Abstract
Modigliani and Miller's (1958) irrelevance theory established the foundations of capital structure theory. They showed that, in a capital market free of taxes, transaction costs, asymmetric information, and other frictions, the value of the firm is independent of its capital structure choice. Most of the capital structure theory development that followed tested the irrelevance theory with more realistic assumptions regarding market frictions and information asymmetries. The vast amount of empirical research into the extent and effects of bankruptcy costs and taxes on capital structure, as well as cross-industry and cross-country examination of observed capital structure, led to the mainstream view that firms act as if there is a unique, optimal capital structure that results from the tradeoff between tax and agency cost benefits of increased debt use and the increased bankruptcy and agency costs that higher levels of debt entail. As an alternative to the trade-off model, Myers (1977) put forward the Pecking Order hypothesis of capital gearing. This states that because of information asymmetry and different stock market reactions to debt and equity issues, firms follow a "pecking order" in their financing decisions, i.e. they would first prefer to use internal funds rather than issuing securities. If forced to resort to external financing they would use debt before equity. Section one of this study undertakes a comprehensive review of the theoretical literature on capital structure to date, emphasising those theories that are more pertinent to the empirical study carried out in section two. Another school of thought which tries to explain the use of debt is transaction cost economics (Williamson, 1975, 1996), which sees debt and equity as two governance mechanisms, the choice between which is strongly dependent on asset specificity. Empirical tests are carried out in this study using regression analysis to try to establish whether the capital structure of firms in the UK hotel and retail industries is better explained by a pecking order model or by a target adjustment model. The last chapter presents an empirical analysis of different variables that are likely to influence the observed capital structure patterns. This panel data analysis assesses the role of size, earnings volatility, profitability, asset structure, non-debt tax shields, leasing and management contract (this latter is specific to the hotel industry) variables on gearing ratios. The conclusions of the empirical study are that the industry data analysed are much better explained by the target adjustment model than the pecking order model. However, a number of independent variables appear to contribute to the "target adjustment effect" and the debt tax shield is just one of them.