Impact of The Financial Crisis of The Late 2000s on the Capital Structure Decisions of Companies - Essay Example

The Impact of The Financial Crisis of The Late 2000’s on the Capital Structure Decisions of Companies in Light of Capital Structure Theories Introduction The financial crisis of the late 2000s is said to have begun in the U.S. before diffusing to Europe and to the rest of the world (Aubuchon and Wheelock 2009, p.2). The crisis did have a lot of negative impacts on all sectors of the economies particularly financial institutions and markets. However, its immediate effects were felt on the financial markets, which were greatly disrupted, in addition to reducing the debt and equity capital that were being used to finance business and finally creating recession in the U.S. and Europe such as the U.K. and Greece. Fosberg (2010, p.2) notes that the crisis began due to default on debt instruments and subprime mortgage loans supported by those loan types. However, it was not until 2007 that companies began realizing that the default on subprime mortgages was likely to cause a crisis on the financial sectors of the economy. This follows the discovery by Bear Stearns that realized that some of its assets, which were held by the subprime hedge funds, were slowly becoming valueless (Mizen 2008, p.15). However, the devastating effect of the subprime mortgage defaults on other markets were felt a year later in February 2008 following the subsidence of the auction rate security market. Fosberg (2010, p.2) notes that buyers failure to bid for the securities during a public auction resulted in an end to these securities market. However, the first major financial market collapses in March 2008 following the liquidation of Bear Stearns after going bankrupt. In the same year in September, another financial institution called Lehman Brothers also went bankrupt signaling a crisis. This prompted government intervention with the aim of forestalling further effects of the financial crisis on the financial market, which resulted in the passage of TARP Act (Fosberg 2010, p.2). The act soon became law in October 2008 as noted by Mizen (2008, p.15). However, the law did not help much in preventing the crisis from continuing biting the financial markets and institutions. In fact, many countries still suffer from the effects of this crisis which no sign of full recovery anytime soon. Some of the countries still suffering from the effects of this crisis include the U.K., the U.S. Greece and Turkey just to name but a few (Brigham and Ehrhardt 2002, p.12). In addition, the financial crisis also affected the issuance of securities in the market. What was also evident is that the financial crisis of the 2000s created a recession, which financial management experts expect to have also affected the capital structure of firms (Mizen 2008, p.16). This is because firms that suffered from the recession were forced to adjust to issues such as the decline in profitability, which makes identification of the capital attributable to such effect possible. The purpose of this paper is to analyze the extent to which the financial crisis of the late 2000’s affected the capital structure decisions of companies. The analysis will be carried out with the help of capital structure theories such as the pecking order and static trade off theories. Literature Review Brigham and Ehrhardt (2002, p.16) note that the capital structure is a very crucial tool that can be used by businesses for maintaining control of a business of losing it all together. They also found out that the capital structure of a firm is also related to the bankruptcy risks faced by suppliers of a firm as a result of proportion of the capital given by firm stakeholders. This makes it easy for equity holders to increase their returns by increasing their leverage. Nevertheless, the opposite may result if things go wrong as during financial crises like that experienced in the 2000s as noted by Brigham and Ehrhardt (2002, p.16). This clearly shows how important the capital structure instrument is, therefore, should be taken into consideration when making firm policies. However, several attempts have been made in the past trying to explain a firm’s capital structure choice. The first attempt was made by Modigliani and Miller (1958, p.3) stating that a firm’s market value is independent of its capital structure in the absence of transaction costs, taxes and bankruptcy costs. The two then introduced taxes (Modigliani and Miller 1965) where they demonstrated that the value of a firm and its leverage level has a positive correlation. It was then that Miller looked at the impacts of both personal and corporate taxes to demonstrate that, in spite of tax deductibility, the value and structure of a firm are independent of each other (Miller 1977). This pronouncement by Modigliani and Miller (1977) prompted more researchers to go deep into the mater leading to the advancement of a number of theories in an attempt to explain a firm’s capital structure choices. The theories include pecking order theory, static-trade off theory, asymmetric signaling theory and agency theory. The static trade-off theory is a theory advanced by Kraus and Litzenberger (1973) that predicts that large and profitable companies have a high likelihood of taking debts to finance their operations with a lower likelihood of going bankrupt because of their strong financial base. At the same time, the trade-off theory suggests that such companies command lower interest rate due to their large collateral scale. In addition, the trade of theory hypothesizes that the value of a firm is maximized by selecting the optimal debt to equity ratio (Fama and French 2002, p.23). This theory suggests that, as the leverage level of a firm increases, a trade-off occurs through tax deduction benefits on the paid interests and accessing additional capital without necessarily diluting shareholders base. The financial distress cost here includes the agency and bankruptcy costs. Despite the fact that this theory can be used to explain the capital structure choices of a firm, Myers (1984, p.45) found it to be irrelevant in this regard compared to other theories such as the pecking order theory. The pecking order theory, on the other hand, is a theory that maintains that businesses have financial choice preferences according to the information asymmetries between the potential financiers and the business. This is to imply that there are no optimal debt levels. In this regard, the pecking order theory hypothesizes that financing using retained earnings is the most preferred by firms followed by debts, with equity financing coming last according to Myers (1984, p.46). From the hypothesis, Myers (1984, p.46) concluded that many firms prefer using international financing to external financing. However, in situations where external financing is necessary, firms will have a preference for debts to equity. As a result, evidence has showed that firms tend to use the pecking order in making their financial decisions. The agency theory has also been found to be relevant in explaining the capital structure decisions of firms. The agency theory is the theory that view debt as a tool used in reducing antagonism between debtors and shareholders. This is based on the fact that evidence has shown that agency cost can be reduced by debt financing by controlling the free cash flow accessible to managers as noted by Jensen (1986, p.66). This enables managers to focus more on debt clearance. However, under riskier ventures, Jensen (1986, p.66) noted that higher prices might be charged by debtors thereby limiting managers’ free cash flow spending for discretionary spending. Asymmetric information problem also exists where firms can limit scrutiny from outside stakeholders using internal funds. As a result, the market timing theory developed by Baker and Wurgler (2002) claims that capital ration does not exist. Instead, firms will give preferences to misplaced capital. Under this theory, a firm would be expected to make an offer when the prices of their shares are extremely overvalue so as to minimize cost of equity and prevent having negative impacts on already existing shareholders according to Kraus and Litzenberger (1973, p.86). In an attempt to determine the capital structure of a firm, Bradley, Jarrell and Kim (1984, p.857) noted that the industry in which the firm belongs to have a huge impact on some debt rations. This observation has been supported by Geltner and Miller (2001) who concluded that big companies with strong financial bases are highly geared than non-property related firms. On the same note, Myers (1984, p.45) also found out that the net tax gain to corporate debtors is negative at the point where the marginal tax rate is zero. Such scenarios were evident during the analysis of the determinants of the Australian Real Estate Investment Trusts (A-REITs) capital structure for the period 2006-2009, when the company was experiencing the effects of the financial crisis. Findings showed that externally managed Real Estate Investment Trusts have a higher debt ration because external managers are normally compensated in accordance with the size of the assets under their control. Zarebski and Dimovski (2010, p.5) noted that this enables the external managers to prepare adequately to maximize their salaries as the internal managers tend to focus more on increasing interest expenses. Zarebski and Dimovski (2010, p.8) also discovered that non tax shield, growth opportunities, share price and liquidity performances all have a negative impact on leverage whereas the size of a firm have a positive effect, which supports predictions put forwards by a number of capital structure theories. Deesomsak, Paudyal and Pescetto. (2004, p.7) noted that managers have a tendency of making varying decisions regarding the capital structure internationally because of the considerations differences in different countries. This was witnesses during the 2000s financial crisis on the Asian markets in which Deesomsak, Paudyal and Pescetto. (2004, p.7) realized that the explanatory variable impacts were changed by the Asian financial crisis. Giambona, Harding and Sirmans (2008, p.111) noted during a study that Real Estate Investment Trusts possessing high market values have a relatively lower debt ratio, therefore, tend to use shorter maturity debts to evade underinvestment. Morri and Berretta (2008, p.68) later on supported the pecking order theory when he found out that more profitable companies, highly risky companies, and those experiencing low growth opportunities tend to avoid using debt financing. Impacts of the 2000s financial crisis on capital structure decision-making. The financial crisis of 2000s had its origin in the United States before spreading to Europe then to the entire world. The crisis is reported to have adversely affected the capital market of the countries which were affected by the crisis such as the U.K., which still continue to suffer from the effects of the crisis to date according to Bradley, Jarrell and Kim (1984, p.859). For instance, the crisis is said to have caused a fall stock market by over 30% in some of the European countries like the U.K. and Greece (Morri and Berretta 2008, p.68). The fact that the crisis happened suddenly caught many investors unaware affecting them adversely, as well. As a result of this crisis, the European capital markets underwent significant outflow of international investments with government responding to the crisis in different ways (Deesomsak, Paudyal and Pescetto. 2004, p.9). This is because the crisis made sourcing funds difficult within the countries that were adversely affected by the crisis due to the fact that interest rates were raised and since investors are risk averse, they consequently expected protection from the government (Giambona, Harding, and Sirmans 2008, p.112). This forced some countries like Greece to seek a bail out from European countries to help it meet its obligations. However, it is noted that the financial crisis did affect the process of capital structure decision, which means that an overall changer of the economic environment has the potential of altering the determinants of a company’s decisions (Bradley, Jarrell and Kim (1984, p.859). The determinants of capital structures that were affected by the financial crisis include the size of a firm, liquidity, non-debt tax shield, earnings volatility, assets tangibility, and the performance of share prices. In this regard, Morri and Beretta (2008, p.16) note that determinants such as liquidity, non-tax shield and size of the firm are significant during the post-crisis period. On the other hand, they found out that other determinants such as earning volatility, assets tangibility, and performance of share prices are affected directly by the crisis. In overall, the 2000s financial crisis influenced significantly the role of firm size on a firm’s capital structure decisions. Morri and Beretta (2008, p.16) noted that prior to the crisis, the firm size role was not significant to for many countries such as the U.K., the U.S. and Greece, but only became significant after the crisis. This is a clear indication that firms only became bothered about their bankruptcies risks and survival after the crisis. It is also possible to conclude that the crisis prompted lenders to be more risk averse by inclining to lending to large firms only as a precaution for default (Giambona, Harding and Sirmans 2008, p.113). In this regard, lenders avoided lending money to small firms because they become riskier due to the fact that they could default easily in the event of the crisis. However, contrary to this, growth opportunity appears to differ from one country to the next. In this regard, a study conducted by Fama and French 2002 p.16) in Thailand and Malaysia, after the crisis noted that the growth opportunity became insignificant after the financial meltdown to Thai firms, but remained significant for Malaysian firms. They attribute the difference to the fact that Malaysian economy recovered very fast from the crisis in comparison to Thai economy. The faster recovery by the Malaysian economy enabled its firms to borrow less soon after the crisis, which is in accordance with the predictions of the agency theory. Regarding non-debt tax shield as a determinant of processes of capital structure decision, it was noted that this determinant is insignificant to firms before a crisis and become significant only after a crisis (Fama and French 2002 p.19). This is attributed to the fact that the crisis normally increases bankruptcy risks and cost of borrowing, thereby forcing firms to look for an alternative means of reducing tax. This makes the non-debt tax shield relevant to capital structure decisions. In addition, findings show that the coefficient of liquidity increases after the 2000s financial crisis in most firms that were affected, which also shows its significance to the capital structure decisions according to Deesomsak, Paudyal and Pescetto (2004, p. 13). In overall, evidence shows that capital structure decisions are influenced by both the country and firm specific factors. At the same time, the 2000s financial meltdown appears to have had impacted differently in different countries as some were adversely affected with some only affected to a small extent. In this regard, research conducted by Fosberg (2010, p.7) discovered that a firm’s leverage has a direct relationship with firm-specific determinants. In this regard, findings showed that the financial crisis of 2000s impacted hugely on the capital structure decisions of companies in Europe and other regions at the level of both country-specific and form-specific determinants. For instance, it came out that leverage and the financial activity of the stock market (FACT) had a significant relationship and negative as hypothesized by the pecking order theory (Fama and French 2002 p.26). However, the most remarkable findings following the financial crisis suggests that many businesses were more cautious about the effects of inflation caused by the financial crisis on the firm’s cost of capital compared to immediate risk of default (Deesomsak, Paudyal and Pescetto. 2004, p.16). In addition, the dummies of a country also confirm that leverage influences country-specific factors because most coefficients are significant despite bearing different signs. Findings have also revealed many low leveraged firms almost found themselves back to pre-crisis profitability patterns soon after the 2000s crisis (Fama and French 2002 p.29). Contrary to this finding, high leverage companies have not been able to return to their pre-crisis profitability patterns as having been witnessed in the U.K. and Greece where many firms high leverage firms still continue to struggle. This has prompted many firms to consider leveraging themselves from a crisis by having a low debt ratio. This is based on the findings, which show that having a low leverage help in immunizing the firm against the economic crisis shocks as noted by Giambona, Harding and Sirmans (2008, p.116). In fact, many companies today, particularly those in countries still feeling the effects of the recent economic crisis such as the U.S., the U.K., and Greece are c considering immunizing themselves by having low leverage. Finding also reveals that high leverage companies are expected to increase their profitability during the post-crisis period by decreasing their leverage (Giambona, Harding and Sirmans 2008, p.116). This is attributed to the fact that high leveraged firms tend to incur huge losses in the post-crisis period. Therefore, to increase profitability, a high leverage firm is expected to issue equity finance, which has a close association with the firm’s corporate governance system of a country. However, (Aubuchon and Wheelock 2009 p.2) noted that firms operating without any legal protection for its minority investors are not capable of raising equity finance in the third world countries with ease. Therefore, it is also important for high leverage firms to consider having low leverage at times of a crisis since this is one of the best ways of immunizing against bad economic situations. Conclusion Indeed the recent financial crisis of the 2000s impacted so negatively on financial markets all over the world, which significantly reduced issuance of securities by companies and lending by financial institutions such as banks. In fact, several countries still suffer from the impact of the crisis such as the U.S., the U.K. and Greece. These countries have not yet recovered fully from the impacts of the crisis, which saw the economies of these countries decline to almost negative growth rate. 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