Revista Internacional de Economia e Ciências de Gestão

Traditional versus Modern Perspectives of Capital Structure Theories: A Comprehensive Review.

Abstract

Bimpong Patrick, Thomas hezkeal Khela Nan, Abel Obeng Amanfo Ofori, Arhin Ishmael, Danso Edward, Kwakye Sammuel, Arthur Benedict, Tettey Grace

Capital structure is as yet a riddle among researchers especially in the finance literature. The capital structure puzzle has been evolving over the years and there are several theories that seems to provide ideal solution or explanations. These theories are grouped into traditional and modern theories of capital structure. The overarching purpose of this study is to review extensively from traditional to modern the existing theories of capital structure that have been suggested in finance research to serve as guide for practitioners in taking decision about capital structure mix. The traditional theory assumes three approaches which are Net Operating Income Approach, Net Income Approach, and Traditional Approach. Traditional Approach to capital structure assume that the value of the firm increases with debt to a definite point, then remains constant with judicious use of leverage and falls at last. Therefore, the main substance of Traditional Approach is that cost of capital rely on capital structure and hence there exists an optimum capital structure. Net Income Approach on the other hand, concluded that cost of utilizing equity and debt remains constant with variation of debt-equity ratio. This logically means the average cost of capital diminishes as debt-equity ratio increases with the value of the firm. Hence optimal capital structure under Net Income Approach would be 100% leverage financing. The substance of Net Operating Income Approach is that the capital structure decision of a firm is irrelevant. Thus, any fluctuation in leverage will not trigger any change in the total value of the firm and the market price of equity shares as well as the overall cost of capital is independent of the degree of leverage used. Starting from assumption of perfect capital market of capital structure, four major theories emerged over the years as modern theories of capital structure. Peaking order theory argued that there is no defined optimum capital structure rather firms will always resort to internal source of financing (retain profit) then debt (borrowed fund) and finally Equity financing (issuing of new shares). Trade-off theory argued that managers would prefer leverage financing because of the set-off between tax benefit, bankruptcy cost, and agency cost. Market timing theory also, argued that fluctuations in share price influence capital structure of a firm and consequently the financing decision of the firm. They further explain that firms issue shares when shares are overpriced and buyback when they are undervalued hence they concluded that the main determinant of capital structure is the stock returns. Credit Rating hypothesis which is believed to be an extension of trade-off theory concluded that any firm closer to the credit rate, will prefer less debt composition as compare to firms not closer to the credit rate change. Interestingly, there is no single theory that provides a decisive optimal capital structure that firms can utilized to enjoyed tax advantage. Hence, the question still remains ‘‘How do firms or Managers determine their capital structure.