It is the mix of debt and equity capital maintained by a firm. Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Under the agency costs hypothesis, high leverage or a low equityasset ratio reduces the agency costs of outside equity and increases firm value by constraining or encouraging. Agency theory becomes more complicated when debt holders interest is considered. Capital structure is also referred as financial structure of a firm. Contracts we will focus on contracts in which the agents total compensation for the period of the contract, denoted by w, is a linear function of output.
Trade off theory assumes that firms have one optimal debt ratio and firm trade off the. Jun 24, 2010 this paper surveys 4 major capital structure theories. Capital structure is also referred as financial structure of a. Capital structure and profitability of nigerian quoted firms. This primarily involves the relation between two parties. Another theory of capital structure is market timing theory of capital structure which has been suggested by baker and wurgler 5. Corporate finance introduction capital structure is a mix of debt and equity capital maintained by a firm. Most commonly, that relationship is the one between. Han, 1978, a meanvariance theory of optimal capital structure and. Traditional tradeoff theory and pecking order theory are most acceptable theories of capital structure. This paper surveys 4 major capital structure theories. For example, managers can be seen as the agents of shareholders, employees as the agents of. In the finance, the agency theory attempts to describe the behaviors of numerous agents that mediate in the firms funding managers, stockholders and debt holders and to evaluate the influence of these behaviors on the financial structure.
According to this theory, current capital structure is based on past equity market timing. The pecking order theory is behavioural in nature showing the perception and attitude of managers towards financing their activities. Further research on the theory of capital structure uses modigliani miller as a benchmark, and then relaxes some of the assumptions. Agency theory, capital structure and firm performance. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm. Pdf agency theory in the capital structure of islamic banking.
Efforts made to evaluate the empirical impact of pecking order theory of capital structure produced mixed result meier and tarhan, 2007. This is followed by an overview of pros and cons for each theory. Most research on capital structure has focused on public, non. The capital structure theory and its practical implications. The shareholders, true owners of the corporation, as principals, elect the executives to act and take decisions on their. Capital structure, financial performance, agency cost 1. Based on the agency theory, the purpose of this paper is to empirically investigate the impact of capital structure choice on firm performance in india as one of the emerging economies. Agency theory and capital structure linkedin slideshare. Accordingly to the agency theory, the optimal financial structure of the capital results from a compromise between various funding options equity, debts and hybrid securities that allow the reconciliation of conflicts of interests between the capital suppliers shareholders and creditors and managers. The theory of capital structure wiley online library. The starting point for the analysis is the agency theory by jensen and.
This theory also implies that when firms share price is overvalued they issue equity and. The theory of capital structure milton harris and artur raviv abstract this paper surveys capital structure theories based on agency costs, asymmetric information, productinput market interactions, and corporate control considera tions but excluding taxbased theories. The extent literature is full of theories on capital structure. Agency theory in the capital structure of islamic banking. In this paper, i explore a range of sociological and anthropological theories that either i stress structural determination, ii stress agency and intentionality, or iii attempt to reconcile both the structural and agential dimensions of social.
This work examined capital structure and profitability of the nigerian listed firms from the agency cost theory perspective with a sample of seventy 70 out of population of. Theories of capital structure explained with examples. The papers discussed in this section provide a theory of capital structure related to takeover contests. Agency theory in corporate governance is an extension of the agency theory discussed above. An agency theory perspective on capital structure agency theory is chiefly interested in the design of alternative governance structures to mitigate the agency conflict arising from the possible divergence of interests between shareholders.
A descriptive study slideshare uses cookies to improve functionality and performance, and to provide you with relevant advertising. Dec 01, 2014 based on the agency theory, the purpose of this paper is to empirically investigate the impact of capital structure choice on firm performance in india as one of the emerging economies. The theory of capital structure harris 1991 the journal. It is aimed to explore the main ideas, perspectives, problems and issues related to the agency theory through a literature survey. In this paper we draw on recent progress in the theory of 1 property rights, 2 agency, and 3 finance to develop a theory of ownership structure for the firm. If you continue browsing the site, you agree to the use of cookies on this website. Pdf understanding the structure and agency debate in. This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a.
Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost. These implications are compared to the available evidence. Accordingly to the agency theory, the optimal financial structure of the capital results from a. It relates to a specific type of agency relationship that exists between the shareholders and directorsmanagement of a company. By reconciling empirical evidence with theory practical strategies for managing capital structure in transition are suggested. In evaluating a companys capital structure, the financial analyst must look at the capital structure of the company over time, the capital structure of competitors that have similar business risk, and companyspecific factors, such as the quality of corporate governance, that. Theory suggests that the choice of capital structure may help mitigate these agency costs. Jan 14, 2019 agency theory is used to understand the relationships between agents and principals.
For each theory, a basic model and its major implications are presented. The theory of capital structure 299 tion of the relationships among similar models. This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. Another way to generate balanced conclusions is to account for. The tradeoff theory emphasizes taxes, the pecking order theory emphasizes differences in information, and the free cash. Brief explanations of the two perspectives are followed by a comparison between them. Chapter iii concepts and theories of capital structure and profitability. Agency theory can offer some insights into the management behaviour of soes in vietnam, since the heart of the enterprise reform programme is, by and large, about incentive structure, authority delegation and decentralisation see chapter 5. Capital structure is not only the result of the various financial characteristics of the firm but is also determined by the decision makers. The study of capital structure attempts to explain how listed firms utilise the mix of various forms of securities in order to finance investment. This work examined capital structure and profitability of the nigerian listed firms from the agency cost theory perspective with a sample of seventy 70 out of population of two hundred and fortyfive firms listed on the. Capital structure is the proportion of all types of capital viz. When traditional corporate financial theory breaks down, the solution is. Agency theory to keep the exposition simple, we will make a very specific assumption.
Capital structure and its 4 important theories ni, noi. Agency theory in financial management mba knowledge base. Following modigliani and miller 1958, most theories such as the pecking order theory, agency theory and trade off theory have sought to explain capital structure by. The agent represents the principal in a particular business transaction and is expected to represent the best.
Under the agency costs hypothesis, high leverage or a low equityasset ratio reduces the agency costs of outside equity and increases firm value by constraining or encouraging managers to act more in the interests of shareholders. Apr 18, 2019 agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. The pecking order, tradeoff, signaling, and markettiming. The data from scandinavian bank boards and risk measures shows that some of the agency theory prescriptions may lead to increased risktaking. If the capital markets and financing systems are not supportive of hostile takeovers. This thesis tries to answer the question whether ownership structure matters for. It is the employment of an asset source of finance for which. Agency theory is helpful in explaining the actions of the various interest groups in the corporate governance debate. It discusses the theoretical aspects of agency theory and the various concepts and issues related to it and documents empirical evidences on the mechanisms that diminish the agency cost. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. In the corporate finance, the agency theory tries to explain the behavior of various agents that intervene in the companys funding managers, shareholders and debt holders and to analyze the impact of these behaviors on the financial structure.
This pecking order theory suits large firms wip and which has th high enough internal funds in the form of retained earnings and depreciation. Mar 29, 2014 agency relationships occur when one party, the principal, employs another party, called the agent, to perform a task on their behalf. As a financing strategy, debt is widely discussed in capital structure literatures. First, all three papers conclude that takeover targets will increase their debt levels on average, and this will be accompanied by a positive stock price reaction. Following modigliani and miller 1958, most theories such as the pecking order theory, agency theory and trade off theory have sought to explain capital structure by introducing frictions omitted in. The study from the perspective of the agency theory, examines the relationship between ownership structure and the capital structure of the automobile industry in india from 2001 to 2014 by using panel data analysis. Moreover, majority of companies are showing concerned regarding capital structure and decision on capital structure and is quite. Agency theory in corporate governance meaning, example.
Capital structure and firm performance federal reserve. Agency relationships occur when one party, the principal, employs another party, called the agent, to perform a task on their behalf. Modigliani and miller 1963 demonstrate that in order to raise the value of a firm, the amount of debt financing should be as big as possible for tax subsidy. We have identified four categories of determinants of capital structure. Agency theory is used to understand the relationships between agents and principals. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. Thus the higher the risk and volatility in the economy, the lower the proportion of debt in the capital structure should be. As the traditional tradeoff theory asserts, firms have one optimal debt ratio target. Under the agency costs hypothesis, high leverage or a low equityasset ratio reduces the agency costs of outside equity and increases.
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