Capital Structure
Author: Priyal Kadam
Venture capital in capital structure
Becsky, Karaszi, (2015) presented this topic discusses the role of venture capital (VC) financing, particularly the use of convertible preferred equity, in the capital structure of companies. Theoretical research suggests that convertible preferred equity is an optimal financing method due to its ability to protect investors, reduce ownership dilution, and manage agency problems. However, empirical studies show that its use varies across countries. In the U.S., it is commonly used due to favourable tax laws, while in other countries like Canada, common equity and debt are more frequently used. The choice of financing method depends on the type of company, the agency problems present, and local market conditions. Overall, there is no single optimal method for all situations.
Market Timing and Capital Structure
Jeffrey & Malcolm, (2001) Studies the concept of equity “market timing” in corporate finance, where firms issue shares at high prices and repurchase at low prices to exploit temporary fluctuations in the cost of equity. The theory contrasts efficient capital markets, where there are no gains from such actions, with inefficient markets, where market timing benefits ongoing shareholders but harms those entering or exiting. The paper aims to explore how market-to-book ratios influence capital structure decisions, especially through net equity issues, and whether market-to-book ratios have persistent effects on leverage. The study focuses on COMPUSTAT firms that went public between 1968 and 1999, with data on their IPO dates and market-to-book ratios. The sample excludes financial firms, those with small asset bases, and outliers. The goal is to understand how leverage evolves over time and how market-to-book ratios affect financing decisions.
Application of cost of capital for capital structuring in croatian firms
Orsag, Mitar, (2014) Examines the application of the cost of capital in capital structuring decisions in Croatian firms. It highlights the evolution of capital structure theory, from early discussions in the 1950s to theories such as the trade-off theory, pecking order theory, and others. Croatia’s economic transition, firms began incorporating the cost of capital in their capital budgeting, often using the required rate of return or the Capital Asset Pricing Model (CAPM). A survey found that 76 out of 100 Croatian shareholding firms calculated the cost of capital for their investment decisions. The study aims to investigate how much Croatian managers consider the cost of capital in structuring their capital and whether this practice contributes to improving company performance.
Theories In Capital Structure
Decisions Herczeg, (2014) this study explores various objectives in capital structure decision-making. The primary goal is to maximize the value of the firm, while a narrower goal focuses on maximizing stockholder wealth. In efficient markets, the aim is typically to maximize the stock price, but this objective is the most restrictive, as it assumes bondholder protection, market efficiency, and minimal social costs. Firm value maximization is less restrictive, as it does not require bondholder protection. The passage explains that actions increasing firm value will only lead to stockholder wealth and stock price maximization if the stricter conditions hold. For privately held firms, the objective is firm value maximization, as stock price data isn’t available. These firms lack the feedback that publicly traded firms receive when making significant decisions. In summary, firm value maximization is the broader goal, with stock price maximization being relevant only for publicly traded companies.
Leasing, Capital Structure and Debt Displacement
Maria, (2005) presented various theories on capital structure, focusing on the relationship between debt and leasing. Initially, Modigliani and Miller proposed that the debt-equity mix didn’t matter, but later adjusted this theory by incorporating taxes, leading to the “borrow all you can” concept. However, by the 1970s, considerations of agency costs and bankruptcy costs shifted the view, with Myers suggesting that firms should not borrow as much as possible. The “trade-off” model emerged, followed by the “pecking order” model, which prioritizes internal funds first, followed by debt, and then equity issuance. Empirical studies by Shyam-Sunder and Myers and Kang and Long provided evidence supporting the pecking order model over the trade-off model. In terms of leasing, studies by Myers, Dill, and Bautista suggested the concept of debt displacement by leasing, but the exact value of this displacement (λ) remained unclear. Further studies, such as those by Ang and Peterson, found that debt and leasing are complementary, rather than substitutes.
Bank Market Structure and Firm Capital Structure
Lieven, Rudi, (2008) the literature identifies two main hypotheses that explain the supply of bank loans: the market power hypothesis and the information-based hypothesis. According to the market power hypothesis, higher market concentration may lead to reduced competition, allowing banks to exercise greater control over lending terms. On the other hand, the information-based hypothesis suggests that banks, with their informational advantage, can provide more tailored loans based on detailed knowledge of borrowers.The authors also control for the demand side of external finance, incorporating firm characteristics known to influence capital structure, such as collateral and firm size. Collateral is particularly important because it is closely linked to relationship lending, a practice where banks use collateral to secure loans and reduce lending risks. The paper argues that these firm characteristics, especially collateral and size, interact with bank market concentration to influence the availability and terms of bank loans. Thus, understanding the interplay between these factors is essential for assessing how changes in market structure can impact firms’ access to finance.
Impact of Capital Structure on Shareholder’s Wealth
Tak, (2016) the research identifies capital structure of a firm refers to the mix of debt and equity used to finance its business activities. It is a crucial decision, as it directly impacts the profitability and financial stability of the company, affecting shareholder wealth. The study aims to explore the relationship between capital structure and its impact on shareholder wealth, specifically within the cement industry of Pakistan. It also seeks to identify which capital structure theory best applies to this industry for wealth maximization. The theoretical foundation of capital structure originates from Modigliani and Miller’s (M&M) work in 1958, which introduced the capital structure irrelevance proposition. This theory, along with other capital structure models, is used to analyze the optimal debt ratio and financing strategies for firms in different institutional environments.
Thin Capitalization Rules and Multinational Firm Capital Structure
Blouin, (2014) these study present thin capitalization rules restrict the deductibility of interest on debt above certain levels to prevent tax avoidance through excessive debt financing. Multinational firms, particularly foreign subsidiaries, can adjust their leverage by shifting debt internationally. To counter this, many countries have implemented thin capitalization rules to limit tax deductions on interest payments, which affects the capital structure of multinational firms’ foreign affiliates. This study examines the thin capitalization regimes in 54 countries from 1980-2004, using data from US multinationals and their foreign affiliates. The findings suggest that these rules significantly influence the capital structure of foreign affiliates by restricting debt levels and, consequently, the tax benefits from interest deductions.
Capital Fundamentalism and Structural Transformation
Achmad, (2021) the study discusses the relationship between capital investment and economic development, particularly in the context of structural transformation. Structural transformation, as introduced by Lewis (1954), involves reallocating resources from subsistence sectors to more productive ones. The paper aims to explore whether capital injections, as exemplified by the IDT (Inpres Desa Tertinggal) program, can drive economic development. The IDT program was Indonesia’s first anti-poverty initiative, implemented between 1994 and 1996, aiming to accelerate poverty reduction in underdeveloped villages. The government provided lump-sum grants for small business loans in selected villages. Initially, the program targeted about one-third of Indonesian villages using a scoring system based on various criteria.
Inflation and Capital Structure
Jose, (2001) the study examines effect of steady inflation on corporate financial leverage, focusing on how inflation influences firms’ capital structure and dividend policy. Several theories link inflation to corporate capital structure, often through the demand or supply of corporate bonds. For example, inflation lowers the real cost of debt, increasing the demand for corporate bonds. Conversely, as inflation decreases, the return on bonds may outperform stocks, increasing demand for bonds. Another key factor is the tax structure. suggests that even with deductible interest payments, the firm’s value remains independent of its capital structure, while Dammon (1988) argues that inflation and progressive tax rates make adjusting capital structure challenging. This leads to changes in corporate leverage, as higher inflation encourages investors to shift from bonds to stocks, reducing firms’ debt-to-equity ratios.
Conclusion
The research on capital structure explores various theoretical and empirical perspectives that shape corporate financing decisions. Key themes include the role of venture capital, market timing, cost of capital, leasing, bank market structures, and regulatory policies like thin capitalization rules. Studies highlight that there is no universally optimal capital structure, as firms adapt their financing strategies based on market conditions, taxation, shareholder value considerations, and industry-specific factors. Overall, the research underscores that capital structure is a dynamic and context-dependent decision-making process. Firms must continuously evaluate financing options in response to changing economic, financial, and policy landscapes to optimize their growth and financial stability.
Reference
Becsky-Nagy Patricia & Karaszi Erika, 2015. “Capital Structure And Venture Capital,” Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 1(1), pages 783-791, July.
Herczeg Adrienn, 2014. “Summary Of Theories In Capital Structure Decisions,” Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 1(1), pages 912-918, July.
Jeffrey A. Wurgler & Malcolm P. Baker, 2001. “Market Timing and Capital Structure,” Yale School of Management Working Papers ysm181, Yale School of Management.
Jennifer Blouin & Harry Huizinga & Luc Laeven & Gaëtan J.A. Nicodème & Gaëtan J.A. Nicodeme, 2014. “Thin Capitalization Rules and Multinational Firm Capital Structure,” CESifo Working Paper Series 4695, CESifo.
Jose Noguera, 2001. “Inflation and Capital Structure,” Finance 0111001, University Library of Munich, Germany.
Lieven Baert & Rudi Vander Vennet, 2008. “Bank Market Structure and Firm Capital Structure,” Working Paper / FINESS 2.1, DIW Berlin, German Institute for Economic Research.
Maria Andrada Georgescu, 2005. “Leasing, Capital Structure And Debt Displacement,” JOURNAL STUDIA UNIVERSITATIS BABES-BOLYAI NEGOTIA, Babes-Bolyai University, Faculty of Business.
Orsag, Silvije & Mitar, Josip, 2014. “Application Of Cost Of Capital For Capital Structuring In Croatian Firms,” UTMS Journal of Economics, University of Tourism and Management, Skopje, Macedonia, vol. 5(2), pages 151-158.
Tak, Alina, 2016. “Impact of Capital Structure on Shareholder’s Wealth,” MPRA Paper 116421, University Library of Munich, Germany, revised 13 Oct 2022.
Tohari, Achmad & Parsons, Christopher & Rammohan, Anu, 2021. “Capital Fundamentalism and Structural Transformation,” IZA Discussion Papers 14444, Institute of Labor Economics (IZA).