Introduction
The following is an empirical review of the benefits of the use of debt and its implication to equity holders within a company’s capital structure. The study focuses on the factors that determine the capital structure of IT firms in China. The study analyzes the capital structure of 92 IT Chinese firms.
Capital structure is also known as the financial structure refers to a mix of equity and debt capital that a company maintains. The firms’ financial structure plays an important role in meeting the various needs of stakeholders. Modigliani and Miller in their empirical evidence commonly known as MM proposition dealt with the capital structure.
The MM-theorem is also referred to as the irrelevance principle of capital structure. Modigliani and Miller in their first preposition dealt with the value of the firm and they concluded that there are no two identical firms that will command different values because one firm may be geared whereas the other firm is not geared. Modigliani and Miller say that if this happens, the investors will practice the arbitrage process to restore the value of the two firms to equilibrium (Parsons, & Titman, 2009, 1).
Literature Review
This study recognizes the importance of the capital structure theory of the firm. The capital structure theory of the firm helps to balance the sources of funds appropriately and therefore, an understanding of the capital structure theory of a firm is essential. Though several studies about the theory of capital structure exist, the theory is among the puzzles of corporate finance and controversies exist among the corporate finance scholars with regards to capital structure.
The researchers of corporate finance have not been successful in reaching a consensus concerning the capital structure theory. Most of the theoretical literature in the context of corporate finance has not provided a clear consensus regarding the capital structure theory of a firm (International Monetary Fund et.al. 2000, 10).
Classical Capital Structure Theory argues that capital structure is irrelevant while other views hold that the use of debt in the capital structure brings about a tax advantage thereby ultimately lowering the cost of capital to the business. Modigliani and Miller were the ones who devised the capital structure theory in the year 1958. They held the view that the capital structure is usually irrelevant as far as the value of a firm as well as future performance is concerned.
However, recent studies by various authors have provided evidence that the capital structure of a firm and the firm’s value are interrelated in one way or another. The literature by several authors among them Lubatkin and Chatterjee show that capital structure influences the value of a firm in one way or another and so this paper is thus a review of studies on a range of theories concerning capital structure theory of a firm(Master of Science in Management Swen Beyer,2010,4).
The empirical study of capital structure theory identifies various factors that determine the firms’ financial structure. The study by Timan and Wessels (1998) suggests that it is difficult to choose the explanatory variables for analyzing the capital structure of a firm. The debt ratios of a firm provide most of the empirical evidence regarding the capital structure e.g. the study by Graham (1996) e.t.c.
The study by Horakimian (2003) identifies the following characteristics that determine the firms’ financing choices i.e. research and development, firms’ profitability, the size of a firm e.t.c. Banner (2004) in his study of capital structure of firms in Visegrad nations identified the following factors as the main determinants of capital structure i.e. the size of a firm, the profitability nature of a firm, volatility of a firm among others. However, most empirical studies regarding the capital structure theory of a firm are mainly found in developed nations.
Thus there are relatively few studies on developing nations and transitional economies such as China. Chen (2004) was the first person to carry out studies regarding the factors that determine the capital structure of Chinese firms (Brigham, & Houston, 2007, 441-442).
Huang and Song (2006) examined the capital structure of Chinese firms by using data that contained 1000 Chinese firms for a period of six years i.e. from 1994 to the year 2000. Huang and Song in their study reported that the gearing level of Chinese corporations is influenced by the size of the firm, the profitability nature of the firms, and how the firm correlates with others in the industry. LinPing (2005) in his studies identified that the size of a firm determines the capital structure of a firm.
The Innovation and Technology industry (IT) is fast gaining momentum in China as a means of promoting sustainable growth. To achieve sustainable development, IT firms need to finance their operations. It is thus crucial the have an understanding of how the Information and Technology firms in China finance their activities by identifying the factors that determine their capital structure.
Analysis and Discussion
The empirical studies of 92 IT Chinese firms revealed the following; the empirical studies revealed that many large firms are advantageous because they have lower bankruptcy risks as opposed to smaller firms. The empirical study also revealed that large firms also have the advantage in that they can access the bond markets (Brigham, & Gapenski, 1994, 166).
The empirical studies also revealed that the capital structure of a firm is negatively correlated with its profitability nature. Most firms prefer to finance their activities by using retained earnings as opposed to equity financing. This is because retained earnings are not associated with transactional costs. In addition, the issuance of new equity has the effect of declining the share price of a firm because most of the equity of a firm is issued by allotting the shares.
The empirical studies examined that equity financing is preferred by most Chinese firms as opposed to debt financing. However, the relationship between the capital structure of a firm and the firms’ size is irrelevant because Chinese firms tend to focus on how they can fund instead of focusing on the most ideal way of obtaining the funds. Thus, the empirical studies enable us to have an understanding of the characteristics of Chinese IT firms i.e. they are highly indebted, they have high external funding, and they have high indirect funds (Eckbo, 2008, 65).
The empirical studies also identified the benefits of using the debt capital in Chinese firms; the interest expenses are usually tax-deductible. This implies that the company’s earnings are shielded against taxes and this is important as it reduces the annual tax liability as the interest is usually quoted by banks on what is known as the prime interest rate.
This tax advantage of paying lower interest rates has the effect of lowering the cost of debt capital and this implies that as the tax rate rises, the deductible tax also increases (Furrer, 2010, 74).
Debt capital is beneficial because the earnings per share of the firm are not diluted. When a company uses debt capital for financing, the control of the company remains with the shareholders. Debt capital enables a firm to earn the same returns as the rate of interest on borrowed funds and therefore, the earnings that are available to equity shareholders remain unchanged (Khan, 2005, 16).
The other benefit that is derived as a result of using debt capital is that the cost remains fixed and on the other hand, interest rate and the principle remain unchanged. The cost of equity is usually higher than the cost of debt as a result of the tax benefit that is associated with debt capital. The use of debt capital thus helps to maximize the firm’s value (Brigham, & Houston, 2007, 441-442).
Conclusion
The capital structure of a firm is essential as it helps to maximize the value of a firm and therefore, the paper proves that the capital structure of the firm is relevant as far as the films’ performance is concerned. Scholars have not been successful in reaching a consensus on whether the capital structure is relevant or needs.
However, the benefits that are associated with debt financing such as tax advantage e.g. provide empirical evidence that capital structure theory is relevant. The recent studies provide empirical evidence that firms gains as a result of tax deductibility. Debt financing is ideal since it helps to lower the overall cost and his in turn increases the returns of equity holders.
Despite some of the assumptions of the arbitrage process being unrealistic, Modigliani and Miller’s irrelevance is however important as it provides us with evidence on what is needed for capital structure to be considered as relevant. This in turn helps to determine the value of the firm.
Reference List
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Brigham, E.F. & Gapenski, L.C., 1994. Financial management: theory and Practice. New Delhi: Atlantic Publishers & Distributors.
Eckbo, B.E., 2008. Handbook of corporate finance: empirical corporate finance. Amsterdam: Elsevier.
Furrer, O., 2010. Corporate Level Strategy: Theory and Applications. London: Taylor & Francis.
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Khan, M.Y., 2005. Basic financial management. Naiad: Tata McGraw-Hill.
Master of Science in Management Swen Beyer., 2010. Capital Structure – Specifics in Emerging European Economies. Munich: GRIN Verlag.
Parsons, C & Titman, S., 2009. Empirical capital structure: a review. London: Taylor & Francis.