Economics Perspectives and Policy - Coursework Example

Running Head: ECONOMICS PERSPECTIVES AND POLICIES Economics Perspectives and Policy of the of the Economics Perspectives and Policy Macroeconomics and Microeconomics The field of Economics has two branches that are microeconomics and macroeconomics. The learning of the whole economy in the world is called Macroeconomics, including inflation rate, business cycles, business growth and the rate of unemployment. On the other hand, Microeconomics is the study of individuals and how their choices influence the flow of the economy. (Giannetti, 2003, 190) Microeconomics and Macroeconomics are linked with each other. For example, the price of gas in California is about 10% higher than the national average. California is one of the largest states in the USA in population and land. Californians choose to drive everywhere and mostly alone, causing the demand for petroleum in the state to rise immensely which increases the supply. The Law of Supply states that the amount of product supplied increases as the prices increase as long as other factors are constant, and vice versa, if supplies decrease so will the prices. (Desai, 2004, 2460) The Law of Demand states that the amount of product demanded rises as the prices fall or prices rise when the amount of product demanded falls so long as all other factors are equal. Rutherford (2005) reviewed the prior researches and obtains extra evidences, and he finds that Japanese, French and German companies have higher leverage level than American and UK companies. Borios study (2007) confirmed this view and he cataloged firms in Anglo-American economics as "low leverage" and firms in Japan and continental Europe as "high leverage". The capital structure differentials across countries have been wildly and deeply studied. Rajan and Zingales (2006) (RZ) achieve different results with previous studies. They analyze G-7 countries and find that the German and UK companies have the lowest leverage level and other countries have almost the same leverage level. RZ (2006) claim that the differences between their results and previous one may due to four possible reasons, including differences in measures, different adjustments to correct for differences in accounting, different samples and capital structure may have been changing continually in different countries. Although RZ (2006) made a significant improvement on the data analysis and proposed a large number of unsolved research question, limitations still exist. Only listed companies with consolidated balance sheets are taking into consideration as explainable samples. This prejudice may not only cause the cross-country investigation biased but also the analysis within countries analysis biased. Giannetti (2003) filled this gap by investigating leverage level in different countries with both listed and unlisted companies. The results state that, adding unlisted companies would influence the results without unlisted companies significantly. However, the reliability of data for unlisted companies is not considerably high. Other limitation in both RZs work and earlier researches is that only developed countries at approximate level are explored. Boot, Aivazian, Demirguc-Kunt and Maksimovic (BADM) (2001) examine the capital structure in 10 developing countries such as Mexico, Turkey and South Korea and in developed countries such as Japan, Germany and United Kingdom. They try to answer three basic questions: whether there are differences leverage of firms in developed countries and developing countries; whether factors which influence the cross-sectional changeability are the same or not in developed countries and developing countries; whether the prediction of capital structure models works by only knowing nationality of the firms. Conclusions from BADM (2001) show that the institutional differences seem unlikely to be significant between developed and developing countries; even if at the point of theoretical view, they should be. Macroeconomic performance and Institutional Differences Many studies emphasize the aggregate data of capital structure and the differences of institutions. According to RZ (2006), despite the difference in the legal policy and development of financial systems between countries, the levels of aggregate leverages are similar. However, the evidence of the capital structure of firms in a country is highly heterogeneous, thus the firm factors within country are also significant to be noticed. In general, the firm characteristics concerning leverage are tangibility of assets, firm tax shields, growth opportunities, firm size, the volatility of return, the probability of financial distress, and uncertainty of product profit (RZ, 2006). Some studies attempt to further estimate the effects of these factors on capital structure and determine the correlation between firm factors and leverage within country based on the research of between country differences. For example, RZ (2006) analyzed the data from United States and cross-counties respectively and found out specific factors which correlated to leverage, including ratio of tangible assert to total asset, the market-to-book ratio, firm size, and profitability. Since they reveal that there is a lack of diversity of firm factors and leverage when listed companies are included, the later study from Gianetti (2003) mixed the unlisted companies data with listed firms and expanded the results of previous researches. Although capital structure can be influenced by those factors which investigated by Harris and Raviv (2007), four factors, which are tangibility of assets, investment opportunities, firm size, and the profitability, showed up constantly according to previous research such as the work form Bradley, Jarrell and Kim (2004) and Long and Malitz (2003). Tangible assets are considered as an important indicator by creditors and highly affect the level of leverage and the maturity of loans, since the ratio of fixed assets reflects the ability of liquidation and can be treated as the collateral that it can reduce the risk of unperformed debts. RZ (2006) reveal that the book leverage had a growth by about 20% on its standard deviation after the standard deviation of tangibility of assets has increased in all observational countries except Japan where 45% growth had. But it may be due to the fact that there was a high appreciation of land in Japan. It seems that the effect of tangibility on leverage is weak. Gianetti (2003) supports this result and indicates that fixed assets may be valuable when there is an insufficient protection to lender s rights in that countries. Namely, the companies which possess a large amount of intangible assets may be more easily obtained loans when an effective legal system for protecting creditors right included. Nevertheless, he also shows that higher ratio of tangibility implies longer maturity of loans firm can obtain. Research from Rampini and Viswanathan (2008) states an opposite rustle that tangible asset is the key determinant of firm leverage, to RZs (2006) work. One reason for this difference may lay in the sample Rampini and Viswanathan chose is based on compustat companies. Besides this, a more important reason caused this differential is Rampini and Viswanathan adjusted rented and leased asset which were not popular used 10 years age into the tangible asset. They claim that the "true" leverage level should include both rented and leased assets and leverage level is affected by development of capital market continually. Furthermore, investment opportunity is also a key point for firms to decide the capital structure. Researches also reveal that, for the same investment opportunities, companies with more leverage have stronger incentive to hedge. RZ (2006) employ the market-to-book ratio to substitute for the growth opportunity, since it means the ratio of market value of assets to the book value of assets which reflects the proportion of capital financed by equity to debt. In their study, there is a negative correlation between market-to-book ratios and book leverage. Recommendations to the World Bank The capital structure differentials across countries have been wildly and deeply studied. Most of the studies come to the conclusion that firms in the Anglo-American economics have lower leverage level than those in Japan and continental Europe. This is recommended that firms with high leverage should restrict their investment opportunity on some long-term projects and thereby it may influence the growth ability. Research of Smith and Watts (2005) confirms this as well. According to their work, companies with more leverage obtain lower incentive to hedge and fewer growing opportunities. Furthermore, issuing equity is more suitable for the firms to achieve high growth rate. From the theoretical point of view, this has been suggested that companies with high leverage level should be discount at higher rate as the potential financial distress is priced in efficient market. This indicates that firms with low market-to-book value ratios would drive the negative correlation greatly between leverage level and market-to-book value. However, according to RZ (2006) research, it seems that high market-to-book ratio seems to have greater impact on the changes of leverage. Explanation from them claimed that negative correlation between market-to-book value and leverage level may due to firms prefer to issue shares when the share price is highly connected with earnings or book value. Analysis result from them supported their claim. All these studies focused on the listed companies while unlisted companies which hold a large proportion were not included. Various other researchers argue that it is difficult to obtain an explicit negative relation between growth opportunity and leverage when unlisted companies are considered. It is due to that listed and large companies can easily finance funds in equity market, whereas unlisted firms are impossible to obtain funds by issuing equity. References Rampini and Viswanathan, (2008), Collateral and Capital Structure, working paper, University of Duke. Booth, Aivazian, Demirguc-Kunt and Maksimovic, (2000), Capital Structure in Developing Countries. Journal of Finance, 56, 87-130. Borio. C (2007) ‘Leverage and financing of non-financial companies’, Economic Papers 27. Bradley, Michael, Gregg Jarrell, and E. Han Kim, (2003) on the existence of an optimal capital structure: Theory and evidence. Journal of Finance 39, 857-878. Harris, Milton and Artur Raviv (2007), The design of bankruptcy procedures, C.R.S.P. working paper, University of Chicago. Long, John, and Ileen Malitz, (2004) Investment patterns and Financial Leverage, in Benjamin Friedman. Ed.: Corporate Capital Structure in the United States (The University of Chicago Press, Chicago). Baker and J. Wurgler, (2002), Market Timing and Capital Structure, Journal of Finance, 01, 1-32 Desai, C. Foley and J. Hines, (2004), A Multinational Perspective on Capital Structure Choice and Internal Capital Markets, Journal of Finance, 06, 2451-2487 Giannetti, (2003), Do Better Institutions Mitigate Agency Problems? Evidence from Corporate Finance Choices, Journal of Finance and Quantitative Analysis, 185-212 Rajan. G, and L. Zingales. (2006) ‘What Do We Know about Capital Structure?’ Journal of Finance, 1421-1460. Rutherford, J (2005) ‘An international perspective on the capital structure puzzle’ Eds: New Developments in International Finance, pg1-2. Smith. C, Watts. R, (2005) ‘The investment opportunity set and corporate financing, dividend, and compensation policies’, Journal of Financial Economics, 263-29. Read More