Captial Structure and Firm Performance.

There are many theories that look into the relationship of capital structure and firm performance each of these theories have a different insight into whether this relationship is either positive, negative or even if there is a relationship at all. Within this paper relevant theories will be analysed and then evaluated using empirical data to the come to a conclusion as to whether capital structure does have an effect on firm performance and to what extent. The theories that will be evaluated will be Modigliani and Millers (1958) MM theory, Myers (1984) trade-off theory and Myers and Majiluf (1984) pecking order theory.

Capital structure is seen as the mix of a firm’s long-term financial leverage. Within this paper these will be both a firm’s debt level and equity level. The way in which a firm chooses to mix these two leverages can have different effects and the firm’s performance which will be discusses further in the paper. When speaking about firm performance there is a wide range of definitions however only the firm value and profitability will be looked into in this paper.

The first researchers to publish material on capital structure was that of Modigliani and Miller they published the MM theory. Capital structure can be an important tool in helping investors choose which firms to invest in. This theory looked into firm to try and theorises the effects that capital structure had on firm performance.

The MM theory was then split into three parts. The first of which is called proposition one or the irrelevancy theorem. This states that the firm value is not affected by the way the firm chooses to finance investments or pay-out dividends. Thus stating that both a leveraged and unleveraged firm will both have the same value. Position one is also called the irrelevance theorem because it shows that capital structure is irrelevant to the value of the firm and does not impact firm performance. The MM theory is very widely looked at in today’s research. Position two on the other hand states that when there is any increase in leverage there will need to be an increase in the return on equity as the firm is now more risky to invest in (Allen, 2008). the firm is seen as more risky when there is increased leverage because there is now high risker risk of financial distress. And therefore shareholders will need to gain a higher return. Although this does not necessarily mean that there will be an increase in firm value.

However, although the MM theory found these results in setting curtain assumptions. These were that the firms were operating in perfect capital market. A perfect capital market is one in which there are no taxes, transaction costs, bankruptcy or agency costs and that there is symmetric information.

Modigliani and Miller (1958) then introduced a scenario in which there were taxes, to which they found that due to there being tax shelters it was beneficial to have high levels of debt. Due to there being interest rate shelters firms were able to pay less tax on interest and thus keep more finances within the firm. Therefore, they found that due to the benefits of these tax shelters firms should try and gain as much debt leverage as they can thus showing that firms should hold 100% debt.

Although Modigliani and Miller (1958) had a very good theory explaining why capital structure did not affect firm performance all of their evidence was purely theoretical and therefore did not have any real work examples supporting it.

With this being said it was proposed that due to there being no effect on firm performance due to capital structure in perfect markets then this could be giving evidence to there being an effect when the markets are realistic and imperfect.

As Miller (1982) stated “seeing what doesn’t have an effect can imperially show what does”.

To try and build more real world theories Myers (1984) published the trade-off theory this explains that that can be an optimum level of capital structure to what the added tax benefits from the increase in debt is then offset by the costs of the increase in financial distress. Therefore, trade-theory shows that there is an optimum point to be found. This theory would show that there should be a positive relationship between capital structure and firm performance.

However the opposite was viewed as it was shown that firms with high levels of profitability has a negative relationship with capital structure and leverage (Myers, 2001).

A further study supporting Myers (2001) findings of a negative relationship was that of Lavorskyi (2013). Lavorskyi conducted a study that looked into 16.5 thousand Ukrainian firms, and what was found was that here was a negative relationship between leverage and firm performance. However, this could be due to Ukrainian firms having partner firms abroad to which they then set up profit centres which allows them to be paying taxes into Ukraine which means that they will