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Our study does not confirm that the rate of growth of deposits is related to profitability. In order to analyze the influence in profitability the level of income interest and expences interet should be

taken in consideration. We find evidence for our theoretical prediction that a bank’s lending history should also be taken into account when explaining its current net interest income. Also the macroeconomic factor as the economic growth or inflation are considered. The economic growth explains the profitability where as in terms of inflation no evidence of retation is shown.

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CAPITAL STRUCTURE AND FIRM PERFORMANCE:

A REVIEW OF LITERATURE Anila Çekrezi, PhD-Candidate

Lecturer at Faculty of Economy, University “A.Xhuvani” Elbasan - Albania email: vocianila@yahoo.com

Abstract:

The relationship between capital structure and firm performance has been the subject of debate of earlier and actual studies. This debate consist on whether there is an optimal capital structure for a firm or whether the use of debt is irrelevant to the firm’s performance or value as Modigliani-Miller theory of 1958 suggest. Many studies are focused on optimal capital structure and each firm has an optimal (target) capital structure, defined as that mix of debt, preferred and common equity that causes its stock price to be maximized. This paper provides a brief review of literature of the main capital structure theories .The paper also provides review of literature of different studies which have proved the existence of a relationship between capital structure and firm performance.

Keywords: Capital Structure; Modigliani and Miller Theory; Trade off Theory; Pecking Order Theory and Agency Theory; Firm Performance.

JEL Classification: G32.

1. Introduction.

According to Brigham and Ehrhardt (2008) capital structure refers to the firm’s mixture of debt and equity.

Firms may raise funds from external sources or plow back profits rather than distribute them to shareholders. In reality, capital structure may be more complex including different sources.

The Modigliani-Miller theorem in 1958 forms the basis of further studies on capital structure. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. For this reason their theorem is called

“The Irrelevance Theorem” (Modigliani and Miller , 1958). But in the real world capital structure is relevant, that is, a company's value is affected by the capital structure it employs.

Many studies are focused on optimal capital structure and each firm has an optimal (target) capital structure, defined as that mix of debt, preferred and common equity that causes its stock price to be maximized. Therefore a value-maximizing firm will establish an optimal capital structure and then raise new capital in a manner that will keep the actual capital structure on target over time (Brigham and Ehrhardt 2008).

Myers (1984) takes another position in contrast to earlier studies saying that different capital structure theories don't seem to explain actual financing behavior, and it seems presumptuous to advise firms on optimal capital structure when we are so far from explaining actual decisions. De Wet (2006) proved that at the financial structure that yields the lowest WACC, the value of the firm as a whole is also maximized .So according to his study he identified a correlation between the increase in firm’s value and the optimal level of leverage and showing how the value of a firm can be increased with increased levels of debt. According to Rajan and Zingales (1995), profitability is negatively correlated with leverage and the negative influence of profitability on leverage should become stronger as firm size increases.

And Myers (2001) writing on optimal capital structure, concludes that: ”There is no universal theory of the debt-equity choice and no reason to expect one (Myers, 2001).

Hovakimian and Opler and Titman (2001) conclude that the different effect of profitability on the debt ratio and the debt-equity issue choice appear to be consistent with a pecking order behavior in the short-run and revision to the target in the long-run. This leads to the possibility that firms do not view the pecking order and trade-off theories as mutually exclusive and support the existence of “generalized version of the trade-off theory’’.

The literature on the relationship between firm performance and capital structure has produced different results( Modigliani and Miller ,1958;Myers ,1984;Titman and Wessels, 1988; Harris and Raviv, 1990; Rajan and Zingales ,1995; Frank and Goyal, 2003). The starting point for all the theories on firm’s capital structure is the Modigliani and Miller (1958) propositions in a world of perfect capital market and no taxes. Their first 'proposition' was that the value of a company is independent of its capital structure.

Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk.

That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created.

2. Trade off Theory.

By including market imperfections, firms seem to get an optimal, value-maximizing debt-equity ratio by trading off the advantages of debt against the disadvantages. So firms will set a target debt ratio and gradually will move towards achieving it (Myers, 1984).

One of the main assumptions in the Modigliani and Miller (1958) is that there are no taxes. The trade-off theory is a development of the MM theorem but taking in consideration the effects of taxes and bankruptcy costs. This theory is considered as the first step for the development of many other theories which have studied how firms choose their capital structure. Modigliani and Miller’s (1958) theory can be used to describe how firms use taxation to manipulate profitability and to choose an optimum debt level.

Debt level at the other side increases the risk of bankruptcy or as we call it the bankruptcy costs because as the debt to equity ratio increases the debt holders will require higher interest rates but also the shareholders will pretend higher profits for their investments. (Brealey and Myers, 2003) According to Brealey and Myers (2003) financial managers often think of the firm’s debt–equity decision as a trade-off between interest tax shields and the costs of financial distress.

Sogorb and López (2003) used a sample of 6482 Spanish SMEs during the five-year period 1994–1998.Using panel data methodology, they found evidence that SMEs attempt to achieve a target or optimum leverage (like that suggested by the trade-off model) which is explained as a function of some specific characteristics of the firm, and they found less support for the view that SMEs adjust their leverage level according to their financing requirements (pecking order model). Also according to their study the coefficient of the effective tax rate is positive and statistically significant, so if SMEs have to pay more taxes they should increase the use of debt to reduce tax bills, but there are other costs like depreciation which are considered non-debt tax shields, that reduces the importance of the fiscal advantage of debt.

At the other side Serrasqueiro and Nunes (2010) study of 39 companies for the period of 1998 to 2006, conclude that the attempt for a trade-off between debt tax shields and bankruptcy costs seems to have little relevance in explaining the capital structure of quoted Portuguese companies. They used financial data from the balance sheets and income statements of the companies selected from Analysis System of Iberian Balance Sheets. Using OLS regressions they found that the firms adjust their actual level of debt towards a target debt ratio, but because of higher transaction costs the adjustment towards a target debt ratio of quoted Portuguese companies is slower than that found in similar studies of German, British, Spanish (Sogorb and Lopez, 2003) and USA companies.

3. Pecking Order Theory.

The pecking order theory contradicts the existence of financial targets, and states that firms follow a financing hierarchy: internal funds are preferred above external financing(Myers, 1984;

Myers and Majluf, 1984) When firms need additional funds they follow the below pecking order: First they use internally funds ( retained earnings),they adjust they target dividend payout in order to let unaffected the dividend flow (also if a firm has insufficient cash flow from internal sources, it draws down cash and marketable securities), and at last if external finance is required firm prefer (in order of preference):debt, hybrids securities(for example convertible bonds) and issue equity. (Myers, 1984; Myers and Majluf, 1984). So, firms do not have e target debt ratio and the reason for this hierarchy is that internal funds are supposed to be the less costly source of finance not subject to any outside interference. This theory suggests a negative relationship between profitability and leverage.

The pecking order theory was first suggested by Donaldson in 1961 and it was modified by Myers and Majluf in 1984 (Sogorb and Lopez, 2003).The pecking order hypothesis is an important theory explaining capital structure decisions of firms (Seifert and Gonenc, 2008).

Pecking order theory advocates that companies in its capital structure decisions do not search for a target debt ratio (Myers, 1984; Myers and Majluf, 1984):” The choice between debt and equity financing should not matter either”

(Myers and Majluf, 1984). According to them the level of debt is determined by the need to finance growth opportunities, when internal finance is exhausted.” If managers assume active shareholders, then only the investment decision matters” (Myers and Majluf,1984). So the only information which is considered important by the decision to issue risk-free debt and invest is that the firm has a positive-NPV project causing a positive price change.

Pecking order theory (Myers, 1984; Myers and Majluf, 1984) describes a hierarchy of financing choice a firm makes due to information asymmetry.

1. Firms prefer internal finance.

2. They adapt their target dividend payout ratios to their investment opportunities, although dividends are sticky and target payout ratios are only gradually adjusted to shifts in the extent of valuable investment opportunities.

3. Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internally-generated cash flow may be more or less than investment outlays. If it is less, the firm first draws down its cash balance or marketable securities.

4. If external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom. Each firm's observed debt ratio reflects its cumulative requirements for external finance (Myers, 1984).

Internal funds hold no adverse selection risk because the cost is internal and completely controlled by the entrepreneur. (Handcock, 2010)Debt is a higher risk, there is the need to repay it,but the costs are external and therefore are considered to be moderate, or incur minor adverse selection risk. Equity comes with a higher adverse selection risk and information asymmetries between the investor and firm are significant. Therefore, the cost of such finance is much higher with the investor factoring in the higher risk thus looking for a higher return. Therefore, equity is only sourced after the ability to borrow funds is exhausted (Frank and Goyal 2003).

Pecking Order Theory has been supported by a number of studies in various environments. (Shyam-Sunder and Myers ,1999; Swinnen,Voordeckers and Vandemaele,2005; ª en and Oruc ,2008; Serrasqueiro and Nunes ,2010).Shyam-Sunder and Myers (1999)study tested the pecking order theory for USA quoted companies (a sample of 157 firms from the set of all publicly traded American firms over the period 1971 to 1989) using time series cross sectional tests were to analyze the data. The idea was that the debt financing is used to fill the internal financing gap, which is constructed from an aggregation of dividends, investment, change in working capital and internal cash flows. The attraction of interest tax shields and the threat of financial distress are assumed second-order in the pecking order theory (Shyam-Sunder and Myers, 1999).

Shyam-Sunder and Myers (1999) found strong support for pecking order theory and they conclude their study with the sentence: “Thus our tests have power with respect to the pecking order”( Shyam-Sunder and Myers ,1999). The

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