capital stracture
E. Capital structure
5.1 Key factors that affect structure choice
5.1.1 Profitability and variation of profitability
Profitability is one of the most tested company characteristics in empirical research regarding companie’s choice of capital structure. The trade-off theory predicts that higher profitability is associated with increased debt levels and the reason for this is twofold. First, companies achieving high profitability have less risk of financial distress and bankruptcy, so the cost of debt is lower. Second, higher profitability means that companies can achieve higher utilization of the interest tax shield by increasing the amount leverage and hence the promised interest payments each period. Similarly, increased debt will serve as a disciplinary factor for managers when free cash flow likely increase with increased profitability. However, as dynamic trade-off theory predicts adjustment costs will prevent companies from adjusting the capital structure immediately and the unlikelihood of companies being at their refinancing points at the time of measurement causes the prediction of the found relationship between leverage and profitability to be negative due to the static nature of the determinant analysis.
Retained earnings are the favored financing according to the pecking order theory which contradicts the predictions made by trade-off theory. Higher profitability should enable the company to retain more earnings which is the preferable source of funding, and as such, the amount of leverage needed by the company should decrease. Empirically, profitability is consistently found to be negatively related to leverage, as predicted by both theories. Therefore the following hypothesis is made
5.1.2 Asset Tangibility (Asset in place)
The thought behind asset tangibility as a determinant is that tangible assets provide more security for potential investors as assets can serve as collateral. This will reduce the risk for debt holders and ultimately
5.1 Key factors that affect structure choice
5.1.1 Profitability and variation of profitability
Profitability is one of the most tested company characteristics in empirical research regarding companie’s choice of capital structure. The trade-off theory predicts that higher profitability is associated with increased debt levels and the reason for this is twofold. First, companies achieving high profitability have less risk of financial distress and bankruptcy, so the cost of debt is lower. Second, higher profitability means that companies can achieve higher utilization of the interest tax shield by increasing the amount leverage and hence the promised interest payments each period. Similarly, increased debt will serve as a disciplinary factor for managers when free cash flow likely increase with increased profitability. However, as dynamic trade-off theory predicts adjustment costs will prevent companies from adjusting the capital structure immediately and the unlikelihood of companies being at their refinancing points at the time of measurement causes the prediction of the found relationship between leverage and profitability to be negative due to the static nature of the determinant analysis.
Retained earnings are the favored financing according to the pecking order theory which contradicts the predictions made by trade-off theory. Higher profitability should enable the company to retain more earnings which is the preferable source of funding, and as such, the amount of leverage needed by the company should decrease. Empirically, profitability is consistently found to be negatively related to leverage, as predicted by both theories. Therefore the following hypothesis is made
5.1.2 Asset Tangibility (Asset in place)
The thought behind asset tangibility as a determinant is that tangible assets provide more security for potential investors as assets can serve as collateral. This will reduce the risk for debt holders and ultimately