Theories Linking Capital Structure with Financial Performance 2018

Abstract

The choice of capital structure is one of the most important and fundamental aspects of corporate finance studies. It is a controversial topic among finance scholars. In the mid-1950s when Modigliani and Miller devised their concept of "Modigliani-Miller (M&M) propositions," the assumption was made that in a perfect market, capital structure is irrelevant and does not affect a firm's value. Following M&M theory, finance scholars developed various theories based on the assumption of the perfect market. First, trade-off theory assumes that firms trade-off between the benefits and costs of using debt and equity as a source of financing when considering market imperfections such as taxes, bankruptcy cost, and agency cost. Second, pecking order theory examines the issue of asymmetric information between shareholders and firms' managers. The main goal of this theory is to minimize the problem of asymmetric information using internal sources as the first choice, if internal sources are not enough to fund a business as financing requires, then external sources are resorted to be used. Third, agency cost theory argues that corporate governance comprises ownership structure and how processes are properly implemented, given that these impact on firm performance, firm value and subsequently the capital structure. Other scholars examine whether firm performance can be determined by the choices of capital structure which can be predicted by the efficiency risk and franchise value hypotheses. This study aims to shed light on the capital structure theories that have been used by scholars; various empirical studies are reviewed to clarify the capital structure theories.