Case Study Data Findings and Analysis

As mentioned in the previous section, this dissertation’s research method is a qualitative research which is theory based research, so this part’s analysis will mainly focus on the case studies’ finding and analyzes these case studies’ finding with the aim to achieve this research purpose.  Following findings are based on some case studies; these studies were chosen critical, thinkable, and these findings will be used into get some analysis. The case study is organized by investigatory question, where each case study is used to respond to one or more of the questions previously shown in the research framework.  This will allow a focused concentration that develops towards an overall analysis and recommendation.

Capital structure can be investigated on a global scale but would be too broad to interpret.  It is for this reason that this study focused on theories of capital structure rather than basing research on country specific data.  While some country specific information was included, it was on a broad spectrum and only included because it was relative to the theories discussed.

In order to best understand the capital structure of small firms the researcher had to evaluate current literature for the affects of capital structure on small firms.  As means for assessing capital structure affects on small firms, the variables of financial performance and investment decisions were used.  The affects were then compared in a perfect and imperfect market.

The researcher of this study implemented the internet in finding relevant financial journals and study summaries.  Case studies of small firm capital structure were analyzed for evidence of optimal capital structure.  While the internet is a virtual goldmine of information, it had to be approached with caution.  It was essential to determine that each finding was legitimate and the authors’ credentials were accurate.  To avoid unaccredited or inaccurate information, primary sources were used as well as research and study literature from financial experts.

4.1       Case Study 1: What is the role of capital structure played in small firms within a perfect and imperfect market?

Almost all small firms nowadays recognize that they face major uncertainties about the future of their business, yet most firms’ strategic investment decision is primarily based on a single projection of future events.  Although, managers do understand that the failure to include a consideration of uncertainty can lead to costly errors, the difficulty of such planning leads many to ignore the potential costs and hope that serious problems will not arise. The researcher chose the case of Ebix for this part of the study because Ebix is a small company that represents the full definition of capital structure.

Suppose a certain small company or industry considers a strategic decision of building a large new plant or embarking on a large research project.  Major and large projects such as these require significant commitment and devotion of both capital and managerial attention.  The reward that the company would get from the project depends not only on its question on how to incorporate uncertain future outcomes but potential future responses in a prospective analysis of a capital structures project.

            Hence, every entrepreneur or managers all over the world has a responsibility for making capital structures decision.  In this manner, these individuals, for the most part are taking great care and putting a lot of though and time into gathering detailed information regarding their alternative purchasing possibilities and other decisions that would improve their capital structures.

4.1.1 Case Study Descriptive Findings

Small business owners attempting to achieve capital structures are confronted with a number of challenges that include strategic decision making. Capital structures decision is a longer term decision which is related to fixed assets and capital formation.  In this case, the decision should be based on interconnected criteria.  Generally, the managers is accountable for the maximizing the business value of a certain firm by investing in different projects which comprises a positive Net Present Value (NPV), when valued utilising an accurate discount cost.  In addition, these projects or venture should also be appropriately financed, and if such chances does not exist, then the management should send the extra cash to the investors (Damodaran, 2004, 1).

  A number of economists addressed several competitive and strategic aspects of capital structures early on. For example, Roberts and Weitzman (1981, 1261-1288) found that in sequential decision making, it may be worthwhile to undertake investments with negative NPV when early investment can provide information about future project benefits, especially when their uncertainty is great. Baldwin (1982, 763-782) found that optimal sequential investment for firms with market power that are facing irreversible decisions may require a positive premium over NPV to compensate for the loss in value of future opportunities that results from undertaking an investment.

On the other hand, Pindyck (1988, 969-985) analyzed options to choose capacity under product price uncertainty when investment is, again, irreversible. Dixit (1989, 620-638) considered small firm entry and exit decisions under uncertainty, showing that in the presence of sunk or costly switching costs, it may not be optimal in the long term to reverse a decision, even when prices appear attractive in the short term. In addition, Bell (1995, 163) combines Dixit’s entry and exit decisions with Pindyck’s capacity options for the smalll firm under volatile exchange rates. Kogut and Kulatilaka (1994, 123-139) analyzed the international plant location option in the presence of mean-reverting exchange rate volatility, while Kulatilaka and Marks (1988) examined the strategic bargaining value of flexibility in the firm’s negotiations with input suppliers.

4.1.2 Case Study Descriptive Analysis

            Capital structure can be influence small firms by practical considerations such as Asset structures, Control, financial flexibility, growth rates, risk attitudes, and sales stability.  Asset structures means that companies with assets available to offer as security for loans will tend to utilize more debt finance than small firms without such assets. Control includes issues of ownership and management control that can affect long-term financing policy. Shareholders are hesitant to see that their current ownership position will be wasted by new equity; they may act in favor of using debt when it comes to financing choices.

 Financial flexibility includes dealing a situation wherein some firms wishes to retain the company’s cash reserves and spare their borrowing capacity to enable them to respond quickly to investment and market opportunities. For example, a company with substantial cash reserves will probably find it easier to mount a successful takeover bid than a firm without cash reserves. Having cash reserves means that the firm can readily and instantly offer cash to the shareholders of the takeover target whenever needed. This usually makes a takeover offer more attractive to the shareholders of the target company than a straight share swap and increases its chances of success.

A company’s long-term financing policy is likely to be influenced by its growth rate. A brand new, fast growing company will have a high demand for development in its finances. In such circumstances the company may suspend dividend payments; it would rather prefer instead to retain a high proportion of its earnings to finance growth. In addition, a fast growing company will typically need to access the financial markets more frequently than slow-growing or stagnating companies, in order to finance its expansion plans.

The attitudes of managers and owners towards risk will influence corporate borrowing policies. As we know, managers and owners may not want to get risk or they may be risk-seekers, in which case this will influence their financing decisions. An anti-risk or conservative management will incline to use less debt than their more aggressive or risk-seeking counterpart. In sales stability a firm with relatively calm sales levels will have a steadier operating income from which to service debt, which includes interest and principal payments, than a firm with more violent sales levels.

Capital structure decisions may affect a company’s market value because if shareholders found out problems that the company has, they may be less interested with buying shares in the company. If lesser shares are bought from the company its market value may drop and cause problems for the company. If the company makes wrong capital structure decisions it may cause unnecessary events for the company which can not only lead to lower market value but the company’s demise as well.

            A company having lower market value means lesser people will be attracted to buy shares of the company. If people found out that shareholders are less interested in the company, lesser people will buy the company’s product. The market value of a company is one of the things that make up its image. Companies such as ebix, Parlux Fragrance and other well known and most admired small companies have not only good marketing strategy but they have a high market value. People want to buy shares from these companies. These companies are also well known and have acquired profits.

            Ebix offers numerous software applications products for the insurance industry, that ranges from carrier systems, agency systems, custom software development and the financial industry. Ebix is number 55 in the CNNMoney.com America’s fastest-growing small public companies (money.cnn.com). They also have remote headquarters in Australia, Singapore, New Zealand, UK, Canada and India (www.Ebix.com).

            The companies market value determine if it can handle debts and other expenses, this determines the companies future and can be used as a way to determine if the company is profitable or not.

Some corporations have a hard time in determining a precise and accurate capital structure decisions because of these managers need to apply judgment to their analysis. To create such judgment some considerations are being undertaken which includes: Long-run viability; Managerial Conservatism; Lender and Rating Agency Attitudes; Reserve Borrowing Capacity and Financing Flexibility; Control; Asset Structure Growth Rate; Profitability; and finally Taxes.

Long-Run Viability

            Corporations specifically those who offer to consumers’ electricity or telephone services are often requested to provide the outmost continuous service they can offer, because of these companies should not tend to use leverage to the point that the company’s Long-run viability is endangered. The company’s Long-run viability may cause conflict with stock price maximization and cost of capital minimization.

Managerial Conservatism

            Managers tend to be more conservative when they use leverage than an average stockholder would desire. This is because of investors want to eliminate diversifiable risk from the company. Managers view financial stability to be important. Managers tend to set lower target debt ratios than the ones which maximize stock prices.

Lender and Rating agency attitudes

            Lenders’ and rating agencies’ attitudes are important factors of financial structures in spite of a managers own assessment of the company’s financial structure. Usually managers discuss the company’s financial structure with lenders and rating agencies. Lenders and rating agencies use coverage ratios to measure the risk of financial distress.

Reserve Borrowing Capacity and Financing Flexibility

Companies should maintain some reserve borrowing capacity so that they can preserve their ability to preserve their ability to issue debts on favorable terms. Firms use less debt in certain normal conditions to achieve financial flexibility. When companies do this, they start to show a stronger financial picture.

Control

Debt’s effect on the position of management control can influence the capital structure decision. A management group that is not concerned with voting control may think about using equity rather than the company’s debt especially when the financial situation is weak that using debt might give the company more problems. Control considerations do not mean to suggest to a company to use their debt or of equity.

Asset Structure

Firms that have assets those are appropriate as security for loans tend to use debt most of the time.  If the firms’ assets are subjected to high business risk then it tends to be capable to use financial leverage than a firm who with low business risk.

Growth Rate

            Faster growing rate should be more reliable to external capital. Rapid growth needs to use external funds. Slow growth can be financed with retained earnings. Rapidly growing firms most of the time use somewhat more debt than slower growing companies.

Profitability

            Company’s with high rates of return on investment use a little amount of debt. Highly profitable companies do not need debt financing because they have high profits that enables them to do most of their financing tasks with retained earnings.

Taxes

The higher a company’s corporate tax rate, the greater advantage for them to use debt.

4.2 Case Study 2: How does capital structure affect small firms? And: What is the optimal capital structure?

There are many arguments posited in relation to capital structures decision. One of which is the notion the payback period is considered as a criterion for a capital structures decision.  Business capital budgeting decisions rely heavily on the payback period especially those small business firms.  This argument is evident from a number of studies conducted to determine the proper techniques that a firm or a company may use in capital structures decision making.

4.2.1 Descriptive Case Study Findings

The most substantial evidence of optimal capital structure originates from the pecking order theory as evident in Boot and Thakor’s (2002) Disagreement and Flexibilty: A Theory of Optimal Security Issuance and Capital Structure.  Although not the traditional framework of pecking order theory; Boot and Thakor make a significant, evidence-based contribution to the optimal capital structure of small firms.

The study (Boot & Thakor, 2002) examined in the results section discusses leverage as one of the elements influencing an investment decision.  Leverage is defined as the various financial instruments (or borrowed capital) used by firms “to increase the potential return of an investment” (Investopedia 2007, p1).  If a firm is financed more by debt then equity, it is considered highly leveraged.  Leverage has been considered by many financial experts to be an important element of capital structure as it can help the shareholders and firm make investment decisions.  Shareholders may feel that a highly leveraged firm is too risky to invest in because it relies on debt.  Leverage is used as a technique to generate shareholder wealth but it can be a negative factor should the investment be leveraged and fail, thus reducing shareholder value.

Boot and Thakor (2002) research the various theories of optimal capital structure and explain in detail the pecking order theory originated by Myers and Majluf (1984, cited in Boot & Thakor 2002).  The authors explain the pecking order theory as a firm in which the manager is more informed on “payoff-relevant information” than the investors, otherwise known as asymmetric information. The consequence of asymmetric information in the pecking order theory is that firms will prefer to use internal funds before debt and equity.  Contrary to the European Commission (2003) publication, Boot and Thakor (2002) demonstrate the evidence of asymmetric information in small firms and the consequences of such a presence.

Boot and Thakor (2002, p8) tested their equity-based model theoretically on a sample firm which is reviewed at four points in time and includes several agents of that firm.  Stock prices at the beginning time point reflect “the market’s assessment of the firm’s future prospects”, for example upcoming possible investments.  By the second checkpoint new investment opportunities are reviewed.  It is at the third time point, when payoffs are realized, that consequences of the investment decision made at the second time point is visible.  At the time of payoff, at the third time point, “the corporate income tax rate” is (0,1) (Book and Thakor 2002, p9) and the discount rate was set at zero.

Book and Thakor (2002) formulated existing activities present in the first time period so that output at the third time period equals zero.  The researchers did this so the price of the issued securities would only reflect the firm’s investment opportunity.  At the second time point, once the investment opportunity arrived, the firm had to choose from a “riskless ‘mundane project’ or a risky ‘innovative project'” (Book & Thakor 2002, p9).  The researchers (Book & Thakor 2002) assumed that a firm would not seek external funding unless an investment project is available.  The payoff differences between the two types of investments is that the mundane investment project, which “is a routine extension of the firm’s existing business” such as “a division with investment equal to its annual depreciation” (Book & Thakor 2002, p9) is assumed to have a positive value after taxes visible at the third time period.

The innovative project, which is a project taken outside of the firm’s routine, has a random payoff in which the firm and financiers may disagree as to its value present in time period two.  The innovative project is a higher risk and will likely cause disagreement between firm and financiers.  The firm’s objective is to maximize shareholders wealth.  In order to raise funds for the investment project the firm can choose equity or debt; for simplicity this case study (Book & Thakor 2002) assume the firm can be one hundred percent financed by either choice of funding.  They also assume that bondholders will always prefer mundane projects due to the limited risk.

Boot and Thakor (2002) contribute the disagreement in a projects value between firm and investors, not to asymmetric information, but rather the two sides interpret the project information differently.  For the purpose of their study, the researchers considered a firm with a project that is one-hundred percent equity financed in order to understand the possible disagreements in a projects value.  The researchers considered equity to be more flexible than debt and therefore equity is more advantageous.  They did note however, that should this flexibility not be present than debt would be the primary choice for project financing because of tax-shield advantages present with debt financing.

The value of the firm, according to its stock prices, was considered when choosing between equity and debt for financing.  The researchers (2002) evaluated the value of the firm’s equity for the choice of equity financing.  Boot and Thakor (2002) analyzed the relationship between investors and the firm which they feel influences the value of the firm.  Effective communication between firm and investors, according to Boot and Thakor (2002), regarding new investment opportunities is important for forming a “common set of information signals” which inspires more loyalty and raises the value of the firm (2002, p10).

Boot and Thakor (2002) concluded that debt is more preferable means of financing because although the shareholders may not accept an innovative project, and the firm will have to settle for mundane project, debt offers an extra incentive because of its tax shield advantage.

4.2.2 Case Study Descriptive Analysis

The difference between how the firm’s manager and the investors influence the firm’s decision to issue equity or debt.  This is important because as discussed in section two, debt is much more difficult to obtain due to the lack of assets and collateral often associated with small firms.  Debt however, is more profitable in most cases and has the tax shield advantage.  If a firm is financed more by debt then equity, it is considered highly leveraged.  Leverage has been considered by many financial experts to be an important element of capital structure as it can help the shareholders and firm make investment decisions.  Shareholders may feel that a highly leveraged firm is too risky to invest in because it relies on debt.  Leverage is used as a technique to generate shareholder wealth but it can be a negative factor should the investment be leveraged and fail, thus reducing shareholder value.

The consequence of asymmetric information in the pecking order theory is that firms will prefer to use internal funds before debt and equity.

A neutral level of risk and the firm is financed completely by equity with existing assets and the knowledge that by the second time point an investment opportunity may arrive.  While the firm is equity based at the first time point, the agents are aware that by the second time point the firm’s capital structure may change dependent upon the securities issued at that point.  Should no investment opportunities be available then securities are not issued however, the investment decision takes place during the second time point if opportunities are available.  The firm must choose to issue debt or equity.

The difference with equity financing is that shareholders generally desire the same outcome as managers and will therefore want to invest in the innovative project.  Even if shareholders did not want the innovative project, the firm could still invest in an innovative project because equity is not strictly structured as debt is.  Depending on the corporate governance structure of the firm, the shareholders could veto the innovative project and the firm will have to instead continue with the mundane project.

A better firm/investor relationship creates trust in that the investors will value the firm’s opinion on a new potential investment.

Firms looking to pursue innovative projects will likely issue equity regardless if shareholders are in agreement if the value of the firm is high.  This may upset shareholders thus decreasing firm value and equity flexibility, making equity less attractive.  If the firm recognizes that shareholders will likely choose mundane projects over innovative projects, the firm could choose to issue debt in order to take advantage of the tax shield.

Based on the description of Boot and Thakor above, the following analysis of the attributes in which capital structure affects small firms can be made:

Chart 5: Affects on Small Firms

The WACC is important in such firms for several reasons as it affects the actual conditions of the firms. The WACC is that rate which, in general, is used for capital budgeting purposes. The firm’s WACC is also often used as the basis for developing risk adjusted project or divisional discount rates. Additionally, at the optimal or target capital structure, the WACC will be minimized and the value of the firm and the firm’s stock price, in general, will be maximized. (2005)

The cost of capital is used primarily to make decisions that involve raising new capital.  Furthermore, there is a focus on today’s marginal costs for WACC. The situation could then affect the market conditions and the firm’s capital structure as well as dividend policy. The firm’s investment policy and firms with riskier projects generally have a higher WACC. The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Different projects have different risks.  The project’s WACC should be adjusted to reflect the project’s risk.

In practice, most firms pay cash dividends, although paying dividends is costly in various ways. Thus, practical evidence on whether dividend policy affects a firm’s value offers contradictory advice to corporate managers; many academicians and corporate managers still debate whether dividend policy matters (Powell & Baker, 1999).

Bradley, Capozza and Sequin (1998) examine the link between cash-flow volatility and dividend payout. They find that this link provides a novel method for distinguishing between the agency-cost and signaling theories of dividends. According to the agency-cost hypothesis, dividend payouts serve to reduce agency costs. By distributing free cash flows in the form of a dividend, management can divert fewer funds to projects that are in their best interests, but not in the interests of their shareholders (Bradley, Capozza & Sequin, 1998).

Firms with high cash-flow volatility are also those with the greatest potential agency costs. According to Bradley, Capozza and Sequin (1998), when cash flows are variable, it is difficult for investors to accurately attribute deviations in cash flows to the actions of corporate managers or to factors beyond management’s control. Thus, the higher the expected variance in cash flows, the greater the potential agency costs, and the greater the reliance on dividend distributions. The value of dividend payout as a guarantee against non-value-maximizing investments should be greatest for those firms with the greatest cash-flow uncertainty (Bradley, Capozza & Sequin, 1998). Therefore, the agency-cost theory predicts that firms with volatile cash flows will, on average, pay out a greater proportion of their cash flows in the form of a dividend.

Given that researchers and managers typically believe in dividend relevance, the next question is “What explanations of dividends do managers tend to favor?” Researchers have offered four common explanations of dividend relevance: the bird-in-the-hand, signaling, tax preference, and agency explanations.

In the bird-in-the-hand explanation, it is argued that a relationship exists between firm value and dividend payout is that dividends represent a sure thing relative to share price appreciation; and that because dividends are supposedly less risky than capital gains, firms should set a high dividend payout ratio and offer a high dividend yield to maximize stock price. However, Miller and Modigliani (1961) disagree and state that a high dividend payout ratio will maximize a firm’s value the bird-in-the-hand fallacy. In addition, Levin and Travis (1987) argues that the reasoning underlying this explanation is fallacious. The risk factor of a project’s cash flows determines a firm’s risk. An increase in dividend payout today will result in an equivalent drop in the stock’s dividend price. Thus, increasing the dividend today will not increase a firm’s value by reducing the risk brought about by future cash flows (Powell & Baker, 1999).

A firm’s dividend policy reflects management’s decision as to what portion of accumulated earnings will be distributed to shareholders and what portion will be retained for reinvestment (Goshen, 1995). On the other hand, a firm’s retained earnings represent the amount of financing that the firm can utilize without having to compete against other firms in the capital markets. But because dividend policy wholly determines the amount of earnings that a firm retains, dividend policy also determines the extent to which a firm can escape the scrutiny of participants in the capital markets.

Inefficient managers might try to escape a market inspection of their performance by adopting a low-payout dividend policy and avoiding the competitive external market for financing. Seemingly oblivious to this threat of managerial opportunism, state courts have established that directors possess sole discretion over whether or not to declare dividends, and that, absent abuse of discretion, the law will not second-guess the business judgment of corporate officers (Goshen, 1995). In granting management the protection of the business judgment rule, courts have placed a heavy burden on shareholders who wish to challenge management’s dividend policy. A shareholder suit to compel dividend distribution, based on the claim that management is investing in bad projects, has virtually no chance of succeeding. In fact, in the last one hundred years, there has not been a single case in which U.S. courts have ordered a management-controlled, publicly traded corporation to increase the dividend on its common stock.

Although a few scholars have recognized the need to restrain managerial discretion over dividend policy, a thorough analysis of the dividend policy issue has not appeared in either the law review or finance literature. Moreover, to date, proposals to reform dividend law have been ineffective.

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace.  Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm’s bonds and stocks.  (Barton and Matthews, 1989)

Moreover, the cost of capital is the required rate of return that the firm must pay to generate funds; it becomes a guideline for measuring the profitability of different investments. (p.1) When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability.

According to sources, the cost of capital becomes a guideline for measuring the profitabilities of different investments. Research findings believed that the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm.  When investors are shopping for places in which to invest their funds, they have an opportunity cost.  The firm, given its riskiness, must strive to earn the investor’s opportunity cost. (Barton and Matthews, 1989)  If the firm does not achieve the return investors expect for instance, the investor’s opportunity cost, investors will not invest in the firm’s debt and equity.  As a result, the firm’s value both their debt and equity will decline.

4.2.3 Descriptive Case Study Findings: What is the optimal capital structure?

Capital structure represents the major claim to a corporation’s assets. It includes publicly issued securities, private placements, bank debt, trade debt, leasing contracts, tax liabilities, pension liabilities, deferred compensation to management and employees, performance guarantees, product warrantees, and other contingent liabilities (Sterk and Vandenberg, 1990).  1  The importance of capital structure is evident in the size of the external funds generated by U.S. corporations in general.  In generating these external fundings, companies use either debt or equity capital, creating a major corporate question as to whether or not there is an optimal mix of debt and equity that firms should seek.

This mix is in fact that of debt and equity that is known as the capital structure, piling up the cash flows of the firms to a relatively safe stream going to the debtholders and a riskier one going to the stockholders. Searching for the optimal capital structure has been a major preoccupation of corporate finance, generating scores of capital structure theories, the most popular of which are based on agency costs, asymmetric information, product/input market interactions, and corporate control considerations. As stated by Harris and Raviv, there are four categories of the determinants of capital structure emanating from the desire to

·         Like in the case of Ebix, a software company, ameliorate conflicts of interest among various groups with claims to the firm’s resources, including managers (the agency approach);

·         Convey private information to capital markets or mitigate adverse selection effects (the asymmetric information approach);

·         Influence the nature of products or competition in the product/input market; or Affect the outcome of corporate control contests.

Basically, financial risk is the risk placed on the common stockholders as a result of the decision to use debt financing, or financial leverage, in the capital structure. Management is therefore interested in determining the amount of debt or financial risk that maximizes firm value. In the case of Ebix, which has $200,000 in assets and is all equity financed? Assuming earnings before taxes (EBIT) of $40,000, the rate of return on equity (ROE) is computed as follows:

Now, assume that the Ebix decides to issue $100,000 of debt at an interest rate of 10% to be used to retire $100,000 of common stock. The ROE will be as follows:

Optimal capital structure arises when shareholders and managers hold less than 100% of the residual claim. For example, in the case of Ebix of managers can invest less effort in managing firm resources and may be able to transfer firm resources to their own, personal benefit, e.g., by consuming “perquisites” such as corporate jets, plush offices, building “empires,” etc.

4.2.4 Descriptive Case Study Analysis

Capital structure is a subject that has generated so much awareness and attention in the field of financial management. Despite the numerous attempts to uncover and explain the different capital structure determinants, there has so far been no successful effort in creating a theory that has been proven to be accurate (Harris and Raviv, 1991). In addition, many of the studies conducted by financial experts were done in the United States (US). This case was chosen because Clinical Data is small in size and implements optimal capital structure and in this way, the impact of capital structure can be seen.

There is very little knowledge on what really causes the variety of capital structure in countries all throughout the world. In fact, Aggarwal (1981) analyzed 500 largest European firms and concludes that country factor is an important determinant of capital structure. However, Kester (1986) finds that only firms in the mature, capital intensive industries in Japan are using more debts than their counterparts in the U.S. Sekely and Collins (1988), on the other hand, provide evidences on the differences in capital structure across 23 countries. Borio (1990) also suggests that firms in Japan and Continental Europe are more highly leveraged than firms in the U.S.

In the Case of Clinical Data with higher liquidation value, e.g., those with tangible assets, and/or firms with lower investigation costs will have more debt and will be more likely to default but will have higher market value than similar firms with lower liquidation value and/or higher investigation costs. The intuition for the higher debt level is that increases in liquidation value make it more likely that liquidation is the best strategy. Therefore, information is more useful and a higher debt level is called for. Similarly, decreases in investigation costs also increase the value of default resulting in more debt. The increase in debt results in higher default probability.

Harris and Raviv also obtain results on whether a firm in bankruptcy is reorganized or liquidated. They show that the probability of being reorganized decreases with liquidation value and is independent of investigation costs. Using a constant-returns-to-scale assumption they show that the debt level relative to expected income of Clinical Data, default probability, bond yield, and the probability of reorganization are independent of Clinical Data size. Combining these results, Harris and Raviv argue that higher leverage can be expected to be associated with larger firm value, higher debt level relative to expected income, and lower probability of reorganization following default.

The optimal capital structure in Stulz is determined by trading off the benefit of debt in preventing investment in value decreasing projects against the cost of debt in preventing investment in value increasing projects. Thus, as in Trigoris (1995), firms with an abundance of good investment opportunities can be expected to have low debt levels relative to firms in mature, slow-growth, cash-rich industries. Moreover, Stulz argues that, in general, managers will be reluctant to implement the optimal debt levels but are more likely to do so the greater is the threat of takeover. Thus, firms more likely to be takeover targets can be expected to have more debt, ceterisparibus, while firms with anti-takeover measures will have less debt. Finally, firms whose value-increasing investment opportunities create more value than the value-decreasing ones destroy will have less debt than firms in the opposite situation. The reason is that such firms are primarily concerned with not losing the value-creating opportunities.

4.3 Case Study 3: How do financial barriers affect a small firm’s capital structure?

The EC Observatory 2003, a part of the Economic Commission, provided extensive research on the financial statistics pertaining to small firms; including financial barriers.  Data collected from the EC Observatory 2003 report will be analyzed in section four in order to support the theory that small firms are at a financial disadvantage.

The European Commission’s EC Observatory report (2003) covers both small and medium firms.  This study however only covers small firms; the researcher will only mention information related to small firms; unless to do so will cause the information to be inaccurate without the inclusion of medium firms.

4.3.1 Case Study Descriptive Findings

The European Commission EC (EC Observatory 2003, p7) found that “52% of micro-enterprises rely on one single bank”  which limit the possibility of obtaining different and less expensive financial resources (See Appendix A).  When investigating bank/firm relations the EC found that many small firms do not change banks once accepted for financing because the terms are unfavourable.  It was reported in 2003 that only twelve percent of small and medium firms switched banks (EC Observatory 2003).

The amount of credit provided to small firms using one bank is inadequate in most cases, with the firm receiving less than 100,000 Euro.  In terms of financing cost, small firms are charged higher interest rates and bank charges because of their limited assets and credit.  Although between 2000 and 2003, seventy-six percent of small and medium firms received their requested bank loans, these firms do not have the same access to debt financing “due to additional collateral requirements and/or high interest rates” (EC Observatory 2003, p7).

The cost and availability of capital is affected by the economic climate.  The 2003 EC Observatory report stated that there was evidence of a weak business cycle in the economic framework of many of the countries included in the study.  The weak business cycle has caused lenders to be more selective; there was a five percent decrease in bank lending in the Euro-area from 2001 to 2002. The increase in the profitability requirement of banks has caused banks to reduce the number of loans to small firms.  The EC Observatory (2003, p35) explains; “the higher returns requested by investors lead to the development of a shareholder value culture, where banks compete intensively for investors on a world-wide scale.  Therefore, high profitability and low risks are important for banks in order to prove their efficiency and to obtain favourable ratings, which are also needed to decrease refinancing costs.”

The availability of guarantee schemes varies by country, the EC Observatory (p 39 2003) reports that in a 2002 Enterprise Study, eighty percent of European small (and medium) firms “did not benefit from direct support services.  This report showed that only 12 percent of small firms under five years old are using loan guarantees as means for obtaining financing; eight percent for firms ten years and older.

The Economic Commission (2003) reported evidence of the effects of financial systems on the capital structure of small firms.  The increased need for alternative financing in market-based systems allows more small firm friendly regulations.     There are two types of financing systems in Europe; bank-based and market-based financial systems.  The UK is a market-based system whereas Germany and Austria is bank-based (EC Observatory 2003).  Ina bank-based system, the preferred financial investment source are loans in which banks are the most common financial providers.  In a market-based system, competitive markets are present and there is a higher need for different forms of finance such as equities and bonds.

A reoccurring trend of country specifics is again identified when investigating financial systems among various countries; the majority however uses bank-based financing with an evident “lack of alternative finding sources (EC Observatory 2003, p19). Small firm capital can be provided by its own capital or debt capital.  The Bach database of the European Commission contains information on the equity ratio of small firms.  The data provided in the Bach database demonstrates “that there is no clear link between the equity ratio and firm size” (EC Observatory 2003, p20).  The database also demonstrates that country specifics are important factors to consider when analyzing the affects of capital structure in small firms.  The size of equity ratios is quite different among various countries.

Taxation systems affect the capital structure of a small firm.  The EC Observatory (2003) found that the majority of European small firms have low equity ratios and therefore rely on external financing. Differing taxation systems such as the percentage of income or corporation checks and the type of financial system, whether it be market-based or bank-based systems greatly affect small firms.  Requirements such as the amount of minimum equity needed for start-ups and accounting regulations are also barriers to obtaining small firm financing.  Smaller firms need external financing more than larger firms due to the low equity ratio found in smaller firms.  Therefore external financing, the need for working capital, according to the EC Observatory (2003) is the most substantial barrier to small firm success.

When analyzing the affects of capital structure in small firms, the EC found that within the nineteen country report, capital structure varied heavily due to country specifications.

From the EC Observatory the percentage of equity in the debt/equity ratio can be attributed to;

• Differing taxation systems
• Differing financial systems
• Legal frame conditions
• Financial traditions

Currently, the average interest rates for small firms is 6.9% for loans in the amount of £15,000 to £25,000 or for the amounts of £1,000 and £25,000 should the firm choose fixed monthly repayments (HSBC 2007).  While it is still quite difficult for small firms to obtain loans through banks, the ones who fit the requirements will find a reduction in AIR from 2006 to 2007.  The HSBC Bank UK offers the Small Firms Loan Guarantee (SFLG) which is an alternative to conventional loans for firms without assets.

In conjunction with other lenders and the Department for Business, Enterprise and Regulatory Reform (BERR), most small firm sectors are able to receive financial assistance.  It is required that the business be in the UK, have an annual turnover of no more than £5.6million, and the firm cannot be more than five years old (HSBC 2007).  The guarantee to the lender is seventy-five percent of the loan totals; “a 2 per cent premium on the outstanding balance of the loan” is required of the borrower (HSBC, 2007, p1).  The length of the loan could be up to ten years and the guarantee is for the maximum loan amount is £250,000 (2007).

Table 2: Rates for Small Firm Loan Amounts According to HSBC Bank UK

Note: As the table demonstrates, the AIR for small firm loans has declined from 2006 to 2007 which is good news for small firms.

Purchasing power parity (PPP) theory states the price of a basket of particular goods should be roughly equivalent in each country. PPP theory predicts that the exchange rate will change if relative prices change.  The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates, but not of short-term movements. The failure of PPP theory to predict exchange rate changes more accurately may be due to the existence of transportation costs, barriers to trade and investment, and the impact of psychological factors such as bandwagon effects on market movements and short-run exchange rates (Howie and Shilling, 1988).

However, deviations from PPP and IFE can persist for considerable periods of time, especially at the level of the individual firm. The resulting variability of net cash flow is of significance as it can subject the firm to the costs of financial distress, or even default. Modern research in finance supports the reasoning that earnings fluctuations that threaten the firm’s continued viability absorb management and creditors’ time, entail out-of-pocket costs such as legal fees, and create a variety of operating and investment problems, including underinvestment in R&D. In line with this, small firms should be equipped with efficient and effective measures and methodologies to trace market variables that directly and indirectly affect the condition of the business. Market researches should be able to report minute trends in the currency rate exchanges taking note of the involve currencies that the bank is involve in.

4.3.2 Case Study Descriptive Analysis

The case study above shows multiple financial decisions and barriers that will affect a small firm’s capital structure.  First, banking trends show that small firms depend highly on bank financing, although they need alternative sources to lower the debt and equity ratio.  Small firms also do not change banks often because new terms at another bank are often unfavourable, which shows that there is a high demand but a low supply of appropriate financing terms.

Small firms depend primarily on banks for financing which has negative implications for firms with a low equity ratio.  This ultimately limits the small firm from securing different and less expensive financial resources.  Small firms receive barely adequate credit, and are charged higher interest rates and bank charges because of their limited assets and credit.

Small firms are most often denied bank financing because of a lack of collateral. Because it is often hard for small firms to receive customer payments, Late Payment directives exist with banks to shorten the length of time the firm must wait for payment as well as an increased interest rate paid to the firm for payments not paid on time.

High profitability and low risks are important for banks in order to improve their standings and gain bank favour.  This may be hard for the small firms, and so mutual guarantee associations work for the best interest of the firm, negotiating loan deals between the firm and bank and business support to the firm.

The HSBC Bank UK offers the Small Firms Loan Guarantee (SFLG) which is an alternative to conventional loans for firms without assets.

The following table outlines the financial systems that currently act as threats and benefits, with a third column of supportive opportunities towards a small firm’s financial barriers and capital structure:

Table 3: Benefits, Threats, and Opportunities

The debt/equity ratio of capital structure is based on several influential elements such as financing and the firm’s potential cash earnings if its capitalization were not leveraged (no debt), which are internal characteristics impacted by external forces.  Manager’s decision making skills in capital structure must take into account the benefits and threats that exist while seeking financing.

In order to increase the availability of finance to small firms new financial support measures have been implemented at the government level in several European countries for specific groups.

4.4 Case Study 4: How does capital structure play within the interactions between financial performance and investment decisions?

Bancel and Mittoo’s (2002), The Determinants of Capital Structure Choice: A Survey of European Firms.  Initially, this study was dismissed because the majority of the study focused on large European firms.  After some consideration, the researcher felt that Bancel and Mittoo’s (2002) study offered the opportunity to compare the results of their study on the determinants of capital structure to data compiled in this study to better understand the usage of capital structure in small firms.  By understanding the basic determinants and influences of larger firms, the researcher is able to better understand how these determinants affect small firms by highlighting which of the large firm determinants positively influence their capital structure and finding out why these same determinant cause barriers to small firms.  After a more details of Bancel and Mittoo’s (2002) study, it was realized that a portion of their survey respondents were managers from small firms and the results from their responses were extremely helpful in supporting claims in this study.

4.4.1 Case Study Descriptive Findings

The theory of capital structure has puzzled most corporate financial experts and analysts even up to now. As a matter of fact, Bradley et al (1990) stated that Capital structure theory continues to be one of the most tackled problems in the world of corporate finance.

Many experimental studies have found out that usually, during an announcement of a seasoned equity offering (SEO), stock prices usually drop dramatically. On the contrary, there has been a positive reaction whenever a rumor of regarding additional debt arises. In fact, most of the studies in relation to capital structure highlight the significance of tax shield benefits.

On whether tax arguments can indeed influence the various market reactions when it comes to security issues still remains a question. Nonetheless, investigating companies that are tax-exempt have always been done in order to make sure that all business corporations conform to national standards.

On the other hand, Howe and Shilling (1988) took it upon themselves to investigate the reactions of people towards stock prices whenever new security issues came up. This included debt and equity, as well as the Real Estate Investment Trusts (REITs) that are tax-exempt. Furthermore, they were actually able to find out that there was indeed a positive reaction on debt-issue related announcements while negative reactions surfaced quickly whenever equity issues came about.

The corporate financial approach to explaining a business firm’s capital structure configuration is found in the work of Modigliani and Miller (1958, 1963). Assuming there are perfect markets and there is perfect competition, Modigliani and Miller presented three propositions concerning the debt to equity ratio of firms. First, they claimed that financial leverage has no effect on shareholder wealth. Their second proposition states that the rate of return shareholders expect to receive will increase as the firm’s debt to equity ratio increases. Their third proposition resolved the incongruence between the first two by stating that any increase in expected return is offset by an increase in risk and, therefore, in shareholders’ required rate of return.

The theory has been criticized primarily because it assumes perfect markets, and rational economic behavior. The model assumes that profit maximization is the only goal for a firm. However, managers have other goals for their businesses, for example, growth (Goshen, 1995). Due to these limitations modern financial theory has been unable to explain the capital structure decision in large, public firms (Barton & Gordon, 1987: Myers, 1984).

Given its inability to explain the capital decisions of large public firms, the model does seem particularly useful for explaining the capital structure decisions in small firms. First of all, small business ventures do not have to respond to market assessments. Therefore, the preferences and goals of managers achieve greater significance in capital structure decisions (Barton & Matthews, 1989).

Levin and Travis (1987) suggest that small firms choose debt based more on personal preference as compared to large firms. Also, the tax advantages of debt are diminished in small firms as they generally have lower marginal tax rates than larger firms, i.e., the tax deductibility of debt is not as advantageous to small firms as to large firms (McConnell and Pettit, 1984). Finally, small firms have higher bankruptcy costs than large firms which increases the financial risk of debt (McConnell & Petit, 1984).

The existing standard of the capital structure decision does not include factors such as owner’s values or goals which are relevant to the financing decisions of both large and small firms (Barton & Gordon, 1987; Barton & Matthews, 1989). Strategy scholars, on the other hand believe that the dominant coalition or top management of the firm determines the strategic course of action A corporate strategy perspective is superior to a finance perspective in explaining small firm financial decisions. This perspective involves exploring the link between owner’s goals and risk preferences and their relationships to financing decisions.

4.4.2 Case Study Descriptive Analysis

The majority of the sample firms paid dividends and selected the maturity of debt or raising capital based on hedging.  Another component was targeted debt to equity ratio, half of which maintain a debt to equity ratio of one, but because small firms have extreme financial barriers which affect their ability to obtain debt, it is important to note that the majority had issued equity; and a strong number had also issued convertible debt.  The number one influence of debt policy was the lowering of weighted average cost of capital.  The timing of debt and equity issue was reported as being moderately important.  Other managers in small firms reported that it is important to them that the firm issues long term debt during poor economic times in order to minimize the risk of refinancing.

To analyze the manner in which capital structure plays within the interactions between financial performance and investment decisions, it is first important to understand what the majority of those financial decisions are, based on the above case study:

Figure 1: Majority Financial Decisions

Then it becomes important to analyze the manager’s decision making structure, which in the above chart would be the arrows that indicate the decisions being made from one capital structure choice to the next.  Expanding on the above chart, the arrows indicate that there is a decision process between capital structure investment decisions.  These decision processes are within the manager of a small firm’s realm, where the following arrow chart expands on the decision processes.

The manager’s decision tools can be expressed as:

Figure 2: Manager’s Decision Tools

The theory of capital structure has puzzled most corporate financial experts and analysts even up to now. As a matter of fact, Brounen and Eichholtz (2001) stated that Capital structure theory continues to be one of the most tackled problems in the world of corporate finance.

Many experimental studies have found out that usually, during an announcement of a seasoned equity offering (SEO), stock prices usually drop dramatically. On the contrary, there has been a positive reaction whenever a rumor of regarding additional debt arises. In fact, most of the studies in relation to capital structure highlight the significance of tax shield benefits. On whether tax arguments can indeed influence the various market reactions when it comes to security issues still remains a question. Nonetheless, investigating companies that are tax-exempt have always been done in order to make sure that all business corporations conform to national standards.

On the other hand, Howe and Shilling (1988) took it upon themselves to investigate the reactions of people towards stock prices whenever new security issues came up. This included debt and equity, as well as the Real Estate Investment Trusts (REITs) that are tax-exempt. Furthermore, they were actually able to find out that there was indeed a positive reaction on debt-issue related announcements while negative reactions surfaced quickly whenever equity issues came about.

Assuming there are perfect markets and there is perfect competition, the debt to equity ratio of firms. First, they claimed that financial leverage has no effect on shareholder wealth. Their second proposition states that the rate of return shareholders expect to receive will increase as the small firm’s debt to equity ratio increases. Their third proposition resolved the incongruence between the first two by stating that any increase in expected return is offset by an increase in risk and, therefore, in shareholders’ required rate of return.

The theory has been criticized primarily because it assumes perfect markets, and rational economic behavior. The model assumes that profit maximization is the only goal for a firm. However, managers have other goals for their businesses, for example, growth. Due to these limitations modern financial theory has been unable to explain the capital structure decision in large, public firms (Barton & Gordon, 1987: Myers, 1984).

Given its inability to explain the capital decisions of large public firms, the model does seem particularly useful for explaining the capital structure decisions in small firms. First of all, small business ventures do not have to respond to market assessments. Therefore, the preferences and goals of managers achieve greater significance in capital structure decisions (Barton & Matthews, 1989).

Levin and Travis (1987) suggest that small firms choose debt based more on personal preference as compared to large firms. Also, the tax advantages of debt are diminished in small firms as they generally have lower marginal tax rates than larger firms, i.e., the tax deductibility of debt is not as advantageous to small firms as to large firms (McConnell and Pettit, 1984). Finally, small firms have higher bankruptcy costs than large firms which increase the financial risk of debt (McConnell & Petit, 1984).

The existing standard of the capital structure decision does not include factors such as owner’s values or goals which are relevant to the financing decisions of both large and small firms (Barton & Gordon, 1987; Barton & Matthews, 1989). Strategy scholars, on the other hand believe that the dominant coalition or top management of the firm determines the strategic course of action A corporate strategy perspective is superior to a finance perspective in explaining small firm financial decisions. This perspective involves exploring the link between owner’s goals and risk preferences and their relationships to financing decisions.

Finally, to analyze the question relative to Case Study 4, it is also important to consider the case study’s exemplification of manager’s perceptions and how it impacts capital structure of firms.  Each circle within the arrow chart above represents a point at which the manager has made a judgment call based on his or her perception of the situation.  This is relative to each point in the above chart, where each point is impacted by the following manager perceptions.  Based on this idea, and the case study information, the manager’s perceptions that influence decisions (which influence investments and capital structure as shown in the first chart of this section) the following chart examines how a manager’s perception impacts the final decision making model:

Figure 3: Manager’s Perceptions

Based on this analysis, capital structure plays within the interactions between financial performance and investment decisions on multiple levels, including the perceptions, decision-making, and options management has regarding investment decisions.

4.5 Case Study Conclusion

The case study analysis attempted to answer the four investigative questions brought forth in the previous literature review and key problems chapters.  These questions were:

1. What is the role of capital structure played in small firms within a perfect and imperfect market?
2. How does capital structure affect small firms?

• What is the optimal capital structure?

1. How do financial barriers affect a small firm’s capital structure?
2. How does capital structure play within the interactions between financial performance and investment decisions?

The analysis of the role of capital structure in small firms within imperfect and perfect markets is, at its most basic definition, to increase or decrease leverage.  As the market moves away from perfection, the capital structure of a small firm must navigate decisions to increase leverage.

Capital structure can be influenced by practical considerations such as Asset structures, Control, financial flexibility, growth rates, risk attitudes, and sales stability.  Capital structure decisions may affect a company’s market value because if shareholders found out problems that the company has, they may be less interested with buying shares in the company. A company having lower market value means lesser people will be attracted to buy shares of the company. If people found out that shareholders are less interested in the company, lesser people will buy the company’s product.

Capital structure represents the major claim to a corporation’s assets. It includes publicly issued securities, private placements, bank debt, trade debt, leasing contracts, tax liabilities, pension liabilities, deferred compensation to management and employees, performance guarantees, product warrantees, and other contingent liabilities. A firm’s capital structure can refer to the relationship between debt and equity finance in its long-term funding arrangements. Debt finance refers to external borrowings such as long-term loans: equity finance refers to the funds provided by the firm’s owners, the shareholders. The firm usually raises long-term debt and equity financing through the financial markets.

Part of capital structure is gearing.  There are two dimensions to a firm’s total gearing, financial gearing and operating gearing. Financial gearing refers to the way in which the owners of a firm can use debt finance to prepare and present well the assets and earnings of the firm. The greater a firm’s borrowings, the greater will be its financial gearing and its financial risk.

Operating gearing refers to the proportion of fixed operating costs in a firm’s total operating costs. The higher the proportion of fixed costs, the higher the level of operating gearing and also the higher the firm’s operating or business risk.

Capital structure decisions are considered to be very important; it is critical not to oversee the fact that it is investment decisions and actions which ultimately determine a firm’s future and value. The capital structure decision has previously been approached from various points of view and from different perspectives. This gives a cost of capital, which is to be used to assess the value of individual projects. These projects are the foundation of the firm and its riskiness and thus the determinants of capital structure. Companies should maintain some reserve borrowing capacity so that they can preserve their ability to preserve their ability to issue debts on favorable terms. Firms use less debt in certain normal conditions to achieve financial flexibility. When companies do this, they start to show a stronger financial picture.

Chart 7: Capital Structure Tool

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