The Capital Structure Of The Firm

Published Date: 02 Nov 2017

CHAPTER 1

Introduction

Background

Studying firm’s capital structure is important as it plays important role in creating value for the firm via the effect tax, information asymmetry, and agency cost. Besides, financial theory also has been used by firms to choose the best composition of capital structure that enhances the firm’s value. Therefore, study on capital structure would provide valuable insights on how strategic decision of firms in implementing investments would affect its value, which in return, used to determine its position in the market.

This study tried to general call for interactive between finance and strategy by examining how financial decision is related to corporate strategy (Kochhar and Hitt 1998) used listed companies on Mongolian Stock Exchange. With relatively few exceptions, strategy management and finance appear to be in schizophrenic tension, if not in direct opposition (Grundy 1996). Bettis (1983) argued that modern financial theory and strategic management are based on very different paradigms, resulting in opposing conclusions.

The polarity between finance and strategy, two areas of study that traditionally are studied difference, is just apparent, instead, these two areas present many connections, and it is relevant to understand the way in which these areas function individually and to interact. The choice of financial policy is the most important decisions of the company. The financial policy refers to the decision regarding firm’s capital structure.

The capital structure of the firm consists of the mix of debt and equity instruments, used to finance firm’s assets. This mix basically consists of common stock, debt, and preferred stock. The managers plan to do strategy the capital structure that minimize the cost of financing and hence maximizes the value of the firm. The biggest challenge for the managers at a firm is to choose the capital structure that minimizes the cost of financing the firm’s activities and thus maximizes the value of the firm. This right mix is referred to as the optimum capital structure; however in practice it is very difficult to attain the optimal level. There are several factors that may have an impact on firm’s financial choice and several empirical studies have tried to explore the most important strategy of capital structure.

In particular, the link between financial decisions and strategy is largely undiscovered. An extremely relevant topic, notoriously controversial, to the finance and business community relates to capital structure decision and their effects on firm’s creation of value. A firm’s capital structure refers, generally, to mix of its financial liabilities. In analyzing capital structure we focused on the type of funds, debt or equity, used in the firm for financing. Debt and equity are two types’ classes of liabilities, with debtholders and shareholders representing the two types of investors in the firm. Each of these associated the different levels of risk, benefits and control. While debtholbers exert lower control, they earn a fixed rate of return and that are protected by contractual commitment with respect to their investments. Shareholders are the residual claimants, bearing most of risk, and correspondence, has greater control over decisions.

In the past, financial theorists suggested that, in perfect and efficient market, financing decision may be "irrelevant" for firm’s strategy (Modigliani and Millet 1958); however, in the real world such choices may differentially affect firm value, explicitly because there are several imperfections (Myers and Majlut 1984). Several strategy scholars have argued that financial decisions have strategic importance (Barton and Gordon 1987, Kochhar 1996), especially in affecting corporate governance (Jensen 1986). Oviatt (1984) pointed out that a theoretical interactive between the two disciplines is indeed possible, and that according to the way managers, firm’s financial stakeholders and firm’s non-financial stakeholders interrelate, transaction cost economics and agency theory provides possible method. Barton and Gordon (1987) pointed out that corporate strategies complement traditional finance paradigms and enrich the understanding of a firm’s capital-structure decision. In addition to tax reasons, the value of a firm can be affected by financing decisions in the moment those information asymmetries between the firm’s management and its stakeholders are noted, or when "real" decision differ from financing decisions, because of agency problem, for example, or whether costs of financial distress are generated due to debt. Therefore, it is important to greater concept the potential interactive between capital structure and corporate strategy.

In general, the literature on finance and strategy analyses how the strategic behavior of key players (shareholders, debtholders, managers, suppliers, competitors, works, etc) impact firm value and the allocation of value between shareholders. It is possible to provide a different role on these corporate players according to how "close" they are to the main of the corporation, if they are corporation’s owners, as shareholders and debtholders, or if they are at the boundary of the core, as suppliers, competitors, customers, etc. Specifically, capital structure decisions can concern value creation process 1) influencing impact investment decision according to the existence of conflict of interest between managers and firm’s financial shareholders and debtholders and (2) affecting the relationship with non-financial stakeholders, as competitors, suppliers, customers, etc.

From one side, this paper provides the factors affecting agency problems with the financial stakeholders, explaining how debt can cause shareholders to take on projects that are too risky and to pass up profitable investment, but also identifying various situations in which debtholders and shareholders may argued on the decision to liquidate the firm. The interactions between managers, shareholders and bondholders can influence the process of identifying, selecting and choosing investment project and, as a result, the processes of value creation. The presence of these conflicts, together with information asymmetries and incomplete contracting, can give rise to investment strategy that do minimize the firm’s value but rather benefit only a specific category of subjects.

On the other side, debt policy can affect the non-financial stakeholder’s behavior and the competitiveness in the product market, directly influencing the firm’s competitive strategy and, as a consequence, the processes of value creation. A new way of research has analyzed the possible connections between capital structure, stakeholder theory, market structure, and a firm’s strategic behavior. First, capital structure affects the behavior of non-financial stakeholders, as claimants to the firm’s cash flow in addition to shareholders and bondholders. Second, debt level impact market structure and thus leads to either higher or lower industry concentration levels. In addition, capital structure can to attend upon as a mode to allocate to certain product market strategy. According to the underlying assumptions of this notion, leverage will cause firms to behave more or less aggressively, which makes competition "together" on "softer". Therefore, the paper describes how firm’s financial situation is likely to affect its sales, its capable to attract employer and supplier, the competitors behavior in the market, and in general the ability of a firm to operate its business profitably. In all the cases it is important to realize, and be aware, about the role of capital structure in mitigating corporate governance problems and leveraging the firm’s competitive advantage.

This paper intends to discuss these interactions and the consequences on the value processes. The rest of the paper is organized as it follows. The second part highlighted how the interaction between managers, shareholders and debtholders affects capital structure and investment decision. The third paragraph focused on interrelated between how a company is financed and how it is views by its non-financial stakeholders, suggesting that capital structure decision must be incorporated into the overall corporate strategy of the firms. The last paragraph on discussed the main conclusion, providing direction for future research.

1.2. The significance of Capital Structure

In practice, most financing decision involves choosing between debt and equity. When facing such choices, managers have to evaluate whether debt it the most suitable form of funding with respect to the firm’s particular conditions. However, capital structure is not static but changes constantly making it very difficult for financial managers to pinpoint a specific optimal proportion between debt and equity in each circumstance. The optimal relationship is likely a matter of whether the project activity generates strong cash flow, the general marketability of the company’s assets, predictions about the industry’s outlook, the level of interest rates, regulations, social factors and the economy in general. Financial managers seeking funds for a new project, but at the same time are unwilling to reduce dividends or to make rights issue, have to evaluate and consider the debt option. However, when firms make their financing decision to obtain the optimal capital structure, they consider the benefits of tax advantages and incentives versus the cost of default. Thus the main arguments for using debt to finance company activities rely on its relative cost. Usually, debt capital is less expensive for firms than equity since the pre-tax rate of interest is lower than the return required by shareholders. The interest on debt is tax deductible, lowering the cost of debt relative to equity. Moreover, issuing debt involves lower administrative costs as it does not necessarily require an underwriter.

Furthermore, the choice of capital structure has a significant impact on the value of the firm. Traditionally, a small increase in the debt-to-equity ratio does not affect shareholders return requirements as long as the probability of financial distress remains low. Thus, the substitution of equity to debt can enhance shareholder returns and create wealth in good financial years. Consequently, it can lower the overall or weighted average cost of capital (WACC) and in turn raise the market value of the enterprise. This is based on the assumption that the rate of return requirement by shareholders and the interest rate remain constant. However, this positive effect on shareholder return can be observed only at relatively safe gearing levels. As debt levels grow, especially when firm’s conditions worsen, the variability in net earnings will increase which in turn may enhance the risk default. This means that shareholders face additional financial risk that is different from the trading risk specific to the business, and will therefore seek higher return. Additionally, lenders of further debt will toughen their requirements as they perceive the prospect of default more significant. As the rate of shareholder return and the interest rate move upwards the WACC will also rise, hence reducing firm value. Debt can be risky to company survival; hence it is of huge significance that managers carefully assess whether or not debt is the most appropriate financing choice considering the company’s actual situation. These reflections are considered in three prominent theories in the area of capital structure.

The static trade-off theory implies that firms tend to choose the level of debt at which the tax benefits of additional debt balances the cost of default. Simply, they trade off the cost benefits of debt against the risks associated with it. According to the pecking order theory, when firm internal cash flows are not strong enough to finance real investment, they will most likely raise capital by selling debt rather than issuing new equity. This advocates that firms have an order of priorities when choosing different forms of funding. Initially, they rather employ internal funds to finance projects. However when internal funds are exhausted they prefer to borrow, i.e. use debt to a suitable debt/equity combination. Eventually, they consider equity by issuing new shares as a last resort. Information asymmetry is the main motive behind this order of preference. Managers have an information advantage about the firm’s performance relative to outsiders. The free cash flow theory is more relevant to mature overinvesting firms. It suggests that firm’s leverage level is dependent on the strength of their operating cash flows, indicating that high leverage will increase value, despite of the risk of financial distress. (Titman and Wessles 1988;). This theory accentuates the agency cost phenomenon, which is due the fact that managers are agent of shareholders. Shareholders neither observe the firm’s cash flow not managements action. This relationship creates conflicting interests, and the reason lies yet again in information asymmetry. Shareholders advocate cash payouts in order to restrain manager’s control over the free cash flow that is the cash flow that exceeds the amount required for funding all positive net present value projects (NPV). On the contrary, managers value investment as they seek out to grow their business. Investment also increases manager’s power and perquisites even though the firm invests in negative NPV project. Debt plays a major role in lowering these agency costs of firm, hence motivating managers and their organizations to be proficient. Dividends can be reduced in the future, thus still leaving managers with control over the free cash flow. However, introducing debt to a firm’s capital structure force managers to pay out future cash flows, otherwise debt holders have the right to take the firm to bankruptcy court if it does not meet the interest and principle payments (Jensen, 1986).

This control function has a huge impact on determining the optimal level of capital structure; however it does not necessarily apply to all types of firms. Early stage businesses are more likely to grow rapidly and have large and substantially profitable investment projects, but no or negative expected free cash flows. These organizations lean more on equity than debt financing, and have to turn frequently to capital markets to obtain capital. On the other hand, large more established businesses have low growth opportunities, but produce positive and large free cash flows. In these organizations, the risk of squandering cash flows on negative NPV project could be grave; hence shareholders may want managers to issue more debt to lower this risk (Jensen 1986).

1.3. The Mongolian Institutional Context

Country Context

Mongolia is landlocked between two powerful neighbors; it borders Russia to the north and the People’s Republic of China to the south, east and west, low-middle income country with a population of about 2.9 million and a per capita gross domestic product (GDP) of about $4743 in 2012.

Economic activity in Mongolia has traditionally been based on herding and agricultures, even though development of extensive appeared as a driver of industrial production. One side mining (21.8% of GDP) and agriculture (16% of GDP), strong industries in the composition of GDP are distribution and retail trade and service, storage, transportation and real estate activities. The grey economy is estimated to be at least one-third the size of the official economy. As of 2006, 64.8% of Mongolia’s export to the PRC and PRC supplied 28.9% of Mongolia’s import.

Mongolia is placed as lower middle income economy by the World Bank. 22.4% of the population lives on less than 1.25 US$ a day. GDP per capita in 2011 was $3100. Despite growth, the proportion of the population below the poverty line was estimated to be 36.5% in 1998, 36.1% 2002-2203, and 32.3% in 2006. Because of a boom in the mining sector. Mongolia has high growth rates in 2007 and 2008 (9.8% and 8.7% respectively). In 2009, sharp decrease in commodity prices and impact of the global financial crisis caused the local currency to decrease 40% against the US dollar. Two of the 16 commercial banks were taken into receivership. GDP growth in 2011 was expected to increase 16.4%. However, inflation continued to erode GDP profit, with an average rate of 12.6% expected in Mongolian at the end of 2011. Although GDP has increased steadily since 2002 at the rate of 7.5% in an official 2006 estimate, the state is still working to overcome sizable trade deficit. The Economist expects this trade deficit of 14.5% of Mongolia’s GDP to transform into a surplus in 2013.

Government’s Sector Strategies

In the 1990s the Government adopted a strategy that included macroeconomic stabilization to address immediate problem, sustainable economic growth, and implementation of reforms considered necessary for a successful transition to a market economy, as well as central role for commercial banks. The main objective of the reform program was to promote establishment of a competitive, autonomous, market-based, and sound financial system that could regain public confidence and efficiently mobilize and allocate resources for economic growth. The financial sector reform program was therefore expected to: (i) strengthen financial intermediaries, (ii) strengthen the legal and regulatory framework for the financial sector, and (iii) establish a market-based financial intermediation process.

In 2000, the Government formulated a Medium-term strategy for Financial Sector Development (covering the period 2000-2050, based on lessons from efforts to reform the financial sector during the previous decade. It also addressed the liquidity and solvency problem faced by commercial banks as a result of the 1999 financial crisis, which was caused by serve drop in the prices of major commodity export.

In 2003, the Government prepared the National Action Plan for 2007-2011. That plan highlighted the importance of continued financial sector reforms to achieve a GDP growth rate of about 6% over the medium term. Accordingly, the plans set out to (i) consolidate financial sector stabilization, (ii) strengthen the stock exchange to mobilize savings for productive investment, and (iii) develop a broader range of financial services and instruments.

1.4. Research Questions

Traditional financial theories of capital structure as the result of mainly financial, tax and growth factors (Modigliani and Miller, 1958). Corporate governance theories (Jensen and Meckling, 1976) and business strategy theories (Barton and Gordon, 1988), however, suggest that other factors may also influence capital structure. Focusing on the Mongolian corporate, this research moves beyond the conventional approach and includes models of capital structure that recognize the importance of business strategy and corporate governance as well financial factors. These different perspectives will be used to help examine the fundamental research question:

What are the determinants of capital structure in Mongolian listed companies?

Within this fundamental question, there are two important secondary question:

What is the relative effect of financial factors, strategy factors and governance factors on capital structure?

Are the observed relationships consistent with the theory and empirical evidence derived from studies in developing market economies?

1.5. Research Objectives

A number of corporates have guided the direction of this work:

The importance of capital structure in the development of firms and with that, the ambiguity of their findings the rapidly changing disposition of Mongolia as an open market economy, and the effect that internal and institutional developments have on capital structure and the development of firms with these motivations in mind, this research sets out to achieve a number of objective:

To establish a multi-disciplinary theoretical framework incorporating financial, business strategy and corporate governance factors in order to examine the determinants of capital structure of Mongolian Stock Exchange (MSE) listed companies. The studies will apple trade-off- theory and pecking order theory in the traditional financial approach as the basis of the framework.

To review the process of Mongolia SOE reform from the perspective of the theoretical framework in order to identify the Mongolian institutional factors that may impact the capital structure and assess the relevance of capital structure theories for the Mongolian corporate;

To design, on the basis of the theoretical framework, multi-variable and multi-level statistical models of capital structure using data collected from 144 companies and to test the hypotheses test with relevant theories;

To design, on the basis of the theoretical framework, research methodology using both ordinary least square models and estimate the significance of various statistical models;

To investigate the empirical evidence for the determinants of capital structure, on the basis of the theoretical framework, particularly the impact of financial variables, asset specificity, ownership structure and ownership concentration on capital structure.