Small Business Finance - Literature review Example

Running header: Small business finance Student’s name: Instructor’s name: Subject code: Date of submission: Capital structure theories Background Contrary to Modigliani-miller theorem that haw a firm is financed is irrelevant to its value in a perfect market, a firm’s capital structure has a lot to do with its value. In other words, the capital structure adopted by a firm will greatly affect its value. This is because a capital structure may determine the level of bankruptcy and agency costs the firm is exposed to as well as tax savings the firm may obtain. Thus a firm’s capital structure will greatly depend on the firm’s characteristics and the need to ensure that the structure exposes the firm to minimum risks. Some of the firm’s characteristics that determine its capital structure include its profitability, tangibility and its growth prospects. The firm’s financial lifecycle has also been cited as a determining factor to a firm’s capital structure. This paper uses study’s by Cassar and Holmes (2003), La Rocca and Cariola (2011) and Qui and La (2010) in investigating the various capital structure theories and the factors that guide small businesses in determining the nature of their capital structure. In addition, their contribution to the understanding of the capital structure theory is also analysed. Cassar and Holmes (2003) 1. In their study, Cassar and Holmes have explored the following theories; i) Trade off theory – according to Cassar and Holmes, businesses must bear in mind the level of bankruptcy costs and agency costs they are willing to be exposed to and compare the costs with the tax savings that they are likely to realise as a result of interest payments on any debts they assume (Johansen, 2005). This means that the capital structure adopted by the firm will be based on the trade off between the above costs and the potential tax savings the firm would realise from using debts. ii) Pecking order theory –Cassar and Holmes are of the view that firms follow a specific order in satisfying their various financial needs. According to them, the information asymmetries that exist between the firm and potential financiers make finance costs to vary among alternative finance sources. As such, firms find it necessary to first make use of the cheaper sources of finance which are mostly internal before gradually advancing to external financing sources of debt and external equity respectively. The balance between the alternative sources will hence determine the firm’s capital structure. iii) La Rocca, La Rocca and Cariola (2011) In their study, La Rocca and Cariola have focused on the following capital structure theories; i) Pecking order theory –according to La Rocca and Cariola, firms adapt a certain order in satisfying their financial needs which is largely dependent on the cost of financing information and the related transaction costs. Thus, firms will utilize internal sources of finance (retained earnings) first before looking for alternative external financing of debt and equity respectively (Cheng and Shiu, 2007). According to them, the order followed will also depend on where the firm is in its financial lifecycle. ii) Financial lifecycle- the capital structure of a firm at a particular time is dependent on where the firm is in its financial lifecycle. In this regard, small/young firms will find it easier to first utilize outside capital first due to asymmetric information problems. As firms mature and become profitable, they will gradually replace the outside funds with retained earnings while debt financing will their last option in meeting the succeeding financial requirements. iii) Reputation effect – Small or young firms lack precedent experience and a track record which financiers may require in making their financing decisions. This means that young firms have little debt capacity implying that firms are only able to use debt in their maturity stages when they have reputation and have gathered experience. iii) Qiu and La (2010) In their study, Qui and La examine the following capital structure theories; i) Signaling and Pecking order theory- according to Qiu and La investors bear in mind a firm’s managerial view regarding existing security prices and prospect of issuing new debt or equity stocks in making their investment decisions. For instance, there may be a negative reaction from investors on new security issues since they know that firms time their equity issues when their current stocks are overvalued. Contrally, a firm’s management may prefer new debt to equity when they know the firm has a bright future and thus they may want to structure their financing in such a way that the potential investors will be unable to share in the growth of the firm. This being the case, the market/potential investors will interpret a new equity issue to be a worse sign than a debt issue (David, 2010). It is based on this signaling effects and the associated cost of financing that firms should follow a pecking order in financing by adopting the route of least resistance. The firm should thus first take advantage of internal financing before seeking external financing and this will eventually determine the firm’s capital structure. ii) Trade off theory-Debt financing is associated with potential tax savings on interest payments and as such, debt financing may be preferred by firms according to Qiu and La. On the contrally, high levels of debt increases bankruptcy risks and hence there should be a trade off between the potential tax savings and the associated bankruptcy and agency costs in determining the firm’s capital structure (Garry, 2001). Large and profitable firms with many tangible assets should therefore adopt debt financing in a bid to lower their tax obligation owing to their lower bankruptcy cost per share unlike small and young firms who mainly possess intangible assets. 2. Sample data i) Cassar and Holmes (2003) The study sample included 1,155 SME’s. They were selected from 13,000 business units selected from Australian Bureau of Statistics (ABS) whose scope included all business units in the Australian economy (Cassar and Holmes, 2003). The selection criteria included provision of information on the debt-equity composition of their balance sheets from 1994-98 as well as requirement to have positive sales during these years. Firms lacking all the required statistics for the multivariate analysis were excluded from the study. The firms also had to have assets ranging from $500-$25,000,000. The analysis did not include mining firms (ANZSIC code 1). The sample only included SME’s financed independently thus excluding all firms externally financed. In addition, any firm with over 100 percent leverage was excluded from the study. ii) La Rocca, La Rocca and Cariola (2011) The sample used in the study complied with EU definition of SME’s and hence data was got from businesses with fewer than 250 workers and cumulative sales of between 2 and 40 million Euros (La Rocca, La Rocca and Cariola, 2011). The study period was between 1996 and 2005.The sample comprised of 10,242 Italian non-financial SMEs not involved in bankruptcy process. The sample included on the firms with all essential variables whose records for at least five years were available. These variables were based on book values. iii) Qui and La (2010) All firms used in the study are constituent of the Australian Stock Exchange All Ordinary Index (ASXAORD) except banks, insurance firms and financial institutions. The sample incorporated 65 SMEs in 1992 and 412 SMEs in 2006. The data collected from the samples included ended year data on book values of all interest bearing debt, preference stock, property, plant and equipment, common equity, market value of equity capitalization and profits before interest and tax (Qui and La, 2010). The time series of total return index for common stock of each sampled firm and for ASXAORD stock index on a daily basis were also obtained. 3. Findings for Capital structure i) Cassar and Holmes (2003) The results of this study lead to a conclusion that asset structure, profitability and growth greatly influence SMEs financing and hence their capital structure. In addition, size and risk also influence SMEs financing and capital structure choices though to a small extent. This is in line with capital structure theories including the pecking order theory which rely on agency, bankruptcy and tax costs and pecking order theory which depend on information asymmetries. ii) La Rocca, La Rocca and Cariola (2011 This study has concluded that financial lifecycle of a firm has a role to play in its capital structure. According to the pecking order theory, the degree of informational opacity greatly determines the firm’s financing behavior especially with regard to the various stages of its lifecycle. Higher profitability and mature firms are less reliant on debt while young firms are more dependent on debt. Startups and young businesses have been found to rely on debt to sustain their operations regardless of their location or industrial affiliation. However, but as they mature, they balance their capital structure by replacing debt with internal capital. This informs the conclusion that a firm’s financial lifecycle is vital in determining its capital structure. iii) Qui and La (2010) This study concludes that a firm’s debt ratio increase with asset tangibility while it diminishes with the firm’s profitability, prospects of growth and business risk measured by unlevered beta of equity. It has been found that unlevered SMEs have low levels of tangible assets though with better growth prospects compared to levered firms (Fluck, 2000). In addition, unlevered firms have been found to be less profitable indicating that unprofitable SMEs are more worried of financial distress costs with profitable firms being more worried of agency costs in determining their capital structures. The study also concludes that the firm’s size does not have a momentous impact on a firm’s preference of debt ratio. In addition, bankruptcy costs, issuance costs of new securities and signaling effects greatly influence a firm’s choice for its capital structure. This is in conformity with the trade off theory and the pecking order theory of capital structure. 4. Contribution to understanding i) Cassar and Holmes (2003) The study adds to understanding on capital structure in that it introduces the need to distinguish between long-forms and short-forms of debt when studying capital structure choices. The study finds that long-term debt structure is positively linked to long-term asset structure. In addition, the study also explains how financing by banks vary from other external financing with banks being found to over-emphasis on the firm’s asset structure and mainly issuing debt to low risk and lower growth firms. This also contributes to further understanding on factors that influence a firm’s capital structure. ii) La Rocca, La Rocca and Cariola (2011) The study by La Rocca and Cariola contribute to the understanding on capital structures in that it successfully proves that lifecycle is a pertinent factor in a SMEs financing behavior. The study also further recommends for further research that should center on the connection between investment horizons and institutional aspects which should further contribute to the knowledge on capital structure. iii) Qui and La (2010) The study by Qui and La contributes to understanding on capital structure in a number of ways. The study uses unlevered beta of equity to proxy for business risk. This leads to the finding that a stockholder’s primary concern on risk is the systematic risk of equity which they can’t avoid through diversifying. In addition, the study shows that tax savings of debt financing is a secondary concern to signaling effects and agency costs in a tax imputation environment. 5. Comparison of results The three papers although investigating different aspects of capital structure have largely arrived at the same results. The papers agree that firms follow a certain order in making their financing decisions in compliance with the pecking order theory. The decision to follow this order is greatly influenced by information asymmetries between firms and potential investors. As such, the papers agree that the Oder followed by firms in determining their capital structure would involve the firm first utilizing the less costly and readily available sources of finance before advancing to the more costly sources of finance. However, the papers differ in the order of financing that firms adopt. While Qui and La as well as Cassar and Holmes seem to agree that small firms would prefer to use internal sources of finance first before going for external sources of debt and external equity, La Rocca and Cariola are of a different view as they see young firms prioritizing debt financing to other sources of finance and rebalancing their capital structure as they grow with retained earnings and external capital (William, 2005). Cassar and Holmes also agree that bankruptcy costs and tax savings greatly influence the firm’s decisions regarding its capital structure. Qiu and La however differs with this. This complies with the trade off theory of capital structure. La Rocca and Cariola on the other hand find that the firm’s financial lifecycle is a vital factor in determining the firm’s capital structure. In conclusion, despite their different findings, the three papers agree that asset structure (tangibility), profitability and growth greatly influence a firm’s capital structure with risk, and size being minor factors. 6. Capital structure conclusion The above studies have led to very important conclusions regarding capital structure. It has been established that firms are concerned about bankruptcy and agency costs and tax savings that result from acquiring debts. The desire to strike a balance between these costs and savings and the need for firm owners to regain control of their firms is what determines the composition of a firm’s capital structure. In addition, based on the signaling effects and pecking order theory, firms have been found to follow a specific order I n meeting their financial obligations where they make use of less costly finance sources first before advancing to more costly sources (Shafie, 2008). All in all, tangibility, profitability and growth prospects are some of the factors that firm’s consider in deciding how to finance their operations. The firm’s financial lifecycle has also been established as a significant factor in determination of a firm’s capital structure since young firms may not have access to information regarding finance and may also not have generated enough profits to fund their operations. However, the kind of funding a firm will adopt regardless of whether it is young or old will depend on fund availability and the cost of acquiring finance. References: Cassar, G. & Holmes, S. (2003). ‘Capital structure and financing of SMEs: Australian evidence’. Accounting and Finance, 43, pp. 123-147 La Rocca, M., La Rocca, T. & Cariola, A. (2011) ‘Capital structure decisions during a firm’s life cycle’. Small Business Economics, 37, pp. 107-130 Qui, M. & La, B. (2010) ‘Firm characteristics as determinants of capital structures in Australia’. International Journal of the Economics of Business, 17(3), pp. 277- 287 Garry, T. (2001) Capital structure and taxes: Evidence from the Australian dividend imputation tax system. International review of finance, 2, pp. 217-234. Johansen, B. (2005). The determinants of capital structure: An international perspective, Oxford University Press. Cheng, S., & Shiu, C. (2007). Investor protection and capital structure: International evidence, Journal of Multinational Financial Management, 17(1), 30-44. David, B. (2010). Financing the small enterprise. London, Rutledge. William, G. (2005). Comparing the tradeoff and the pecking order theories of capital structure. Journal of finance. 105, 92-95. Shafie, D. (2008). Theories of capital structure. John Willey & Sons: Brisbane. Fluck, Z. (2000). Capital structure decisions in small and large firms: A life time cycle theory of financing. Working paper. New York: Stem School of Business. Read More