Global Journal of Management and Business Research, B: Economics and Commerce, Volume 22 Issue 4

interdependence between them. This article also strives to explain why the concepts of the optimal capital structure of an industry and the power of lenders are indispensable elements of any completely specified paradigm of the attractiveness of an industry. II. K ey A ssumptions and D efinitions Prior to advancing further, it is essential to; explain vital concepts; describe the bounds of this essay; deliberate upon the circumstantial foundation of the protracted theoretical paradigm of the attractiveness of an industry proposed; and scrutinize the significant assumptions that led Porter (1980) to exclude the optimal average industry capital structure and the power of lenders from his model. a) Definitions and Scope For the purpose of clarity and precision, I will provide a working definition of important concepts applied in this essay and delineate the scope of the model of interest. Andrews (1949) defined an industry as any cohort of individual businesses which are characterized by operational processes and systems that are tremendously comparable and having adequately analogous foundations of knowledge and experience such that each of them could produce the specific product that is the focus of consideration, and would undertake that if it is adequately profitable. Hofstrand (2009) posited that profitability is the principal objective of the entirety of business organizations. In the absence of profitability, the business will lack the capacity to subsist in the long run, all other factors held constant. He further highlighted that profitability could be measured with a statement of income and expenses. While revenue is money engendered by the firm’s economic activities, expenses constitute the cost of resources expended in the course of undertaking the economic activities of the firm. The attractiveness or potential profitability of an industry is not cast in stone and can change over a period of time, given that firms can influence the strength of the five competitive forces through competitive strategy (Porter, 1980). We can predict the profit potential or the attractiveness of an industry by utilizing the five-forces framework (Porter, 1980). In this essay I propose that the power of lenders and the optimal capital structure of the industry be incorporated into the framework for the assessment of the attractiveness of an industry. Finally, in this paper, the optimal capital structure is delineated to imply or infer the optimal usage of debt in the structure of the firm’s capital (Bowen, Daley & Huber, 1982). b) Applicable Theories of Corporate Finance Given perfect capital market conditions, Modigliani and Miller (1958) proposed that the market value of any business organization is not dependent on its capital structure and is derived by discounting its expected cash flows at the discount rate suitable for the firm's risk. Therefore, the theory proposed by Modigliani and Miller (1958) helps us to understand that in the absence of perfect capital market conditions, capital structure is an important determinant of a firm’s market value because of the tax benefits of debt, financial distress costs associated with debt and agency costs of asymmetric information. Berk and DeMarzo (2006) enumerated several costs and benefits of incorporating debt in the capital structure. Tax benefits of debt result from the reduction in the taxable income of the firm arising from the tax deductibility of interest expenses on the debt of the firm. Thus, interest tax shield contributes to an increase in the value of a firm. Debt can assist the equity holders or investors of the firm in extenuating agency costs connected to the uncoupling of ownership from the management of the firm. Capital structure is also crucial for the reason that agency costs can emanate from asymmetric information. There is an occurrence of asymmetric information whenever the management of the firm is in possession of information about the firm’s risk, potential profitability, and prospects that are inaccessible to the investors or other imperative stakeholders of the firm. In this situation debt capital, or commonly the nature of the firm’s capital structure can be applied to signal the projections and prospects of the firm to members of the investment community and other crucial stakeholders of the firm. This can be monumental in ensuring that investors allocate the firm a befitting valuation in the course of any round of capital raising. Furthermore, debt can support the shareholders in precluding the managers of the firm from embarking on unwarranted consumption of perquisites or executing projects that do not engender positive cash flows for the firm. Although the usage of debt can be advantageous to a firm by enhancing the value of the levered firm, on the flip side, the existence of debt in the capital structure can generate substantial explicit and implicit costs in the event of crystallization of financial distress upon the firm. We understand that a firm can be in financial distress regardless of its capital structure. However, the exploitation of leverage can significantly raise the risk of bankruptcy since the firm is obligated to make payments of interests and repayments of capital borrowed, notwithstanding its liquidity and profitability. If the firm is wholly financed with equity capital, it is more likely to encounter a lower risk of financial distress because it is not obligated to make payments to shareholders. Jensen & Meckling (1976) provided an exhaustive explanation of the agency costs associated with financing provided by outsiders. Jensen & Meckling (1976) identified that rational investors anticipate that their stake in the organization will alter the manager’s incentives. Therefore, they discount the value they are The Determinants of the Attractiveness of an Industry: An Extension of The Porter’s Five-Forces Framework 82 Global Journal of Management and Business Research Volume XXII Issue IV Version I Year 2022 ( ) B © 2022 Global Journals