Small Business Finance - Assignment Example

Capital Structure Theories Name: Tutor: Subject: Date: Tables of Contents Table of Contents Tables of Contents 2 Capital Structure Theories 4 1.Cassar and Holmes (2003) 4 1.1. Static trade-off theory 4 1.2. Pecking Order Theory 5 1.3 Agency theory 5 2.La Rocca, La Rocca and Cariola (2011) 6 3.Qui and La (2010) 7 Sample data 7 1. Cassar and Holmes (2003) 7 2. La Rocca, La Rocca and Cariola (2011) 8 3.Qui and La (2010) 9 Findings for Capital structure 10 1. Cassar and Holmes (2003) 10 2. La Rocca, La Rocca and Cariola (2011) 10 3.Qui and La (2010) 11 1)Signaling theory 11 2)Bankruptcy cost theory 11 3)Agency cost theory 11 Contribution to understanding 12 1. Cassar and Holmes (2003) 12 1)It improves liquidity of the company because no interest will be paid 12 2)It reduces debt liabilities of the company 12 3)Eliminates cost of financing external debts 12 2. La Rocca, La Rocca and Cariola (2011) 12 3.Qui and La (2010) 13 Comparison of results 13 Conclusion 14 References 14 Capital Structure Theories 1. Cassar and Holmes (2003) There are various theories that explain the nature of the capital structure of small business finance. Some of the common theories that were developed to explain the sources of capital comprised static trade-off theory, hypotheses derived from the pecking order theory and hypotheses derived from agency theory. Initially, these three theories were developed to explain the nature of theories in the field of corporate finance. However, the scientific managers, after their extensive research, concluded that the theories can as well be applied in SMEs studies. 1.1. Static trade-off theory According to Reimann (2013), trade-off theory in the SME literature is not sufficient to explain the significance of the theory because small business organization delivers low profits as compared to a large financial corporation. It is, therefore, a reality that SME do enjoy the use of debt-tax shield due to low profits being realized in this business setup, ceteris paribus. Young business faces various challenges in building their capital structures. In most cases, the SME faces greater risk as compared to corporate finance. This theory, therefore, try to emphasize the usefulness of the size of the company, the nature of the assets and the prudence when developing the capital structure of the company. To draw effective conclusion, it is vital to analyze other theories on capital structure of SMEs. 1.2. Pecking Order Theory This theory seeks to explain the fact that the managers of a certain company have a better understanding of the capital structure as compared to ‘outside’ investors. Managers understand the effects of financing the company on various sources that are available. According to…….it is essential to finance the company using internal funds such as retained earnings than sorting for external means of raising the capital. When raising the capital, the sources available are adopted in a certain manner. There is a protocol to be followed. Companies will resort to external financing after exhausting the internal sources. This is because the external sources is a bit expensive as compared to the internal sources (Berk and DeMarzo, 2013). Research has revealed that SME prefers pecking order theory due to relatively greater information asymmetries. Corporate firms are interested in retaining the control of the firm and the managerial independence. SME will always source their capital from pecking order of their own money. This is always the first and the most preferred option. The second preferred option is the short term borrowings and the last preferred option is calling on investors. A number of studies support the use of pecking order theory for the SME because it is less costly for the company. The external financing needs to be the last resort and can be opted for when growth and expansion of the company is in progress. The source of finance for nay company will depend on the nature and the size of the company in terms of the growth. For the startup business, it is essential to raise capital through personal savings. 1.3 Agency theory In this theory, there is a relationship between the agent and the principal of the company. In large corporations, the agent of the company is the managers while the principals are the shareholders and debtholders. In most cases the managers are not managing and running the affairs of the company as expected by the principals. In SME, this is not the case, however similar conflict is experienced there. In SME there are inside and outside contributors of the capital. Both parties clash on how the affairs of the company are being run and managed. This is because in the SME there is no detailed information and lack of proper accounting records. 2. La Rocca, La Rocca and Cariola (2011) The organization has different sources of finances. It is arguably that sources for companies regardless of the sizes depends heavily on their life cycle. The SME, for example, can access certain type of finance depending on its stage of the life cycle in the business. According to this research, it recognizes the benefit of adopting the peck order theory though it emphasizes that the theory will be efficient depending on the stage of the Lifecycle of the company. This research also emphasizes the fact that well developed companies tend to adopt peck order theory by raising its capital from the retained earnings of the company. The research favors the large companies because they are able to raise profits that can be used to expand the business. It is cheaper to use earned profit as the source of capital as compared to long term or even selling of shares to the investors. The Lifecycle criteria does not favor small startup companies because most of them are informationally opaque. Lenders find it hard to lend to startups because the business does not meet the minimum required. This makes the lenders to raise the interest rates in order to minimize the risk of default in repayment. 3. Qui and La (2010) The sources for the capital for various companies vary depending on the nature of the company’s assets. Companies with tangible assets are better in place than the SME with no tangible assets. Financing the company with debt as the main sources of capital increases the risk of bankruptcy. However, it is evidence that the companies despite of their sizes in growths should adopt the peck order theory. This is because smaller companies can source their funds from personal savings while the well established companies can utilize their retained profits as internal sources of finance. According to Salminen (2013), the managers should be firm on their decision provided that the decision is beneficial to the company. It is essential to use the profit generated to finance to interest on the loans acquired. Companies, in most cases, seek loans for expansion and this loan are offered to be repaid with interest. Sample data 1. Cassar and Holmes (2003) This focus on assessing the performance of the business companies in Australian especially the SMEs. They identify and classify companies according to their growth rate and their performances. The collection of this statistic was necessary for the Australian government because it could be used to determine the economic growth rate of the economy. Furthermore, it is vital to analyze organizations in the country to establish whether the organizations have complied with the requirements that are required. Some of these requirements comprise compliances license and taxation and whether the SME meet minimum start-up capital as per the requirements of the monetary authorities. Australian business laws require companies especially profit making organizations to provide their annual accounting transactions to the public so that the public cannot be misinformed when buying shares from these companies. To ensure that the accounting information provided is accurate the government has established the Australian Bureau of Statistics to regulate the conduct of the companies. In addition, the Australian government has established the Business Longitudinal Survey that is responsible in deleting companies that are not performing because such companies can mislead and exploit the public by providing false information regarding their performance. 2. La Rocca, La Rocca and Cariola (2011) According to this research, companies' performance varies depending on many factors such as sources of capital and their capital structures. After careful analysis of small and medium companies across the world, it was noticed that these small and companies depend heavily on external finances is their main source of capital. Furthermore, these companies face problems information. Most of them lack vital information concerning the market status, the relevant strategies and finally poor communication because of highly bureaucratic system used (Al Zoubi, 2013). This sample of various companies, both small and medium, satisfies the theory of peck order theory that the SME adopt certain sources of capital depending on the their life cycle. However, small and medium companies in different countries differ in how they operate. They differ in terms of the number of employees the employ and also in terms of capital structures. 3. Qui and La (2010) This research paper aims to examine the effect of certain sources of capital in the company. The research was conducted within Australian firms though it excluded all banks, financial institutions and the insurance companies. According to Qui and La (2010), Australian firms i.e. the small and medium size companies was selected and used as a sample to test the effectiveness peck order theory. The research focused so much on the sizes of the assets and the tangibility of those assets. This was because assets are considered to be the main determinant of the capital structure to be adopted, and can also help to determine the amount of loan equity a company can access. Furthermore, the research reveals that market model is a vital tool that can be used in measuring the exposure limit of the company. A company regardless of its size is possible to measure its exposure limit in terms of business risk and the financial risk. These exposure limits are the essential elements in measuring the size of the equity of a company. Finally, the research indicates other relevant strategies of determining the capital structure of SMEs. Some of this includes the regression equation. Investors are interested in this equation because it reflects the future performance of the company. Findings for Capital structure 1. Cassar and Holmes (2003) The research finding indicates that the SMEs should resolve to adopt short term debt as their main source of capital. This is essential because their profit margin is not high enough to service long term debt that calls for a higher amount to be repaid. Furthermore, the long term debt requires many securities and conditions that cannot be met by this SMEs. However, loans that are acquired from banks normally call for securities that are in the form of assets. Banks normally provide financing that is secured by the assets of the company. This makes it difficult for the SMEs to acquire these funds. Most small companies do not have high valued assets that can be used as securities. This is a clear indication that pecks order theory is the most appropriate for SMEs because the theory emphasizes on the need of sourcing the capital for small medium, enterprises from personal savings. This finding of Cassar and Holmes (2003), differs with the sample data of Qui and La (2010) that explains the effects of the business or financial risk on the capital structure or the sources of capital to the SMEs. According to Cassar and Holmes (2003), there is no relationship between risk and the level of debt nor the sources of capital finance for small and medium companies. 2. La Rocca, La Rocca and Cariola (2011) The finding of this research indicates that even though the small and medium-sized firms depends so much on debts, the capital structure of these firms depends on the economic growth of the country. Small companies in Italy depend on debt. There is no young firm in Italy that can operate without debts. In addition, the research reveals that profitability index is vital in young firm because they will use to finance the debt liability, and also to expand the operation of the company. This finding supports the theory of pecking order theory which emphasizes the utility of retained profit to expand the level of capital (Kallberg at al, 2013) 3. Qui and La (2010) According to this research, levered firms are more attractive to investors because of high profit. Such firms tend to be stable because there tangible assets are of high value. This finding supports the following theories: 1) Signaling theory 2) Bankruptcy cost theory 3) Agency cost theory The theories named above shows that the debt ratio of a company is directly related with the amount of profit made by the company. In addition, the findings support the pecking order theory because the theory focuses on ploughing back profit realized by the company. However, the findings did not focus so much on the trade-off theory. Contribution to understanding 1. Cassar and Holmes (2003) The contributions made by this research indicates that the credit extension and the profit margin are influenced by the economic status of the country. Furthermore, the country's monetary authorities can influence the type of capital structures adopted. Personally, the understanding that I got on this research is that companies prefers pecking order theory because the theory emphasis in ploughing back the retain profits for the expansion purposes. The importances of ploughing back profits are as follows 1) It improves liquidity of the company because no interest will be paid 2) It reduces debt liabilities of the company 3) Eliminates cost of financing external debts I completely agree with this research findings. Every organization needs to reduce or eliminate external liability that are likely to affect the net profit margin, and even affect the return on assets for stakeholders and shareholders. This is because it can lower the reputation of the company in terms of competitiveness in the market (Malm and Roslund) 2. La Rocca, La Rocca and Cariola (2011) The small sized firms face capital problem because they lack assets to secure loan terms loans for expansion. The contributions to this is that companies need to acquire loans as part of the capital so that they can be able to deliver products and services in an effective manner. Furthermore, the managers need to educate shareholders on the need of ploughing back profit for expansion purposes. Finally, it is essential for smaller-sized firms to utilize the little profit they make for expansion purposes (Marangos, 2013). 3. Qui and La (2010) Risk affecting companies vary depending on various factors such as the capital structure, the sources of capital and the management efficiency. Companies in Australia prefer paying dividends to shareholders so that they can attract more investors. In addition, there is no double taxation in Australia making the country attractive to investments (DeAngelo and Stulz, 2013). Companies need to balance all parties that can affect a company in one way or another. Other parties who need to be handled with care are the lenders so that they can be able to lend to the company without calling complex requirements. Comparison of results The main similarity is the adoption of the pecking order theory because it helps the company reduce the debt burden. Using the retain profit as the primary source of capital is essential in any profit making organization. This is because the company will reduce the liability of servicing external sources of capital. Another similarity among the three research indicates that all the small sized firms depend on the private sources as their source of capital. This is because the small-sized firms do not meet the minimum requirements of long term loans. Conclusion In conclusion, peck order theory is the main universally accepted because of its relevance in the company. The theory focused on reducing the obligation of the company by focusing on internal funding rather than the external one. However, the levered firms are more secure because they have tangible assets and the capital base is enough to absorb any economical shock. Finally, levered companies are more profitable than the unlevered companies. Research indicates that the levered company faces low risks as compared to un-levered companies. References Al Zoubi, T. (2013). Corporate cash-holding decisions: Amman stock exchange. Berk, J., & DeMarzo, P. (2013). Corporate Finance: The Core. Pearson Higher Ed. DeAngelo, H., & Stulz, R. (2013). Why High Leverage is Optimal for Banks. Fisher College of Business Working Paper, (2013-03), 08. Kallberg, J., Liu, C. H., & Villupuram, S. (2013). Preferred stock: Some insights into capital structure. Journal of Corporate Finance. Lauenstein, P., & Reimann, P. (2013). The Impact of Stock Prices on Capital Structures. Malm, S., & Roslund, E. The Bond-to-Total Debt Ratio and its Impact on Firms' Performance. Marangos, J. (2013). Consistency and Viability of Capitalist Economic Systems. Palgrave Macmillan. Salminen, J. (2013). Capital Structure and Firm Growth: R&D Intensive Companies. Read More