Capital Structure and Leverage of Firms - Research Paper Example

Capital Structure and Leverage Introduction This paper presents an investigation about capital structure and Leverage of firms in explaining the differences in capital structures across firms. Capital structure and Leverage concerns significant, specialized assets and other unique features of firms. The results indicate that outcomes of firms would contribute mostly to the difference in Leverage, suggestive of a solid link between Leverage and capital structure. Various studies on capital structure have resulted in a combination of tax advantages of debt costs related to Leverage and ideal capital structure. Hence, tax advantage would be traded against the possibility of incurring costs of bankruptcy. Importance of the study This study will be more important especially since it seeks to establish the relationship between Leverage and capital structure of firms and the impact of the link. Furthermore, the paper would determine how market imperfections, such as, the existence of penalties against bankruptcy and taxation of profits may be fundamental to the impact of capital structure and Leverage in the presence of positive theory. Tax advantage to debt financing would be seen to result from taxable interest costs of the firm’s profits. In the event that firms earn tax commitments, the paper tries to establish how financial Leverage would increase the after tax operating earnings while lowering the corporate income tax liability of firms. Literature Review The research conducted by Chittenden et al. (1996a, pp. 42-51) aimed at using panel data to examine hypotheses determined for the study. It also studied the dynamics of adjustments that measures the effects and identifies undetectable information on real time data. The methodology employed the use of flexible intercept models. These researchers utilize panel data to provide more data that would increase the level of freedom and reduce explanatory variables. As a result, this improved the efficiency of econometric estimates. The results of the least squares analyses would be used to calculate the ratio of the variable effects on short term debt ratios, against the variable effects on long term debt ratios. These results determined to what extent the different explanatory variables influenced the maturity arrangement of debt. The regression coefficients of variable, marginal tax rates were statistically insignificant in all of the three models used. The coefficients were also negative, contrary to the predictable, positive relationships by the theory of finance. Moreover, the coefficient of depreciation charges, were insignificantly not the same from zero for neither short-term debt nor total debt. However, the coefficients would be positive contrary to the intended influences of no debt tax guards. The observations indicated that business firms do not give the impression to consider tax impacts in their short-term capital structure decisions (Chittenden et. al., 1996a, pp. 62-66). Research conducted by Jordan et al. (1998, pp. 1-8) aimed at establishing financial policies on the relationship between debt ratios and tax structures of capital structures. Tax positions of selected firms provided a base to examine the impact of debt policies on both long term and short-term capital structures. They established a substantial, positive relationship between long-term debt ratios and no debt tax guards. This relationship provides a number of inadequate evidence that tax considerations could become an essential component of long-term capital structure decisions. Nevertheless, it would be difficult to state that the tax position of firms could have predictable, material impacts on debt policies. In addition, it would be hard to categorize firms by their tax status without indirectly categorizing them on other scopes, as well. Firms with large tax losses carried forward may also be experiencing financial distress with high debt ratios. Conversely, firms with vulnerable incomes and high operating profits may have growth opportunities and valuable intangible assets. The negative relationship between Leverage and effective tax rate regime indicate that firms would employ simpler mechanisms. It is worth noting that results indicated that when firms use their fixed assets as collateral for debt financing, the extent to which the firm would seek for long-term financing would increase. The contrary would be true for inventory aspects. They also reported a positive relationship between average Leverage ratio and asset structures of firms. Although their results showed a positive relationship between total debt and asset structures, long-term debt ratios and short-term debts, Jordan et al. (1998, pp. 11-27) reported a negative effects of asset structures on short-term debt ratios with positive impacts on long-term debt ratios. In addition, their results indicated that firms with higher operating financial risks would tend to use more long term and short-term debts. Bradley et al., in 1984, performed a research to determine the risks and effects of bankruptcy associated with Leverage and capital structures (pp. 867-873). Levels of financial distress would be used to establish the relationship between Leverage and risks associated with capital structures. Their outcomes indicated an observable positive relationship between Leverage and associated risks. This, however, contradicted their hypothesis and consequently counteractive. Several researchers have theorized that costs of bankruptcy would be high; thus, leading to a negative relationship between Leverage and risks associated with capital structures. However, research outcomes indicate that bankruptcy costs would be relatively smaller for small firms as compared to that of large firms. Earlier researches indicated that bankruptcy costs would not be significant to make certain a negative relationship between capital structure risks and Leverage. Van der Wijst and Thurik (1993, pp. 55-57) carried out a research on the determinants of profit levels on the capital structures of firms and the associated relationship to profitability. Their methodology employed the use of regression coefficients to determine the financial abilities and associated borrowing levels by firms. From their research, there exists a negative relationship between profitability and Leverage. Hence, firms would select financial sources that minimize ownership boundaries in the presence of asymmetric information. This finding represents the preference by business owners to external financing over internal financing. This occurs because of their tendency to use retained profits while incurring debts only when additional financing would be essential. It would be a good practice to make use of initially generated internal funds, since firms that make use of external funds would be those with lower profit levels. Firms with high profit levels would have additional internal funds available, thus, they would incur less financial borrowing. The negative relationship between Leverage and profitability of firms could also be seen from their research study. Additionally, the results also indicated that the maturity arrangement of debts by firms would be affected by profitability, thereby, providing proof for the preference of short term financing over the long term financing in businesses. The impacts of profitability could be higher on the long-term debt ratios. It would be worth to note that, when internal profits become more available, internal capital structures and equity would then replace long-term financing. There also exists a negative relationship between Leverage and age. Older firms make more financial operations and profits from the use of accumulated internal sources as compared to young firms financed externally due to presenting higher average Leverage ratios (Van der Wijst and Thurik, 1993, pp. 59-61). A positive coefficient of adjustable net debtors suggests that firms experiencing late payments tend to increase both long term and short term financial borrowing. These firms would pay compensation for their inability to alleviate customer’s late payments by delaying payments to creditors. The results also indicated that debtors would be primarily financed with short term instead of long-term finance. Regression coefficients for the total assets would be observed for the existence of scales effect in the Leverage ratios of firms. The larger the firm the higher the Leverage ratio it would be able to attain and maintain, unlike smaller firms experiencing higher financial barriers. When considering long term and short-term financing, the Leverage ratios for small firms would be lowered because of significantly lower percentage of long-term financing and short term high debt ratios. Therefore, there exists an inverse relationship between the effects of firm size on long term and short-term debt ratios, indicative of size as having influence in relation to the overall level, as well as the maturity structure of debt (Van der Wijsk, 1993, pp. 61-65). A research study performed by Lowe et al. in 1991 (pp. 175-179) looked forward to discover the influence that the size of firms would have on their capital structures and leverage given a long-term debt ratio. Their approach utilized the observation of market trends on the behavior of debt ratios incurred by firms during the recession and the related industrial impacts. It could be concluded that as firms become larger, increases in the long term financing would be proportionately larger than the increases in the short-term financing. It could be argued that differences in financial aspects may be reflective of higher transaction costs, which small firms encounter whenever they incur long-term debts. Consequently, these firms would have to depend more heavily on lower total debt ratios and short term financing than larger firms. Moreover, industries have a significant impact on the maturity of capital structure as well as the total level of debt of small firms. The difference between the extent of industrial impact on long and short-term debts varies from one industry to another. Although industrial impact would be higher on short-term debt ratios as compared to long term debt ratios, this would be true for the retail trade, wholesale, and construction industries (Lowe et al., 1991, pp. 180-186). On the other hand, there would be a repetitive positive relationship between economic growth and the time coefficient values of long-term debt. This would suggest that the ability of small firms to elevate higher levels of long-term debts would be representative of the presence of better economic conditions in the marketplace. Hence, time has an impact both on the general level of debt as well as on the maturity structure of small firms. In fact, the impact of time would be much strong on short-term debt ratios when compared to long-term debt ratios. This situation would be occurring during the recession period. The impact of time on short-term debt may be fifty times stronger than the time impact on long-term debts during recession. Small firms appear to be depending more on long-term debts and less on short-term debts leading to a more rapid growth of the economy and likewise. During economic recessions, the requirement of working capital may increase as the levels of stock would be increasing, and payments from customers would be delayed further. In the event of this situation, small firms would have to incur short-term debts in order to finance possible shortages reflected on cash flows. However, most valuable investments that would require long-term financing may be cancelled or delayed. This would cause long-term debt ratios to move downwards. On the other hand, retained profits would begin accumulating when the economy regains growth levels. There would be a payoff for the high levels of short-term debts raised during the recession. New investments would be initiated under such circumstances, and this may lead to increases of long term debt ratios (Lowe et al., 1991, pp.186-190). Comparison of results According to Lowe et al., the average short-term debt ratio of small firms would increase during economic recession periods. However, this would decrease with improving economic conditions of the industrial market. Hence, the borrowing needs by small firms vary with changes in the economic conditions of the industry. On the other hand, the findings made by Chittenden et al. established that the coefficient of depreciation charges were insignificantly not the same from zero for neither short-term debt nor total debt. However, a negative relationship between Leverage and risks associated with capital structures resulted from the study by Bradley et al. Their research outcomes indicate that bankruptcy costs would be relatively smaller for small firms as compared to that of large firms. Similarly, Jordan et al. established a negative relationship between Leverage and effective tax rate regime indicates that firms would employ simpler mechanisms. In addition, their results indicated that firms with higher operating financial risks would tend to use more long term and short-term debts. Van der Wijst and Thurik noted that the larger the firm the higher the Leverage ratio it would be able to attain and maintain, unlike smaller firms experiencing higher financial barriers. In their view, there exists an inverse relationship between the effects of firm size on long term and short-term debt ratios, indicative of size as having influence in relation to the overall level, as well as the maturity structure of debt. Summary This paper has utilized and empirically looked at the implications of the capital structure theory of firms by providing proof on the significance, direction, and magnitude of regression coefficients of the different determining factors of capital structures, across industries and time. The essential conclusions, made from the empirical application of the theory of capital structure on firms, suggest that asymmetric information and agency costs have an impact on the level of both the short-term and long-term debts of small firms. The existence of higher costs on information asymmetry and agencies implies that small firms with lower ratios of collateral assets have lower levels of external debt financing. The outcomes of this research study also indicate that tax impacts do not have influence on the total debt situation of small firms. The specific industrial impacts and time determine the maturity capital structure, as well as the total debt level raised up by small firms. Financers and policy makers need to recognize that, requirements governing borrowing by small firms would not be stable across industries and over time. Government policies that would target lending policies, as well as small firms would vary across industries and over time, to adopt the ever-changing borrowing needs of small firms. Evidence also reveals that small firms tend to utilize retained profits first but incur debts only when additional financing would be essential. Therefore, policy makers have the challenge of providing suitable environments in which small firm owners could be able to retain sufficient profits adequate for funding the highest possible number of economically viable business projects. The use of fiscal policies such as tax allowances would encourage investments in growth related strategies as well as provide motivation for retaining profits. It would be more appropriate for governments to undertake fiscal policies that would encourage business owners to expand their enterprises. They, however, discourage the use of tax cuts that would speed up consumer spending. The outcomes of this study reveal that, any cross-sectional investigation of the determinants of capital structure would only get hold of a section of the whole representation. Hence, this calls for further research that would examine the determinants of capital structure in small firms given a long run period with various economic phases. References Bradley, M., Jarrel, G., & Kim, E. H. (1984). On the Existence of an Optimal Capital Structure: Theory and Evidence. Journal of Finance, 39(3), pp. 857–880. Retrieved from: http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1984.tb03680.x/abstract Chittenden, F., Hall, G., & Hutchinson, P. (1996a). Small Firm Growth, Access to CapitalMarkets and Financial Structure: Review of Issues and an Empirical Investigation. SmallBusiness Economics, 8(1), pp. 59–67. Retrieved from:http://www.springerlink.com/content/n58181g070873k70/fulltext.pdf Jordan, J., Lowe, J., and Taylor, P. (1998). Strategy and Financial Policy in U.K. Small Firms.Journal of Business Finance and Accounting, 25(1), pp. 1–27. Retrieved from:http://onlinelibrary.wiley.com/doi/10.1111/1468-5957.00176/abstract Lowe, J., Tibbits, G. E., & McKenna, J. (1991). ‘Small Firm Growth and Failure: Public PolicyIssues and Practical Problems’ in Renfrew, K. M. and R. C. McCosker (eds.). TheGrowing Small Business. Proceedings of Fifth National Small Business Conference, pp. 175–190. Retrieved from: http://onlinelibrary.wiley.com/doi/10.1111/j.1759-3441.1991.tb00858.x/abstract Van der Wijst, N., & Thurik, R. (1993). Determinants of Small Firm Debt Ratios: An Analysisof Retail Panel Data. Small Business Economics, 5, pp. 55–65. Retrieved from: http://www.springerlink.com/content/p2605705662wk276/fulltext.pdf Read More