Capital Structure Pre and Post Global Financial Crisis - Dissertation Example

Capital Structure Pre and Post Global Financial Crisis Introduction: The capital structure of a company represents the mix of the different sources of capital that the company makes use of for financing the activities of the company targeted towards achievement of its goals and objectives. It is concerned about the relative proportions of debt and equity in the financing of the activities. When debt financing is concerned, it includes borrowing from the banks, financial leasing, and bond issuing in the bond market. Equity financing mainly constitutes the retained earnings and issuing of additional shares in the stock market. Capital structure has its own importance in a company. There are primary two reasons supporting this fact. Firstly, debt and equity having differences in the costs, in the interest rates, and the required rates of return, there arises a need have an appropriate combination of debt and equity that can maximize the value of the firm by reducing the total cost of the company. This is achievable through the capital structure of the company (Broyles, 2003, pp.303-304). Secondly the knowledge and understanding of capital structure proves important since the borrowing of capital has an influence on the financial risk of the firm. The volatility of the net income or earnings per share of a company increases with the interest payments that represent additional fixed expenses for the company. This in turn increases the payment of interests on the issuing of bonds. The cost of equity capital also increases in the stock market as a result of borrowing. All these factors might eventually lead a company to financial distress or risk that leads to the increasing need for an appropriate capital structure (Broyles, 2003, p.304). Thus the importance of capital structure being reflected, it can also be understood that the global financial crisis may be significantly associated with the capital structure of different companies in a country. The present study focuses on the firms in the United Kingdom (UK) and evaluates the capital structure of the UK firms in general pre and post the global economic crisis trying to determine how the financial crisis might affect the capital structure of firms in a country. Aim and Objectives: The primary aim of the study is to evaluate the capital structure of firms in the UK before the global economic crisis in the years around 2007 and after the financial crisis in the years 2011 or 2012. In order to achieve the above mentioned aim of the study, the following objectives have been considered: Review theories on capital structure in order to determine how it might change during a period of prolonged recession and liquidity crisis. Compare and contrast the capital structure of public UK companies in 2007 and in 2011/2012. Evaluate the extent to which any changes in capital structure are due to the ongoing global crisis. Capital Structure: An Understanding towards the Effect of Economic Crisis: There are four basic theories related to capital structure of a firm. These are: Net Income Theory of Capital Structure: This theory stresses on a firm’s ability to choose a capital structure where the level of share capital or equity is less than the debt of the firm. This helps a firm to increase its market value and thus decrease the weighted average cost of capital of the company. If the content of the debt in the capital structure mix is high, it is referred as financial leverage increasing which increases the value of the firm (Theories of Capital Structure, 2010). Thus it can be understood that when there is an economic crisis prevailing in a country, the availability of the debt reduces that affects the ration of the debt to equity and hence the capital structure of a firm would alter as a result. Net Operating income Theory of Capital Structure: According to this theory, the concept of increasing financial leverage does not exist. It believes that changing the capital structure of a firm does not bring any change in the overall financial cost and value of the firm. That is, based on this theory, the market value of a firm is never affected by any change in capital structure (Theories of Capital Structure, 2010). Thus, although this theory focuses on the fact that changes in capital structure do not influence the value of the firm, it does not give a proper idea as to whether financial crisis in a country may lead to such changes or not. Traditional Theory of Capital Structure: A mix of net income approach and net operating income approach of capital structure is the basis of this theory and constitutes three stages. Firstly, the company is supposed to increase its debt to increase its market value. In the second stage, when the company gets an optimal position in capital structure where the value increases with reduction in the cost of the firm, then there remains no further need for increasing the debt part of the capital structure. In the last stage, the firm can loses its value in the market because increasing the amount of debt in capital structure after its optimum level increases the cost of debt and overall cost of capital (Theories of Capital Structure, 2010). Thus this can be understood to get affected as a result of long term financial crisis since the lot of dependence is on the debt part in the initial stages which may not be available with ease during the periods of crisis. Modigliani and Miller: As against the traditional concept, this theory believes that capital structure and cost of capital of a firm do not have any particular relationship. Thus an increase or decrease in debt does not have any effect on the cost of capital. According to this theory, it is the expectations of the investors that largely determine the value of a firm as well as its cost of capital. Such investor expectations might be depended on several factors (Theories of Capital Structure, 2010). Thus in this regard it can be said that a global economic crisis has the ability to affect the mindset of the investors, their choice of investments which can thus affect the capital structure and cost of capital of a firm. During and after the late 1980s, the domestic financial markets have become more open to foreign investors and institutions bringing a major structural change in the economies of different countries. At a country level, several positive effects of financial integration have also been obtained. These include decrease in costs of capital, higher growth in economy, and increasing number of private investments (Lucey & Zhang, 2011, p.1228). Studies have revealed that “higher levels of credit market integration result in higher leverage and that greater equity market integration leads to lower leverage” (Lucey & Zhang, 2011, p.1229). A study considering a set of 4477 public firms in 24 countries during the period of 1995-2007 reflects that increased integration of the credit and equity market has the ability to initiate greater use of debt and equity financing, respectively. Such financial integration has been obtained to bring economic benefits to a country through expanded financing options and decreased costs of capital. Moreover, the effect appears to be more marked for companies that present a high growth than for companies with lower growth with respect to credit policies. In this regard, policy makers need to promote further financial integration because it enables local firms to lift funds externally for their investment projects contributing to the growth of these firms in the long run (Lucey & Zhang, 2011, p.1237). Considering such studies, it can be realized that while on one hand such financial integration proves beneficial for emerging economies, balancing the capital structures of firms and decreasing their costs of capital, on the other hand, situations of economic crisis might affect the countries as a whole since they remain integrated. This might affect the capital structure of the firms. When the economic conditions within a country remains normal, one of the major complications for a firm is the access to finance as per need. Optimal investments and growth opportunities are not possible without the availability of adequate funds. For companies that are up to new ventures, the financial capital proves to be even more significant. On the other hand, availability of huge resources of finance enables a firm to make more investments in innovative activities and marketing, recruiting employees who are highly qualified, and who can work flexibly at the times of financial troubles or threats. In situations where a country encounters an economic crisis, it becomes difficult for companies to arrange for the adequate funds that they need for their activities. This eventually affects a firm’s performance, investment, employment, growth and may even lead to failure (Venancio, 2012, p.1). Thus capital structure of a firm can be realized to get affected at the times of economic crises within a country that makes it difficult for firms to collect debt or gather funds for their performances and activities. Capital Structure of UK Public Companies: Pre and Post the Global Financial Crisis: UK is considered as one of the leading economic country in the world and studies reveal that the country has the ability to make benefits from the economic recovery across the world. Like every other country, the recent global economic crisis had affected UK as well. Over the last 15 years before the crisis the country had presented a strong yet unbalanced growth. However with the crisis in place, the growth of the country got affected severely. It was again after the second half of 2009 that the country started reviving gradually (The UK Economy, 2011). With respect to the country’s ability to target investors, the UK is known to have large stock of companies that include small, medium as well as large businesses (Great Britain: Parliament: House of Commons: Treasury Committee, 2007, p.90). All limited liability companies in the UK are incorporated with the Companies House thereby registered either as private or public firm. A public company has no restrictions on the issues of shares or debentures to the public allowing them to be listed in the stock exchange. A study based on FAME database and the firms of the UK listed in the database has considered the topic of capital structure significantly. According to the study, public firms are on average older and larger, with respect to both their total assets and total sales. Among all the firms studied, it has been observed that 38.4 percent of the public firms are involved in equity market. The public firms’ average and median short term debt as a percentage of the total debt of the companies have been obtained as 36.9 percent and 29.0 percent respectively (Brav, 2009, pp.269-278). The following chart presents the Sample Summary Statistics for Public Companies depending on which the study had been conducted by Brav. FAME Obs Mean Median Equity Issues 4,248 0.384 0.000 Equity Retirements 2,914 0.133 0.000 Leverage 9,863 0.227 0.199 Sht to Long 9,686 0.369 0.290 Net Leverage 9,288 0.113 0.126 Total Assets 9,912 410,506 50,106 Turnover (Sales) 9,962 429,581 58,812 ROA 8,558 0.049 0.087 CAPEX/Total assets 7,700 0.070 0.042 Growth 8,909 1.226 1.066 Cash/Total assets 9,288 0.124 0.063 Div Payer 10,012 0.718 1.000 Div to EBIT 7,493 0.275 0.234 Age 9,261 35.498 21.312 Table 1: Sample Summary Statistics from Public Companies in UK (Brav, 2009, p.275). Brav indicated through his studied that the debt ratios of the public firms in the UK are significant subjects to rebalancing activity. This is primarily because they are more receptive to specific characteristics of firms that include factors like growth (Brav, 2009, p.283). Thus keeping in focus the above facts, it can be understood that debt and capital depend largely on the availability of funds in the market and from the investments which is again depended on the financial status of a country. Impact of Capital Structure on Agency Costs: Studies have revealed that there is a direct linkage between the capital structure of a firm and the agency costs and this has been studied on the public companies in UK as well. It has been observed that agency costs come about due to partial association of the interests of the agent and the owner (Zhang & Li, n.d., p.1). In general, “the agency costs associated with debt consist of the opportunity wealth loss, which is caused by impact of debt on investment decisions of the firm, bankruptcy costs and monitoring and bonding expenditures” (Zhang & Li, n.d., p.3). This particular study had considered 323 public companies in the UK where both multivariate and univariate tests had been conducted on the data. A negative relation between leverage and agency costs had been determined through the multivariate test. The opposite relation has been found to be significant at 10 percent level. Also, the size of the firm has been found to be negatively related to agency costs where the level of significance has been obtained at 1 percent. The performance of the firm has been found to be insignificantly related negatively to the agency costs. The results from the univariate test have also been found to be similar implying that increase in leverage reduce the agency costs (Zhang & Li, n.d., pp.5-16). Thus with the fluctuations in the economic status of the country, and the financial crisis, the financial leverages get affected affecting the agency costs as well. Potential Impact of the Recent Global Financial Crisis on the Capital Structure of UK Companies: Post Recession Condition: The recent financial crisis that the world witnessed experienced “the collapse of financial institutions, the bailout of banks, downturns in stock markets and a general decline in economic activity” (Jones, n.d., p.1). Jones’ study had been focused on the impact of the global crisis on the capital structure of the firms in UK with special emphasis on the industry of Imperial Tobacco. From the year 2007 till 2010, the share prices of the Imperial Tobacco reflected significant changes. The stock markets have been severely impacted towards the end of the year 2008 and the beginning of 2009. The values of both FTSE100 and Imperial Tobacco had declined during this period. Being a low risk business, although the firm had not done very badly during the crisis, yet it had been impacted as far as the capital structure of the firm is concerned (Jones, n.d., p.2). Imperial Tobacco had been used in the study as a representative of other companies in the country since the firm had followed the status of the FTSE100 during the period of crisis. FTSE100 represents an index that constitutes 100 large companies of the UK as listed on the London Stock Exchange (The FTSE 100- what does it all mean?, n.d.). As far as Imperial Tobacco is concerned, the debt of the company had increased largely in the year 2008, owing to takeover of Altadis in late 2007 leading to huge borrowings for the company. Since the recession or the economic crisis had struck during this period of time, the capital structure of the company was severely impacted with the value of the shares of the company in the market being declined drastically. However in the last couple of years, the company has been reducing its debt in response to the financial crisis (Jones, n.d., p.3). The reduction in debt and increase in the gearing has been a common measure adopted by several UK companies during the time of the crisis. “For example, over the last year of each company’s respective yearend, Barclay’s debt/equity ratio had fallen from 36.32 to 16.16, British Airway’s had fallen from 2.29 to 2.09 and BP’s had fallen from 0.36 to 0.34” (Jones, n.d., p.4). The study has focused on the fact that before the economic crisis was in place, many companies surrendered to the inducement of a capital structure that was burdened with debt. This could benefit them through reduction in the interest payments. A company that is in a profitable situation is benefited through this since reduces the cost of borrowing (Jones, n.d., p.4). Owing to the current crisis, investors would likely try to avoid all risks associated with their investments and financing, thus the costs of financial distress (in particular bankruptcy) getting elevated and qualified with lower levels of debt than before. Also, the tax shield benefit of debt cannot be expected to be as relevant because many UK companies are not making adequate profit to completely being advantageous. In terms of the trade-off as the trade-off theory of capital structure presents, this would indicate that the value of the firm is maximised at a lower ratio of debt/equity. This makes clear why UK companies such as Imperial Tobacco have been reducing debt and increasing equity in their capital structures. The change in capital structure reflects that a corporation’s capital structure alters to be a sign of different economic conditions. This has been observed through the firms’ intensions to rebalance their capital structure during different economic conditions (Jones, n.d., pp.6-7). Thus the recent financial crisis has led the capital structure of UK companies to constitute lesser amounts of debt. According to the theories of optimal capital structure this occurs since the value of a company gets maximized when the levels of gearing are low particularly in such situations of crisis. The maximization of value being the most important criteria for any firm it can be understood why the financial crisis significantly affects or influences the capital structure of the firms in a country (Jones, n.d., p.8). The UK has started reviving its position since the latter half of 2009. The government of the country has its significant concerns with the rebalancing of the economy and returning to the sustainable economic growth as the country witnessed earlier. Thus with improvement being initiated in the budgets and the tax considerations, it can be expected that the country would soon revive the financial status of the country thereby allowing the public firms to re-organize their capital structure policies (The UK Economy, 2011). Conclusion: From the above study it can be concluded that not only care the capital structures of companies influenced by the economic conditions in a country, but in the UK, the public firms have represented this fact significantly. While there are several theories associated with the concept of capital structure, it has been obtained that with the changes in the economic conditions, the level of considerations of the debt and equity to form the capital structure mix gets affected. Since during a state of severe financial crisis in a country, the availability of funds is significantly affected, accompanied with the investors fearing the risks associated with finance, companies tend to be in a risky state if they allow huge debts. Thus as has been visible in the case of the UK companies, the firms have lowered their debts in response to the current economic crisis. Thus from the study it can be understood and concluded that prolonged economic crisis has the ability to alter the capital structure of firms in a country. Considering the UK, it has been clearly observed that before the crisis, the companies had depended on huge debts that had been severely impacted, particularly in high risk companies, with the crisis in place. As a result of the global recession, the UK companies took the measures of lowering the debts which can thus be considered as a response to overcome the crisis and in other words the impact of the economic crisis over the capital structure as is prevailing in the current times as well while the country is trying its best to revive its earlier position. Reference 1) Brav, O. (2009), Access to Capital, Capital Structure, and the Funding of the Firm, The Journal of Finance, Vol.LXIV, No.1, pp.263-308, available at: http://file.si/pthumbs/square/220890/07_11CS.pdf (accessed on June 11, 2012) 2) Broyles, J. (2003), Financial Management and Real Options, New Jersey: John Wiley & Sons 3) Great Britain: Parliament: House of Commons: Treasury Committee (2007), Private Equity: tenth report of session 2006-07, Vol.2: Oral and Written Evidence, United Kingdom: The Stationery Office 4) Jones, S. 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