Observed Capital Structure Patterns/ Empirical Regularities Observed capital structures show distinct national patterns.

Among industrialized nations, American, British, German and Australian companies have lower average book value debt ratio than do their counterparts in Japan, France, Italy and other European countries. On the other hand, British and German firms have by far the lowest market value leverage ratios. Among developing (newly-industrialized) countries, debt ratios in Singapore, Malaysia, Chile and Mexico are typically lower than in Brazil, India or Pakistan.
The exact reasons for these differences are unclear, but historical, and even cultural factors all probably play a part, as does a nations reliance on capital markets versus banks for ccorporate financing.

Capital Structure have pronounced industry patterns, and these are the same around the world. In all developed and developing countries, certain industries are characterised by high debt-to-equity ratio (utilities, transportation companies, and mature, capital intensive manufacturing firms), while other industries employ little or no long-term debt financing (service firms, mining companies, and most rapdly growing or technology-based manufacturing companies).
These patterns are very strong suggesting that characteristics of an industrys optimal asset mix, plus the variability of its operating environment, significantly influence the actual capital structure chosen by firms in that industry anywhere in the world.

Within industries, leverage is inversely related to profitability. Regardless of the industry in question, the most profitable companies borrow the least.
This empirical relationship between profitability and leverage suggests that observed capital structure are at least partly residual in naturemeaning thay are artifacts of a companys historical profitability (and dividend policy) rather than the result of a deliberate

capital structure policy choice. This distinction is crucial because it goes to the heart of whether a firms capital structure is the cause or the result of its other financial policy choices.

Taxes clearly influence capital structures, but are not alone decisive. Research has shown that increases in corporate income tax rates are associated with increased debt usage by corporationsat least in those countries where interest is a tax deductible expenseand that decreases in the personal tax rates on equity income (dividends and capital gains) relative to those on interest income are associated with decreased corporate debt usage. Leverage ratios appear to be inversely related to the perceived costs of financial distress. Both across industries and across countries, the larger the perceived costs of bankruptcy and fiancial distress, the less debt will be used.
In addition, some industries seem able to tolerate far higher leverage ratios than others because they can pass through periods of financial stress (or even bankruptcy) with relatively little dead weight loss in economic value. For example, companies rich in collaterizeable assets such as commercial real estate and transportation equipment typically are far less sensative to financial distress than are companies whose principal assets are the human capital of its employees, the band image of its products, or other intangible assets.

Existing shareholders invariably consider leverageincreasing events to be good news and leveragedecreasing events to be bad news.
Stock prices rise when a company announces leverage-increasing events, such as, debt-for-equity exchange offers, debt-financed share repurchase programs, and debt-fianced cash tender offers to acquire control of another company. On the other hand, leverage-decreasing events, such as, equity-for-debt exchange offers, new stock offerings, and acquisition offers involving payment with a firms own shares are almost always associated with share price declines.

Changes in the transaction costs of issuing new securities have little apparent impact on observed capital structures.
Transaction costs may influence the size or frequency of security issues, but not capital structure choice.

Ownership structure clearly seems to influence capital structures, though the true relationship is ambiguous.
Family-controlled firms tend to be more levered than similar publiclytraded firms with more diffused share ownership; and individual managers who place a high value on the personal benefits of controlling a coprporation will tend to prefer new debt to new equity issues for financing, because this minimizes dilution of their ownership stake.

Corporations that are forced away from a perceived capital structure tend to return to that structure over time.
There is evidence that corporations like to operate within target leverage zone, and will issue new equity when debt ratios get too high and will issue debt if they fall too low.

1) Agency Cost/Tax Shield Trade-Off Model

Observed capital structures are the result of individual firms tarding off the tax benefits of increased debt usage against the increasingly severe agency costs that result as debt ratios approach critical levels. This model evolved from modifications to the original MM capital structure irrelavance hypothesis and is the mainstream choice of most academics and financial practitioners. It is based on a capital market equilibrium and value maximizing arguments.

2) The Pecking Order Hypothesis Myers (1984)

It is based on two key assumptions: (a) managers are better informed about companys current earnings and investment opprtunities (an asymmetic information assumption); (b) managers act in the best interests of existing shareholders. Given these assupmtions, Myers demonstrated that a firm will sometimes forgo positive NPV projects, if accepting these projects means the firm will have to issue new equity at a

price that does not reflect the true value of the companys investment opportunities. This in turn provides a rationale for firms to value financial slack, such as large cash and marketable security holdings, and even unused debt capacity. This model is based on four observations about corporate behavior: (1) Dividend policy is sticky. Managers try at all costs to maintain a constant taka-per-share dividend payment, and will neither increase nor decrease dividends in response to temporary fluctuations in current profits; (2) firms prefer internal financing (retained earnings and depreciation) to external financings of any sort, debt or equity; (3) if a firm must obtain external financing, it will choose the safest security first: (4) as a firm is required to obtain external financing, it will work down the pecking order of securities, beginning with very safe debt, then progressing through risky debt, convertible securities, preferred stock, and finally common stock as a last resort. It can explain: (1) why debt ratios and profitability are inversely related; (2) why markets react negatively to all new equity issues and why managers seem to make such issues only when they either have no choice (following an unexpected earnings decline) or they feel the firms shares are over-valued; and (3) why managers of even highly regarded firms choose to hold more cashand issue less debt than either the trade-off theory suggest they should. Whereas trade-off theory explains observed corporate debt levels fairly well, the pecking order theory offers a far superior explanation for observed capital structure changesespecially those involving security issues.

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