Effects of Capital Structure on Performance: A Critical Review
Abstract
The capital structure is a combination of different types of debt and capital which a firm uses to finance its assets, operations and growth. This study critically examined the relationship between capital structure and firms performance. Capital structure is a dynamic process that changes depending on the variable that influence evolution or performance of a company. Appropriate capital structure decision is one of the most crucial decision often confronted by financial managers and analysts of firms. Capital structure plays an important role in a firm especially when the firm wants to fulfil the needs of their stakeholders through investments in capital assets, profitability, payment of dividend, debt, salaries on time and other financial obligations. Capital structure is normally made of equity capital, preference capital and long-term debt capital. Debt capital such as long-term bond is used by the firm to finance mainly its investment decision in long term assets such as property, plant and equipment. The decision centers on the mix of debts and equity in financing firms immediate and long term assets and operations. The combinations of different capital types will have differing impact on firm performance. Capital structure is used as a benchmark when raising funds for investment in new capital projects. Managers have numerous opportunities to exercise their discretion with respect to capital structure decisions. The capital structure employed may not be meant for value maximization of the firm but for protection of the managers interest especially in organizations where corporate decisions are dictated by managers and shares of the company closely held. The managers are caught up in a dilemma of structuring their finance in order to determine its impact on performance. The performance of the business is crucial to the value of the firm and consequently, its survival. The question firms are faced with is making a decision on the capital structure choice to use. The decision is crucial given that it has effect on the financial performance of firms. The capital structure of a firm is generally the specific mix of debt and equity the firm uses to finance its operations. The paper sought to assess the relationship between the capital structure and performance. The paper is anchored on agency cost theory and supported by the static trade-off and the pecking order theory. The paper revealed that financial leverage has a positive and significant effect on firm performance. The paper further reveals that there is positive relationship between capital structure and financial performance. Capital structure was found to have a significant effect on financial performance of the firm. The paper concludes that every firm should make good capital structure decision to earn profit and carry on their business successfully.
Keywords: Capital structure, Debt, Debentures, Equity, Leverage, Financial performance
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