Corporate Capital Structure Theories And Modern Research Work Finance Essay

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Methodology: Regression model is used to analyze the data taken from Pakistani firms in sugar sector, listed on Karachi Stock Exchange, during the period 2001-2008. Keywords: Static trade-off theory, Pecking order theory, Agency cost theory, leverage ratio, listed firms, corporate capital structure.

1. Introduction

In the opening chapter, the background, problem discussion and purpose of the study are presented. The chapter ends with targeted group and limitation of study.

1.1 Background and problem discussion

Capital structure is one of the most prolific domains of research in corporate finance. Research is spinning around a few theoretical models of capital structure since over than forty years but could not be able to provide the conclusive assistance to managers and practitioners for choosing between debt and equity in financial decisions.

An important question that companies face in need of new finance is whether to raise debt or equity. A number of theories have been proposed to explain the variation in debt ratios across firms. The theories suggest that firms select capital structures depending on attributes that determine the various costs and benefits associated with debt and equity financing. In spite of the continuing theoretical debate on capital structure, there is relatively little empirical evidence on how companies actually select between financing instruments at a given point in time. The problem of capital structure choice has been heavily discussed by international researchers for the last few decades that:

What are the determinants of capital structure choice?

How do firms choose their capital structures?

"Given the level of total capital necessary to support a company’s activities, is there a way of dividing up that capital into debt and equity that maximizes current firm’s value? And, if so, what are the critical factors in setting the leverage ratios for a given company?"

Modigliani and Miller’s (M&M) theory (1958) is considered as fundamental corporate structure model in the modern corporate finance. The theory ascertained the irrelevance of capital structure to firm’s value in perfect markets, without taxes and transaction costs. Following on the this perfect classification of market, most subsequent research focused to demonstrate that a firm’s capital structure decision does consider corporate and personal taxes, agency costs, bankruptcy cost, and other frictions. These aspects of corporate environment are referred as "determinants of capital structure". Main research in corporate structure is focused on following two competitive theories:

The first one is the traditional "static trade-off" theory, which derives form the Modigliani and Miller’s (1963) hypothesis of capital structure irrelevance and suggests that firms choose their optimal capital structures by trading off the benefits and costs of debt and equity. The main benefit of debt is tax deductibility of interest, which is balanced against bankruptcy costs (Kim 1978) and agency costs (Jensen and Meckling 1976; Myers 1977). It suggests the existence of a target optimal capital structure, which companies try to reach.


Contrary to the above is the "pecking order"

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