bonddonraj
February 25th, 2007, 02:19 AM
ABSTRACT
This paper provides new insights on the way in which the capital structure and market
power and capital structure and profitability are related. We predict and show that
capital structure and market power, as measured by Tobin’s Q, have a cubic
relationship. That is, at lower and higher ranges of Tobin’s Q, firms employ higher
debt, and reduce their debt at intermediate range. This is due to the complex
interaction of the market conditions, agency problems and bankruptcy costs. We also
show saucer-shaped relation between capital structure and profitability because of the
interplay of agency costs, costs of external financing and debt tax shield. To our
knowledge, we are the first to uncover these results.
Key words: capital structure; market structure; market power; Tobin’s Q; riskshifting;
moral hazard; agency problems; pecking order; trade-off theory; asset
substitution.
This paper provides new insights on the way in which the capital structure and market
power and capital structure and profitability are related. We predict and show that
capital structure and market power, as measured by Tobin’s Q, have a cubic
relationship. That is, at lower and higher ranges of Tobin’s Q, firms employ higher
debt, and reduce their debt at intermediate range. This is due to the complex
interaction of the market conditions, agency problems and bankruptcy costs. We also
show saucer-shaped relation between capital structure and profitability because of the
interplay of agency costs, costs of external financing and debt tax shield. To our
knowledge, we are the first to uncover these results.
Key words: capital structure; market structure; market power; Tobin’s Q; riskshifting;
moral hazard; agency problems; pecking order; trade-off theory; asset
substitution.