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1、DETERMINANTS OF FIRMS FINANCIAL LEVERAGE:A CRITICAL REVIEWByRahul KumarAbstractThe purpose of this review paper is to critically investigate the underlying factors that affect firms financial leverage from the perspective of theoretical underpinnings. We reviewed 107 papers published from 1991 to 20
2、05 in the core, non-core and other academic journals. On the basis of critical review, this research has identified a number of determinants of financial leverage based upon logical argume nts identified in the literatures. Major findings show that various frameworks like leverage irrelevance, stati
3、c trade off, pecking order, asymmetric information signaling framework have partly helped us in understanding the underlying factors determining the firms financial leverage, there is no consensus and there is no universal factor determining financial leverage. The paper sets out two challenges for
4、future research: one, how to integrate different factors determining firms financial leverage into a common framework and second, what are the explanatory factors determining firms financial leverage in a network phenomenaKeywords : Capital structure, financial leverage1. IntroductionIn general, com
5、panies may raise money from internal and external sources. They can raise money from internal sources by plowing back part of their profits, which would otherwise have been distributed as dividend to shareholders. Or, they can raise money from external sources by an issue of debt or equity. When a c
6、ompany issues shares, shareholders hope to receive dividend on their investment. However, the company is not obliged to pay any dividend. Because dividend is discretionary, it is not considered to be a business expense. When a company borrows money by way of debt, it promises to make regular interes
7、t payment and to repay the principal (i.e. the original amount borrowed). If profits rise, the debt holders continue to receive a fixed interest payment, so that all the gains go to the shareholders. On the contrary, when the reverse happens and profits fall, shareholders bear all the pain. If times
8、 are sufficiently hard, a company that has borrowed heavily may not be able to repay its debt. The company is then become bankrupt and shareholders loose their entire investment. Because debt increases returns to shareholders in good times and reduces them in bad times, it creates “financial leverag
9、e” (leverage). An “unlevered firm2” uses only equity capital whereas a “levered firm” uses a mix of equity and various forms of debt. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The importance of leverage in the capital structure3 of the company is that
10、its efficient use reduces the weighted average cost of capital (WACC) of the company. Lowering the cost of capital increases the net economic returns which, ultimately increases firm value. In sum, the guiding principle of leverage is to choose the course of action that maximizes the firm value and
11、the value of the firm is maximized when the WACC is minimized.The firms leverage decision centers on the allocation between debt and equity in financing the company. However, how the leverage of a firm is determined in a world in which cash flows are uncertain and in which capital can be obtained by
12、 many different media ranging from pure debt instruments to pure equity instruments is an unsettled issue. A number of researchers have attempted to understand financing choices of the firm and to identify the effect of changes in financial structure on the WACC of the firm and its value. A survey o
13、n capital structure theories by Harris and Raviv (1991) provide a summary of determinant of financial leverage of the firm, as identified and discovered by the researchers up to the time. However, in the absence of any review of published papers in the area since then, a need was felt to do this typ
14、e of review and objective was decided. The literature review is done to understand the progress of research on the subject and to identify the future direction of research. The present study reviews the literatures from January, 1991 to December, 2005, and summarizes various hypotheses determining t
15、he leverage of firm as discovered by the researchers. The review work follows from the perspective of theoretical underpinnings developed by the researchers during this time. This paper is organized as follows. In Section 2, we present methodology of review. Section 3 presents classification, discus
16、sion, and summary of hypothesis brought forth in the published papers during January, 1991 to December, 2005 from different theoretical underpinnings propounded in the subject area, though the divide line is oblique. Section 4 is the last section devoted to conclusions and future directions of the r
17、esearch. Section: 2For the purpose of our study, we systematically exclude certain topics that, while related to the leverage structure of the firm, but do not keep the determinants of the leverage as its central focus. These include literature dealing with call or conversion of securities, dividend
18、, bond covenants and maturity, bankruptcy law, pricing and method of issuance of new securities, common and preferred stock. Second, we briefly discuss the theories on leverage under various subsection of section 3. Though such theories are undoubtedly of great empirical importance, we found that su
19、ch theories have extensively been surveyed by Harris and Raviv (1991), Bradley et. al. (1984) and for the purpose of convenience we referred the authors for detailed explanation on the theories. Grouping variables driving leverage allows discussion of the variables in one place and facilitate an exa
20、mination of the relationship among similar variables. The researchers in the past have looked into the capital structure from various theoretical perspectives and brought forth a number of theories on capital structure. Accordingly, the determination of firms leverage was postulated to fall under va
21、rious theoretical model/framework. These are:-1. Irrelevance theory: Research in this area was initiated by Modigliani and Miller(1958);2. Static trade-off theory: Research in this area was initiated by Myers and Majluf(1984);3. Asymmetric information signaling framework : This stream of research be
22、gan with the work of Ross (1977) and Leland and Pyle (1977);4. Models based on Agency cost :Research in this area was initiated by Jensen and Meckling (1976) building on earlier work of Fama and Miller (1972);5. Pecking order Framework: This stream of research began with the work of Myers and Majluf
23、 (1984) and Myers (1984);6. The legal environment Framework of capital structure: Research in this direction was initiated by La Porta et. al.(1997);7. Target leverage Framework (Mean reversion theory): Research in this direction was initiated by Fischer et al. (1989);8. Transaction cost Framework:
24、Research from this perspective was initiated by Williamson (1988).For the purpose of our study, we followed the above distinct categories as have been brought forth by the researchers. Over and above the above theoretical framework we found that there is some variables not fitting into any of the gi
25、ven categories, which we have put into others category. For the purpose of our study, Papers published in the Journals listed in table-1 in the last fifteen years (from 1991 to 2005) are reviewed.Zivney and Reichenstein (1994) categorized academic finance journals as core and noncore. Based on their
26、 definition, we categorized the journals into three categories: (i) Core, (ii) Non Core, and (iii) Others. We understand that our sample is the true representative of the population to reflect the state of research in determining the variables affecting the firms leverage. We reviewed articles in th
27、e journals through the EBSCO research database, Proquest database, Emerald full text database, Elsevie rs Business management and accounting collection, and JSTOR database. Section 33. Classification, Discussion, and Summary of HypothesisThe researchers have captured a number of factors determining
28、firms leverage. In this section, we report the factors identified in the published literature under different theoretical framework propounded over the period by the researchers.。分类，讨论和总结的假说研究人员已经抓获了确定公司的杠杆因素。在本节中，我们发表的文献报告中确定的根据不同的理论在研究期间所propounded框架的因素。3.1. The leverage “irrelevance” framework 3.
29、1。The genesis of research in the area started with the seminal paper of Modigliani and Miller (1958). Modigliani and Miller (1958) in their seminal paper “The cost of capital, corporation finance, and the theory of investment” demonstrated that in the absence of transaction cost, no tax subsidies on
30、 the payment of interest, and the same rate of interest of borrowing by individuals and corporations, firm value is independent of its leverage and is given by capitalizing the expected return at the rate appropriate to that asset class. Modigliani and Miller (1958) concluded that a firm cannot incr
31、ease its value by using leverage as part of its capital structure. The traditional belief was that the capital structure of the firm is determined by the rate of interest on bonds, so the firm will push the investment to the point where the marginal rate of yield on physical assets equals the market
32、 rate of interest. Hence a firm can increase its market value by generating yield on assets that exceeds the market rate of interest. Modigliani and Miller (1958) challenged the traditional notion that a firm can increase its value by using debt4 as part of its capital structure. Ghosh et. al. (1996
33、) investigated the valuation effects of exchangeable debt calls and indicated that the shareholders of firms calling exchangeable debt do not experience any significant changes in wealth. They found that the negative effect of a decrease in leverage due to the call is offset by the calling firms cha
34、nge in asset composition. Current empirical researches documented significant decline in equity prices both around the announcement of a new equity issue and for the immediately subsequent years and validated Modigliani and Miller argument.3.2. Static trade -off framework: tax benefit and bankruptcy
35、 costsAs we have discussed above, payment of interest on debt is a mandatory charge on the business of the firm, which is allowed as expenses for tax purpose. As a result, the presence of bankruptcy cost5 and favorable tax treatment of interest payment led to the development of static trade off fram
36、ework. The framework was first propounded in 1984 (Myers and Majluf, 1984). The proponents of static trade-off model argues that firms balance debt and equity positions by making trade-offs between the value of tax shields on interest, and the cost of bankruptcy or financial distress. In other words
37、, keeping other things constant, higher the cost of bankruptcy, lower the debt and vice versa. Secondly, keeping other things constant, higher the maximum marginal rate of tax, higher the debt and vice versa. on financing, is greater than zero.Consequently, they proposed that firms in goods producin
38、g industries will have a higher debt to equity mix than will firms in service industries. Rajan and Zingales (1995) proposed that one cannot easily dismiss the possibility that taxes influence aggregate corporate leverage. Other results that support the static trade off model include Farrino & Weisb
39、ach (1999), Cassar & Holmes (2003), Morellec & Smith (2003). Morellec (2004), and Parrino & Weisbach (2005). The researchers have also observed result inconsistent with the prediction of static trade off theory. Fama and French (1998), despite an extensive statistical research, could find no indicat
40、ion that debt has net tax benefit. Bagley et. al. (1998) critiqued the static tradeoff theory for it does not explicitly treat the impact of transaction costs; does not explain the policy of asymmetry between frequent small debt transactions and infrequent large equity transactions; does not explain
41、 why the debt ratio is allowed to wander a considerable distance from its alleged static optimum, or how much of a distance should be tolerated.In short, static trade off theory offers a partial explanation of the factors determining firms choice of leverage.3.3. Asymmetric Information Signaling Fra
42、meworkThe proponents of Information signaling model argue that the existence of information asymmetry between the firm and the likely finance providers causes the relative cost of finance to vary between the different sources of finance. For instance, an internal source of finance, where the funds p
43、rovider is the firm, will have more information about the firm than new equity holders; thus new equity holders will expect a higher rate of return on their investments meaning that it will cost the firm more to issue fresh equity shares than using internal funds. The conclusion drawn from the asymm
44、etric information theories is that there is a hierarchy of firm preference with respect to the financing of their investments (Myers and Majluf, 1984). Ooi (1999) investigated the corporate debt maturity structure of property companies quoted in the UK over the period 1989-95 and showed that, in ord
45、er to distinguish themselves from firms in other risk classes and to mitigate the information asymmetry effects, property companies with potential good news employ more debt in their capital structure, which is consis tent with the signaling hypothesis. Bayless and Chaplinsky (1996) found that when
46、there are low levels of information asymmetry (i.e., in hot markets) the announcement-period returns are significantly higher than in cold markets. They concluded that firms try to take advantage of these windows of opportunity7 as they decide when to schedule a new equity or debt issue. Frank and G
47、oyal (2003) argued that large firms are usually more diversified, have better reputations in debt markets, and face lower information costs when borrowing, therefore, large firms are predicted to have more debt in their capital structures. Hall et. al. (2004) argued that because much of the data whi
48、ch small firms will supply to banks, in their applications for loans, will not be readily verifiable, hence, the problem of information asymmetry that they face will be particularly acute, so debt would be positively related to firm size. Bhaduri (2002) proposed that young firms are more vulnerable
49、to the problem of asymmetric informatio n, and hence they are likely to use debt and avoid the equity market. Further, the author argued that a firm with a reputation of dividend payment faces less asymmetric information in accessing the equity market, therefore, an inverse relationship is predicted to exist between leverage and dividend payment. Bancel and Mittoo (2004) found in their sample survey of mana