The Prominent Capital Structure Theories - Literature review Example

Assignment 2 Name Course Tutor’s Name Date: 1. Capital structure theories In literature (Ahmadina, Afrasiabishani & Hesami, 2012; Huang & Ritter, 2009; Luigi & Sorin, 2010), the trade-off theory, the market-timing theory, the Modigliani Miller theory, and the pecking order theory are indicated as the prominent capital structure theories. Agency theory is also cited by Grigore & Stefac-Duicu (2013) as another prominent theory of capital structure. Four of the five aforementioned theories (i.e. trade-off theory, pecking order theory, Modigliani Miller theory and agency theory) have been cited by Cassar and Holmes (2003), La Rocca, La Rocca and Cariola (2011), and Qiu and La (2010) as indicated below: i. Cassar and Holmes (2003) discuss the trade-off and pecking order theories’ applicability in small and medium enterprises in Australia. The authors find out that agency, tax costs and bankruptcy arguments are relevant to the trade-off theory, while information asymmetries are relevant to the pecking order theory. ii. La Rocca, La Rocca and Cariola (2011) discuss the pecking order theory and its applicability in an industry’s financial lifecycle pattern. The authors acknowledge that the pecking order theory is a reflection of asymmetric information problems. The authors indicate that ideally, firms use retained earnings as capital, acquire debt as the next step of financing, and take up equity as a last option of raising capital. The authors also use a financial lifecycle hypothesis, which suggests that small firms use equity as the first source of capital, followed by retained earnings, and finally, debt. They also cite the reputational effect hypothesis, the reputational searching hypothesis, and the reverse financial lifecycle hypothesis. iii. Qiu and La (2010) discuss the pecking order theory, the agency cost theory, the Modigliani Miller theory, and trade off theories in the Australian context, and indicate that the pecking order theory and the agency cost theory are of much relevance compared to the trade-off theory. The agency costs theory, which according to Niu (2008) suggests that conflict between principals (shareholders) and agents (managers) affects capital structure, was also found to be of relevance in the Australian context. Qiu and La (2010) further found out that the pecking order is more likely to be used by profitable firms as a way of reducing costs related to new security issues. The trade-off theory is therefore not common among profitable firms in Australia, hence disapproving the trade-off theory, which suggests that large profitable firms are more likely to use debt financing since they have lower bankruptcy costs. . 2. Sample data Sample data is indicated to be “the recorded factual material commonly accepted in the scientific community as necessary to validate research findings” (NCSU Libraries, 2013, para.1). Such data is obtained from a selected part of the population, with the view that the results obtained from the research can be generalised over a larger population with similar characteristics. The sample data used in the three articles are: i. Cassar and Holmes (2003) used a sample of 1,555 firms from the small and medium-sized firm category. The sample was drawn from all business units in Australia with the exception of government enterprises, non-employing businesses and selected business based on specific industry codes (e.g. ANZSIC code 1 for mining firms). To qualify for inclusion in the sample, firms had to be willing to disclose their debt and equity financial information. Additionally, the firms were required to prove positive sales for at least four years. Firms whose assets exceeded $25 million, or were less than $500 were eliminated from the sample. ii. La Rocca, La Rocca and Cariola (2011) used a sample of 10,242 Italian small and medium-sized firms drawn from different sectors with the exception of the financial sector. To meet the sampling criteria, firms had to have less than 250 employees and annual earnings of less that €40 million. The sampled firms were selected from the Analisis Informatizzata Delle Aziende (AIDA) database. The firms were studied over a ten year period starting in 1996 and ending in 2005. iii. Qiu and La (2010) studied all firms listed at the Australian Stock Exchange all Ordinaries Index (ASAORD), with the exception of financial institutions, insurance firms and banks. The sample constituted 65 firms studied in 1993, and 412 firms studied in 2006. The authors collected six types of data every end year with a keen interest on the book value of: interest-bearing debt; plant, equipment and property; common equity; and preference stock. The authors also collected data relating to pre-interest and pre-tax earnings, and firms’ equity capitalisation value. 3. Findings for Capital structure i. In their study, Cassar and Holmes (2003) gathered some empirical evidence, which reconcile with the trade-off theory of capital structure. Specifically, they found evidence related to the tax costs, agency problems and bankruptcy as indicated in the trade-off theory. The authors also gathered evidence that supports the pecking order theory, especially in relation to information asymmetries. ii. La Rocca, La Rocca and Cariola (2011) found out that informational vagueness determines a firm’s decision toward financing. Where certainty is high, managers were indicated as having less dependence on debts for financing. Debt financing was especially lower among large firms with more certain futures. La Rocca et al. (2011) also indicate that debt financing is common among SMEs, not only because they have less certain futures compared to their larger counterparts, but also because their internal capital resources are insufficient to cater for all their financing needs. iii. Qiu and La (2010) found out that profitability leads to a decline of debt ratios in levered firms, and as such, concluded that the pecking order theory is relevant in the Australian context. The authors also found a positive correlation between debt-asset ratio and asset tangibility. However they found an inverse relationship between debt-asset ratio and business risks and growth prospects. Based on the foregoing findings, the authors concluded that the agency cost theory was also relevant in the Australian context, while there were contradictions to the trade-off theory. 4. Contribution to understanding i. Cassar and Holmes (2003) contributed to knowledge and understanding through their observations that the capital structure theories, which were typically developed for application in large firms, can also be applied in small and medium-size enterprises. The foregoing contribution is important because as the two authors note, SMEs constitute a majority of the business entities in the Australian economy. ii. La Rocca, La Rocca and Cariola (2011) came up with some political implications related to their findings, which suggested that despite small firms having a relevant need to external finance, debt is not usually a suitable source of finance. In light of the foregoing, La Rocca et al. (2011) recommend that policymakers should intervene to make alternative forms of capital (e.g. equity financing) to be more accessible to small and medium-sized firms. The authors however admit that debt is essential to SME start-ups. However, SMEs may not always have the capacity to use own internal capital instead of debt. The findings by La Rocca et al. (2011) are similar to other findings by Giannetti (2003) and Michaelas, Chittenden and Poutziouris (1999), who indicated that in developing financial markets, the capital structure theories may not explain how SMEs acquire capital. In developed markets like the US however, SMEs’ capital structures fit into existing theories as indicated by Chang, Lee and Lee (2009) and Fluck, Holtz-Eakin and Rosen (1998). iii. Based on their findings relating to levered and unlevered firms, Qiu and La (2010) observe that the pecking order is more likely applicable on profitable firms as opposed to non-profitable firms, which are more concerned about their financial situation. Their findings further reveal that smaller, riskier, and less profitable firms are less likely to use debt when compared to the indebted firms. Qiu and La (2010) further find out that a firm’s size has no effect on its choices in regard to debt ratio. As such, the authors indicate that most Australian firms’ concerns about capital structure are related to agency costs, bankruptcy costs, cost of new securities and the signalling effects. 5. Comparison of results The results in Cassar and Holmes (2003) indicate that both the pecking order theory and the trade-off theory can be applied in SMEs in Australia. On their part, Qiu and La (2010) found out that debt ratio decreased with profitability, but increased with asset tangibility. The negative coefficient between debt ratio and profitability had also been observed by Cassar and Holmes (2003) thus reflecting the possibility that the pecking order theory is more applicable and/or relevant in the Australian context. La Rocca et al. (2011) have similar findings to Cassar and Holmes and Qiu and La (2010) with the only exception being that their research findings were obtained from an Italian context. From the three studies however, it would appear that the pecking order theory is more applicable in most contexts (i.e. be it SMEs or larger firms) across countries (at least in both Australia and Italy). The applicability of the trade-off theory on the other hand seems less likely, with agency cost theory receiving positive confirmation in Qiu and La (2010). Overall, and despite the differences in samples, and geographical setting in the case of La Rocca et al. (2010), which is in Italy, the three articles do not have major differences. 6. Capital structure conclusion The optimal capital structure for any firm minimizes the cost of capital while maximising its value for a firm. From the three articles featured herein, it would appear that the pecking order theory best explains how businesses (large and small) chose to engage with capital structure. Initially, they use internal resources, then use debt, and finally, utilise equity capital solutions. From Qiu and La (2010) it also appears that agency cost theory is relevant in some instances, since the information asymmetry between principals and agents can affects the decision about where to source capital from. Generally and as noted by Welch (2004) and Myers (1984), the appeal for debt financing is reduced by the costs associated with such form of acquiring capital. Yet, it would appear that debt financing remains the first alternative that firms consider in their capital structure (at least according to the pecking order theory and its applicability in the three articles featured herein). In the articles, the trade-off theory is indicated as having some relevance in Australian SMEs as indicated by Cassar and Holmes (2003). The foregoing means that some SMEs set a target for debt-ratio, and gradually move towards the attainment of the set ratio. Overall, it would appear that the capital structure theories are applicable in real-life situations, although in the context of the three articles featured herein, some theories (e.g. the pecking order theory) are more applicable than other competing theories. References Ahamadina, H., Afrasiabishani, J. & Hesami, E. (2012). A comprehensive review on capital structure theories. The Romanian Economic Journal XV (45) 3-26. Cassar, G. & Holmes, S. (2003). Capital structure and financing of SMEs: Australian evidence. Accounting and Finance 43, 123-147. Chang, C., Lee, C. & Lee, F. (2009). Determinants of capital structure choice: A structural equation modeling approach. The Quarterly Review of Economics and Finance 49(2), 197-213. Fluck, Z, Holtz-Eakin, D. & Rosen, H. (1998). Where does the money come from? The financing of small entrepreneurial enterprises, Working Paper. New York: Stern School of Business. Giannetti, M. (2003). Do better institutions mitigate agency problems? Evidence from corporate finance choices. Journal of Financial and Quantitative Analysis, 38(1), 185-212. Grigore, M. Z. & Stefan-Duicu (2013). Agency theory and optimal capital structure. Challenges of Knowledge Society & Economic, 862-868. Huang, R & Ritter, J. (2009). Testing theories of capital structure and estimating speed of adjustment. Journal of Financial and Quantitative Analysis 44(2), 237-271. La Rocca, M., La Rocca, T. & Cariola, A. (2011). Capital structure decisions during a firm’s life cycle. Small Business Economics 37, 107-130. Luigi, P. & Sorin, V. (2010). A review of the capital structure theories. 314-320. Michaelas, N. F., Chittenden, F., Poutziouris, P. (1999). Financial policy and capital structure choice in UK SMEs: Empirical evidence from company panel data. Small Business Economics 12, 113-130. Myers, S.C. (1984). The capital structure puzzle. Journal of Finance 39, 575-592. NCSU Libraries. (2013). Defining research data. Retrieved September 21, 2013, from http://www.lib.ncsu.edu/guides/datamanagement/define.html Niu, X. (2008). Theoretical and practical review of capital structure and its determinants. International Journal of Business and Management, March, 133-139. Qiu, M & La, B. (2010). Firm characteristics as determinants of capital structures in Australia. International Journal of Economics of Business 17(3), 277-287. Welch, I. (2004). Capital structure and stock returns. Journal of Political Economy 112, 106-131. Read More