Literature Review on Capital Structure and Firm Performance

Abstract

Capital structure theory suggests that there is no effect of capital structure on firm performance in perfect economy (with no tax and no transaction costs), and there is a positive relation between capital structure and firm performance in a real economy (with tax). On the other hand, in the presence of financial distress cost (bankruptcy costs and agency cost of debt), there is a positive relation between capital structure and firm performance at lower level of debt, and a negative relation at higher level of debt. This paper summarizes the development of the theory of capital structure since 1952. We consider both theoretical and empirical literatures that investigate the relationship between capital structure and firm performance. This paper concludes that the relation between capital structure and firm performance can be different due to differences in variables, corporate environment, leverage measures, performance measures, control variable, data issue, data analysis technique, market type, market location.