Optimal Capital Structure and Internal Financing as Most Attractive Source of Financing - Literature review Example

Abstract This paper will articulate research studies on several theories that explain the optimal capital structure. It will identify the interpretation and application of these theories in different studies in order to identify their viability or faulty arguments. Some of the capital structure theories include agency costs of debt, market timing model and pecking order theory. The issue to be critically considered is the impracticality or inapplicability of capital structure theories in specific instances, and underlying complexities therein. This topic is likely to contribute to further studies and to the capital structure application by providing areas that require further research and developing the literature on the existing loopholes. This paper establishes that Agency cost debt theory has not been given enough audience by authors and may require further research. Although the theory appears applicable, this is not the case in the real world. The theory’s assumptions hint on the underlying weaknesses. This paper also finds out that there could be other reasons behind the theories hypothesis such as higher debt financing than equity financing and why internal financing is most attractive source of financing. Introduction Capital structure is the manner in which corporations combine equity, debt and hybrid securities to finance their assets and investments. The Modigliani-Miller theorem was eveloped by Merton Miller and Franco Modgiliani. It takes a purely theoretical approach but disregards many capital structure procedures. It suggests that ceteris paribus, the manner in which a corporation finances its assets is irrelevant to its value. This perhaps explains why capital structure is relevant in world applications. The value of a company is determined by its capital structure and others such as taxes, bankruptcy costs, information asymmetry, and agency costs (Frank and Goyal 2003). When the company minimises the weighted average Cost of Capital and maximises the market value of assets, it builds an optimal capital structure. The traditional capital structure theory presupposes that the value of the firm rises up to a specific debt level, and remains constant until it begins to decrease. Similarly, it implies that wealth can’t be created by merely investing into assets but by using the correct blend of equity and debt. While challenging the trade-off between equity and debt, miller inferred it to a balance between the horse and the rabbit (in a one horse one rabbit stew). He suggested that taxes are certain and often large but bankruptcy is rare and has a dead weight cost. He furthered by suggesting that the evidence of the trade-off would see companies having a larger debt than they do in reality (Modigliani and Miller 1963). Fama and French are also critiques of the pecking order theory and the trade-off theory. They implied that the theories had many weaknesses and were not practical. Despite several criticisms, these theories are actively applicable in the scholarly work in corporate capital structure. This is because it is has been empirically challenging to reject them. Brusov-Filatova-Orekhova has gone ahead to make the trade-off theory the modern theory of capital. It is important to identify whether the trade-off theory takes into account the weighted average cost of capital, when making assumptions on debt and leverage (Modigliani and Miller 1963). A firm’s capital structure determines a company’s ability to meet shareholder’s needs. The Modigliani and Miller hypothesis (Modigliani and Miller 1963) is an irrelevance proposition, but it presents conditions necessary for firms to be able to make financial decisions without having dire effects on their value. Some of the capital structure theories include agency costs of debt, market timing model and pecking order theory. Agency costs of debt occur where shareholders do not act in the best interest of the firm but on their own. Market timing model theory expects managers to sell new shares when they have reason to believe that the stock is undervalued. Lastly, Pecking order theory states that the order of financing investment is internal funds, debt and finally equity. These theories argue that with the exception of taxes, the market value and cost of capital are invariant to the firm’s capital structure (Frank and Goyal 2003). Since the pecking order lists debt as the second method of financing, this article helps to show how this theory could deviate from the facts. When corporate tax rates increased and debt appeared appealing because of the value of the tax shield, then companies could prefer debt over internal financing. Similarly, their propensity to consume debt was directly correlated to decreasing uncertainty and the availability or supply of debt. Given these assumptions, the theory may not apply. This article develops a theoretical framework that has an aggregate context. It mostly delves on aspects related to changes in aggregate leverage. In their model, when leverage increases firms are likely to have an increase in distress and agency costs. 􀁸 Body Graham, Leary and Roberts’s article looks at the evolution of financial policy and the history of debt to equity ratio (2014). It aims at establishing whether empirical models of capital structure account for the changes in corporate capital structures over the past 100 years. This could help to validate or dismiss the capital structure theories. The authors also extrapolate on factors that could play a big role in explaining any variation in financial policy in the last century. They suggest a shift in financial policy for U.S firms during this period especially for unregulated firms. Firms increased their propensity for debt consumption. They explained this trend as a result of corporate taxes, decreasing uncertainty, increased financial intermediaries, and lowering government borrowing. Russo’s article aims at stressing on the impact of interaction play and heterogeneity on macroeconomic systems to cause financial instability. The author uses credit/debit linkages to analyse the spread of financial distress through the credit network and its effects on the business cycle. The relationship between macroeconomic evolution and financial instability infer the overall impact of having increased debt ratios. Their argument counters that of Graham et al. by proving that the example of the Lehman Brothers bankruptcy and the global recessions are only the tip of what could happen with debt having first preference (2014). Particularly, he dilutes the role of many financial institutions that ensure availability of funds for debt by stating that banks can face financial distress and lose their liquidity capability. His article provides insight on the consequence of excessive leverage and fragility. This could support the pecking theory because internal funds could therefore emerge as more preferable, and may even make equity appear a little more favourable than debt. However, he adds that heterogeneity of financial variables and the percentage of distribution in financial linkages. This could give rise to systemic risks. According to Luigi and Sorin, financing is relevant as a consequence of taxes and the different information and agency costs. Capital structure theories differ in interpretation of tax, agency and information costs. They aren’t meant to be general. In the Pecking order theory, he corporate use of debt may arise from adverse selection, while in the trade off theory tax and bankruptcy lead to the corporate use of debt. All theories have some weaknesses. The market timing theory does not provide an optimal capital structure. This means that the market timing decisions pile over time in the capital structure outcome. This means that the market timing theory offers the best explanatory interest. According to Hovakimian, Opler and Titman (2001), when a firm adjusts its capita; structure it tends to shift towards a debt ratio that is consistent with the costs and benefits trade-off. They further reveal that firms are likely to meet obstacles when moving towards their targeted debt to equity ratios. Moreover, such ratios change over time due to changes in profitability and stock price. On the market timing theory, the authors argue that the issuance decision does play a big role as the repurchase decision when it comes to buying or selling stock by investors, instead, the deviation from the target ratio and the actual ratio may influence investors more. The capital structure often constitutes of debt and equity. The main criticism of the MM theory is its lack of practical use, since it does not have direct guidance to lead companies to identify capital structure in real life. Researchers have attempted to identify the ideal capital structure by expanding debt ratio and tax advantage. Apparently, only the introduction of transaction costs, and information asymmetry problems could offer some guidance. It is not clear to date how information differences and agency costs affect capital structure. These elements are crucial in making the theory bear some elements of reality. The theories also place a perfect alignment between firm agencies and firm investors which does not exist. Company agents ‘manager’ will always place their own interests ‘salary, reputation’ ahead of the firm’s interests. They are prone to use entrenchment investments which can easily align the capital structure and asset to their managerial knowledge and skills in order for them to acquire a bargaining power in the eyes of the true company holders. According to Myers (2001), this transferred value may be reduced by different control and supervising methods. However, such methods are costly and may affect returns. Since Equity investors bear the entire investments costs while debt holders receive interests which are a major part of the investments, equity holders may have low incentive to invest in companies that have value-increasing especially with a high likelihood of bankruptcy in the short term. This means that a company that has a higher portion of debt in its capital structure would automatically receive low equity and will be geared to reject more value-increasing business investment projects. Alternatively, a different argument counters the previous by suggesting that debt contracts will give equity holders an incentive towards sub-optimally investments because in case of limited liability will make debt holders vulnerable to the decline in debt value. However, in case the investment generates high yields, equity holders will receive high returns above the debt value. Therefore the high interest on debt is intended to prevent debt holders from unfair treatment. Equity holders would usually get less in that debt than originally anticipated from debt holders. This means that the agency costs is indirectly created by equity holders who are responsible for the issuance of the debt and not the debt holders’ reason. According to Kayhan and Titman (2007), there is a consistent disagreement on the relevance of the concept of target debt ratio. They aimed at establishing the influence of stock price on capital structure primarily in the long and short run. Although the cost benefits trade-off may lead to an optimal capital structure, it is possible that at an optimum, debt ratio and the firms’ value have a weak relation. This means that the cost of moving away from such an optimum position would be low. This makes the concept of target debt less important. Given this interpretation, the authors believe that the capital structure is influenced by the market consideration and transaction costs which can affect the relative costs of debts temporarily and the equity financing. This argument contradicts that of Hovakimian, Opler and Titman (2001), who supported the idea of a target debt ratio. Kayhan and Titman (2007), argue that although companies believe that they have a target debt ratio, they have a cash flow, stock price realizations and investment needs which tend to deviate against such targets. The preconditions for a reliable target debt ratio are the large range debt ratio. Like Russo, the authors believe that high financial deficits lead to high leverage. They also agree that stock returns have an impact on capital structure. The change in stock prices affects the target debt ratio because they may influence an increase or decrease of the growth of opportunities. Jensen and Meckling (1976), article integrates elements from the theory of property rights, theory of finance and the theory of agency in order to come up with the theory of the ownership structure of a firm. They explain the relationship between agency costs and separation of control aspects and investigate the agency costs that relates to debt and outside finance. They go ahead to explain the Pareto optimality of the existence of these elements. They further elucidate on the debt and equity creation and issuance, and why it is a supply side problem under completeness of markets. According to the authors, the growth in the number of both equity holders and debt holders is evidence that the agency problem has not affected the two systems of financing in an abnormal way. However, agency costs are real and they depend on statutory and common law and human ingenuity when devising contracts. Agency problems arise from the imperfect observable reward mechanism between the managers and the investors. The manager is responsible of the entre firm but only benefits from a small portion of the profits, yet they bear the entire costs of the business on their actions. The two parties have different measuring standpoints when looking at their interest in the firm. In relation to the capital structure theories, the agency costs arise from two conflicts; the equity-debt holder’s conflicts and between equity holders and managers. Jensen and Meckling emphasize that the debt-equity holder’s conflict increases the agency problems which are necessary in computing the capital structure (1976). Majluf (1984) argues that the management often knows more about the organization than investors. In his research, he investigates different aspects of corporate financing behaviour including the pecking order theory. In their model, they establish that it is safer to issue safe securities over risky ones, and that a firm should avoid issuing dividends if it means selling stock or getting into other risky security. Ultimately, they validate the theories’ conclusion that when managers have access to internal information, and issue stock, the stock prices will fall. Their model also stipulates that changes in dividends highly correlates with the estimate that managers place on the value of assets. Shyam-Sunder, and Myers (1999), argue against the pecking order theory, using statistical power and tests on a trade-off model. The authors were concerned with the theories explanatory power, and tested the empirical literature on capital structure. Their conclusion indicated that although the pecking order is applicable as a first order descriptor, it’s coefficient and significance does not apply in case of a joint model alongside corporate financing behaviour. Therefore, firms anticipate financing through debt. Especially for companies dealing with intangible assets, the pecking order does not apply in real life. Levati and Qiu (2012), test the MM theory in a lab market and establish that participants were conscious of the changes in systematic risk in equity from increased leverage, and would thereby demand for a higher return. In contrast, they underestimated systematic risk from low leveraged equity. On the market timing theory Dierkens validates its viability by examining the relevance of the information asymmetry between managers in the firm and the market in which there’s the issue of equity. Using four proxies on information asymmetry and three groups of the tests, he investigates the reaction of equity issue announcements before and after and carries out a cross-section regression analysis. His conclusion is that information asymmetry is significant equity issues. Ultimately, an increase in leverage increases systematic risks making it less appealing than equity. However, since the higher return offsets low market value of bonds, the WACC remains constant making the pecking order theory inapplicable. Despite this, most of its hypothesis cannot be dismissed in the market. This theory has some benefits and some weaknesses. 􀁸 Conclusion Information is valuable to shareholders, and inside information may affect old and new investors differently. The main issue boils down to whether the firm will risk having old investors selling off their stock, and get finance from new investors. If the managers want to retain their existing stock holders, it means that they will not issue any shares at all. This means passing up any great investment opportunities that have positive or high NPV. It’s interesting to find out whether this factor should be included when calculating the NPV. This theory does not provide enough insight on the behaviour of new investors. If this theory is fully validated and assumptions in Majluf’s paper considered viable, then an issue of new stock raises issues with the issue-invest relationship because their analysis fails to provide an analysis on the interchange/inflow of stockholders basing on this theory. Most authors faulted some areas of the theory while supporting the line of argument that led to its hypothesis. Its lack of full support may be as a result of market imperfections. Market imperfections include those elements which interfere with trade and cause participants in the market to move away from a market portfolio or from a risk level that they prefer. Some findings on these theories could be affected by a single call market or fact that arbitrage opportunities were excluded. For future research, it is important to ascertain whether such design choices are paramount and if the theory’s violations are genuine. Agency cost debt theory has not been given enough audience by authors and may require further research. However, on the onset, this theory appears applicable in the real world. Considering adverse selection and the lemons problem for instance, an owner of a good used car will seldom sell his car because of the market situation. Therefore all cars in a market end up being priced as lemons and no good used cars reach the market. Agency problems can be solved through screening and signalling especially in a market that has asymmetric information (Ebsen 1986). In cases where the company wants to issue shares, managers are always informed about the prospects of those shares. Similarly, investors know that managers have this knowledge. Authors still disagree on whether the investors will buy or sell such stock based on this information. The main issues with the pecking order theory are taken care by its assumptions. It seems to explain observable phenomena. These include the reason behind higher debt financing than equity financing and why internal financing is most attractive source of financing. Retained earnings are more profitable than either debt or equity, and debt has preference over equity because it does not dilute ownership. According to Frank and Goyal (2003), trade-off theories offer competing alternative hypothesis. Most authors had support for both theories. In conclusion, these theories offer a great deal of information on capital structure and its participants. Since there is no optimal capital structure, and the decisions of market participants are fully subjective, it is challenging to arrive at a certain model that takes into account the facts in real life that would make the theory applicable. There is a research gap on the decision making trends and intrinsic perspectives for such participants. References Eckbo, Ebsen (1986): “The Valuation Effects of Corporate Debt Offerings,” Journal of Financial Economics, 15(1–2), pp. 119–52. Flannery, M. J., and K. P. Rangan, 2006, Partial Adjustment toward Target Capital Structures, Journal of Financial Economics 79: 469-506. Frank, M. and Vidhan Goyal (2003): "Testing the Pecking Order Theory of Capital Structure," Journal of Financial Economics 67(2), pp. 217-248. Graham, J. R., M. T. Leary, and M. R. Roberts. 2014. A Century of Capital Structure: The Leveraging of Corporate America. Working paper. Feb 18. Available at SSRN: http://ssrn.com/abstract=2223302 Hovakimian, A., T. Opler, and S. Titman. 2001. The Debt-Equity Choice. Journal of Financial and Quantitative Analysis 36: 1-24. Jensen, M.C., and W. H. Meckling. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3: 305-360. Kayhan, A., and S. Titman. 2007. Firms' Histories and Their Capital Structures. Journal of Financial Economics 83: 1-32. Levati, V. Qiu, J. (2012), “Testing the Modigliani-Miller theorem directly in the lab,” Springerlink, DOI: 10.1007/s10683-012-9322-z Luigi P., and Sorin V. (2009), “A review of the capital structure theories” Annals of the University of Oradea, Economic Science Series, Vol. 18 Issue 3, p315-320. 6p Modigliani, F., and M. H. Miller. 1963. Corporate Income Taxes and the Cost of Capital: A Correction. The American Economic Review 53: 433-443. Myers, S.C., and N. S. Majluf. 1984. Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have. Journal of Financial Economics 13: 187-221. Nathalie Dierkens (1991). Information Asymmetry and Equity Issues, Journal of Financial and Quantitative Analysis, 26, pp 181-199. Doi:10.2307/2331264. Read More