Key Factors to Be Considered by Management When Deciding upon a Particular Capital Structure - Literature review Example

THE KEY FACTORS TO BE CONSIDERED BY MANAGEMENT WHEN DECIDING UPON A PARTICULAR CAPITAL STRUCTURE by 26 June The Key Factors to Be Considered by Management When Deciding Upon a Particular Capital Structure Introduction Managers take financial decision on a day-to-day basis. Dozens of calls are made and hundreds of pages of financial reports are read, before the final capital structure decision is taken. It goes without saying that capital structure decisions are affected by a variety of internal, external, and other factors. More often than not, managers rely on the principles of financial planning and avoid sticking to any particular capital structure theory. Capital structure can be defined as “the composition or make-up of the company’s capitalization and includes all long-term capital resources, i.e., loans, reserves, shares and bonds” (Patra 2006, p.237). The importance of capital structure decisions cannot be overestimated, since firms are willing to utilize available business growth opportunities even when they lack sufficient financial resources to meet their strategic targets. What factors are the most important when considering capital structure decisions is difficult to define. The current state of literature of theoretical and empirical literature does not provide a single, comprehensive answer to the problem of capital structure decisions and the aspects, which influence them. It would be fair to assume that key aspects, which influence capital structure decisions, will vary across firms and depend on the circumstances of each particular decision. However, managers must be able to create a complete picture of internal, external, and other factors affecting every single capital structure decision. Capital structure decisions: What do managers think? Contemporary scholars are increasingly interested in the relationship between capital structure decisions and various factors affecting them. Recent studies provide a brief insight into managers’ perceptions about capital structure options and alternatives and the role of external and internal influences on their decisions. Surprisingly or not, managers in European firms rarely or never rely on definite theoretical assumptions; rather, practical financial planning considerations play crucial role in the development of solid capital structure frameworks (Bancel & Mittoo 2004). Earnings per share dilution and financial flexibility are the two most important factors of capital structure decisions among European managers (Bancel & Mittoo 2004). Hedging considerations play an important role in how managers decide to manage firms’ financial capital (Bancel & Mittoo 2004). “Financial planning principles dominate specific capital structure models in governing financial decisions for the firms” (Pinegar & Wilbricht 1989, p.87). Mean industry leverage and financial risks are considered, too (Goyal & Frank 2004). The significance of financial structure decisions and knowledge of the aspects influencing them are justified by the fact that the prevailing majority of managers (82%) are willing to depart from the existing capital structure and leverage new resources, whenever they are presented with attractive growth opportunities (Pinegar & Wilbricht 1989). That managers do not stick to one particular capital structure model is further explained by the fact that “there is actually no universal capital structure theory, and there is no reason to expect one” (Myers 2001). Obviously, managers taking capital structure decisions must take into consideration a variety of factors and influences. What exactly matters will depend upon the conditions and circumstances of each particular capital structure decision. Capital structure determinants and factors affecting capital structure decisions The determinants of capital structure decisions are numerous and varied. Collateral value of assets is believed to have defined effects on how managers manage firms’ capital. Simply stated, “capital structure decisions are heavily influenced by the type and cost of assets currently owned by firms” (Titman & Wessels 1988). Non-debt tax shields do play a role in what managers decide to do in term of leveraging capital and its structure (Titman & Wessels 1988). Growth prospects are negatively correlated with long-term levels of debt (Titman & Wessels 1988). Despite a wealth of literature on the topic, all factors affecting capital structure decisions can be roughly divided into three main categories. Internal factors include bankruptcy risks, firm size and dividend paying, profitability and net operating loss, as well as the cost of capital, control factors, and capital structure planning criteria. External factors usually cover macroeconomic conditions of firms’ performance, interest rates and lending institutions’ policies, corporate taxes, median industry rates of capital leveraging, as well as statutory restrictions. Eventually, such characteristics as firms’ organizational structure, stability, and managers’ subjective beliefs about capital structure have to be taken into consideration. Internal factors. Years of extensive research into capital structure decisions have added to the body of knowledge about the most important factors affecting these decisions in national and international firms. According to Goyal and Frank (2004), the most important internal factors of capital structure decisions include bankruptcy risks, dividend paying, and collateral value of assets, net operating losses, and profitability. Here, the costs of capital, bankruptcy risks, control factors, and capital structure planning must create a foundation for taking the most relevant capital structure decision. Leveraging capital always comes at a cost. As a result, managers taking capital structure decisions must be confident that the costs of raising capital will not exceed the revenues brought by this very capital. In terms of the cost of leveraging, equity funds are always much more expensive than borrowed ones (Barclay & Smith 1999). This is mainly because the dividend rates are usually higher than the interest rates on the borrowed capital, and because the interest rates paid to financial institutions and other borrowers are exempt from taxation, whereas dividend payments are integrally linked to profits and profit-related payments (Fama & French 1998; Green & Hollifield 2003). Bankruptcy risks exemplify an important internal factor of capital structure decisions across firms. The “interior leverage optimum is determined by a balancing of the corporate tax savings advantage of debt against the deadweight costs of bankruptcy” (Goyal & Frank 2004, p.7). However, there are also other risks to be considered. Whenever borrowed capital comes into play, managers must ensure that they (a) meet their payment commitments, and (b) pay out the total sum of the borrowed capital on time, without enforcing the sale of the firm’s assets used to secure the borrowed capital (Goyal, Lehn & Racic 2002). Again, whenever managers feel that they may not be able to meet their contractual obligations, the prospects of bankruptcy may become even more formidable. To avoid these risks, managers can apply to the benefits of equity capital, which is associated with minimum bankruptcy risks and does not require using the firm’s assets to secure the deal. However, again, the costs of the borrowed vs. equity capital vs. bankruptcy risks have to be estimated. Managers must also remember that in case equity capital is raised, stakeholders may have their control rights and influences diluted against the mass of new equity owners (Burkhart, Gromb & Panunzi 1997). As a result, whenever managers take capital structure decisions, they must ensure that (a) leveraging additional capital comes at the lowest possible cost; (b) securities issues to leverage capital are easily transferable; and (c) new securities do not affect the rights and control capabilities of the existing shareholders. These internal factors and influences need to be further weighed against external market and organizational forces. External factors. Macroeconomic conditions play a definite role in how capital structure decisions are made. It would be fair to say that macroeconomic conditions are the most important external factor affecting management decisions about capital structure. This is particularly the case of financially unconstrained firms, whose capital decision-making patterns are directly related to macroeconomic cycles (Korajczyk & Levy 2003). Macroeconomic conditions generally account for more than 70% variations in capital leverage (Korajczyk & Levy 2003). Firms that are limited in their resources are less likely to consider macroeconomic conditions and their effects on capital structure: they are driven by the need to raise additional capital by all possible means, disregarding the long-term consequences of their financial decisions (Korajczyk & Levy 2003). Macroeconomic conditions are closely related to changes in external financial performance, namely interest rates, lending institutions’ policies, and taxes. Actually, corporate taxes create a great deal of fuss around capital structure decisions across businesses and firms (Goyal & Frank 2004). Government taxation policies affect both individual and corporate incomes, and can either expand or reduce leveraging capabilities by firms (Fama & French 1998). These macroeconomic considerations are further followed by the importance of lending policies and statutory restrictions, if any. The former presuppose imposing the standards and rules of borrowing from various financial institutions. Recent financial crisis has rendered previous models of lending and borrowing ineffective. Banks and lending organizations develop new approaches and models of financial cooperation with firms. Scarcity of liquid financial resources in economy makes it particularly difficult for firms to meet their capital needs. Yet, the harsher the rules of lending the less likely firms will be to go into the lending/ borrowing agreement. Again, lending policies are closely linked to the perceived risks of bankruptcy and probability that the firm will fail to meet its financial obligations on time (Goyal, Lehn & Racic 2002). Whenever businesses feel that the terms and conditions of lending burden them, using equity capital should become a preferable option. The relevance and importance of macroeconomic conditions also depends upon whether or not the firm can survive with available capital resources: at times, in the most difficult situations, firms will tend to disregard broader macroeconomic influences for the sake of continuity of business operations. Other factors. Other factors like organizational structure and managers’ attitudes to different capital structure decisions also play an important role in how firms manage their capitals. Berger, Ofek and Yermack (1997) found that managerial entrenchment was directly associated with capital structure decisions. Leverage levels appear to be positively related to CEO stock option holdings and stock ownership (Berger, Ofek & Yermack 1997; Scheifer & Vishny 1989). CEO tenure, the size of the board of directors, and leverage levels are negatively related (Berger, Ofek & Yermack 1997; Jensen & Meckling 1976). Simply stated, the bigger the board of directors the less likely the firm to take a pro-leveraging capital decision. The constitution of the company is an important capital structure consideration: public limited companies may find it particularly difficult to leverage additional equity capital, since it will inevitably lead to the subsequent dissolution of equity rights among the existing shareholders (Wald 1999). Company characteristics and stability of organizational performance are the two essential factors to be considered, whenever capital structure decisions are being taken. The size and reputation of the firm greatly affect it capital structure (Wald 1999). Large companies with established reputation have better opportunities to bargain in the financial market and leverage borrowed capital on terms and conditions that are acceptable and reasonable (Wald 1999). Smaller companies are more likely to focus on equity capital, since they may not have enough credit and stability in the market to tap into lending agreements with financial institutions and banks (Wald 1999). Furthermore, firms that expect their sales and revenues to be relatively stable over time will rather leverage borrowed capital, instead of dealing with the complexities of equity capital planning. Which of these factors are the most important depends on the situation. There are no universal capital structure theories, and there are no universal factors affecting capital structure decisions. What factors to consider each manager decides for themselves. At some point, borrowing conditions and dissolution of shareholder control may become the most important capital structure consideration. Some other time, macroeconomic conditions may serve the determining factor affecting capital structure decisions. The future research must focus on the development of a unified capital structure decision framework, which will help managers to define the most relevant and irrelevant factors of capital structure decisions in various situations. Conclusion Managers take financial decision on a daily basis. The importance of capital structure decisions cannot be overestimated, since firms are willing to utilize available business growth opportunities even when they lack sufficient financial resources to meet their strategic targets. Key factors affecting capital structure decisions will vary across firms and change, depending upon the circumstances of each particular decision. The future research must focus on the development of a unified capital structure decision framework, which will help managers to define the most relevant and irrelevant factors of capital structure decisions in various situations. References Bancel, F & Mittoo, UR 2004, ‘Cross-country determinants of capital structure choice: A survey of European firms’, Financial Management, vol.33, no.4, pp.103-132. Barclay, M & Smith, CW 1999, ‘The capital structure puzzle: Another look at the evidence’, Journal of Applied Corporate Finance, vol.12, pp.8-20. Berger, PG, Ofek, E & Yermack, DL 1997, ‘Managerial entrenchment and capital structure decisions’, The Journal of Finance, vol.52, no.4, pp.1411-1438. Burkhart, M, Gromb, D & Panunzi, F 1997, ‘Large stakeholders, monitoring and the value of the firm’, Quarterly Journal of Economics, vol.112, pp.693-728. Fama, EF & French, KR 1998, ‘Taxes, financing decisions, and firm value’, Journal of Finance, vol.53, no.3, pp.819-43. Green, RC & Hollifield, B 2003, ‘The personal tax-advantages of equity’, Journal of Financial Economics, vol.67, pp.175-216. Goyal, V, Lehn, K & Racic, S 2002, ‘Growth opportunities and corporate debt policy: The case of the U.S. defense industry’, Journal of Financial Economics, vol.64, pp.35-59. Goyal, V & Frank, MZ 2004, ‘Capital structure decisions: Which factors are reliably important?’, Financial Management, vol.38, pp.1-37. Jensen, MC & Meckling, WH 1976, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economies, vol.3, pp.305-360. Korajczyk, RA & Levy, A 2003, ‘Capital structure choice: Macroeconomic conditions and financial constraints’, Journal of Financial Economics, vol.68, no.1, pp.75-109. Myers, SC 2001 ‘Capital structure’, The Journal of Economic Perspectives, vol.15, no.2, pp.81-102. Pinegar, JM & Wilbricht, L 1989, ‘What managers think of capital structure theory: A survey’, Financial Management, vol.18, no.4, pp.82-91. Shleifer, A & Vishny, RW 1989, ‘Management entrenchment: The case of manager-specific investments’, Journal of Financial Economics, vol.25, pp.123-139. Titman, S & Wessels, R 1988, ‘The determinants of capital structure choice’, The Journal of Finance, vol.43, no.1, pp.1-19. Wald, JK 1999, ‘How firm characteristics affect capital structure: An international comparison’, Journal of Financial Research, vol.22, no.2, pp.161-87. 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