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In the course of this research work, the researcher reviewed work done by different authors on the research topic and related topics. The review started with the implications of capital structure.
2.1 IMPLICATION OF CAPITAL STRUCTURE
Capital structure of a business organisation has its risk and reward implications for equity investors.
Reward Implication: Debt in the capital structure carries with it tax shield interest on debt are deducted from company’s earnings before being taxed and this reduces the tax liability of the company concerned. According to Sihler (1971:13) adding debt to capital structure in vast majority of instances, increases earnings per share more than does raising the same amount of money from common stock. Once interest is paid, all additional income goes to the existing shareholders, and it does not have to be shared with new comers providers of debt.
Risk of Financial Distress: A firm’s risk can be divided into two categories risk and business risk. Business risk is the risk inherent in the firm’s operations the uncertainty surrounding revenues and operating costs. According to Ben-Horim (1987-275) financial risk results from the use of debt, which introduce a fixed charge – interest expense. Firms in different industries, facing different degrees of operation leverage may vary with respect to their use of financial leverage. The leverage ratio is regarded as an indicator of risk as high level of debt create a high fixed interest commitment which must be paid to the company irrespective of whether profits are made or not. To quote s etal (1992-441) as the proportion of debt in capital structure increases not only do the risks of equity owners increasing proportions of debt the likelihood of incurring cost of financial distress increase as does the cost of the ultimate financial distress has a cost, and as companies take on higher and higher levels of debt, this cost will have a negative effect on firm value offsetting the value of the tax shield from extra interest payment made. In these circumstance the value of a levered firm can be found as followed as given by etal (1992) value of a levered firm: value if firm is all equity financed + PV of tax shield on borrowing –PV of cost of financial distress. The chance of financial distress increases as leverage increases because with debt capital a fixed interest payment has to be made annually whatever the profit or cash flow position of the company, whereas it is possible to postpone a dividend payment. The cost of financial distress can be dividend into direct and indirect costs. The direct costs include fees for lawyers and the managerial time used in administration. The indirect costs are less tangible and arise because of uncertainties in the minds of suppliers and customers. They include lost of sales, lost profit and lost good will. The presence of the possible distress cost is likely to increase the cost of capital because the shareholders will want a greater return for what they see as additional risk. This means that whether bankruptcy costs are a threat or not, the shareholder perceive them as threat. Unfortunately there are only a few studies that have attempted to measure the cost of financial distress and according to etal (199:453), there is a considerable disagreement as to the real size of he bankruptcy cost and hence their importance compared with tax relief.
2.2 DETERMINANTS OF CAPITAL STRUCTURE
Capital structure can be planned initially when company is incorporated. The initial capital structure should be designed very carefully. The financial manager has also a deal with an existing capital. The company needs fund to finance its activities continuously. Thus capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances. The following approaches or factors should be considered when deciding on a firm’s capital structure.