A number of empirical studies have identified firm-level characteristics. As a result of these studies, some broad categories of capital structure determinants have emerged.
One of the main theoretical controversies is the relationship between leverage and profitability of a firm. Profitability is a measure of earning power of a firm. The earning power of a firm is the basic concern of its shareholders. The effect of profitability on leverage was well explained by the “pecking order” theory that was suggested by Myers (1984). According to this theory, firm has an ordered preference for financing whereby they prefer retained earnings as their main source of funds for investment which is followed by debt. The last resort sought by a firm would be external equity financing. The reason for this ranking was that internal funds were regarded as ‘cheap’ and not subject to any outside interference. External debt was ranked next as it was seen cheaper and having fewer restrictions than issuing equity and the issuance of external equity is seen as the most costly way of financing a firm. Therefore, when firms which was profitable is seen to have more retained earnings and choose to have lower leverage, hence a negative relationship between profitability and leverage is expected.
2.COLLATERAL VALUE OF ASSETS
Collateral value of assets, also known as Asset Composition or Tangibility; are those assets that creditors can accept as security for issuing the debt. In an uncertain world, with asymmetric information, the asset structure of a firm has a direct impact on its capital structure since a firm’s tangible assets are the most widely accepted sources for the bank borrowing and secured debts. If banks have imperfect information regarding the behavior of the firm, firms with few tangible assets find it difficult to raise funds via debt financing. The type of assets the firm holds plays a significant role in determining that firm’s capital structure. The reason can be that when a large fraction of the firm’s assets is tangible, assets can serve as collateral, which diminishes the risk of the lender suffering agency costs of debt.
