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1、DETERMINANTS OF FIRMS FINANCIAL LEVERAGE:A CRITICAL REVIEWByRahul KumarAbstractThe purpose of this review paper is to critically investigate the underlying factors that affect firms financial leverage from the perspective of theoretical underpinnings. We reviewed 107 papers published from 1991 to 20
2、05 in the core, non-core and other academic journals. On the basis of critical review, this research has identified a number of determinants of financial leverage based upon logical argume nts identified in the literatures. Major findings show that various frameworks like leverage irrelevance, stati
3、c trade off, pecking order, asymmetric information signaling framework have partly helped us in understanding the underlying factors determining the firms financial leverage, there is no consensus and there is no universal factor determining financial leverage. The paper sets out two challenges for
4、future research: one, how to integrate different factors determining firms financial leverage into a common framework and second, what are the explanatory factors determining firms financial leverage in a network phenomenaKeywords : Capital structure, financial leverage1. IntroductionIn general, com
5、panies may raise money from internal and external sources. They can raise money from internal sources by plowing back part of their profits, which would otherwise have been distributed as dividend to shareholders. Or, they can raise money from external sources by an issue of debt or equity. When a c
6、ompany issues shares, shareholders hope to receive dividend on their investment. However, the company is not obliged to pay any dividend. Because dividend is discretionary, it is not considered to be a business expense. When a company borrows money by way of debt, it promises to make regular interes
7、t payment and to repay the principal (i.e. the original amount borrowed). If profits rise, the debt holders continue to receive a fixed interest payment, so that all the gains go to the shareholders. On the contrary, when the reverse happens and profits fall, shareholders bear all the pain. If times
8、 are sufficiently hard, a company that has borrowed heavily may not be able to repay its debt. The company is then become bankrupt and shareholders loose their entire investment. Because debt increases returns to shareholders in good times and reduces them in bad times, it creates “financial leverag
9、e” (leverage). An “unlevered firm2” uses only equity capital whereas a “levered firm” uses a mix of equity and various forms of debt. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The importance of leverage in the capital structure3 of the company is that
10、its efficient use reduces the weighted average cost of capital (WACC) of the company. Lowering the cost of capital increases the net economic returns which, ultimately increases firm value. In sum, the guiding principle of leverage is to choose the course of action that maximizes the firm value and
11、the value of the firm is maximized when the WACC is minimized.The firms leverage decision centers on the allocation between debt and equity in financing the company. However, how the leverage of a firm is determined in a world in which cash flows are uncertain and in which capital can be obtained by
12、 many different media ranging from pure debt instruments to pure equity instruments is an unsettled issue. A number of researchers have attempted to understand financing choices of the firm and to identify the effect of changes in financial structure on the WACC of the firm and its value. A survey o
13、n capital structure theories by Harris and Raviv (1991) provide a summary of determinant of financial leverage of the firm, as identified and discovered by the researchers up to the time. However, in the absence of any review of published papers in the area since then, a need was felt to do this typ
14、e of review and objective was decided. The literature review is done to understand the progress of research on the subject and to identify the future direction of research. The present study reviews the literatures from January, 1991 to December, 2005, and summarizes various hypotheses determining t
15、he leverage of firm as discovered by the researchers. The review work follows from the perspective of theoretical underpinnings developed by the researchers during this time. This paper is organized as follows. In Section 2, we present methodology of review. Section 3 presents classification, discus
16、sion, and summary of hypothesis brought forth in the published papers during January, 1991 to December, 2005 from different theoretical underpinnings propounded in the subject area, though the divide line is oblique. Section 4 is the last section devoted to conclusions and future directions of the research. Section: 2For the purpose of our study, we systematically exclude certain top
