Capital formula below shows the use of trade-off theory:

Capital structure theory defines as the combination
of the owned capital such as the reserves, equity, and surplus and borrowed
capital such as loans from banks, financial institutions and so on. The capital
structure theory benefits people to understand about the factors in the
relationship between capital structure and the value of the company. The theory
is beginning from Modigliani-Miller theorem. It is a theorem that have
explained about the capital structure and it is as a basis of modern thinking
on capital structure. In 1958, this theorem came out by Franco Modigliani, an
Italian economist, a professor at Carnegie Mellon University and MIT Sloan
School of Management and also with Merton Howard Miller who is an American economist.
Although it is a nice structure theorem, but it is irrelevant in a perfect
market because it must have some imperfections which exist in the real world.
So, there are four types of theories that can help to overcome the
imperfections. There are trade-off theory, pecking order theory, agency cost
theory and signaling theory.

            First
of all, one of the main capital structure theories is trade-off theory. It is
about the formulation of capital structure and it is optimal capital structures
by trading off the benefits and cost of debt and equity. It is a primary theory
that had come out by Modigliani and Miller in 1963. As the result in
introduction, there are some imperfections in perfect market today. Danso &
Adomako (2014) stated that Trade-off theory recommended the modified MM proposition
stress out that the benefit of tax shield are offset by the firm costs of
financial distress and agency cost.  So,
trade off theory had took part in the categories of the interest tax shields
(benefits), cost of financial distress and the firm value.

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The formula below shows the use of trade-off theory:

V (firm) = V + PV
(interest tax shields) – PV (costs of financial distress)

            The
formula above explains that the value of firm is equal to the value of firm
plus present value of interest tax shields and minus present value of the costs
of financial distress. Based on Sheikh & Wang (2010), the trade-off theory
need to choose a capital structure that can help to minimize the costs of
prevailing market imperfections so that it can maximize the firm value.

Moreover, trade-off
theory is also named as tax based theory and bankruptcy costs. Based on Awan
& Amin (2014), it expected every sources of money have their own costs and
returns. These are the connections between the earning capacity of firm and the
business or failure risks. So, the firm get more tax advantages will increase
their debt to their financed business operation. Therefore, the cost of
financial distress always in the balance condition with the benefits from
interest tax shield (Chen, 2011). Next, bankruptcy cost is about the distress
cost which is a type of cost suffer when the shareholders or investors estimate
that the firm will going to be terminate. Actually, the debt can benefit the
firms too. Debt is a type of valuable signal for firms. According to Ross
(1977), the leverage will increases firm’s value because enhancing leverage is
related to the market’s realization of value. Next, equity will also be
diminish by debt which related with agency costs.

Secondly, it turns for
the pecking order theory. The 2nd International Conference in
Management and Muamalah 2015 (2nd ICoMM) on 16th and 17th
of November 2015 had come out an argument which is Trade Off theory did not
reflect the irregularity of information. So, Pecking Order theory had used to
introduce about it. Pecking Order theory is a theory about the conflict between
the insider and outsider due to the asymmetry of information. So, it is no
target capital structure in this theory. Based on Schoubben & Hulle (2004),
this theory also consider signaling effect.

Pecking Order Theory is
a theory that suggested by Myers and Majluf in 1984 and Mostafa and Boregowda
in 2014. Mostafa and Boregowda (2014) have stated the supply and demand factors
is the main factor which determining the level of debt ratios. However, most of
the decisions of sources in financing is depends on the preference.

Myers and Majluf have
argued the asymmetry of reality information between managers who act as
insiders and investors who act as outsiders. By following the argument, the
managers have more confidential information compare to the investors and they
will benefits more for their old shareholders. Danso & Adomako (2014) have
detailed the financial cost determined the hierarchy that have involved in the
corporate financing decision. It is because the companies should minimize the
additional cost and maximize their value. If a company’s funds are not enough
to finance investment opportunities, the firm should choose to get an external
financing or finance a new investments that is more cheaply available sources. Myers
& Majluf (1984) have argues about it because if managers more take care for
their old shareholders, the managers will not send out a new shares that is
undervalued. A firm will only emanate new stock in equilibrium during the
market down price (Mostafa & Boregowda, 2014), mentioned by Myers (1984).

Furthermore, Kim and
Stulz (1988) have mentioned that the announcement of debt declaration increase
will cause the share price rise too. Therefore, when managers declare the
equity or release the equity to enable it as an alternative of riskless debt,
the firm’s share price will fall because it normally will be markdown by the
outsiders. So, managers prefer to avoid the declaration of equity as possible
(Luigi & Sorin, 2009). On the other hand, Myers and Majluf (1984) also
argued that if firms maintain the investment opportunities by using its
retained earnings without issue new security, the asymmetric of information can
be overcome. This indicates that the problem of equity will become worse because
the asymmetric information of insiders and outsiders increase.

Moreover, the pecking
order theory consider the market-to-book ratio as a measure of investment
opportunities (Baker & Wurgler, 2002). According to this theory, it
explained that the higher profitability of firms, the less debt will be issues.
Then, that firm can finance their company’s activities with their internal
funds possiblely. Hence, the small firms that have more growth opportunities
should dispute more debt than equity (Mostafa & Boregowda, 2014). As a
result, the firm should collect benefits from satisfying the financial stagnant
for supplying the equity when information asymmetry is less. It will enable the
debt with more elastic.

Accordingly, the debt
capability point is almost same to the target debt ratio which has explained in
trade-off theory. Based on the explanation above, we can identify that whether
firm use all internal sources at the time of IPO check or not, if company do so
for investing in new plan, then the pecking order theory will be carry out for
the next.

 

Thirdly, according to
Akerlof and Arrow, signaling theory defined as a first studied in the context
of job and product markets. 7 Spence (1973) had described that it was developed
into signal equilibrium theory. 7 Spence (1973) also said that a good firm can
discriminate itself from a bad firm by transferring the reliable signal about
its quality to capital markets.

Debt as a signal can be
used to separate the good from the bad firms. Signals from firms are as a vital
roles to get the financial resources under the asymmetry information between
insiders and outsiders. Ross also mentioned that the insider smart in
distribution of firm returns but outsiders do not. The firms with high quality have
signaling higher debt level. In contrast, the lower quality of firms will have
lower debt level. By the ways, the low quality firms will not try to attract
scrutiny because they do not want to be find out. Next, there are two types of
signaling through information have been proposed. Spence (1973), Leland and
Pyle (1977), Ross (1977) and Talmor (1981) have discussed about the costly
signaling equilibrium. However, Bhattacharya and Heinkel (1982), Rennan and
Kraus (1984) have discussed about the costless signaling equilibrium. Besides
that, the debt can be used to be a signal to discriminate the potential of
those fresh and new firms (Poitevin, 1989).

 

Fourthly, agency costs
are a type of costs that must be paid to agent as a behalf of capital. When
there are some conflicts of interest between shareholders and managers, these
costs will arise. It is because the shareholders prefer to benefit in their
shareholders’ value. However, managers wish to maximize their personal benefits
compare to the interests of shareholders. Agency costs are the sum of
monitoring expendirtures by the principal, the bonding expendituresby the
agents and the residual loss.

Agency
costs = Monitoring Expenditures + Bonding Expenditures + Residual Loss

Professor Micheal
Jensen who was from Harvard Business School and Professor William Meckling who
was from Simon School of Business, University of Rochester have wrote “Theory
of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”. Both
of them focus on the analysis of agency costs that had generated by the contractual
arrangements between the owners and top management of the corporation.

Agency relationship has
been explained as “a contract under which one
or more persons (the principal) engage another person (the agent), to perform
some service on their behalf which involves delegating some decision making
authority to the agent” (Jensen and Meckling, 1976).Based
on their thought, if both utility of insiders and outsiders are maximize, then
there will be believe that the agent will not always act in the best interests
of the capital. Besides that, they competed that the firms can limit the
diversities of principal from the interest by giving the appropriate incentives
to their agents and leading the monitoring costs consist of monetary and
non-monetary.

            In addition, the bonding costs will be paid to the agent
for expanding the resources and it can avoid the agents take certain actions to
harm the principal. However, Jensen and Meckling (1976) argued that the agency
cost is the costs that cannot be avoid since it is accepted by the owner. The
owner just can suggest to hope the costs be minimizes so that the decisions of
agents would maximize the welfare of the principal. The dollar equivalent of
the reduction in welfare experienced by the principal as a result of this
divergence is also a cost of the agency relationship, and we refer to this latter
cost as the “residual loss” (Jesen and Meckling, 1976).

When there is
cooperative efforts involve it, the agency costs will arise although there is
no clear principal and agents relationship (Alchian and Demsetz , 1972). As a
result, it is clear that the definition of agency costs has a bit of different views
with the importance of theory that came out by Alchian and Demsetz (1972).

The agency cost that
generated in the corporate form was introduced by Jensen and Meckling (1976)
which leads to an ownership structure theory of the firm. Jensen and Meckling
(1976) just focus a general problem in their journal, that was the analysis of
agency costs which generated by the contractual arrangements between the shareholders
and managers of the corporation. “We focus almost entirely on the positive
aspects of the theory. That is, we assume individuals solve these normative
problems, and given that only stocks and bonds can be issued as claims, we
investigate the incentives faced by each of the parties and the elements
entering into the determination of the equilibrium contractual form
characterizing the relationship between the manager (i.e., agent) of the firm
and the outside equity and debt holders (i.e., principals)” written by Jensen
and Meckling (1976).

As a conclusion, the
capital structure theories can be used in the long-term financing of company.
It provides a unique blend of financial sources to the whole company. The
equity and debt are the important characters in these theories. As a result, we
can know that debt equity ratio reveal the stability, internal and external
threats and opportunities of company. The higher the leverage of firm will have
less risk compare to those companies which within high debt. The combination of
company’s’ debt and equity, the total value of the company is not really because
of the capital structure. However, it still has some effects and it is
regarding to the irrelevance of capital structure. So, we should use in right
ways in right situations and problems.