Industry Differences in Capital Structure - Leverage as a Proxy for Firms’ Capital Structure

1. Industry differences in capital structure (leverage as a proxy for firms’ capital structure

There are some differences in capital structure among industries. Because there are different factors affects the debt level in different industries. For example, industries that need to make huge investments in fixed assets also face high fixed costs which often lead to higher level of leverage. In contrary, there are industries with lower fixed costs and thus lower level of leverage. there are significant differences in debt ratios among industries.

2. Background – Modigliani and Miller theorem

According to the trade-off (trade-off between the potential benefits and costs of debt financing) theory every company should have an optimal capital structure. although firms can benefit from tax deduction by increasing their debt level, each firm should move toward their own optimal capital structure, which can mean either increasing or decreasing debt. interest payments negatively affect firms’ liquidity and financial performance, which increases the financial risk in terms of bankruptcy and insolvency. the optimal capital structure can be determined by finding the balance between the debt benefits of tax savings and the debt costs of higher risk for financial distress

The theory suggests that companies issue new shares when they believe the stock prices are overvalued and repurchase the shares or issuing debt when the stock prices are undervalued or when the market interest rates are low (Graham and Harvey, 2001; Baker and Wurgler, 2002). Consequently, fluctuations in the market have an impact on firms’ choice of capital structure.

3. size and capital structure

smaller firms are more likely to use equity finance, while larger firms are more likely to issue debt rather than stock.

Cassar andHolmes (2003), Esperança et al. (2003), and Hall et al. (2004) found a positive association between firm size and long-term debt ratio, but a negative relationship between size and short-term debt ratio.

4. growth and capital structure (age)

Growth is likely to place a greater demand on internally generated funds and push the firm into borrowing. In addition, firms with high growth will capture relatively higher debt ratios.

small firms---high growth firms will require more external financing and should display higher leverage

5. profitability and capital structure

pecking order theory

6. asset structure and capital structure

Firms that invest heavily in tangible assets also have higher financial leverage since they borrow at lower interest rates if their debt is secured with such assets.

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