Abstract
This paper presents a theoretical and as well as empirical understanding of the relationship
between institutions and capital structure. At first the overall understanding of capital structure is
described from various academic sources. The later part of the paper mainly focuses on the
various capital structure models and the correlation of capital structure in banking and non
banking institutions.
Introduction
An institution’s capital structure can be defined as the accumulation of all the securities it issues
in order to finance its operations (Brav & Maug, 1998). Capital structure a method that a firm
employs to combine equity and debt to maximize value. So, the value of a firm is the summation
of the market value of debt plus the market value of equity (Ross, Westerfield, Jaffe & Kakani,
2009). At the very basic form it is nothing but the way a company employs various financing
instruments namely debt, equity and sometimes a combination of both to fund its day to day
operations, capital expenditures, acquisitions, various investments and also to evolve in the long
run. The risk and return of a firm is directly associated with the capital structure which is
typically expressed as a debt-to-equity or debt-to-capital ratio.
The capital structure of any institution is dependent on a number of factors and it varies greatly
from one company to another due to various reasons such as the nature of business, tradeoff
between risk and return and so on. Moreover, the capital structure of a firm does not need to
remain the same for the whole course of its business operation. Both internal and external factors
compel a firm to rearrange its share of debt and equity to stay afloat. A technical definition
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postulates that the optimal capital structure decision results in the minimization of Weighted
Average Cost of Capital (WACC). However, this is not always the case as firms often use a
strategic or philosophical framework for determining the capital structure.
Capital structure dynamics
A company’s capital structure reflects some key features regarding the overall nature of the
business. The debt instruments of a capital structure include:

Short-term debt (secured)

Long-term debt (secured)

Notes Payable

Subordinated debt (unsecured)
Equity is consisted of:

Preferred stock

Common stock

Retained earnings
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An Institution
Capital Structure
Debt
Assets
Equity
The investment dynamics of any institution is directly correlated with the capital structure.
The debtors face low risk as they have the first claim on assets at times of bankruptcy. As the
risk the debtors face is lower, so is the return. They only get a fixed periodical interest payment
along with a fixed repayment schedule for the capital. Although a cheaper source of capital as
compared to equity, debt limits the flexibility of business operation. Finally, the debtors do not
enjoy ownership right in the company.
On the other side of the coin, the equity holders are the ones with high risk. During bankruptcy,
equity holders only have the right over the residual value after debt holders are paid off. The
return the equity holders get is higher than that of debtors as a simple consequence of taking
higher risk. They get dividend as well as capital growth. Equity holders are the owners and have
the voting right in an organization with no entitlement of fixed payments and interest payments.
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Impact of capital structure on a business: A scenario
For further analyzing the impact of differing capital structure choices have on a business let us
consider the scenario of two companies: Company A and Company B.
Similarities between the two companies are:

Amount of total invested capital is the same

Profitable and generate positive working capital

Have unlimited growth opportunities
Assuming everything else being the same for both the companies, only the capital structure is
different. Company A is 100% equity financed and Company B is 60% debt and 40% equity
financed.
Capital Structure
Company
Equity
Debt
Company A
100%
0%
Company B
40%
60%
 Impact on Growth: From the above scenario let us determine which company can
utilize internally generated cash flow to support faster growth. Growth in any
organization usually consumes operating cash flow as a result of the buildup of accounts
receivable and inventory. No doubt the differing capital structure of the companies stated
above will have different impacts on cash flow. Being a 100% equity financed business
entity, Company A is not bound by current payment requirements and as a consequence
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does not consume even the slightest bit of cash flow generated by the operation of the
company. On the flip side of the coin, with a large debt component to its capital structure,
Company B requires to pay monthly interest payment as well as principal payments to
repay the temporary capital. As, under the circumstances stated above, Company B will
have to pay for the debt from the cash flow generated by the operations of the business,
Company A will have relatively higher cash flow to support a higher growth rate as
compared to Company B.
From this example it is evident that if all other factors stay the same, the higher
percentage of equity in a capital structure will enable a company to reap more growth
through internally generated cash flow.
 Impact on Investment Return: Putting aside the issue of growth, the second
consideration that could be built upon the initial scenario stated above is return from the
investment. To further clarify the issue let us see the return of $5,000,000 capital from
both the companies. The owner/investor investment in Company A is $5,000,000 due to
the firm’s 100% equity financed capital structure. For Company B the owner/investor
capital is $2,000,000 (40% of $5,000,000). Now if both the companies generate EBIT
(Earnings before interest and taxes) of $475,000 then, Company A, which has zero debt
financing, will also has an EBT (Earnings before taxes) of $475,000 and the pre-tax
return on investment for the equity investors will be 9.5% ($475,000/$5,000,000). In
contrast, if Company B has to pay an interest rate of 5% on income, the company will
have an interest expense of $150,000 and thus the EBT for the equity holders will be
$325,000. As the invested capital from equity is $2,000,000 in Company B, the pre-tax
return on investment for equity holders is 16.25% ($325,000/$2,000,000). The weighted
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average cost of capital for Company A is 20% and on the other hand, the weighted
average cost of capital of Company B is 11% ((.40 x 20%) + (.60 x 5.0%)). The increased
return from investment in company B here is due to lower weighted average cost of
capital. So we can conclude that, if all other factors stay the same, if the percentage of
debt in a capital structure increases, the return on equity invested also increases.
 Impact on Risk: As observed from the above circumstance, leverage (debt) in any
institution is a tool that could be used to dramatically increase the return on equity
invested. For this very reason, many investors and owners of businesses push the
leverage to higher and higher level to gain increased return on equity. Needless to say,
this higher return comes at the cost of higher risk. Up to a certain point, increasing debt
has minimal impact on risk but beyond that point the risk starts to increase heavily. When
a business is highly levered, say 10% equity and 90% debt, the risk of bankruptcy is
dramatically increased as the interest payment and debt amortization eat up a
considerable amount of free cash flow of the organization. At times of major negative
event in the economy, the company might not be able to generate sufficient free cash
flow to serve its debt and might be forced into bankruptcy. This is the nightmare for
equity investors as they could lose their entire investment.
Now the optimal capital structure of any institution suggests that the level of debt should be
limited up to the level where risk from increased leverage is higher than the benefits of debt.
Capital structure modeling is a complex issue that requires situational analysis as well as
estimation of various variables. While applying this theory into practice one thing becomes
evident that the optimization of capital structure is as much art as science.
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We can further conclude that decisions on capital structure have strong implications for the firm
in terms of its value and cost of capital Firer et al, (2008). Weak capital structure decisions can
lower the net present value (NPV) of a firms many investment projects by increasing the cost of
capital. For this, many investment projects can become unacceptable. On the contrary, efficient
capital structure decisions will result into lower cost of capital and increased NPV of investment
projects. This would ultimately lead to more projects being acceptable and thus increasing the
value of the firm as a whole (Gitman, 2003). Although the importance of capital structure as a
tool to increase value of an organization cannot be denied, numerous theoretical literature and
empirical findings have failed to give guidance to practitioners regarding choice between debt
and equity in the capital structures (Frank and Goyal, 2009).
Models of Capital Structure
Modigliani-Miller Theorem
The basis on which modern capital structure philosophy has been molded is the ModiglianiMiller Theorem. It is one of the most significant components of economic theory that influences
the way institutions and firms view capital structure in comprehensive practice. The idea
suggests that, a firm does not experience any variance in its course of operations in response to
debt financing or equity financing. In a broader term, earning power and the risk associated with
the total assets of any institution determines the market value of its capital structure. The theory
articulates that the risk of assets and earning power do not have any relation with the investment
methods and dividend distribution.
Over the time many flaws have been marked in this theory as it failed to run in the real world
market. It fails to identify various components of the overall market which are important
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determinants of capital structure. For instance, (Fan et al., 2006) stated that firm capital structure
is heavily reliant on institutional features and it was concluded after analyzing a cross-section of
39 developed and developing countries. A substantial share of the cross-country variation in
leverage is described by a country’s legal and tax system. Other important factors are the level of
corruption, and the availability of information intermediaries. Moreover, it also fails to take the
impact of taxes, transaction and bankruptcy costs into consideration. Because of many
limitations like these, many new theories have sprung up to address the imperfections of real
world market in order to lessen the postulations made in the Modigliani-Miller model. Some of
the well-known theories that are commonly used in the real world of modern markets are as
followTrade-off theory
It is the theory of balancing the costs and benefits of a firm by determining the ratio of debt
financing and equity financing. The theory explains how companies use a mixture of debt and
equity financing to benefit from leverage till they reach the optimum capital structure.
Furthermore, profitability is the reason behind the rise of debt and fall of a firm’s debt can be due
to rise of growth opportunities and intangible assets. This however is subjected to the
characteristics of the individual institutions. According to this theory, companies could borrow
more and provide better assurances to reduce the cost of debt that have more tangible resources.
Therefore, TOT theory is anticipated to succeed better in institutions with better contracting
environments. (La Porta et al., 1997, 1998; Levine, 1998, 1999; and Rajan and Zingales,1998).
Pecking order theory
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The POT model suggests that a firm’s debt drops with profitability but increases with growth
opportunities and intangible assets (La Porta et al., 1997). In this theory financing decision is
made using a ranking system. It simply posits that institutions maintain a hierarchy to regulate
their preferred source of financing. In this process highest preference is given to internal sources
of financing and least to external sources. Firms move to external sources only when they fail to
generate adequate funding from internal sources. Finally, equity is issued as a last option when
dispensing more debt is no longer a practical option. Here risk increases as sourcing moves
outwards. Hence, cost of financing also rises as firms move more towards external financing.
POT theory is expected to sustain better in poor contracting settings where stockholders fail to
resolve the conflicts of interest related to information asymmetries, thus internal funds are
preferred to counter the challenge of external funds. (La Porta et al., 1997, 1998; Levine,1998,
1999; and Rajan and Zingales, 1998).
Agency costs
Agency theory attempts to describe the clashes raised from the conflict of interests amid agents
(managers, stockholders and debt holders) involved in firms and the costs incurred from these
conflicts. The theory suggests that the optimum capital structure comes from the settlement of
various funding choices which ultimately resolve the conflicts between capital providers and
managers. Here optimum level is the one that promises the minimum agency cost. The theory
also proposed that, firms can obtain extra benefits from tax by using more debt than equity as the
interest payments are tax deductible. It also highlighted the relationship between leverage and
costs where more levered firms have more bankruptcy costs. According to this theory, there is a
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positive relationship between profitability of firm and its leverage and those having more
tangible resources have smaller agency costs (Jensen , 1986).
Structural corporate finance
It is the dynamic area of finance where all the discussed models are translated and evaluated in a
controlled hypothetical setup in order to find probable outcomes in the real world. Here all the
components from contracts to investment returns and so forth are taken into consideration to
observe the outcomes.
Capital Structure in Various Institutions
Banking Institutions
Size plays a crucial role in the efficiency of the bank and ratios of capital as giant banks tend to
encompass greater investment prospects and easy entrance to capital marketplace.
The optimum capital structure is determined by various noticeable variables of banks. For
example, a high intensity of loan failure provisions specifies an anticipation of added difficulty
in the banks’ portfolios which results in more need for capital. Moreover, a higher loan-todeposit ratio (LTD) indicates banks do not have adequate liquidity to deal with any unexpected
fund necessities. If a bank decides on to raise capital by using retained earnings, the bank’s
capital is ancipated to be positively affected by its profitability. (Ding and Sickles, 2018)
Macroeconomic like recession and as well as falling housing prices may also influence the ratios
of capital and banks’ portfolio.
Microfinance Institutions (MFI)
A study conducted by (Tchuigoua, 2014) suggests that MFIs seem to be better leveraged in
common-law countries. Moreover, countries with better banking sectors appear to compliment
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microfinance sectors. However, there isn’t any strong association between the development of
banking segment of a country and the leverage. Therefore, institutional environment variables
certainly do not initiate deposits. The volume of deposits that MFIs can raise is seldom
influenced by institutional framework. The study also highlights a constructive and noteworthy
connection between the potency of lawful rights and exterior debt though creditors can
contribute a little in MFIs to raise external debt. Furthermore, the study also concluded that in
case of extremely developed banking sector MFIs seem to be prompted by banks where the
banking sector and its financial development are significantly associated with external debt and
thus have progressive influence on borrowing. A thorough research on the paper helped to find
out how institutional surroundings influence the capital formation of MFIs. In case of nonfinancial sector, institutional environment does not push deposit funding.
Determinants of capital structure for Firms and Industry
Empirical results founded in the study of (Li & Islam, 2018) observe that industry-specific
features are important and have influence on the development of capital formation both directly
and indirectly. Moreover, country-specific aspects have also substantial impact in formation of
capital structure.
While the impact of industry related factors is persistent through firms inside a country in case of
leverage decisions (Booth et al., 2001; Psillaki and Daskalakis, 2009; Fan et al., 2012; Moosa
and Li, 2013), it fluctuates in terms of signs, magnitudes, like business setting, industry policy,
and competition, are imperative for firms’ capital formation choices. (Mackay and Phillips,
2005).For example, mining industry firms have the lowest leverage ratio, while aerospace
industry firms likely to have the maximum average ratio of leverage. (Li & Islam, 2018)
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The lone firm-specific variable which constantly influence capital formation determinant across
businesses is the size of the firm itself. (Bunkanwanwanicha et al., 2008) found size to be a
significant component of capital formation in Indonesia before the Asian financial crisis and
during it. However, this variable changes across industries. Size also helps large firms to limit
their coverage to recurring instabilities in one row of assembly as they can diversify their
investment projects easily and reduce corporate risk.
In addition, industry-specific variables such as- rate of industry revenue increasement, turnover
margin, beta, market competition, ratio of P/E also play significant role while determining
industry capital structure. Frank and Goyal (2009).Moreover, firms that run in economically
important industries tend to borrow more as their leverage ratio is substantially related to the
GDP contribution of industry in a positive way. These firms are also likely to get better
government support and credit allocation. Li & Islam (2018).So it can be said that industryspecific features crucially influence firm-specific capital formation.
Conclusion
By considering all the discussions stated above, it can be said any institution cannot solely rely
upon one specific model for the optimization of capital structure rather they try to apply set of
theories in determining the optimal level. Moreover, the determinants of capital structure vary
not only from one institution to other but also from one organization to another under a single
institution. So, it is always wise to consider farm specific factors before deciding the optimal
capital structure.
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