Determinants of capital structure of listed construction companies in vietnam”

ACKNOWLEDGEMENT
I owe a deep sense of gratitude to all those who made me able to write this
report. I would like to thank the staff of Advanced Education Program, NEU for their
precious help and relentless effort in allowing me to access research data.
It is my privilege to thank all the staff at Cong ty xay dung phat trien nha Joint
Stock Company for helping me experience this happy three-month internship,
especially my internship guide Mr. Nguyen Anh Hao for taking good care of me.
More importantly, it is a genuine pleasure to express my deepest sense of
thank and gratitude to my supervisor PhD. Le Duc Hoang, whose dedication,
encouragement, and support gave me a lot of strength and advice to complete
this report.

i


TABLE OF CONTENTS
ACKNOWLEDGEMENT...........................................................................................i
TABLE OF CONTENTS............................................................................................ii
STATUTORY DECLARATION...............................................................................v
ABBREVIATIONS...................................................................................................vi
LIST OF FIGURES..................................................................................................vii
LIST OF TABLES......................................................................................................x
EXECUTIVE SUMMARY.....................................................................................xiii
INTRODUCTION.......................................................................................................1
1. Rationale.................................................................................................................1
2. Research objectives................................................................................................2
3. Research question...................................................................................................2
4. Research methodology...........................................................................................2
5. Research scope and scale........................................................................................2
6. Research structure .................................................................................................2
7. Literature review.....................................................................................................3

7.1. International research papers...........................................................................3
7.2. Vietnamese research papers............................................................................4
CHAPTER 1: THEORETICAL FRAMEWORK AND DETERMINANTS OF
CAPITAL STRUCTURE...........................................................................................6
1.1. Basis concepts of Capital Structure.....................................................................6
1.1.1. Definition of Capital Structure.....................................................................6
1.1.2. Theories of Capital Structure.......................................................................6
1.1.2.1. Modigliani-Miller Theorem (MM).......................................................6
1.1.2.2. Trade-off Theory of Capital Structure................................................10
1.1.2.3. Agency Theory of Capital Structure...................................................12
1.1.2.4. Pecking Oder Theory...........................................................................18
ii


1.2. Determinants of Capital Structure.....................................................................19
1.2.1. Firm size.....................................................................................................21
1.2.2. Tangibility ..................................................................................................22
1.2.3. Growth opportunity....................................................................................23
1.2.4. Liquidity.....................................................................................................24
1.2.5. Market index...............................................................................................24
1.2.6. Corporate tax..............................................................................................25
1.2.7. Profitability.................................................................................................26
1.2.8. Non-debt tax shield.....................................................................................26
CHAPTER 2: REAL SITUATION OF CAPITAL STRUCTURE OF THE
CONSTRUCTION INDUSTRY IN VIETNAM.....................................................28
2.1. Overview of the Construction Industry in Vietnam..........................................28
2.2. Determinants of Capital Structure of the Construction Enterprises in Vietnam
...................................................................................................................................30
2.2.1. Methods and Data.......................................................................................30
2.2.2. Data collection and Correlation matrix of the sample...............................33

2.2.3. Results of regression analysis....................................................................37
2.2.3.1. Debt to Asset model............................................................................37
2.2.3.2. Long-term Debt to Asset model..........................................................40
2.2.3.3. Debt to Equity model..........................................................................43
2.2.3.4. Long-term Debt to Equity model........................................................44
CHAPTER 3: RESEARCH OUTCOME ................................................................46
AND RECOMMENDATIONS ...............................................................................46
3.1. Research outcome..............................................................................................46
3.2. Development and Orientation...........................................................................47
3.2.1. Opportunities..............................................................................................47
3.2.2. Challenges...................................................................................................48
3.3. Recommendations for the authorities................................................................48
iii


3.4. Solutions for firms in the industry....................................................................49
CONCLUSION.........................................................................................................51
REFERENCES..........................................................................................................52
APPENDIX...............................................................................................................58

iv


STATUTORY DECLARATION
I herewith formally declare that I myself have written the submitted Bachelor’s
Thesis independently. I did not use any outside support except for the quoted
literature and other sources mentioned at the end of this paper.
Hanoi, 31/5/2016

v

ABBREVIATIONS
FDI:

Foreign Direct Investment

FTA:

Free Trade Agreement

FEM:

Fixed Effect Model

HNX:

Hanoi Stock Exchange

HOSE:

Hochiminh Stock Exchange

MM:

Modigliani-Miller theorem

REM:

Random Effect Model

TPP:

Trans-Pacific Partnership

WACC:

Weighted Average Cost of Capital

vi


LIST OF FIGURES

ACKNOWLEDGEMENT...........................................................................................i
TABLE OF CONTENTS............................................................................................ii
STATUTORY DECLARATION...............................................................................v
ABBREVIATIONS...................................................................................................vi
LIST OF FIGURES..................................................................................................vii
LIST OF TABLES......................................................................................................x
EXECUTIVE SUMMARY.....................................................................................xiii
INTRODUCTION.......................................................................................................1
1. Rationale.................................................................................................................1
2. Research objectives................................................................................................2
3. Research question...................................................................................................2
4. Research methodology...........................................................................................2
5. Research scope and scale........................................................................................2
6. Research structure .................................................................................................2
7. Literature review.....................................................................................................3
7.1. International research papers...........................................................................3

7.2. Vietnamese research papers............................................................................4
CHAPTER 1: THEORETICAL FRAMEWORK AND DETERMINANTS OF
CAPITAL STRUCTURE...........................................................................................6
1.1. Basis concepts of Capital Structure.....................................................................6
1.1.1. Definition of Capital Structure.....................................................................6
1.1.2. Theories of Capital Structure.......................................................................6
1.1.2.1. Modigliani-Miller Theorem (MM).......................................................6
MM’s Capital Structure Irrelevance Proposition......................................................................7
Modigliani and Miller's Tradeoff Theory of Leverage.............................................................8

vii


1.1.2.2. Trade-off Theory of Capital Structure................................................10
1.1.2.3. Agency Theory of Capital Structure...................................................12
1.1.2.4. Pecking Oder Theory...........................................................................18
1.2. Determinants of Capital Structure.....................................................................19
1.2.1. Firm size.....................................................................................................21
1.2.2. Tangibility ..................................................................................................22
1.2.3. Growth opportunity....................................................................................23
1.2.4. Liquidity.....................................................................................................24
1.2.5. Market index...............................................................................................24
1.2.6. Corporate tax..............................................................................................25
1.2.7. Profitability.................................................................................................26
1.2.8. Non-debt tax shield.....................................................................................26
CHAPTER 2: REAL SITUATION OF CAPITAL STRUCTURE OF THE
CONSTRUCTION INDUSTRY IN VIETNAM.....................................................28
2.1. Overview of the Construction Industry in Vietnam..........................................28
2.2. Determinants of Capital Structure of the Construction Enterprises in Vietnam
...................................................................................................................................30

2.2.1. Methods and Data.......................................................................................30
2.2.2. Data collection and Correlation matrix of the sample...............................33
2.2.3. Results of regression analysis....................................................................37
2.2.3.1. Debt to Asset model............................................................................37
Empirical results.....................................................................................................................38
Durbin-Watson tests of the models........................................................................................40

2.2.3.2. Long-term Debt to Asset model..........................................................40
Empirical results.....................................................................................................................41
Durbin-Watson tests of the models........................................................................................43

2.2.3.3. Debt to Equity model..........................................................................43

viii


Empirical results.....................................................................................................................43
Durbin-Watson tests of the models........................................................................................44

2.2.3.4. Long-term Debt to Equity model........................................................44
Empirical results.....................................................................................................................44
Durbin-Watson tests of the models........................................................................................45

CHAPTER 3: RESEARCH OUTCOME ................................................................46
AND RECOMMENDATIONS ...............................................................................46
3.1. Research outcome..............................................................................................46
3.2. Development and Orientation...........................................................................47
3.2.1. Opportunities..............................................................................................47
3.2.2. Challenges...................................................................................................48
3.3. Recommendations for the authorities................................................................48

3.4. Solutions for firms in the industry....................................................................49
CONCLUSION.........................................................................................................51
REFERENCES..........................................................................................................52
APPENDIX...............................................................................................................58

ix


LIST OF TABLES
ACKNOWLEDGEMENT...........................................................................................i
TABLE OF CONTENTS............................................................................................ii
STATUTORY DECLARATION...............................................................................v
ABBREVIATIONS...................................................................................................vi
LIST OF FIGURES..................................................................................................vii
LIST OF TABLES......................................................................................................x
EXECUTIVE SUMMARY.....................................................................................xiii
INTRODUCTION.......................................................................................................1
1. Rationale.................................................................................................................1
2. Research objectives................................................................................................2
3. Research question...................................................................................................2
4. Research methodology...........................................................................................2
5. Research scope and scale........................................................................................2
6. Research structure .................................................................................................2
7. Literature review.....................................................................................................3
7.1. International research papers...........................................................................3
7.2. Vietnamese research papers............................................................................4
CHAPTER 1: THEORETICAL FRAMEWORK AND DETERMINANTS OF
CAPITAL STRUCTURE...........................................................................................6
1.1. Basis concepts of Capital Structure.....................................................................6
1.1.1. Definition of Capital Structure.....................................................................6

1.1.2. Theories of Capital Structure.......................................................................6
1.1.2.1. Modigliani-Miller Theorem (MM).......................................................6
MM’s Capital Structure Irrelevance Proposition......................................................................7
Modigliani and Miller's Tradeoff Theory of Leverage.............................................................8

1.1.2.2. Trade-off Theory of Capital Structure................................................10
x


1.1.2.3. Agency Theory of Capital Structure...................................................12
1.1.2.4. Pecking Oder Theory...........................................................................18
1.2. Determinants of Capital Structure.....................................................................19
1.2.1. Firm size.....................................................................................................21
1.2.2. Tangibility ..................................................................................................22
1.2.3. Growth opportunity....................................................................................23
1.2.4. Liquidity.....................................................................................................24
1.2.5. Market index...............................................................................................24
1.2.6. Corporate tax..............................................................................................25
1.2.7. Profitability.................................................................................................26
1.2.8. Non-debt tax shield.....................................................................................26
CHAPTER 2: REAL SITUATION OF CAPITAL STRUCTURE OF THE
CONSTRUCTION INDUSTRY IN VIETNAM.....................................................28
2.1. Overview of the Construction Industry in Vietnam..........................................28
2.2. Determinants of Capital Structure of the Construction Enterprises in Vietnam
...................................................................................................................................30
2.2.1. Methods and Data.......................................................................................30
2.2.2. Data collection and Correlation matrix of the sample...............................33
2.2.3. Results of regression analysis....................................................................37
2.2.3.1. Debt to Asset model............................................................................37
Empirical results.....................................................................................................................38

Durbin-Watson tests of the models........................................................................................40

2.2.3.2. Long-term Debt to Asset model..........................................................40
Empirical results.....................................................................................................................41
Durbin-Watson tests of the models........................................................................................43

2.2.3.3. Debt to Equity model..........................................................................43
Empirical results.....................................................................................................................43

xi


Durbin-Watson tests of the models........................................................................................44

2.2.3.4. Long-term Debt to Equity model........................................................44
Empirical results.....................................................................................................................44
Durbin-Watson tests of the models........................................................................................45

CHAPTER 3: RESEARCH OUTCOME ................................................................46
AND RECOMMENDATIONS ...............................................................................46
3.1. Research outcome..............................................................................................46
3.2. Development and Orientation...........................................................................47
3.2.1. Opportunities..............................................................................................47
3.2.2. Challenges...................................................................................................48
3.3. Recommendations for the authorities................................................................48
3.4. Solutions for firms in the industry....................................................................49
CONCLUSION.........................................................................................................51
REFERENCES..........................................................................................................52
APPENDIX...............................................................................................................58

xii


EXECUTIVE SUMMARY
This study aims to examine capital structure determinants of 55 listed
construction companies in Vietnam from 2011 to 2014 by using panel data regression
analysis. The result suggests that there are six determinants, which are firm’s size,
growth opportunity, tangibility, liquidity, non-debt tax shield and profitability have
strong impacts on capital structure. Firm’s size, growth opportunity, tangibility, and
liquidity determinants reveal positive relation with leverage ratios. The study
indicates that larger firms, firms with higher tangibility, liquidity, and growth
opportunity tend to use more debt to finance. On the contrary, firms with high
profitability and non-debt tax shield would consume less debt in the capital structure.
The result indicates negative impacts of the capital structure or leverage ratio on
profitability, suggesting that profitbale firms prefer retained earnings to external
financial resources in order to avoid risks. Meanwhile, non-debt tax shield move in
the opposite direction to leverage ratio, implying that businesses with large non-debt
tax shields have fewer incentives to use debt. The study outcome supports pecking
order theory and trade-off theory. Construction industry has contributed significantly
to Vietnam economy and is expected to grow in upcoming years due to government
regulations, stable economy, high urbanization rate, and new trade agreements.
Hence, the paper come up with some some recommendations and solutions for
construction companies in order to approach the optimal capital structure and
increase firm’s value.

xiii


INTRODUCTION
1. Rationale

Since the ultimate goal of any enterprise is to maximize its value and operate
effectively, managers always ponder over many methods to find the optimal leverage
ratio, which is considered to be one of the most important features influencing
company performance. Although there are many different lending resources for
enterprises, for example, bank loans, borrowing from credit institutions, or stocks and
bonds, managers still find it tough to figure out the optimal capital structure for the
firm. Therefore, in order to get a closer approach of how to implement an appropriate
leverage ratio, managers need to understand capital structure’s determinants and its
impacts on firm performance.
Despite many capital structure research papers gave empirical proofs regarding
determinants of capital structure in the real business world, the results of these
studies about the relationship between determinants of capital structure and leverage
ratio are varied. In addition, there are very limited studies conducted to assess the
impacts of determinants of capital structure on leverage ratio of construction industry
in Vietnam. The assets and investments of these companies in the sector are
especially large compared to other sector, hence, they need to be analyzed to operate
more productively. According to General Statistics Office of Vietnam’s 2015
industry report, construction sector has shown a positive perspective with continuous
growth rate during the last five years, reaching the highest increase of 10.82% in
2015. Construction industry also contributes significantly to Vietnam economy, as
this is the third highest growing sector last year. In addition, although most of
Vietnam construction companies are small and medium enterprises, they constitute a
large proportion of long-term capital. The amended housing law No. 65/2014/QH13,
which was passed on November 25, 2014, and has taken effect from July 1, 2015,
allows foreign individuals, organizations to buy and own residential houses in
Vietnam. The new law is expected to have positive impact on real estate and
infrastructure development. With the stable economy growth rate, increasing
urbanization rate, and amendment to housing law, construction industry is forecasted
to expand rigorously in the upcoming years. Nonetheless, the sector has to deal with
many other obstacles such as rising cost of raw material, unqualified management

skills, and employee quality. Thus, an optimal capital structure will improve
company operation, bringing competitive advantages. For those reasons, the topic
1


“Determinants of capital structure of listed construction companies in Vietnam” is
chosen so as to assess the factors that affect capital structure.
2. Research objectives
The paper aims to understand the idea of four basic theories of corporate capital
structure, to firgure out the factors that affect capital structure and their impacts of
construction companies in Vietnam. Then, several solutions and recommendations
are proposed for the companies in the industry.
3. Research question
What are the factors and how do they have impact on capital structure of 55
listed construction companies in Vietnam?
What are the recommendations and solutions for the listed construction
companies to build optimal capital structure?
4. Research methodology
I was able to collect data in the audited financial statements of 55 listed
construction companies in the Hanoi Stock Exchange (HNX) and Hochiminh Stock
Exchange (HOSE) from 2012 to 2014. Hence, fixed effect and random effect model
are run to evaluate the determinants of capital structure and impacts on firm
performance of construction companies in Vietnam.
There are 165 observations in the sample. The data are provided from the
audited financial statements of these firms, including balance sheets and income
statements. The data are reliable as they are collected from audited financial
statements of the listed construction enterprises on two websites namely hnx.vn and
hsx.vn.
5. Research scope and scale
The study focuses on analyzing the determinants of capital structure of 55 listed

construction companies on HNX and HOSE from 2012 to 2014, and I will propose
some recommendations and solutions for the whole industry.
6. Research structure
The thesis is organized into three chapters. The first chapter gives an overview
of theoritical framework and determinants of capital structure. Then, I go over the
current situation of capital structure of construction firms in Vietnam and run
regression models to analyze the relationship among determinants of capital structure
and leverage ratios. The thesis is ended by the conclusion in which I come up with
2


several solutions and recommendations. Details are as follows:
Chapter 1: Theoretical overview and determinants of capital structure
Chapter 2: Situation of capital structure of the construction industry in
Vietnam
Chapter 3: Conclusion and Recommendations
7. Literature review
7.1. International research papers
The research paper of Zarariah S. et al. (2011) was conducted to find the
impacts of determinants on capital structure of 43 listed Malaysian construction
companies in the period of 8 years from 2001 to 2008. Both fixed effect model and
random effect model were run, showing that growth opportunity factor has negative
impact on leverage ratio while company size moves in the same direction with
leverage ratio. The results support the trade-off theory and pecking order theory. The
empirical finding interprets that larger construction companies tend to have higher
leverage ratio. Whereas, companies that need to expand business are more likely to
use their own equity, as the shareholders do not want to share the benefit of growing
business with creditors. Moreover, according to trade-off theory, growth opportunity
factor is considered to be intangible asset, which could not be pledged as collateral.
Hence, companies with high growth opportunity would probably constrain the

amount of debt. However, the paper did not take other variables into considerations
such as revenue growth, profitability, and tax.
Samiran (2010) examined the determinants of capital structure or leverage ratio
of 37 listed Malaysian construction companies from 2003 to 2008. The panel data
was enacted with seven independent variables, including profitability, growth
opportunity, liquidity, tax changes, tangibility, non-debt tax shield and business
scale. The empirical finding indicates highly negative associations among liquidity
and growth opportunity with leverage ratio. In other words, the study also is
compatible with the pecking order theory. However, other variables are found to be
insignificantly affect capital structure.
A study of Buferna F. et al. (2008) on capital structure of Libyan companies
shows that company profitability, size and asset tangible asset move in the same
direction with leverage ratio while there is a negative relationship between growth
opportunity and the ratio. The paper outcome supports the trade-off theory and the
agency cost theory.

3


Nurul S. B. et al. (2011) in their study on 22 listed construction companies in
Bursa stock exchange from 2001 to 2007, concluded that company size, growth
opportunity, and tangible asset are positively related to total debt to total asset ratio
while profitability is negatively related to the leverage ratio. Meanwhile, tangible
asset variable shows the strongest impact on capital structure of the construction
companies. The study implies that larger companies and companies purchasing more
tangible assets are more dependent on debts. On the other hand, highly profitable
companies tend to consume less debt and more internal financial resources. However,
the paper still has limitation of variables, as other important factors, such as liquidity,
non-debt tax shield, interest rate, and market, were not considered.
In the study of Huang et al. (2002) on 1000 listed companies in China from

1994 to 2000, positive associations between leverage and firm size, tangibility,
volatility of profitability, and intitutional shareholdings were found while
profitability and non-debt tax shield move in the oppostive direction with the leverge
ratio. The authors also argued that the static trade-off theory is better than the
pecking order theory in explaining the capital structure determinants of these 1000
listed companies.
7.2. Vietnamese research papers
Truong et al. (2008) empirically analyzed capital structure determinants of
56 listed companies on Hochiminh stock exchange from 2003 to 2006. The
ordinary least squares regression was run in order to examine the relationships
between leverage or total debts to total asset ratio with company size,
profitability, growth of revenues, and amount of member of the Board of
Directors. Company sector is also considered to be a dummy variable added to the
model. The result indicated a positive relationship between leverage ratio and
company size, company sector, and growth of revenues while the profitability is
positively associated with the leverage ratio. Due to data limitation, the study did
not conclude the optimal capital structure for those 56 listed companies.
Le (2013) examined the determinants of capital structure of listed companies in
Vietnam from 2007 to 2010. Fixed effect model was run with the dependent variable
is leverage ratio, and six independent variables, which are tax rate, inflation, book-tomarket ratio, industry leverage, return on asset, and behavior of managers. Tax rate,
industry leverage, and manager behavior affect leverage ratio positively. On the
contrary, inflation, book-to-market ratio, and return on asset ratio are negatively
related to the leverage. Although the behavior of managers variable is used under the
4


form of number is a new approach, the study needs to verify the appropriacy of the
data collection.
Dang et al. (2014) studied capital structure determinants among 180 nonfinancial companies listed on Hochiminh stock exchange from 2010 to 2013. Fixed
effect model was enacted, showing a positive association between leverage and

company size, profitability and a negative relation with tax rate.
Doan (2010) employed the path analysis by running AMOS program in order to
find the capital structure determinants of 428 listed companies from 2007 to 2009.
According to the paper result, profitability and business risk have negative
relationship with leverage ratio while company size impacts the leverage ratio
positively.
In conclusion, although several research papers have been enacted in order to
find the capital structure determinants of different industries in Vietnam, the time
periods of those studies are short. Hence, researches have not resolved the problem of
the whole economy, especially in the recession or in the boom. In addition, data are
limited. Besides familiar factors, others have not taken into consideration such as tax
policy, legacy, or interest rate.

5


CHAPTER 1: THEORETICAL FRAMEWORK AND
DETERMINANTS OF CAPITAL STRUCTURE
This chapter presents four theories of capital structure and determinants of
capital structure. Although many researches have been conducted to analyze
determinants of capital structure and its impacts on firm performance, the following
four theories are the most prevalent, as they provide the fundamental understanding
of capital structure.
1.1. Basis concepts of Capital Structure
1.1.1. Definition of Capital Structure
“In finance, capital refers to the sources of long-term financing. Capital
structure is the combination of long-term debt, common equity and preferred equity,
indicating how a firm finances its overall operations and growth by using different
sources of funds (Al-Najjar et al. 2008, Hsiao et al. 2009, and Ross et al. 2005). Debt
is the amount of money that the enterprise borrows from credit institutions, investors,

or other lenders to finance the company. Examples of debt are bonds, loans, payables
and commercial paper that make it able for the company to operate and usually pay
back later with interest. Equity is used when stating the ownership of the business,
including common stocks, preferred stocks, and retain earnings. Equity is equal total
assets less total liabilities.
Finding an optimal capital structure is still a contentious matter that any firm
managers need to deal with, as capital structure plays a crucial role in any firm
operations. The optimal capital structure is a strategy which brings minimum capital
costs and maximum market value to company, related to trade-off between costs and
benefits.”
1.1.2. Theories of Capital Structure
1.1.2.1. Modigliani-Miller Theorem (MM)
“Prior to the middle of the 1950s, theoretical analysis was not popular, so the
studies of corporate finance primarily based on explanation of methods and
6


institutions. In this context, Franco Modigliani and Merton Miller, who Ire professors
at the Graduate School of Industrial Administration of Carnegie Mellon University,
originated basic theory and dedicated their inventive article. Initially, although they
did not have any previous experience in corporate finance, they Ire assigned to teach
corporate finance. Unexpectedly, the materials analysis of F. Modigliani and M.
Miller found out crucial inconsistency, then they recorded it into an article in the
American Economic Review. Later, this article was the beginning of the ModiglianiMiller (MM) theorem. This theory developed quickly, becoming a cornerstone of
corporate finance and arguably forming the fundament for modern thinking on
capital structure. MM theorem is a fundamental financial theory of capital structure
which proposed the basis for modern theories, supporting to firm valuation.
MM’s Capital Structure Irrelevance Proposition
According to MM, the basic theorem is applied under a specific market process
known as classic random walk which includes the non-appearance of taxes,

transaction costs, bankruptcy costs, information asymmetry and other market
imperfections. This means that there is an equality between companies and
individuals, both companies and individuals can access same market information,
equivalent borrowing costs, and debts have no effect on firm’s earnings before
interest and taxes. In this case, capital structure of firm does not impact the valuation
of firms. In other words, unlevered firm with only equity in capital structure and
levered financed partly by equity and partly by debt have the same value.
Proposition I:

where

are the value of unlevered and levered firm respectively.

Regarding this proposition of MM, the price to purchase an unlevered firm
should equal the price of levered firm.
Proposition II:

7


where

is the expected return on levered equity, or cost of levered equity;

is

the expected return on equity of unlevered firm, or cost of unlevered equity;

is

debt-equity ratio;

is the expected return on debt, or cost of debt.

MM proposition II states that the cost of equity has linear relationship with
debt-equity ratio. A higher expected rate of return on equity of a levered firm reflects
a higher debt-equity ratio, expressed in market values of common stock. With the
unlevered firm, return of

is required by investors. Due to the extra risk from

borrowing capital of levered firm, return of

must plus

as a risk

premium.
Consequently, it can be seen that the capital structure is irrelevant to stock price
of any firms. The debt-equity ratio does not have any impact on weighted average
cost of capital (WACC) of firm because more of cheaper source of capital leads to
the increase in return on equity. It seems to be not meaningful because the
assumptions of this theorem are unrealistic. However, these propositions are still
crucial and beneficial. This is because the real market violates most of the condition
of theory, which conversely indicates the significant role of capital structure in the
companies. As a result, the determinants are identified to optimize the capital
structure.
Modigliani and Miller's Tradeoff Theory of Leverage
8

The tradeoff theory of MM was developed with the presence of tax shield.
Notwithstanding, there are still some assumptions applied to these propositions,
which are the absence of transaction costs, deductible on dividend payment,
inequality between firms and investors when borrowing; and there is tax deduction
on interest payment on debt.
Proposition I:

where

is corporate tax,

is the value of debt (assumed perpetual debt).

It is easy to see that the value of levered firm is directly proportional to the
value of debt. Hence, the larger proportion of debt capital involves, the more
valuable the firm is. Levered firms can get advantages from interest deduction to
reduce the tax payment.
Proposition II:

where

is the expected return on equity, or cost of levered equity = unlevered

equity + financing premium;

is expected return on unlevered equity, or cost of

equity capital with no leverage, or unlevered cost of equity;

is the expected return

on debt, or cost of debt.
Similar to the conclusion above, the increase in leverage rises the cost of equity
because of riskier investment coming from the debt level. However, in this case, the firm
can save tax payment from interest tax deduction, thereby the ratio between debt and
equity influences the firm’s WACC. The higher the debt level, the lower the WACC.

9


To sum up, related to capital structure, MM theorem states that there is no
optimal capital structure in a perfect market with the absence of taxes, transaction
costs, bankruptcy cost, and information asymmetry. Besides, the optimal capital
structure of a firm with the same conditions above but under corporate tax is 99.99
percent debt level. In reality, figuring out an optimal capital structure is quite hard,
However, the determinants of capital structure can be identified.”
1.1.2.2. Trade-off Theory of Capital Structure
“The trade-off theory refers to a decision that a firm can find out an optimal
capital structure to maximize the market value of firm by balancing benefits and
costs of using debt. The original hypothesis established by Kraus and Litzenberger
(1973) was a classic static trade-off theory. According to them, the deadweight costs
of financial distress and bankruptcy and the benefits from tax saving of debt Ire
considered to the trade-off between costs and benefits. The tax benefits come from
the tax deduction of interest, so that the firm prefers loan rather than equity to get
advantage from tax shield and increase firm value. On the other hand, borrowing loan
also rises the probability of default and financial distress. According to Haugen and
Senbet (1978), the cost of bankruptcy and financial distress belong to both direct and
indirect costs. The direct costs include administrative costs, credit costs, costs of
restructuring company, other legal fee of loan. Indirect costs evolve losses of

intangible assets such as losses of reputation, reduction of customers’ loyalty, and
even the losses of investors, workers, and employees. The manager of a firm must
balance the benefits and costs to optimize operation. In trade-off theory, agency cost
is normally referred to. Agency cost, which is different from two main kinds of costs
mentioned above, should be weighed against the tax saving. This theory helps to
explain why the firms always use partly debt and partly owners’ equity. According to
trade-off theory, the optimal capital structure can be find out by balancing the
marginal benefit of debt from tax saving of interest tax deduction and the marginal
distress cost of debt as Ill as the risk of debt (see Figure 2.1).
Figure 1.1: Debt to Total Assets and Market Value of the Firm

10


Source: Clayman et al. (2012)
While Modigliani-Miller theorem states that there is no optimal capital structure or
optimal structure with full debt under tax shield, with trade-off theory a firm can use an
appropriate proportion of debt to create optimal capital structure. The optimal debtequity ratio is a point where any additional debt would cause the costs of financial
distress lower than the extra tax advantage. None of firms can affirm that they reach
their optimal capital structure. Nevertheless, the factors impacting optimal capital
structure may be used to determine the appropriate choice of management. The business
risks, tax regulations, costs of financial distress, corporate governance, among other
factors should be considered as a tool to choose best debt level.
Figure 1.2: Debt to Equity ratio and Cost of Capital

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Source: Clayman et al. (2012)
As can be seen from Figure 2.2, the growth of proportion of debt in capital

structure leads to the increase of costs of both debt and equity as a risk premium of
high level of debt, which also reduces cost advantage due to greater amounts of loan
known as cheaper financial source. Because of these changes, the weighted average
cost of capital curve has a U shape. Besides, the decisions of using debt of a firm
should fit the target capital structure, based on the current company’s financial
situation, transparency as Ill as market conditions. The market actually fluctuates
continuously, requiring the managers of any firms must make the appropriate
decisions to adapt the changes and get maximum firms’ value and profit.”
1.1.2.3. Agency Theory of Capital Structure
“The agency theory integrates elements from the theory of agency, the
theory of property rights and the theory of finance to generate the concept of
ownership structure, whose main objective is to issue the optimal agreement
among stakeholders of the company (Jensen and Meckling, 1976). Agency theory
is a compromise between two parties, in which, one is called principal, who is the
shareholder, creditor or the owner of the company, and the other is agent, who is
delegated to work on behalf of the principal. Many agency relationships are built
up in every company, for example, creditor and manager, or employer and
employee. Hence, agency costs arise due to conflicts between two parties. The
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