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Capital Structure

Applicable Theories for Capital Structure

Capital Structure


The most critical issue of corporate money is the planning of ideal capital structure. In the past few years, most of the economists working on this area are trying to determine the optimal capital structure for different kinds of organizations. The concept of capital structure and corporate finance gained attention after Modigliani and Miller published their first work on corporate finance, ‘the cost of capital and investment theory’ (Bennett and Donnelly, 1993).

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In their paper, they devised a capital structure irrelevance theorem that focused mainly on the different capital structures of different companies. Since then, many researchers have developed several theories which have attempted to elucidate the financial behavior of the organizations and determine whether companies have been able to design an optimal capital structure or not (Larcker, et. al., 2007).

Over the decades different theories were developed to better understand corporate finance and capital structure. For example, ‘the trade-off theory’ proposed by Modigliani and Miller, ‘the agency theory’ developed by Jensen & Meckling in 1976 and ‘the pecking order theory’ by Myers and Majluf in 1984. Of all the theories proposed till date on capital structure, ‘the trade-off theory’ and ‘the pecking order theory’ has most often helped in explaining the capital structure of companies. The ‘trade-off theory’ proposed by Modigliani & Miller explains that organization’s choice of capital structure largely depends on the trade-off between benefits of debts (such as benefits the firms generate through interest debt tax shield) and the cost of capital (such as direct and indirect costs of bankruptcy) (Noe, 1988).

The ‘pecking theory’, whereas suggests that firms select the source of funding which is cheapest for them; this is due to either lack of information or information asymmetry. Thus in the latter theory organizations select internal funding over external funding and in addition they prefer debt funding over equity funding (Fearnley and Hines, 2003). But, theories of capital structure so far have not been able to fully explain the optimal capital structure of a company. Thus, it is highlighting the precedence of capital structure research within corporate finance.

Financial crisis and capital structure

Another important reason for companies to emphasise on their capital structure is financial crisis. The recent world financial crisis of 2008 is the result of high increase in organizational bankruptcies (Walayat, 2010) forcing companies to evaluate their existing financial strategies. This rapid bankruptcy of a large number of companies in 2008 and the insecurities existing in financial markets created a doubt in the minds of investors about the quality of credit of many organizations (Sadka, 2011).As a result banks tightened their credit and most of the investors were reluctant to invest in company stocks. Such circumstances made it very difficult for the organizations to raise funds from banks and attract investors (Bowen, et. al., 1981).

In UK, most of the companies rely on either banks or investors for raising funds in order to carry out operations smoothly. Therefore many companies suffered badly during financial crisis of 2008as the banking industry of UK crashed due to sub-prime crisis which is the main reason behind the collapse of financial market (Matthey, 2012).

The companies were not able to raise finance from banks as they stopped lending and simultaneously, the investors also resisted to invest in such companies due to poor economic conditions. Most of the banks within UK drastically restructured their lending policy and thus it was not possible for the companies to get money easily (Abraham and Cox, 2007).

Unanswered questions within capital structure

The financial and economic changes in recent years have highlighted the importance of capital structure for the company. Yet there remain questions unanswered. For example, what are the factors that influence the choice of capital structure of an organization? Does the financial department of the company endeavor for an optimal or fixed capital structure? Is debt financing preferred by the companies over equity financing? To what extent the degree of leverage depends upon a broader set of capital structure determinants? How and why the capital structure varies significantly across a series of firm classifications? (Debreceny and Rahman, 2005)

Although there are concurrent views on some of the above stated questions, these are not yet able to fully explain a suitable capital structure that companies can follow. This sets the precedence for the aims and objectives of this current research paper.

  • To understand the concept of capital structure and its components andto study the determinants of capital structure. Objective 1 will analyze the capital structure determination of firms listed on the FTSE 100 Index on the London stock exchange (Fearnley and Hines, 2003).
  • To study the factors that determines the capital structure of the organizations and analyse whether the capital structure of FTSE 100 companies is concurrent with other suggested theories or not (Miller, 2010).
  • To study the impact of leverage on various determinants of capital structure. A study conducted on FTSE 100by (Miller, 2010), suggest that size of the firm significantly affects the capital structure of the company.

Miller’s paper supports the pecking order theory and concludes that leverage is positively related to tangibility. The paper however does not determine whether capital structure varies across a series of firm classifications. Thus, in addition to the above stated objectives this research undertaking will take into consideration the study of capital structure across series of firm classifications.

Potential Significance

Nowadays banks have become more cautious in providing short term debt finance. Instead of relying solely on collateral securities, they are focusing much on examining the earning capacity of companies. In such cases, it will not be possible for the companies to raise debt finance only on the basis of their tangible assets. For example, if a firm is having ample of assets, but its earnings are not as per the standards of the financial institutes, the company will not be able to raise debt finance. A study revealed positive correlation between the long term debt financing and tangibility of the UK firms (Bennett and Donnelly, 1993).

Literature indicates that the credit market of UK has seen notable changes over the last decade or two (Laurance, 2012).Thus the current work focuses on analysing the capital structure of the FTSE 100 companies. In the past, researchers have worked on analyzing the capital structure of the UK companies as a whole and not much work was done specifically on the FTSE 100 companies. The current work focuses on critically and empirically evaluating the determinants of capital structure of FTSE 100 companies. Additionally, the focus is to determine how the capital structure of companies operating in different sectors of UK varies from each other, which has not been studied in the past.

Capital Structure

In views of Brealey, Myers and Marcus, capital structure can be defined as “mixture of long term equity and debt financing”. Though the capital structure informs the way in which the organizations raise funds to finance their assets, it still is inadequate as it only includes long term equity and debt in defining the capital structure. Companies also use convertible debt or short term debt to finance their assets (Brealey, Myers and Marcus, 2001). Therefore, the choice of source to finance assets depends only on the company preference and the type of asset the organization wants to finance (Kothari, 2001).

In these respects, the views of Welch (2011) are somewhat different from the views of Brealey, Myers and Marcus (2001). According to him, it is not only the financial debt and equity that should be included in the capital structure; but one must include total assets and total liabilities. Welch argued that, this leverage method suggests that all the liabilities, either financial or non-financial and equity are included in the capital structure of an organization. So, after reviewing the views of Welch and Brealey, Myers and Marcus, capital structure can be defined as mixture of financial debt that consist of convertible debt, short term debt, long term debt and equity (Brealey, Myers and Marcus, 2001).

Capital Structure Theories
Trade-Off Theory

The ‘trade-off theory’ was proposed by Modigliani and Miller (MM1963) and is still considered one of the best theories in the field of capital structure. It is academically relevant and even in current times is studied by students and researchers alike. A shortcoming of the theory is that it does not consider the value of the company and the average cost of capital. A positive effect is seen on the cost of capital and value of the firm due to the advantages in tax. By including debt in the capital structure, many firms benefit in tax payments (Shi, 2003).

But with the rise in leverage, there is rise in the risk of financial distress and bankruptcy costs. Therefore, before deciding on the amount of debt in the capital structure, it is very essential that the companies properly evaluate different costs that are associated with debt. The essence of the trade-off theory lies in this concept (Le and Ooi, 2012)

Though, MM discussed the positive effect of debt in the cost of capital and valuation of the company, they eventually conclude that the interest is deductible expense under the corporate income tax. Yet, if the capital markets are perfect, stakeholders can accrue gains by having debt in the capital structure (Abraham and Cox, 2007).

Pecking Order Theory

In 1984, Myers and Majluf modified a theory called ‘pecking order theory’ suggested in 1961 by Donaldson. This theory originated due to the uncertainty in the quality of the given product or investment. Akerlof (1970) article “Market of Lemons” discussed the idea of adverse selection. In this article, he discussed the problem associated with the ‘used car market’. Due to asymmetric information between seller and the buyers of the car related to the quality of the car, the buyers and sellers were not able to select a particular product. Same concept of the problem of adverse selection exists in the capital market between the potential investors and the individual companies (Hillier, Grinblatt and Titman, 2008).

The main reason behind occurrence of information asymmetry is the information gap between the manager of the company and its potential investors. Managers of the company have adequate amount of information and they are aware of the quality of information. Conversely investors have incomplete or less information and thus are not able to differentiate between the good quality information and the bad quality information (Hwanget et. al., 2013).

This forms the crux of information asymmetry. Due to information asymmetry, the investors will expect a higher rate of return and thus the companies will find the funding more expensive, and it will increase their cost of capital. In such circumstances, companies with good quality of information will go for some other alternative source of funding so that they can control their capital cost. Thus, the above section presents a basic idea behind the ‘pecking order theory’ proposed by Myers & Majluf (Fama and French, 2002).

According to the ‘pecking order theory’ of capital structure, in case, any organization needs financing for its investments, it will go for the cheapest source of finance. For raising finance, the first preference for companies will be their retained earnings. If the company has sufficient retained earnings; it will not go for any external source of funding as that will add to its cost of capital (Lopes and Rodrigues, 2007). In case, if the company does not have sufficient retained earnings or internal sources, the company will go for external funding and their first priority will be to issue convertible bonds, debts, etc. before issuing equity. Such a type of financing is known as ‘pecking order financing’ by the companies, and the firms follow this kind of financing due to adverse selection (Noulas and Genimakis, 2011).

Capital structure debate

Empirical research has identified factors that determine the capital structure of the companies and has drawn relationship between the determinants of the capital structure and leverage (Drury and Tayles, 2006). The main reason behind the studies was to identify the degree of leverage and its implications on the capital structure of the companies, such as, tax advantages, bankruptcy cost and agency cost (Lillis, 1992).

Rajan and Zingales (1995), Bevan and Danbolt (1999), Michaelas et. al. (1999) concluded that both; the level of gearing and the determinants of gearing significantly varied depending on the statement adopted for defining the gearing (Noulas, and Genimakis, 2011). In their paper, Harris and Raviv (1991) found that the level of different debt components was significantly related to factors such as size of the company; the level of profitability; firm’s tangibility that is, ratio of fixed assets to total assets and level of growth opportunities. They found that:

  • In comparison to small firms, large organizations had relatively higher debt levels and less short term borrowing.
  • There existed negative correlation between the level of debt and the profitability of the company
  • The correlation between tangibility and the level of long term debt was positive, whereas, the correlation between tangibility and short term debt was negative (Bennett and Donnelly, 1993).
  • Certain debt elements were positively correlated with the market to book variable.
Capital Structure of UK and FTSE 100 Companies

In his study, Kashefi concluded that capital structure of the companies is largely dependent on the size of the firms. In addition, the leverage is positively related to tangibility (Molina, 2007). His study essentially supports the ‘pecking order theory’. The paper also described that effective tax rate are positively related to large firms while, for the small firms this parameter does not hold any significance (Lopes and Rodrigues, 2007).

Thus small firms as such are highly volatile; they are not able to take full advantage of interest tax shield. On the other hand, by applying ‘trade off theory’ for the UK companies, it was found that firms are negatively affected from the business risks (Najjar and Taylor, 2008).

In addition to this, the sensitivity of leverage to asset beta is lower for companies operating in main market in comparison to companies operating in AIM (Alternative Investment Market) market. The profitability of UK companies are negatively related to the leverage, but the sensitivity of leverage for both AIM market companies and main market companies is low (Kashefi, 2012).

The capital structure of UK companies is different from that of other developed countries such as US, Germany and Japan. Figure 1 shows the total debt to percentage of GDP (Gross Domestic Product) of the four countries.

Research Methodology

For the present work data of all the FTSE 100 listed companies has been collected from datastream for the period 2003 to 2012. Among all the 100 firms, 36 belongs to service sector, 7 firms are in hospitality sector, 8 in retail and remaining 49 are categorized under industry. On most of the parameters, data was available for all the 100 companies, but in some cases it was missing, so there values have been dropped in the final sample (Saunders, 2003).

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Elements Determining Capital Structure

The above discussed theoretical and empirical studies have shown that factors such as size of the firm, age of the firm, profitability, profit volatility, growth rate, depreciation, and tangibility, affect the capital structure of the companies. On the basis of this, it can be concluded that with the increase in the fixed assets, investment opportunities, non-debt tax shields and size of the firm, there is increase in the leverage, whereas, with the rise in advertising expenditure, volatility, probability of bankruptcy, uniqueness of the product, profitability, the leverage decreases. But, Wald (1999), in his study found that, with the increase in non-debt tax shield, leverage, instead of increasing, decreases (Howorth and Westhead, 2003). The below section will discuss some of the determinants of the capital structure and their impacts on it.

  • Total liabilities to total assets: It is an important variable in determining the adequacy of capital structure as it tells how much percent of total assets are the liabilities of the firm. Company’s long term or permanent capital consists of both, equity and debt. A greater proportion of equity capital
  • Total debt to total assets:It is ratio of total debt to total assets. Rajan and Zingales (1995), Harris and Raviv (1991) have used this parameter while studying the capital structure of the companies. Many firms use debt financing as an incentives and try to enhance their returns on investments. The capital structure theory includes returns and venture trade off and states that excessive use of debt financing increases the risk faced by industrial companies. Khrawish and Khrawish (2008) in their study found positive correlation between total debt to total assets and tangibility, while negative relationship with profitability (Khrawish and Khrawish, 2008).
  • Long Term Debt to assets: This ratio was discussed by Harris and Raviv (1991), Rajan and Zingales (1995) in their work. It tells about the risk a company can face by depending on debt capital for financing its assets. If this value is high, it means company is more dependent on debt which can increase the risk. Khrawish and Khrawish (2008) in their study found positive relationship between long term debt to assets and long term debt while, negative relationship between short term debts.

A lot of researches have been done since Modigliani and Miller, yet a concrete conclusion has not been established on the relationship between leverage and profitability. According to tax based models, profitable companies must borrow more so as to shield more income from corporate tax (Bukland, 1989). On the other hand, pecking order theory suggests that, firstly the companies must use their retained earnings and then if needed, they should issue equity and bonds. This will ensure they have less debt. But, most of the empirical studies show that there exist negative relationship between profitability and leverage (Fama and French, 2002). It is necessary to give proper emphasis on profitability while designing capital structure, because it is the profit only which enables the company to determine how much capital they will be requiring in future.


Previous research studies show that tangibility is positively related to the leverage. Jensen and Meckling found out that if the tangible assets of the company are higher, the firm can use them as collateral, so that it will reduce the lender’s risk. This means, if the firm is going for a high amount of debt, a high fraction of tangible assets must be associated with it. But in case of bankruptcy, the value of tangible assets must be more than intangible assets. The paper presented by Williamson and Harris & Raviv (1991) shows positive relationship between leverage and tangibility (Lang and MAffett, 2011). Tangibility is calculated as ratio of tangible asset to total asset.


Past studies show a positive relationship between leverage and the size. According to the study performed by Marsh (1982), most of the large firms prefer long term debts while small firms prefer short term debts. Since, large firms enjoys the benefits of economies of scale, their bargaining power over creditors is high, therefore, cost of issuing equity and debt for them is negatively related to the size of firm. Moreover, most of the large firms provide higher amount of information to the investors in comparison to small companies. Therefore, they have more equity than debt and thus there leverage is low (Abraham and Cox, 2007). In addition, chances of bankruptcy of large firms are less as they have more stable cash flow and thus size should be positively related to the leverage. A net sale is taken for defining the size. Size of firm is also important to be considered for capital structure as size determines the requirement of funds.

Growth Opportunity

Theoretical studies show negative relationship between growth opportunities and leverage and are consistent with trade off theory which suggests that, companies which are planning for future growth, must focus more on equity finance. Jung, Kim and Stulz (1996), in their study found that, if a company with outstanding debt wants to grow in near future through equity financing, there are chances that the company will forgo such investment opportunities since it will transfer the wealth from the stockholders to debt holders (Bennett and Donnelly, 1993). Therefore, leverage is negatively related to growth opportunities. For this purpose, annual growth rate to total asset of the firms is considered. It is necessary to consider growth opportunity, because if there exists growth opportunity for a firm, it means it will be requiring capital in future (Liu, O’Farrell, Wei and Yao, 2013).


Non debt tax shield and tax deductions from the depreciation are the substitutes of the tax benefits of the debt financing. Past studies show, as there is less debt in the capital structure of the organizations with large non debt tax shield, there exist negative relationship between leverage and depreciation (Ross, Westerfield and Jaffe, 2002). For taking advantage of tax benefits, it is important to focus on this parameter also.

Research methodology

To evaluate the relationship between different variables and impact of different determinants on the capital structure, Ordinary Least Square (OLS) is used, which is based on the following regression model:

The above equation shows that leverage L which is proxy for LTDA, TDA, TLTA depends on various above stated control variables. In the above equation ‘i’ denotes individual FTSE 100 Company, ‘t’ denotes the time period, that is, examined time period which is 2003 to 2012 in current study. ‘β’ is the regression coefficients of elements determining capital structure and ‘e’ is random error.


This research report has explored various factors pertaining to the determinants of capital structure of FTSE 100 companies of UK and fills the gap between various leverage theories and other works performed by different scholars. The first section of this study draws relationship between seven quantitative factors and three proxies of leverage. All the values are in terms of book value and not market value. The final outcome of the regression between the leverage and determinants vary significantly across different parameters. The second chapter helps in gathering sufficient knowledge and information related to the study. It discusses findings of various past researchers that have helped significantly in drawing the conclusion of this work.

The research methodology chapter provides complete information relate to the methods and techniques adopted for conducting this work. This chapter contributes significantly in the research process as the techniques and methods suggested by this chapter simplify the research process. The aim of present study was to identify the factors that determine the capital structure of FTSE 100 companies. In order to achieve this, firstly, a detailed study related to past researcher was performed so as to gain adequate knowledge about the subject.

This helped in determining the factors that determines the capital structure of companies. Further, in order to achieve the objectives of the study, impact of identified factors was studied on the capital structure of FTSE 100 companies. For this, three proxies of leverage were considered, namely, LTDA, TDA and TLTA. Finally, the study also determined the impact of different independent variables across different firm classifications.

In case of FTSE 100 firms, age is negative related to the leverage, this is in-line with the theory of asymmetric distribution of information and pecking order theory. Same is the case with the credit rating which is negatively related to the leverage. This is expected as it shows investors are eager to invest only if performance of the firms is up to the mark. But this is in contrast to the findings of Noulas and Genimakis (2011).

Moreover, it was also found through the study that size of the firm is negatively correlated with the gearing, which means, smaller firms have to pay less and larger firms have to pay more for debt financing. This is also opposite to the earlier studies conducted by Haris and Raviv and trade off theory. Another finding which is in contrast to the capital structure theory is positive correlation between leverage and profitability. Pecking order theory states that if the firm is making profit, it is expected to use more of equity finance as compared to debt finance. But for FTSE 100 companies, it is not so. The study also supports the findings of Ferri and Jones, who found out that firm making higher profit margins, instead of using equity finance, were raising funds through debt finance (Ferri and Jones, 1979).

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