Literature Review on Capital Structure

The ultimate objective of every company is to increase firm’s performance which in fact, associated with firm’s strategic decisions. Decisions regarding choice of leverage are one of the strategic decisions; firms often take this type of decisions to increase their performance.

Capital structure is the composition of the liability of a firm or particularly is the proportional participation of the numerous financing sources. Such as the equity, and debt it included the short term and long term debt Brealey and Myers (1992), Weston & Brigham (2000) and Gitman (1997). 

Modigliani and Miller (1958) argued that capital structure its theories and relationship with firms performance has been creating issue in accounting and corporate finance literature. They further argued that under preventive assumptions of capital market capital structure is unsuitable in determining firm performance or value. According to this intention, firm value is not the combination of the securities it issue but it is determined by real assets. 

Preventive assumptions did not apply in real world for this reason many researchers came up with supplementary explanation for this proposition and showed that capital structure affects firm’s performance and value. After the research conducted by Jensen and Meckling (1976) revealed that leverage size in a capital structure created the agency problem between shareholders and managers to act more for the in the fever of stakeholders and change mangers behavior and affect manager’s decisions. It means leverage size in capital structure affected the firm’s value and performance.

Numerous researches conducted regarding the capital structure and its impact on firm’s performance. Many researchers have conducted study to find out the relationship between firm performance and financial leverage but the result were mixed and contradictory. Some studies have documented positive relationship between firm performance and leverage size such as Roden and Lewellen (1995). Decisions regarding choice of debt or leverage become critical that which type of debt is more associated with firm’s performance.

Mao X Connie (2003) argues that interaction between the two debt agency problems has not been fully understood. He develop a simple model that captures both the risk shifting and the under investment problems. In the model a firm faces a discretionary investment decision, and the terminal firm value is a random variable whose mean and volatility both depend on the size of the investment. Thus risk shifting and under investment incentives will affect the investment decision of a leverage firm in the same or different direction, and the total agency cost of debt will depend on the tradeoff between the two incentive problems.

Mao X Connie (2003) says that if volatility of project cash flows increases with investment scale, risk shifting by equity holders will mitigate the under investment problem. This implies that, contrary to the conventional wisdom, the total agency cost of debt is not monotonically increasing with leverage. Further he suggested that for high growth firms, the optimal level of debt increases with the magnitude of marginal volatility of investment when marginal value of investment is positive but declines with the magnitude of marginal value of investment when marginal value of investment is negative, it is in low growth firm. Empirical findings support these predictions.