Trade-off Theory and Pecking Order Theory of Capital Structure - Literature review Example

Analysis of Three Research Papers 1. Capital structure theories a. Cassar and Holmes (2003) This study tests two theories of capital structure: the trade-off theory and the pecking order theory. According to Cassar and Holmes (2003, p. 125), the trade-off theory of capital structures entails different aspects that include how exposed a firm is to the costs of bankruptcy and the costs of the agency fees as opposed to the potential tax benefits associated with using debt as a means of financing the firm. The bankruptcy costs of a firm refer to the costs that are suffered as a direct result of a firm being likely to fail to meet its financial obligations. On the other hand, agency costs refer to the costs to a firm which result from the relationship between the management of a firm and the debt holders (Michaelas, Chittenden & Poutziouris, 2000, p. 250). Lastly, the tax benefits that are associated with using debt are created as a result of interest on debt financing being tax deductible. According to this theory, these three aspects combine to influence the capital structure of firms. For instance, firms having high agency fees seek little debt financing (Bhaird, 2010, p. 151). Also, tax effects encourage firms to seek debt financing in their operations (Cassar & Holmes, 2003, p. 127). The pecking order theory of capital structures for firms suggests that the financing choices for firms occur in a particular order of preference. This situation arises from the fact that there are always information asymmetries between the management of the firms and the potential financiers of a firm (Bhaird, 2010, p. 156). For instance, whereas internal funding from retained earnings of the firm, by virtue of the availability of inside information, will be much prudent in expected rates of return, external financiers, as a result of asymmetries in information, would have higher expectations, thus proving to be much expensive to the firm in the long run (Ward, 1999, p. 291). b. La Rocca, La Rocca and Cariola (2011) First, this study tests the pecking order theory of capital structure (La Rocca, La Rocca & Cariola, 2011, p. 110). This theory holds that firms would seek external sources of financing only after the internal ones are exhausted (Michaelas, Chittenden & Poutziouris, 2000, p. 251). This hypothesis is tested in light of the financial life cycle of businesses from the start-up stage to the maturity stage. Also, the study examines the certification hypothesis which holds that young businesses seek to gain the reputation of banks by submitting themselves to their monitoring. c. Qui and La (2010) This study tests the following theories of capital structure: trade-off theory, signalling theory and pecking order theory (Qui & La, 2010, p. 278). The signalling theory describes how investment decisions are made based on the reaction to the signals sent to firms by the type of financing that is offered to the market. When there is imperfect flow of information in a market, investors derive their conclusions about the view of the management on the security pricing and the prospects of the firm from whether the firm issues debt or equity financing. When managers offer a new equity issue, this is interpreted in the market as a bad signal on the security of the firm. On the other hand, when managers are confident about the future of the firm, they develop a debt financing arrangement that excludes the financiers from sharing in the profitable future of the firm. According to Stilglitz (1988, cited by Qui & La, 2010, p. 279), in the trade-off theory of capital structure, there is a trade-off between the potential benefits associated with tax saving measures and the costs associated with the possibility of bankruptcy when using debt financing. This theory recommends that large and profitable firms which have a relatively lower risk of facing the costs of bankruptcy use debt financing as a means of lowering their tax obligations. On the other hand, small firms, as a result of having mainly intangible assets, should seek to use equity financing in their operations. This theory also proposes that firms maintain optimal capital structures with a fixed ration of optimal debt that varies between 11% and 20% (Ghosh, 2012, p. 290). The pecking order theory of capital structure, as developed by Myers (1984), suggests that firms should follow a pecking order in their financing. This means that since firms vary in their levels of profitability, they should employ different structures of capital in their financing. For instance, firms that are highly profitable should maintain a lower level of debt since they can manage to finance their activities from their retained earnings. On the other hand, firms that are experiencing a high rate of growth should avoid seeking equity financing and use less debt in order to maintain a high capacity for borrowing (Qui & La, 2010, p. 282). 2. Sample data a. Cassar and Holmes (2003) The sample for this study consisted of 1,555 small and medium sized companies in Australia that satisfied a number of different criteria before being included in the sample. The sample included businesses that had been in operation for at least four years, businesses that were financed independently, those that did not have a leverage value of 100% (Cassar & Holmes, 2003, p. 125) b. La Rocca, La Rocca and Cariola (2011) The sample for this study comprised 10,242 Italian non-financial SMEs that have not been involved in the bankruptcy process. Data based on the firms was analysed to show the relationship between asymmetric information, growth cycle and the decisions for capital structure for the firms during the period between 1996 to 2005 (La Rocca, La Rocca & Cariola, 2011, p. 115). c. Qui and La (2010) This study used the following sample data to test the theories of capital structure identified before. The study included all firms on the Australian Stock Exchange excluding banks, insurance firms and financial institutions. The sample included 65 firms in 1992 and 412 firms in 2006. The following information about these firms was collected: the market value of equity capitalization, preference stock, interest bearing debt, the value of common equity, preference stock and the book value of plant, property and machinery (Qui & La, 2010, p. 278). 3. Findings for capital structure a. Cassar and Holmes (2003) The first finding in this study is that both the level of debt and the financing of SMEs are not affected by risk. The second finding of this study is that there is a positive relationship between the size of the firm and leverage for firms. This is consistent with the influence of asymmetries in the information in the market. The third finding of the study is that when firms are making choices about the preferable type of capital structure, they take into consideration both the long- and short-term effects of debt. b. La Rocca, La Rocca and Cariola (2011) The first finding is that firms primarily use debt financing during the start-up and growth stages. Although debt financing still remains a viable option in maturity, firms use it to a less extent (La Rocca, La Rocca & Cariola, 2011, p. 116). The second finding is that with increasing profitability, firms resort to using internal funds for their operations. This is consistent with the pecking order theory of capital structures. The third finding of the study is that SMEs operating in the southern region of Italy, as a result of being financially constrained, find it difficult to substitute debt financing with internal financing. This means that the capital structure of firms is influenced by the nature of institutional structures in which the firms operate. c. Qui and La (2010) The first finding is that firms that have accessed debt financing are five times larger than those that have not. The second finding is that levered firms have more assets and a corresponding lower degree of business risk than unlevered firms. The third finding is that the size of a firm does not have a significant impact on the debt ratios of firms that are in debt. The third finding is that debt ratio of firms increases with an increase in tangible assets but decreases with increasing profitability, business risk and growth expectations. 4. Contribution to understanding a. Cassar and Holmes (2003) Analysis of the data in the study contributes to the understanding of capital structure of SMEs in Australia in light of the traditional theories that were largely developed for large firms. This is important since the majority of firms listed on the Australian Stock Exchange fall under the category of small and medium-sized enterprises whose capital structures are examined in this study. This study also shows how financing by commercial banks is different from other forms of financing in terms of the degree of emphasis placed on the capital structure of the firm. b. La Rocca, La Rocca and Cariola (2011) By providing information about the capital structures of SMEs at different stages of the business life cycle, this study contributes to development of enterprises by allowing decision-makers to make informed and valuable policy decisions. Also, the study shows the relevance of the life cycle of a firm as a factor that influences the capital structure decisions of a firm. c. Qui and La (2010) The first contribution is that this study shows that when taking debt financing in a tax imputation environment, priority consideration is given to the costs of agency fees and signalling effects. The benefits of potential tax advantage are given secondary consideration. The second contribution is that the study shows that the primary concern of shareholders about risk entails the systematic risk of equity that is inevitable under diversification. 5. Comparison of results The three studies make different conclusions about capital the structures of capital for firms. In Qui and La (2010), the findings of a significant negative impact of the level of profits, prospects of growth and business risks on capital structure are consistent with the theories of signalling, bankruptcy and agency costs. On the other hand, Cassar and Holmes (2003, p. 142), report that the financing and capital structure of SMEs is determined by the structure of their assets, profitability and prospects for growth. Separately, in La Rocca, La Rocca and Cariola (2011, p. 128), it was found out that the capital structure of firms is a function of the life cycle stage in which the business is. Whereas businesses favour debt financing during their earlier stages in the business life cycle, internal financing becomes the option of businesses during later stages of business life cycle. This is consistent with the pecking order theory of capital structure. 6. Capital structure conclusion The signalling theory describes how financiers respond to the signals sent out by the management of firms when seeking financing from the market. On the other hand, the trade-off theory holds that firms maintain a debt ratio in order to balance between equity and debt financing. The pecking order theory holds that firms change from dependence on debt to equity financing as they progress from start-up stage to maturity in the course of time. References Bhaird, C., M. (2010). Resourcing Small and Medium-Sized Enterprises: A Financial Growth Life Cycle Approach. Dublin City: Springer. Cassar, G. & Holmes, S. (2003). Capital structure and financing for SMEs: Australian evidence. Accounting and Finance, 43, 123 – 147. Ghosh, A. (2012). Capital Structure and Firm Performance. Springer, Dublin City. La Rocca, M., La Rocca, T, & Cariola, A. (2011). Capital structure decisions during a firm’s life cycle. Small Business Economics, 37, 107 – 130. Michaelas, N., Chittenden, F. & Poutziouris, P. (2000). A model of capital structure decision making in small firms. Journal of Small Business and Enterprise Management, 5(3), 246 – 256. Qiu, M. & La, B. (2010). Firm characteristics as determinants of capital structures in Australia. International Journal of Economics of Business, 17(3), 277 – 287. Ward, C. (1999). Estimating the cost of capital. Journal of Corporate Real Estate, 1(3), 287 – 293. Read More