CHAPTER ONE
INTRODUCTION
1.1 Background of the study
A firm’s leverage refers to the mix of its financial liabilities. As financial capital is an uncertain but critical resource for all firms, suppliers of finance are able to exert control over firms. Debt and equity are the two major classes of liabilities, with debt holders and equity holders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. While debt holders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their investment. Equity holders are the residual claimants, bearing most of the risk, and, correspondingly, have greater control over decisions. Questions related to the choice of an appropriate financing means (debt versus equity) have increasingly gained importance in management research. Traditionally examined in the discipline of finance, these issues have gained relevance in the past few years, with researchers examining linkages to strategy and strategic outcomes.
The financial management functions of a firm – including its capital structure decision – deals with the management of the sources and uses of finances. Firms enter into transactions with suppliers of finance (be they debt holders or equity holders) when raising capital for assets. The right to partake of the cash flows generated from the assets lies with these suppliers. The debt-to-equity ratio of a firm determines how these cash flows will be shared between debt holders and equity holders. In other words, if firms are set up to maximize equity holder’s wealth, then the proportion of cash flows disbursed to debt holders becomes important. The different types of financing, however, are also associated with different levels of costs. An examination of the net benefit of a firm’s assets should incorporate these cost differences along with the value of such assets. Theory of capital structure is an important theory in finance. It addresses sources of finance available to business organizations wishing to raise funds to finance their operations. These include equity sales, retained earnings, bonds, bank loans, accounts payable and line of credit (McMenamin, 2009 and Ross, et al 2012) and possibly few other interest bearing debts. The capital structure theory originated from the famous work of Modigliani and Miller (M&M) (2008). They argued that, under certain conditions, the choice between debt and equity does not affect a firm value and hence, the capital structure decision is irrelevant, but in a world with tax-deductible interest payment, firm value and capital structure are positively related. M&M (2008) pointed out the direction that capital structure must take by showing under what conditions the capital structure is irrelevant. Titman (2011) lists some fundamental conditions that make the M&M proposition hold as: no (distortionary) taxes, no transaction cost, no bankruptcy cost.
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