CAPITAL STRUCTURE

Capital Structure Influence on Firm's Performance

Abstract

This study highlights the importance of capital structure, its influence on firm's performance and value with regard of agency cost. This research breaks with the earlier literature on capital structure. In the introductory part, study offers a longitudinal assessment of capital structure and the methodological part provides details of the data from the period starting from 2004-2008 of 40 FTSE companies for the empirical alalysis. In the end study concludes with reasonable justifications of the conducted research.

Table of Contents

CHAPTER 1: INTRODUCTION4

Overview4

Research Objective8

Aim Of Study8

Research Hypothesis8

CHAPTER 2: REVIEW OF LITERATURE10

Capital Structure10

Capital Structure Theory11

Modigiliani and Miller Theorem12

Trade-off Theory15

Pecking Order Theory17

Pecking Order Theory vs. The Trade-Off Theory19

Signaling Theory21

Free Cash Flow Theory23

Agency Theory23

Other Attempts to Explain Capital Structure25

Some Recent Studies25

Considerations in Raising Capital27

Determination of Capital Structure28

CHAPTER 3: RESEARCH METHODOLOGY31

Research Design31

The Empirical Model39

Firm Performance39

The Leverage Model45

CHAPTER 4: RESULTS AND ANALYSIS51

Empirical Results51

CHAPTER 5: CONCLUSION60

REFERENCES63

BIBLIOGRAPHY67

APPENDIX85

Table 1: Descriptive Statistics85

Table 2: Efficiency and Leverage Statistics87

Table 3: The Firm Performance Model90

Table 4: The Leverage Model94

Chapter 1: Introduction

Overview

The subjects related to companies' capital structure have belonged to a range of the main reasearch topics among scholars and practitioners for a long time. The fundamental question is whether the companies manage their capital structure knowingly (trade-off theory) or the observed capital structure is a result of random process determined by historical profitability, investment options, dividend policy and capital market conditions (pecking order and market timing theories). There is no consensus and, as argued by many scholars, neither traditional pecking order nor trade-off theory provide satisfactory description of capital structure choices in practice (Gaud et al. 2004, 38). Several studies conclude that companies do have a target leverage ratio which they pursue in long run, but pecking-order behavior seems to dominate over short-run capital structure decisions (recent studies include Mayer and Sussman 2004, 47; Farhat et al. 2006, 39). This notion assumes that companies will gradually reduce the gap between observed and target capital structure once they are pushed away from the target level. Partial adjustment behavior contributes to trade-off theory if adjustment speed is high, otherwise the other determinants, mostly related to pecking-order theory, remain dominant. Again, empirical studies give contradictory results, perhaps due to different methods and leverage specifications used. For example, in recent studies, Flannery et al. (2004, p.50) document the adjustment speed of one-third per year, but Huang and Ritter (2007, p.46) suggest that firms adjust slowly toward their target leverage (speed varies between 11.0 and 21.1 percent per year for book leverage, and between 16.1 and 22.3 percent for market leverage). The results of the extensive study by Farhat et al. (2006, p.39) show the adjustment speed varying between 19 and 48 percent. However, the puzzle remains and one of the reasons for contradictory results might be seen in differences in company-specific factors.

The goal of this study is to research capital structure, its influence on firm's performance and value. Moreover, studies on capital structure have also been done looking at small and medium size firms (Romano et ...