Financial Analysis and the Predictability of Important Economic Events

By Ahmed Riahi-Belkaoui | Go to book overview

11

The Prediction of Capital Structure

INTRODUCTION1

This chapter employs a contingency perspective to examine the impact of the implementation of the multidivisional form (M-form) structure of a firm’s capital structure given different corporate diversification strategies. Theories of corporate capital structure have often focused on the various roles of debt, including the tax advantage of debt, 2 choice of debt level to signal firm quality, 3 the use of debt as an antitakeover device, 4 the agency costs of debt, 5 and the usefulness of debt for restricting managerial discretion. 6 These theories and the related empirical work on capital structure have increased our understanding of the issues. There is, however, no consensus about which of the determinants have an impact on the capital structure decision or how they affect performance. We believe that Barton and Gordon’s 7 suggestion to employ a strategy perspective will add to the understanding of the capital structure decision.

Specifically, we test whether implementation of the M-form structure is associated with a change in capital structure, and whether such changes vary over firms with different corporate diversification strategies. Williamson 8 discusses a theory of the firm’s strategy for financing projects based upon the redeployability of the assets involved and the governance structure best suited to those assets. Both concepts are used in this study to motivate the differential capital structures expected from different diversification strategies. Three major categories of corporate diversification strategy are examined: vertical integration, related business diversification, and unrelated diversification. 9 Our central proposition is that the implementation of the M-form structure affects the capital structure decision differently depending upon which diversification strategy exists prior to M-form

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