a
firm should have 100% debt. In this section we demonstrate this result.

Introducing taxes in the MM setup can be illustrated as follows:

Assume a firm generating pre-tax cash flows equal to X, paying corporate tax at a rate
equal to TC, and interest rate on debt equal to r and with debt amount equal to D.

This implies that, at time t, income before interest and tax2 is Xt

The taxable income after interest is Xt - rD
The payable tax is (Xt – rD)Tc

2
Also known as Earnings Before Interest and Tax (EBIT)

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This means that an increase in D reduces the amount of tax payable. Now, how does that
affect the value of the firm? We shall assume that the firm is financed with a combination
of debt and a risk-free perpetuity bond which pays an interest rate of r forever. The year t
after-tax payments to the firm’s debt and equity holders is expressed as follows:

Payments to equity holders = Xt - rD - Tc(Xt - rD)

Payments to debt holders = rD

Thus year t total payments to the firm’s debt and equity holders are expressed as:

Ct = Xt - rD - Tc(Xt - rD) + rD or:Ct = (Xt – rD)(1-Tc) + rD

Ct  ( X t  rD D)(1  TC )  rD D ………………………………………….…… (1)

We can arrange the equation (1) so that we have the cash flows that the firm would have
generated if it were an all-equity firm plus the additional cash flows generated because of
the tax gain from debt:

So from Ct  ( X t  rD D)(1  TC )  rD D we can expand the first term by multiplying

throughout by (1-Tc) as follows:

Ct  X t (1  TC )  rD D(1  TC )  rD D
 Ct  X t (1  TC )  rD D  rD DTC  rD D

This yields equation (2) below:

Ct  X t (1  TC )  rD DTC ………………………………………………………. (2)

The value of the firm is the present value of its cash flows. In this case it is the present
value of equation (2).

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To determine how the value of the firm changes with a change in the leverage, note that,
X t (1  TC ) is the year t cash flow that would be achieved by an unlevered firm. The

present value of this series, X 1 (1  TC ) , X 2 (1  TC ) ,…………….., X t (1  TC )

must equal the value of the firm if it were unlevered (VU).

That is, PV [ X 1 (1  TC )  X 2 (1  TC )  X 3 (1  TC )  ...............................]  VU

Now, remember the firm’s debt is perpetual debt. Every year the firm’s tax savings are
equal to: rDTc.

By definition the present value of the tax savings is:

Present value of tax shield = (corporate tax X interest payments)/expected return on debt
TC (rD)
=  TC D
r
Value of levered firm = PV of unlevered firm + PV of tax gains/shield

PV of unlevered firm = PV[ X1 (1  TC )  X 2 (1  TC )  X 3 (1  TC )  ............................... ]

PV of tax shield = TCD

Thus the value of a levered firm with a static risk-free perpetual debt is the value of an
unlevered firm plus the product of the corporate debt and the market value of the firm’s
debt as shown in equation (3).

Value of levered firm (VL) = PV of unlevered firm + PV of tax gains/shield

=PV[ X1 (1  TC )  X 2 (1  TC )  X 3 (1  TC )  ............................... ]+TCD

Thus, VL  VU  TC D .……………………………………………………………… (3)

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Equation (3) shows that an increase in the amount of debt (D) increases the value of the
levered firm (VL). We therefore conclude that the value of a firm can be increased by
increasing debt. In the extreme the value of the firm can be maximized by 100% debt
capital structure.

Conclusion: Once we introduce taxes in the MM framework, it is optimal to have a firm

financed by 100% debt.

The corner solution implied by the Modigliani and Miller model is, however, at odds with
the observed firm behaviour. Since the 1960s the important question has been why are
firms not using 100% debt to finance their activities? Research effort has focused on
trying to identify costs associated with debt financing, which firms tend to trade-off
against the tax benefits.

Proposition II (MM II)

Proposition II states that the expected return on the common stock of a levered firm
increases in proportion to the debt-equity ratio (D/E). It states that the expected return on
a firm’s equity increases with the firm’s leverage.

We shall explain the MM II using WACC. A firm’s WACC is a value-weighted average

of the required expected returns on the firm’s debt and equity. The required return on the
firm’s debt is denoted by rD and the required rate of return on equity is denoted by rLE.
 D   EL 
WACC  rD    rLE  
 D  EL   D  EL 
Let WACC be equal to rA (return on assets).
 D   EL 
rA  rD    rLE  
 D  EL   D  EL 
rA ( D  EL )  rD D  rLE E
rA ( D  EL )  rD D  rLE E
rA ( D  EL )  rD D  rLE E

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rA D  rA EL  rD D  rLE E
D D
rLE  rA  rA  rD
EL EL

D
rLE  rA  rA  rD 
EL
rA is constant (recall from MM I the firm’s assets do not change with changes in the
firm’s capital structure).

Therefore the required return on a firm’s equity is a linear function of the firm’s leverage.

Since rA is constant regardless of the change in leverage and also the assumption that

rA > rD we can conclude that there is a positive relationship between rLE and leverage.

Why is RA > RD?

Trade-off Theory
According to the trade-off theory (TOT) value-maximizing firms choose the level of debt
by balancing tax benefits of debt against the costs associated with debt such as
bankruptcy and agency costs. According to the trade-off theory, the value of a firm is as
follows (Myers, 2003):

Firm Value = Value of Unlevered firm + PV (interest tax shields) – PV (cost of financial distress).

Where: PV (interest tax shields) = present value of interest tax shields.

PV (costs of financial distress) = present value of the cost of financial distress.

In this case the firm chooses the level of debt or the capital structure that maximizes its
value. The optimal capital structure occurs where the marginal benefit of increasing debt
by an additional unit is equal to marginal cost of increasing debt by the same unit. It is

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important to note that as the firm increases its debt level the probability of bankruptcy
and financial distress also increases.

This explains why in reality there is moderate, cautious borrowing as opposed to 100%
debt. It must also be noted that in reality it is impossible to obtain debt financing unless
creditors believe that there is sufficient equity cushion.

In perfect capital markets, how a firm raises capital is irrelevant to the value of the firm.
However the possibility of bankruptcy costs and financial distress and the inclusion of
taxes imply that Modigliani and Miller’s irrelevance propositions do not apply in reality3.

The realities imposed by the environment in which firms operate means that a firm may
not have 100% debt. The existence of corporate and personal taxes, bankruptcy costs,
agency costs, asymmetric information as well as non-debt tax credits means that the
capital structure of the firm is relevant in determining its value and also that firms would
not use 100% debt4. Hence the trade-off theory tells us that firms must choose a target
debt ratio towards which they slowly move. The trade-off theory yields an interior
optimum solution for firms. According to Berens and Cuny (1995), the trade-off theory
gives the rationale for cross-sectional variation in corporate debt ratios. This implies that
firms with different characteristics will have different debt ratios. Furthermore, even
those firms with the same target debt-to-equity ratios may have different observed debt-
to-value ratios. According to Myers (1984), this occurs because of the presence of
adjustment costs. As firms move from one debt-to-equity ratio to another, they incur
costs. Hence there will be lags in adjusting to the optimum. Some random events may
push firms away from the optimum.

3
Financial distress refers to the costs of bankruptcy and reorganization and also to the agency costs that
arise when a firm’s creditworthiness is in doubt (Myers, 2001).
4
It must, however, be noted that even in the presence of corporate and personal taxes, Miller (1977)
managed to show that it is still possible to have a scenario whereby the financing decision of the firms
would not affect firm value. Such a situation occurs when the so-called Miller equilibrium obtains.

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Even though firms may not have 100% debt there are a number of studies that support the
fact that firms favour debt. These include Modigliani and Miller (1966), Baxter (1967),
Mackie-Mason (1990) and Graham (1996).

1. Mackie-Mason (1990) - using a probit model, found that tax-paying firms favour
debt.
2. Graham (1996)- used annual data from 10 000 US firms for the period 1980-1992
and found that high tax rate firms use more debt as compared to low tax rate
firms. He also found that changes in long-term debt are positively related to the
firm’s effective marginal tax rate, showing that taxes affect financing decisions.
3. Modigliani and Miller (1966) - also found that tax shields contributed
significantly to the market value in a sample of US electric utilities.
4. Baxter (1967) - also supports trade-off theory, he maintains that firms have low
levels of debt because high debt levels imply higher interests rates and higher
debt-equity ratios increases the probability of default.

In order to establish optimal debt in an imperfect market we need to measure bankruptcy

costs. Bankruptcy costs are however difficult to measure. Bankruptcy costs can be
classified into two categories: direct and indirect bankruptcy costs. According to
Grinblatt and Titman (2002) direct bankruptcy costs relate to the legal and administrative
costs incurred when the firm is being reorganized while indirect bankruptcy costs are not
directly related to the reorganization.

But are bankruptcy costs significant enough to make trade-off theory work? According to
Warner (1977) and Andrande and Kaplan (1998) bankruptcy costs among the US firms
are not significant enough. For example, Andrande and Kaplan looked at highly
leveraged US firms that fell into distress and found that the bankruptcy process was
efficient and thus less costly. In a study of the US railroad industry’s bankruptcies,
Warner (1977) found that direct costs of bankruptcy were practically trivial. According to
Warner (1977) and Andrande and Kaplan (1998), such costs are not significant to
influence firm behaviour when it comes to raising capital. Altman (1984) however argued

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that the inclusion of indirect costs into the picture actually makes bankruptcy costs larger
and can influence firm behaviour. Firms may also restrain themselves from issuing debt
to maintain financial slack in the form of reserve borrowing (Myers, 1984).

Another important reason why firms may have less than 100% debt is because of conflict
of interests between debtholders and shareholders. There is always a possibility of wealth
expropriation of debtholders by shareholders. Because of that, before lenders offer their
funds they tend to require debt covenants to prevent and protect themselves from such
expropriation. Such covenants may require the firm not to exceed a certain debt/equity
ratio. Firms may therefore be afraid of suffering from debt overhang which occurs when
they have a substantial amount of existing debt with covenants that prevent them from
issuing additional debt that is senior to the existing debt (Grinblatt and Titman, 2002).

Pecking Order Theory

The POT is based on information asymmetry. Managers (the insiders) know more about
the firm than the outside investors. Information asymmetry affects the choice between
internal and external funds as well as between equity and debt.

The POT postulates that investment is financed first with internal funds (retained
earnings), then with issues of debt and then finally with new issues of equity.

The important reason suggested by Myers and Majluf (1984) is that of information
asymmetry. Since managers know more about the firm than potential outside investors
they know better the appropriate time to issue equity. They are reluctant to issue equity
when their shares are undervalued and would gladly issue shares when the firm is over-
valued.

Investors are aware of this so when they see a firm issuing shares they tend to think that
the firm is over-valued. Otherwise why would a firm with undervalued shares issue
equity. The result is that whenever a firm announces that it will issue new shares the
stock price of the firm tends to drop. This happens even when the firm is correctly priced.

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This negative stock market reaction to an equity issue may deter firms from issuing
equity, even when they know that the shares of the firm are correctly priced.

So if managers are better informed than investors and both of them are rational, then any
firm that can borrow will do so rather than issue equity. That is, debt will be higher in the
pecking order. The POT explains the dominance of debt financing over new equity issues
in practice. Debt issues are frequent; equity issues are rare. Even in developed economies
like US where the stock markets are advanced the bulk of external financing still comes
mostly from debt.

Equity issues are more difficult in most African economies where the stock markets are
less developed and the degree of information asymmetry is acute.

Implications of the POT:

1. Firms prefer internal to external finance
2. If external finance is required firms start by issuing debt and if more funds are
still needed only then can the firm issue equity.
3. Each firm’s debt ratio reflects its accumulative requirements for external funds.
4. POT explains why most profitable firms tend to borrow less as compared to less
profitable ones. This is because more profitable firms have internal funds or
retained earnings at their disposal which they can use to finance additional
investment. Thus they tend to have lower leverage or debt ratios than less
profitable ones. Less profitable firms issue debt because they do not have
sufficient internal funds and because debt financing is first on the pecking order
of external financing.

Empirical Evidence on POT

1. Shyam-Sunder (2000) - Using a sample of 157 US firms for the period 1971-
1989, Shyam-Sunder and Myers found that POT offered the best explanation of
the firms they covered than the simple debt-equity target adjustment model.

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2. Kyellman and Hensen (1995) - conducted a survey on listed firms in Finland and
found that managers of the listed firms tended to follow the pecking order model.
3. Miguel and Pindado (2001) - tested the POT using 133 listed Spanish firms and
found evidence in support of the pecking order model.
4. Bontempi (2002) - proposed an empirical model for the modified POT in which
both the POT and the trade-off model are nested. Using 20 152 Italian firms for
the period 1985-1995 he found that a modified pecking order model is suitable for
explaining capital structure behaviour in Italy. Further, he noted that there was
widespread use of retained earnings for investment by the Italian firms.
5. Fama and French (2002) - looked at 3000 US firms for the period 1965-1999 and
found that short-term variation in investment and earnings is mostly absorbed by
debt, confirming the POT postulations.
6. De Medeiros and Daher (2004) - using a sample of Brazilian listed firms, tested
both the POT and trade-off theory and found that the POT provides a better
explanation of capital structure behaviour of the firms.
7. Mayer and Sussman (2004) - looked at the financing of large and indivisible
projects and found that POT tended to work in the short run while the trade-off
model tended to work in the long run.
8. Gwatidzo and Ojah (2009) - looked at listed firms from a five African countries
and found that more profitable firms tend to have lower leverage than less
profitable ones – supporting the POT postulation.

Dynamic Capital Structure Theories

The static models looked at in the previous sections do not differentiate between
target/optimal capital structure and actual capital structure. Random shocks can push
firms away from the target or optimal capital structure such that optimal and actual debt
ratios may be different for some firms. A new strand of literature which acknowledges
this possibility and adopts a dynamic framework to explain the financing decisions of
firms has thus emerged. Contribution to this strand of literature includes; Yeh (2011),
Flannery and Rangan (2006), Hass and Peeters (2006).

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Market imperfections such as flotation costs, adjustment costs and credit constraints can
prevent firms from adjusting completely to their target leverage levels and immediately
offsetting the effects of events which take them away from the their target ratios (Ozkan,
2001).
The dynamic capital structure model can set up as follows:

Lvit  Lvit 1  a( Lvit*  Lvit 1 ), with 0    1 ………………………………………(A)

Where Lvit* is the target or optimal capital structure and Lvit is the actual leverage for
firm i at time t.

Case 1: If a = 0, then Lvit  Lvit 1  0  Lvit  0 : thus there is no change in capital

structure; firm does not adjust towards its optimal leverage.

Case II: If a = 1, then Lvit  Lvit 1  1.( Lvit*  Lvit 1 )  Lvit  Lvit* and the firm efficiently
adjusts its leverage level to the target leverage level; such that actual and optimal
leverage are always equal.

The target leverage is given by: Lvit*  xit  it ………………………………….....….(B)

To estimate the dynamic equation we combine equations (A) and (B) to get equation (C)
below:

Lvit  (1  a) Lvit 1  axit   i  t  vit ……………………………………….…………(C)

The above equation is estimated using the Generalized Method of Moments (GMM)
estimation procedure. The GMM and panel data allows a researcher to control for firm
specific effects and firm invariant time-specific effects. Examples of firm-specific effects
include a unique management style in a given firm. The firm-specific effects are
controlled for by estimating the dynamic capital structure model in first differences,

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rather than levels. Time-specific effects are controlled for by including year dummies in
the estimated models (Ozkan, 2001).

Some stylized facts concerning capital structure

1. Debt ratios in developing economies are lower than those in developed
economies.
2. Long term debt ratios in developing economies are lower than those in developed
economies.
3. Industry debt ratios are low when profitability is high.
4. Firms with valuable growth opportunities tend to have low debt ratios.

See table 2 below for the different leverage levels in different countries.
Table 2: Debt Ratios
Country Number of Firms Time Period Total Debt Ratio Long-term Book-debt Ratio
South Africa 137 1990-2000 46.7 12.0
Kenya 34 2000-2004 48.8 15.4
Zimbabwe 59 2002 50.7 17.2
Ghana 17 1998-2003 59.4 10.0
Nigeria 62 1999-2003 23.4 12.9

US 2580 1991 58.0 37.0

Japan 514 1991 69.0 53.0
Germany 191 1991 73.0 38.0
France 225 1991 71.0 48.0
Italy 118 1991 70.0 47.0
UK 608 1991 54.0 28.0
Canada 318 1991 56.0 39.0

Brazil 49 1985-1991 30.3 9.7

Mexico 99 1984-1990 34.7 13.8
India 99 1980-1990 67.1 34.0
South Korea 93 1980-1990 73.4 49.4
Jordan 38 1983-1990 47.0 11.5
Malaysia 96 1983-1990 41.8 13.1
Pakistan 96 1980-1987 65.6 26.0
Thailand 64 1983-1990 49.4 N/A
Turkey 45 1983-1990 59.1 24.2
Zimbabwe 48 1985-1987 40.3 11.1
Note that N/A means information is not available. Total debt ratio is defined as total debt (short term debt plus long term debt) divided
by total debt plus book value of equity. Long term debt ratio is long-term debt divided by total debt plus equity (book value). The data
for South Africa, Kenya, Zimbabwe, Ghana and Nigeria, in the first five rows were collected by the author from the annual reports of
the firms as stated in the stock exchange handbooks of the different countries. Data for US, Japan, Germany, France, Italy, UK and
Canada are from Rajan and Zingales (1995). Data for Brazil, Mexico, India, South Korea, Jordan, Malaysia, Pakistan, Thailand,
Turkey and Zimbabwe, in the last set of rows, are from Booth et al (2002).
Source: Adopted from Booth et al (2002), Rajan and Zingales (1995) and Author’s own calculations

Tendai Gwatidzo, 2017 18

References
1. Myers and Brealey – Principles of Corporate Finance.

2. Ogden et al – Advanced Corporate Finance.

3. Grinblatt and Titman – Financial Markets and Corporate Strategy.

4. DeMatos – Theoretical Foundations of Corporate Finance.

5. MM (1958)-The cost of Capital, Corporation Finance and Theory of Investment.

6. Swanson et al (2003) - The Capital Structure Paradigm- Evolution of Debt/Equity

Choices

Tendai Gwatidzo, 2017 19