2.1. The Gradual Development of the Main Theories Regarding Capital Structure
The work of
Modigliani and Miller (
1958) (henceforth “MM”) and the previous theoretical contributions—among which should be mentioned
Durand (
1952);
Guthmann and Dougall (
1955)—have struggled with various inconsistencies. If the traditional thesis inconveniences stemmed from assuming the certainty of the market structure and interest rates, the MM criticisms are mainly caused by the indebtedness risk. Summarizing, MM’s initial theory stated that the value of a company could not be affected by amending the debt–capital ratio. Despite the rigidity of its assumptions, the model is useful to determine under which conditions the capital structure becomes irrelevant:
there are no transaction costs on the capital market;
it is possible to lend and borrow money at the risk-free interest rate;
there are no bankruptcy costs;
firms could issue only two types of securities: free interest risk bonds and common shares;
all the companies are included in the same risk class;
the cash flows are constant and perpetual;
all the agents have the same information (there is no possibility of arbitration by sending market signals);
the managers want to maximize shareholders value (there is no agency costs);
the cash flows are not affected by the changes in the capital structure.
The absence of costs and arbitration possibility determined by the changes in the capital structure have generated the first hypothesis or Proposition 1, which states that the value of a company fully funded by equity is the same as the one funded both by equity and debt. Following this idea, the authors led to Proposition 2, which says, “the average capital cost of any company is completely independent of the capital structure, and it equals the return rate offered to shareholders by an unlevered firm of the same class” (
Modigliani and Miller 1958). The model assumed that a higher level of indebtedness would transfer a higher risk on shareholders that will require a higher opportunity cost. Supporting these two ideas, we can notice that the premium risk is precisely the difference that keeps steady the capital cost. Agreeing also with the three hypotheses, namely lack of arbitrage opportunity, absence of transaction costs on the market debt, and existence of a risk-free interest rate in the market,
Miller and Modigliani (
1961) yield Proposition 3, sustaining that the dividend policy does not change the value of the company. Despite the restricting conditions, the model has an important predictive value, but ignoring taxation consequences is a concern too significant not to be considered.
Later on,
Modigliani and Miller (
1963) showed that if taxation is taken into account, debt becomes beneficial for companies because interest deduction reduces the taxes. In the authors’ opinion, raising the leverage implies transferring, to shareholders, the tax deductions, a fact that leads to maximizing the level of indebtedness. The approach proposed by MM was highly debated, and we will further discuss some of the most typical points of view.
Stiglitz (
1969) considered that the main critical point of MM’s analysis was to suppose that the bonds issued by firms and individuals have zero default risk. It has been stated that the risk is different depending on the type of the firm, and is influenced by the collateral provided and the market conditions. Likewise, it is pointed out that if debt would not lead to bankruptcy costs, firms would choose to raise as much debt as possible (
Stiglitz 1974). Nevertheless, the conclusion of the study is that there are bankruptcy costs, both direct and indirect, and the relationship is directly correlated with indebtedness, and so is the cost of borrowing.
Fama (
1978) pointed out that the studies previously published were based on the following premises: perfect capital markets, equal access for the companies to different markets, and common expectations on all the markets. In the end, the author affirmed that the distribution of dividends affects the firm’s financial decisions.
Bradley et al. (
1984) argued that the irrelevance of the dividend policy outlined by MM does not imply stable market conditions, but requires the capital market efficiency.
Wald (
1999) contended the market imperfections and how the studies that emerged after MM have reached different conclusions other than MM, such as the agency, bankruptcy, and information asymmetry costs.
Briefly, the studies that have researched the limitations of MM’s theory have highlighted that the capital markets are not perfect, and indebtedness lowers the tax burden, but there are also bankruptcy costs that limit the tax benefits. Indebtedness also mitigates the conflicts between managers, creditors, and shareholders, and the lack of available information between different agents on the market. MM themselves, in 1963, have improved the original version where they were underestimated the tax benefits that a company may have from using indebtedness, and this time they were stating that the optimal capital structure is achieved at the maximum level of indebtedness a company can sustain (
Modigliani and Miller 1963). This assumption will also draw criticism for the reason that a high level of debt also entails high bankruptcy costs. Despite its limitations, MM’s work is important, as it have paved the way for further contributions to the financial economy, stating the cornerstone on understanding the prominence of the financial decisions on the company’s value.
Afterward,
Miller (
1976) focused on bankruptcy costs, and noted that beyond the corporate perspective, for the persons involved, the balance between tax benefits and bankruptcy costs is actually very hard to find. At the same time, the author noted that in a balanced market, the shareholders attempts to benefit from tax advantages would generate a progressive increase of the tax rates in order to restore the balance.
Establishing the capital structure involves, in fact, a series of agreements between the interest groups of a firm, each party aiming to maximize its benefit. For managers, this could mean increasing their control, while the shareholders pursue increased value of the company. This creates the so-called agency cost (
Ross 1977) that determined seeing the capital structure through the conflicts between shareholders, managers, and creditors. For instance,
Abor (
2007) argued that agency issues may determine firms to follow very high debt strategy, hence resulting in poorer performance. The conflicts of interest between shareholders and managers arise particularly when the company’s management has the power to use the free cash flow to achieve personal benefits at the expense of the shareholders. On this issue,
Stulz (
1990);
Harris and Raviv (
1990);
Zwiebel (
1996) argued that debt is a way to reduce conflicts, since the repayments of the debt determine managers to be more conservative and more cautious with excessive investments. In another context,
Majumdar and Chhibber (
1999) argued that the role of debt as a monitoring channel to increase firm performance is not substantial. In addition,
Jensen (
1986) noted that leverage is a manner to diminish the management monitoring cost. Thus, reducing the free cash flow will limit the management opportunities to make significant expenditures in their own interest. Secondly, the conflicts between shareholders and creditors create the so-called idea of asset substitution that occurs by transferring the welfare from creditors to shareholders, when the last ones decide to contract new debts affecting the initial creditors (dilution of rights). Also, between these stakeholders may arise the underinvestment issue—giving up projects with positive net present value that would benefit the creditors, but would prejudice the shareholders, or the issue of requiring higher interest rates when specialized assets are purchased because of the higher risk assumed by creditors (
Myers 2001).
Most of the models regarding capital structure start from the assumption that debt ratio is a static decision. However, in the real economy, firms adjust the debt level depending on the changes of firm value.
Goldstein et al. (
2001) noted that although creditors are protected by contractual agreements, in fact, the firms have the option to contract new credits without extinguishing the existing debt. In case of bankruptcy, all creditors usually receive the same percentage of indemnity, regardless of when the debt was granted. Obviously, such debt is riskier than the ones described by the traditional patterns of capital structure and most of the bond price models, where the bankruptcy costs are assumed to remain constant over time.
Hall et al. (
2000) reported for U.K. small and medium sized enterprises, a positive link between long-term debt and asset structure, but a negative relation between company size and age; further short-term debt appeared to be negatively related to profitability, asset structure, size and age, whereas it was positively linked with growth.
With regards to the information asymmetry, we can state that the information represents a set of data that can be observed by different agents who may have a contractual relationship. Information asymmetry means that some of the agents do not have access to the information, generating three possible issues: the moral hazard, the adverse selection, and possibility to use market signalization. Identifying the sectors and the companies that have good performances becomes, therefore, more challenging, for the reason that some agents may make flawed decisions based on the limited information they have. For some authors, the size of the company is therefore a relevant factor. It is considered that large firms have a lower risk of asymmetry, whereas accessing information about these companies is easier, and their visibility in the capital markets is higher.
Frank and Goyal (
2009) grouped the theories on capital structure into two categories, correlated with the market imperfections:
The trade-off theory shows the importance of limiting indebtedness because of the directly proportional increase of costs determined by the risk of experiencing financial difficulties that counterbalances the tax benefits. The bankruptcy costs consist of direct costs generated by accounting and legal expenses caused by bankruptcy or reorganization, as well as indirect costs represented by lost opportunities because of poor management, such as suppliers and customers’ loss of confidence. This theory implies an optimal ratio between indebtedness and equity, which maximize the company’s value, being considered as the point where the benefits and costs of indebtedness are in balance (
Shyam-Sunder and Myers 1999). However, keeping this balance is seen from different standpoints. Thus,
Jensen (
1994) considered that the balance remains static, and its adjustment is done immediately and cost-free. In contradiction, the dynamic approach requires an expensive process of permanent rebalancing. For this reason, several authors believe that companies are rather trying to keep leverage within a certain range (
Kane et al. 1984). The main factors explaining the trade-off theory are the bankruptcy costs (
Cook and Tang 2010;
Fama and French 2002), the taxes (
Miller and Scholes 1978), the agency costs (
Fama and French 2002), and the costs of financial adjustments (
Antoniou et al. 2008). Among recent studies supporting this theory we can mention
Hovakimian (
2006);
Faulkender et al. (
2012);
Kayhan and Titman (
2007). Although the trade-off theory treats debt as a factor that could favor the firms, still no explanation has been given with regards to the survival of many high performance firms that do not use indebtedness. In addition, an unanswered question is why, in the countries that have reduced taxes or a tax system that cuts the tax advantage determined advantage debt, the firms still have a high leverage.
The pecking order theory (
Myers 1984;
Myers and Majluf 1984) is based on the assumption that investors know they could confront an information asymmetry issue, for example, the managers’ attempt to issue risky securities when they are overvalued. At the same time, managers know that shareholders will try to limit this risk, and this could lead to the inability to finance certain profitable investments through the capital market. Briefly, the pecking order theory argues that if external sources are more expensive than the internal ones, and if attracting capital is more expensive than debt, the capital structure will be affected only if the internal funds are unsatisfactory. For
Myers and Majluf (
1984), the firms that use external funding sources also may face the adverse selection issue that followed the information asymmetry. The adverse selection reflects the market’s failure to individually evaluate each company. The companies are instead ranked according with the sector they belong, and thus companies with cost-effective and high-quality projects can be underestimated, while unsuccessful projects can be overestimated. This model shows that the financial structure of a firm is driven by the needs for financing new investments, and not by the existence of an optimal debt level, choosing debt only when internal resources are scarce. However, the transaction costs support the ranking of financing options in the order presumed by the pecking order theory. Hence, firms will pursue the growth or decrease of indebtedness when the forecasted investments exceed or fall below the internal resources (
Fama and French 2002).
Kayhan and Titman (
2007) stated that the leverage is higher when financial deficit, understood as the difference between financing needs and internal financing sources, is higher. In other words, seen in terms of indebtedness, the leverage is lower when the firms are profitable (
Fama and French 2002), and seen in terms of profitability, it is higher when the firms have more investment opportunities (
Antoniou et al. 2008). In a more complex analysis, balancing these costs can lead the companies with high investment opportunities to maintain a lower level of leverage in order to preserve a certain financing capacity (
Kayhan and Titman 2007), and avoid being in the situation of giving up some valuable investments or issuing risky securities (
Fama and French 2005). However,
Kayhan and Titman (
2007) noted that also those who have no future investment opportunities could maintain a low indebtedness because they tend to capitalize their present results.
The companies that face increased cash flow volatility also tend to be less leveraged, in order to diminish the possibility of having to issue risky securities or losing investment opportunities when their own resources are low, a fact that explains also why dividend distribution is negatively correlated with indebtedness. On the other hand, the cash flow volatility is associated with the restriction of the leverage capacity, which makes
Lemmon and Zender (
2010) consider that by controlling the cash flow volatility, the pecking order theory could adequately explain the financing decisions.
The pecking order theory now has great acceptance, and many companies are not aiming to find the optimal combination of debt and equity, but rather trying to finance their new projects through internal resources, because of the fear of market aversions or because the available information does not provide certainty (
Frank and Goyal 2009). In fact, the authors have analyzed the characteristics of the companies when they choose the form of financing the new investments, taking the two theories as benchmarks, with the objective of validating the arguments of each one.
The market timing theory assumes that there is no optimal capital structure, financial decisions are changing over time (
Baker and Wurgler 2002), and the evolution of capital structure must be seen as the result of the historical funding decisions. MTT suggests that companies will decide to issue new shares depending on the market conditions, and this change will have influence in the coming years, because debt adjustment is not itself a goal (
Hovakimian 2006). Less indebted companies are generally those who have accumulated funds when they have been overestimated, and implicitly, very indebted firms are those who have attracted external funds when their assessments were detrimental (
Baker and Wurgler 2002). At the same time, these circumstances can be noticed when a rise in the price of shares is forecasted, wherein firms will attract capital, or if a decrease is expected, then they will choose indebtedness (
Kayhan and Titman 2007). This suggests a negative relationship between the company’s assessment of the capital market and the level of indebtedness (
Hovakimian 2006). This way, the decisions managers take depend on the variations of shares price and debt cost, and at the same time, these decisions and the fluctuations of the capital markets have a long-term effect on the financial structure (
Baker and Wurgler 2002).
For an enhanced comprehension,
Table 1 presents some drivers of indebtedness and their impact as these are indicated by the three capital structure theories.
Further,
Table 2 provides a short review of the literature on capital structure.
2.2. The Effects of Macroeconomic Instability on Capital Structure
Bernanke and Gertler (
1995) started from the idea that, at least in the short term, the monetary policy has a significant effect on the economy. Thus, the authors noted that if there is a tightening of monetary policy in a period of about four months, there will be a drop in gross domestic product (henceforth “GDP”), and then a price fall within a year. What draws attention is that the monetary policy has a stronger impact on short-term interest rates, and it is expected that the strongest impact would be on short-term asset acquisition, however, the fastest effect of the policy monetary policy is on real estate investments. This finding is odd, as investments in durable goods should be more sensitive to long-term interest rates. The same study shows that long-term investments seem not to be seriously affected by the monetary policy.
Bo and Lensin (
2005) grouped the companies in terms of liquidity and leverage, and noted that companies with low liquidity have greater leverage and a higher reported sales/assets ratio. When the under- or over-indebtedness criterion was considered, it was noted that over-indebted firms are up to three times more sensitive to macroeconomic instability. When the macroeconomic conditions are uncertain, companies become more cautious and borrow less.
Baum et al. (
2009) noted that while in Germany, a country based on the banking system, profitability is influenced by the maturity of debt, in the case of the United States, this correlation is no longer maintained. The result led the authors to assert that financial environment plays an important role in companies’ capital structure decisions and on their subsequent consequences.
Baum et al. (
2017) asserted that the leverage evolution follows a “mean reverting” process, but the speed to adapt at this process depends on company-specific factors (difficulty of financing, firm evaluation on the capital market, company size, profitability, and leverage), on the countries’ macroeconomic conditions, and last but not least, on certain omitted factors which may have a significant impact. In terms of macroeconomic conditions, like
Cook and Tang (
2010);
Drobetz and Wanzenried (
2006);
de Haas and Peeters (
2006);
Baum et al. (
2017) also noticed the importance of the real GDP growth. Risk is considered an important component that has a different influence on the adjustment speed of the leverage according to its current level, and identifies two main sources of risk, respectively, the macroeconomic factors and the specific characteristics of the firms (
Cook and Tang 2010). The impact of the risk on the leverage adjustment speed was explored by
Cook and Tang (
2010) through classifying the financial status of the companies in financial surplus or deficit, and the current leverage as above or below the target level. Thus, the firms whose leverage level is above the target will adjust, more quickly, their capital structure when macroeconomic risk is high and firm risk is low. This is motivated by companies trying to protect themselves against any financial constraints. On the contrary, firms whose indebtedness level is lower than the target and have good results would not primarily seek to adjust leverage, but rather, to maintain the level. On the other hand, companies facing financial deficits and whose indebtedness level is below the target will try to adjust their capital structure when the macroeconomic and company risks are relatively low. In the above-mentioned study, leverage is calculated using accounting indicators, the motivation being that unlike the market size indicators, the accounting measures are not influenced by the market value of capital that can undergo significant changes, even if the level of indebtedness does not change.
Furthermore, several features of the business cycle dynamics of the capital structure have been explored in the literature. For instance,
Jermann and Quadrini (
2012) analyzed the cyclicality of equity and debt over the business cycle by means of a model in which financial frictions affect corporate borrowing constraints, and argued that shocks are important for macroeconomic fluctuations.
Azariadis et al. (
2016) found for the U.S. economy between 1981–2012, that unsecured debt is strongly procyclical, with some tendency to lead GDP, while secured debt is acyclical. According to
Drobetz et al. (
2015), companies amend more slowly in the course of downturns, whilst the business cycle effect on adjustment speed is most noticeable for financially strained firms in market-based nations. As well,
Zeitun et al. (
2017) revealed that the speed of adjustment to the optimal capital structure is, on average, slower after the crisis, due to the lack of debt financing supply. Thereby,
Seo and Chung (
2017) argued the adjusting capital structure is so pricy that firms do not instantly react to capital-structure shocks.
Devos et al. (
2017) asserted that the speed of adjustment towards the optimal debt ratio of the firm is about 10–13% lower when a firm has covenants, related to companies that do not have covenants. For a sample of 1594 Indian manufacturing firms over 1998–2011,
Bandyopadhyay and Barua (
2016) laid down that macroeconomic cycle significantly impacts corporate financing decisions and performance.
Likewise,
Al-Zoubi et al. (
2018) brings important contribution to previous research, showing that companies’ decisions regarding capital structure determine a persistent and cyclical evolution of leverage. Indebtedness cyclicity depends on the business cycle, whereby the duration is calculated between two moments of economic peaks or troughs, and it includes four stages: expansion, peak, contraction, and trough. The study was conducted on the U.S. market, with the database including the period 1975–2016. During this period, the authors have identified six business cycles and five financial crises. The main conclusion was that capital structure is cyclical and persistent. The principal divergence with the three theories—trade-off, pecking order, and market timing—is that the leverage does not follow a mean reverting process, explained by a growing leverage when profitability is high, and leverage contraction when the earnings are reducing, but it follows a cyclical process like the business cycle.
Table 3 shows a brief review of previous papers that examined the adjustment speed of capital structure.