The Optimal Capital Structure

Published Date: 02 Nov 2017

This chapter deals with the firm’s capital structure, which refers to the way it finances its assets through some combination of debt, equity, or hybrids. The main objective is to determine the optimal capital structure such that the firm value is maximized.

The starting point of this study is a frictionless financial environment, in which there are no taxes and transaction costs, and contracts are costless to be designed and enforced. In such environments the value of the firm is not affected by its financing mix and, therefore, the value of the shareholders is not affected by policies that change only the firm’s capital structure, e.g. issuing new stock to retire debt. In the real world, however, there are many frictions that affect the firm’s capital structure, such as laws, regulations and taxes. Because these frictions differ from country to country and change over time, it is impossible to find a single optimal financing mix that applies to all firms.

In this chapter it will be presented an overview of financing possibilities available to a firm. Then, the attention moves on the fundamental theories that are currently employed to explain the capital structure of the firm: trade-off theory and pecking order theory. At the end, it will be given a description of the historical behavioral of the firm’s financing choices in the last decades.

Financing Channels

Every company has two possible instruments in order to raise its funds – debt and equity. This section discusses in detail the characteristics of each instrument and the range of all vehicles available within each category.

Equity

Equity is the first instrument that allows a firm raising funds. It can be of different forms depending on whether the firm is privately owned or publicly traded and on risk characteristics of the firm. For the private firms, the set of available choices is very restricted because they cannot issue securities in order to raise equity. Consequently, they have to make use of the owner’s equity or external entity in order to get the needed equity. Publicly traded firms, on the other hand, have a wider array of choices since they have access to capital markets.

There are five possible vehicles available to the firm that might be used for raising firm’s funds with equity [1] :

Owner’s equity

Owner’s equity resides in all funds brought in by the owner of the company and provides the main financing possibility for growth and eventual success for the firm, particularly for new and small companies.

Private equity

A venture capitalist and private equity investor provides equity to startups or small companies. In return they archive a share of the ownership to the firm. These investors are typically wealthy enough so they can afford to take the risks associated with funding young companies which appear to have a great idea and management team. They invest in such companies because they can earn a massive return on their investments if these companies succeed. However, if these companies fail they experience major losses.

Common Stock

A common stock is a simple security that represents ownership in a corporation [2] . It can be issued by a firm in order to raise equity at a certain price the market is willing to pay. For a newly listed company, this price is estimated by issuing entity, such as an investment banker. For an existing publicly traded company, on the other hand, this price is estimated based on the current market price of the company.

Warrants

A warrant is a derivative security that gives the holders the right to buy company’s shares at a fixed price within a certain time frame. Because their value is derived from the price of the underlying common stock, they have to be treated as another form of equity.

A firm might prefer to use warrants rather than common stock for several reasons. The first is that warrants are priced based on the volatility assigned to the underlying stock; the greater the volatility, the greater the value. Second, warrants by themselves do not create a financial obligation at the time of the issue. Consequently, issuing warrants is a perfect instrument for high-growth firm to raise funds, especially when firms are in financial distress: firm’s current cash flows are either very low or negative.

Contingent Value Rights

A contingent value rights provide investors the right to sell stocks at a fixed price. The value of these stocks is derived from the volatility of the stock and the desire of investors to hedge away their losses.

There are several reasons why CVRs are issued by firms. The most obvious is that firms believe that they are significantly undervalued by the market. In such scenario, the firm offer CVR in order to take advantage of its belief and provide a signal to the market of the undervaluation.

Debt

Debt is the second instrument that allows firms raising their funds. This option creates a fixed obligation to make cash flow payments and provides the lender with prior claims if the firm is in financial difficulties. In order to borrow money a firm can choose among three possibilities [3] :

Bank Debt

Bank debt is the most common source used by a large number of private firms and many publicly traded firms. It provides several advantages to borrow money. The first is that it can be used to borrow relatively small amounts of money. The second is that it provides a convenient mechanism to convey information to the lender that will help in pricing and loan evaluation.

Besides being a source of either long-term or short-term borrowing for firms, banks debt may often offer an option that meet unanticipated or seasonally financing needs, the so called line of credit. In most cases, a line of credit specifies the amount that firms can borrow and links the market rate with the interest rate on the borrowing. The advantage of having a line of credit is that it allows firms access the funds without having to pay interests if the funds remain unused. In many cases, however, firms are required to maintain a compensating balance on which they do not earn interest.

Bonds

Bonds are the primary source to borrow money for larger, publicly traded firms. They provide firms several advantages. The first is that they usually carry more favorable financing terms than bank debt because risk is shared among a larger number of financial market investors. The second is that bond issue might provide a chance for the issuer to add on special features that are impossible to be added on to bank debt.

Leases

A lease is a contract that lay out the details under which one party agree to rent property to another party. It guarantees the renter (the lessee) the right to use the asset and the owner of the asset (the lessor) regular payments from the lessee for a specified period, that can be totally or partially tax-deductible, depending on how the lease is categorized for accounting purposes.

There are two possible types of leases: operating lease and capital lease. For an operating lease, the term of the agreement is shorter than the life of the asset, and the present value of lease payments is generally much lower than the actual price of the asset. At the end of the agreement, the asset reverts back to the lessor, who will offer to sell it to the lessee or somebody else. The lessee has the right to cancel the contract and return the asset to the lessor. Thus, the ownership of the asset in an operating lease resides with the lessor, with the lessee bearing the risk if the asset becomes obsolete.

A capital lease, on the other hand, lasts for the life of the asset, and the present values of lease payments are equal to the actual price of the asset. A capital lease generally cannot be cancelled, and can be renewed at the end of its life at a reduced rate or the asset acquired by the lessee at a favorable price. In general, the lessor is not required to pay any insurance or taxes on the asset. These obligations remain to the lessee who, consequently, reduces its payments.

Optimal Financing Instruments

In the previous section I presented the variety of possibilities in which firms can raise debt and equity. In this section, I lay out a sequence of steps by which a firm can choose the right financing instruments. This analysis is useful not only to determine the type of securities should be issued to finance new instruments, but also to highlight limitations in a firm’s existing financing choices.

As a first step I examine the cash flow characteristics of the assets or projects that are going to be financed, in order to try matching the cash flows on the liability stream as far as possible close to the cash flows on the asset stream. Then, I consider some concerns that may lead the firm to deviate from or modify their financing choices.

Matching financing cash flows with asset cash flows

The most important characteristic a firm should consider in choosing the financial instrument in order to raise funds is the cash flow patterns of the assets to be financed.

Let’s assume that the firm value is defined as the present value of cash flows generated by the assets of the firm. This value will vary over time as a function of firm-specific factors (e.g. project success) or macroeconomic variables, such as interest rates, inflation rates, economic cycles, and exchange rates. The figure below represents the firm value, where changes result solely from changes in macroeconomic variables.

Figure 1.1 – Firm value over time with short-term debt

The firm can decide how to finance its assets and what financing mix to choose. The value of equity is derived as the difference between the firm value and the value of outstanding debt at any point in time.

Let’s now assume that the firm decide to finance its assets with a very short-term debt which value is unaffected by changes in macroeconomic variables. The figure below illustrates the firm value, debt value, and equity value over time. As we can see, there are periods when the firm value drops below the debt value – this may suggest only that the firm is technically bankrupt. Therefore, the firm is going to borrow less.

Figure 1.2 – Firm value over time with long-term debt

Consider now the case the firm finances its assets with debt that matches the assets in terms of cash flows and sensitivity of the debt value to changes in macroeconomic variables. The figure below illustrates debt, equity, and firm value for this firm.

Figure 1.3 – Firm value over time with long-term debt

The possibility of default is reduced or eliminated at all, since debt value and firm value move together. This, in turn, will allow the firm to carry much more debt, providing tax benefits that make the firm more valuable. Thus, the firms will have higher optimal debt ratio if asset cash flows match with liability cash flows.

Matching liabilities to assets

The first step to be considered by a firm in order to make the right financing choices is to better understand how cash flows on its assets vary over time. In this section, there are considered four aspects of financing choices.

Financing maturity

Firms can issue debt with different maturity, ranging from short-term to very long-term. In making this decision they should be guided by the maturity of the cash flows on their assets. In this section I examine how to assess the life of assets and liabilities, and then consider alternative strategies to matching financing with asset cash flows.

Measuring the cash flows lives of assets and liabilities

The duration of an asset or liability is the weighted maturity of all cash flows on that asset or liability, based on the timing and the magnitude of the cash flows. In general, the larger and earlier cash flows are, the bigger is the weight associated.

A simple measure of the duration of a bond can be computed as follows:

where:

N – maturity of bond;

T – period when coupon payments are due;

c – coupon payments;

FV – face value;

r – interest rate.

What does the duration tell us? First, it provides a measure of when, on average, the cash flows of a bond come due. Second, it provides an approximate measure of how much the bond price changes for small changes in interest rates.

It is possible to extend this measure of duration to any asset with expected cash flows. Thus, the duration of a project or asset can be estimated by:

where:

– is the after-tax cash flow at time t;

TV – the terminal value (measure the project worth at the maturity date).

One limitation of this analysis is that it keeps cash flow constant while interest rates change. On real projects, the cash flow will be adversely affected by the increasing interest rates and the degree of this effect will change from business to business. Thus, the actual duration of most projects will be higher than the estimates obtained by keeping cash flows constant.

Duration matching strategies

In the section above I considered how to estimate the duration of assets or liabilities. The basic idea is to match the duration of a firm’s assets to the duration of liabilities. This can be done in two ways: by matching the individual assets or liabilities, and by matching the firm’s assets with its collective liabilities.

The first approach provides a precise matching of each asset’s characteristics to those of the financing used but, however, it has several limitations. First, arranging separate financing for each project is too expensive because of the issuance costs associated with raising funds. Second, this approach ignores the interaction among projects that might make project-specific financing suboptimal for the firm. Consequently, it is useful to use this approach only for companies that have very large, independent projects.

The fixed/floating rate choice

Most of the firms, in general, have to face with the decision to make the coupon rate on bonds (and the interest rate on bank loans) a fixed rate or a floating-rate, pegged to an index rate such as the LIBOR or the ten-year Treasury bond rate. In making this choice, they should take into consideration the characteristics of the project that are going to be financed with debt.

Uncertainty about future project

The duration of assets and liabilities can be synchronized if assets and projects are well identified, interest rate sensitivity can be estimated, and the appropriate maturity of financing can be ascertained. But not all firms find this process so easy. That is why many firms decide to change their business mix by divesting themselves of some assets and acquiring new ones. Other firms, on certain industry, might be confronted with a great change. In such cases, firms may use short-term of floating-rate loans.

Cash flows and inflation

There is a positive correlation between floating-rate loans and market interest rate: the more market interest rate increases, the more interest payments on floating-rate loans increases, and vice versa, as market interest rate fall interest payments on floating-rate loans fall.

If firms have assets whose earnings increase as interest rates rises and decrease as interest rates falls, it would be better to finance those assets with floating- rate loans. This rate will lead to high interest payments in periods when inflation is high and low interest payments when inflation is low. Firms whose earnings increase as inflation rates are high and decrease as inflation rates are low should use floating-rate loans to finance assets.

The currency choice

Many of the points we made about interest rate risk exposure apply also to the currency risk exposure. If a firm’s assets or projects create cash flows in a different currency from that in which equity is denominated, there exists a currency risk. Therefore, the firm should issue debt in these currencies in order to reduce this currency risk.

In recent years, firms have used more prominent classes of traditional bonds in order to manage foreign exchange risk on investments. There are in principal three types of instruments used by firms: dual-currency bonds, exchange rate-linked securities (PERLSs) [4] , and indexed currency option notes (ICONs) [5] .

The bond choice

Firms can be classified based on how much of their value comes from assets or projects they already own and how much of their value comes from future growth options. Hence, different types of financing are used from different firms. Firms that derive the bulk of their value from assets or project in place design their financing in a different way from those that derive their value from future growth options, because the current cash flows on high-growth firms are relatively low w.r.t. the market value firms. These cash flows are expected to grow over time as the firm invests in new projects. Accordingly, the financing approach should not create large cash outflows early.

That is why firms cannot use straight bonds, because they create large investments payments and do not gain much value from the high-growth perceptions. Furthermore, they are likely to include covenants designed to protect the bondholders, which restricts investments and future financing policy. Convertible bonds, on the other hand, seems to be a better instrument since they create much lower interest payments, impose fewer constraints, and gain value from higher growth perception. If the firm is successful, it might prefer convert these bonds into common stock.

Tax implications

As firm becomes more creative with its financing choice, structuring debt that behave more like equity, the more tax authorities are willing to treat the financing as equity in order to prevent firms from deducting interest payments. Because tax benefit is the first and most important benefit of borrowing, firms should try to preserve it, and if possible, increase this benefit.

It is also reasonable that the favorable tax treatment of some financing choices may encourage firms to use instruments than others, even if it means deviating from the choice that would be dictated by the asset characteristics. Thus, a firm that has assets that generate cash flows in South Korean won may decide to issue bonds in dollars in order to finance its assets if there is a large tax benefit from issuing dollar debt than won debt.

The risk of structuring financing with the intention of saving on taxes is that changes in the tax law can render the benefit moot and leave the firm with a financing mix unsuited to its assets mix.

Financing Behavior

In the first section it was analyzed the set of possible financing choices available to a firm. They all represent external financing. Other firms, however, meet the bulk of their needs with cash flows from existing assets.

In this section I present the distinction between internal and external financing and the factors that affect the level firms draw on each source. In order to analyze the firm’s financing decision I will make use of two fundamental theories: trade-off theory and pecking order theory.

Internal versus External Financing

In analyzing the capital structure decision, it is important to distinguish between internal and external financing. Internal financing consists of all cash flows that are generated by firm’s existing assets. They are called internal equity because these cash flows belong to the equity owners of the business. Cash flows raised outside the firm, whether from private sources or from financial markets, are categorized as external financing.

In general, different financing choice deals with different decision process that takes place within a corporation. For a well-established firm which does not undertake any major expansion, financing decision is a simple routine and almost automatic. It consists of deciding on a dividend policy and maintaining a line of credit with the bank. For many other firms, however, that has to raise funds from external sources, the decision process to undertake is very complicated, since outside entities that provide these funds need very detailed plans for the use of the funds, and they want to be convinced that the investment project will produce sufficient future benefits such that justify the expenditure. External financing, therefore, subjects the company more directly to the discipline of the capital market than internal financing.

Hugonnier, Malamud and Morellec (2012) show that the choice between internal and external financing does not follow a strict decision rule and that this decision is related to a number of factors, such as asset tangibility, cash flow volatility, access to capital markets, and agency costs. They show also that sufficiently large investment costs may make it optimal for a firm to decrease cash holdings and instead finance externally.

A firm may prefer internal financing to external financing for several. Private firms, for example, will prefer internal financing because external financing is typically difficult to be raised, and even when it is available, it is accompanied by a loss of control. For publicly traded firms, on the other hand, external financing is easier to rise, but it is still expensive in terms of issuance costs (especially in the case of new equity). Internally generated cash flows can be used to finance operations without incurring large transaction costs or losing control.

Despite these advantages, there are some limits to the use of internal financing to fund projects. First, before the transaction cost differences are factored in, the cost of internal equity is the same as the cost of external equity. The cost of equity, computed using the CAPM or APM, applies both to internal and external equity. Second, internal equity is limited to the cash flows generated by the firm on its operations, and so, these cash flows may not be sufficient to finance the firm’s projects. As a result, the firm will deal with project delays or the possible loss of these projects compared to competitors. Third, using only internal equity for financing projects does not mean that the stock price does not matter. When stock prices decrease, stockholders are much less likely to trust their managers, and they become reluctant to reinvest their cash flows; and vice versa.

The Trade-off Theory

The trade-off theory refers to the idea that the firm capital structure choice results from an arbitrage between costs and debt benefits. It predicts that there exists an optimal target financial debt ratio which maximizes the value of the firm. This optimal point is attained when the marginal value of the benefits associated with debt issues exactly offsets the increase in the present value of the costs associated with issuing more debt (Myers, 2001).

Debt Benefits

Loosely speaking, debt provides two differential advantages over equity. The first is the tax benefit: interest payments on debt are tax-deductible, whereas cash flows on equity are not. The second is the added discipline imposed on management by having to make reasonable judgments on debt capacity.

Tax advantage

Tax advantage can be presented in three ways. The first two measure the benefit in absolute terms, whereas the third measure it as a percentage cost.

In the first approach, the dollar tax savings created by interest expenses can be computed by multiplying the interest expenses by the marginal tax rate of the firm.

In the second approach, the tax benefits from debt is computed by interest payments over time, on the basis of three important assumptions. The first is that the debt is perpetual, which means that the dollar savings are a perpetuity. The second is that the discount rate of the cash flows is the interest rate on debt, because it reflects the riskiness of the debt. The third is that the expected tax rate for the firm is constant over time and that the firm is in a tax-payment position.

In the third approach, the tax benefit from debt can be expressed as the difference between the pretax and after-tax cost of debt.

Added discipline

In many firms where substantial free cash flows and low debt are available, managers have such a large cushion against mistakes, so they do not have any incentive to be efficient in either project choice or project management. In order to control this process firms are forced to borrow money. Thus, the risk of default on projects will increase. This process will also create the commitment to make interest and principal payments.

The argument that debt adds discipline to the process also provides an interesting insight into management perspective on debt. Based on management preferences, the optimal debt level may be much lower than that estimated based on shareholder wealth maximization. The corollary to this argument is that if stockholders have no influence or the power to remove managers, firms will have debt ratios much lower than optimal, because managers enjoy a more comfortable existence by carrying less debt than they can afford to. Conversely, as stockholder acquires power, they will push the firm to borrow more money, and increase their stock prices.

The Costs of Debts

Borrowing money has its disadvantages. In particular, (a) it exposes the firm to default and eventual liquidation, (b) increase the agency problems arising from the conflict of interests, and (c) reduce the flexibility of the firm operation.

Bankruptcy costs

The primary disadvantage of debt consists in the increasing bankruptcy costs. The expected bankruptcy cost can be calculated as a product of the probability of bankruptcy [6] and the direct [7] and indirect [8] costs of bankruptcy. It follows that, there emerge some interesting implications for capital structure decision.

Firms who operate in businesses with volatile earnings and cash flows should use debt less than firms who have stable cash flows.

Firms who are able to structure their debt in such a way such that cash flows on the debt increase and decrease with their operating cash flows should afford to borrow more.

Firms are willing to borrow more if this provides protection against bankruptcy, by providing either insurance or bailouts.

Firms should be able to borrow more if their assets can be easily divided and sold, because the direct bankruptcy costs are lower, when the assets of the firm are easily divisible and not marketable.

Firms who produce products that require long-term servicing and support generally should have lower leverage than firms whose products do not share this feature.

Agency costs

The conflict between bondholder and stockholder interests appears in three different aspects of corporate finance: (A) deciding what projects to take (making investment decisions), (B) choosing how to finance these projects, and (C) determining how much to pay out as dividends.

Risky projects

The conflict of interests, generally, arises when a firm has to make on investment decision. A project should get a return that exceeds the hurdle rate, a risk that is acceptable, and more importantly the firm value will increase. However, if the firm chooses projects that are riskier than expected, bondholders will lose on their existing holdings, because the price of the holdings will decrease to reflect the higher risk.

Subsequent financing

The conflict of interests also arises when new projects have to be financed. The equity investors in the firm may favor new debt, using the assets of the firm as security and giving the new lenders prior claims over existing lenders. Therefore, interest rate on the new debt will decline.

Dividends and stock repurchases

Stockholders and bondholders have different interest on dividend payments and equity repurchases. In general, bondholders prefer that the firm retain the cash, because it can be used to make payments on the debt, reducing default risk. Whereas stockholders prefer that the firm’s cash is paid out as a dividend or used to repurchase stock. It should not come as a surprise that stockholders, if not constrained, will pay the dividends or buy back stock, overriding bondholder concerns. In some cases, the payments are so large that the default risk of the firm increases dramatically.

Reduced financial flexibility

The financial flexibility is important for firm value for two reasons. The first is that the value of the firm may be maximized by preserving some flexibility to take on future projects as they arise. Second, flexibility provides managers with more breathing room and more power, and protects them from monitoring that comes with debt. Thus, although the argument for maintaining flexibility in the interests of the firm is based on sound principles, it is sometimes used as camouflage pursuing their own interests.

So, how can we evaluate the financial flexibility? If flexibility is needed to allow firms to take advantage of unforeseen investment opportunities, its value can be derived by two variables, the access to capital markets and the potential for excess returns on new investments.

The Pecking Order theory

The pecking order theory developed by Myers (1984) is an alternative to the trade-off theory. It starts with asymmetric information – a fancy term indicating that managers have more information about their future prospects and risk characteristics than do financial markets. This asymmetry in information creates frictions when firms want to raise their funds affecting the firm’s choice between internal and external financing and between new issues of debt and equity.

It states that "a firm is financed firstly with internal funds, reinvested earnings primarily; then, if internal funds are not sufficient, they make use of external finance by issuing the safest securities first. That is, they start with debt, then possibly hybrid securities such as a convertible bonds; and finally with new issues of equity" (Myers, 1984).

In this theory, there is no a well-defined target equity-debt mix, because there are two types of equity, internal equity and external equity.

The pecking order explains that most profitable companies generally borrow less, not because they have low target debt ratios, but because they do not need outside money. Less profitable firms, on the other hand, issue debt because they do not have sufficient internal funds for their capital investment programs and because debt is on the top list of external financing.

Trade-off vs. Pecking order theory: empirical evidence

In 2012, Atiyet published a study explaining the explanatory power of the pecking order theory (POT) and the static trade-off theory (STT), using a sample of 88 French companies belonging to SBF 250 over a period from 1999 to 2005 [9] . Basing on the previous studies made by Shyam-Sunder and Myers (1999), he shows that the estimation of both empirical models explaining the financial structure favors the POT on the French companies, whereas STT does not fit to explain the issuance of new debt issue in French firms. The evidence from POM suggests that the internal fund deficit is the most important determinant that possibly explains the issuance of new debt. The models they used to test were proposed by Shyam-Sunder and Myers (1999).

The pecking order model:

where:

– is the amount of debt issued or retired by firm i at time t;

– is the funds flow deficit, given as:

where:

– dividend payments;

– capital expenditure;

– net increase in working capital;

– current portion of long-term debt at start of period;

– operating cash flows, after interest and taxes.

The simple pecking order model predicts that the firm will only issue or retire equity as a last resort. It fill its deficit only by using debt, therefore, it is assumed to have and .

The Static Trade-off model:

where:

- is the target debt level for the firm i at time t.

They proposed that the hypotheses to be tested are , indicating adjustment toward the target, and implying positive adjustment costs.

Ramdani and Vigneroni (2012) extend this analysis using a sample of 335 firms which were part of SBF 250 at least once during the period 2001-2010 [10] . They use linear and non-linear specifications of the relationship between the firm’s debt variation and financial deficit to deal with this difficulty. To undertake this analysis, they firstly replicate the classical versions of pecking order theory tests by financial deficit and trade-off theory by target adjustment through mean reversion. Then, they consider differences in debt financial behavior in both constrained and unconstrained firms.

In the classical linear context, they finding shows that trade-off theory dominates pecking order for constrained firms whereas pecking order theory dominates trade-off theory for unconstrained ones.

For un-linear criteria more specifications are needed. That is, it is difficult to distinguish which theory is a better first order to explain the of capital structure.

Historical Behavior

After describing the set of choices available to the firm for raising money and studying the theory that explains the capital structure of the firm, I analyze the historical behavior of the firms during last decades.

This section analyzes the difference between internal and external financing in small firms and large and consolidated firms, and whether firm’s behavior in developing countries differs from firm’s behavior in developed countries. Khurana, Martin, and Pereira (2006) examine whether the impact of financial market development on the firm’s liquidity demand differs between small and large firms. They show that financially constrained firms exhibit a systematic effort to save cash out of the current period cash flows, small firms exhibit greater cash flow sensibility of cash in both financially developed and underdeveloped countries, and that firm’s tendency to save out of current period cash flows is greater during economic downturns [11] .

This study starts with analyzing first the behavior of U.S. corporations. The figure below illustrates the proportion of funds from equity, debt, and internal funds, for U.S. corporations, between 1975 and 2007.

Figure 2.1 – External and internal financing at U.S. firms, 1975-2007

Source: Damodaran, A. "Applied Corporate Finance".

As we can see, in general, U.S. firms have relied more heavily on internal financing to meet their capital needs than on external financing. Furthermore, when external financing is used, it is more likely to be new debt rather than new equity or preferred stock.

Comparing the financing patterns of U.S. firms with companies in G-7 countries, we can notice that U.S. firms are much more heavily dependent on debt than equity for external financing than their counterparties in other countries. The figure below illustrates new security issues in the G-7 countries. It is of high important notice that U.S. companies, during the period of this analysis, bought back more stock than they issued, leading to negative net equity.

Figure 2.2 – Financing patterns for G-7 countries in 2007

Note: Net equity refers to the difference between new equity issues and stock buybacks.

Source: Damodaran, A. "Applied Corporate Finance".

In addition, comparing the financing patterns in the United States, Germany, and Japan we notice that German and Japanese firms are much more dependent on bank debt than U.S. companies, in which firms are more likely to issue bonds [12] . The figure below provides a comparison of bank loans and corporate bonds as sources of debt for firms in these three countries.

Figure 2.3 – Bonds versus Bank Loans

Source: Damodaran, A. "Applied Corporate Finance".

Next, I move my attention to the behavior of companies across the world. Table 1.1 given below presents the financing patterns across country income groups around the world, from 2002 to 2010. It is possible to affirm that internal financing appears as the most important source of funds for firms in all countries than external finance raised through markets, banks, or alternative financing possibilities. Furthermore, the behavior of the firms in developing countries reflects and firms in developed countries are not at the same level. Second, financial markets (i.e., equity and debt markets) provide the least important source of external capital, while alternative finance is, on average, as important as bank finance.

Table 1.1 – Financing patterns across country income groups, 2002-2010

 

Internal Sources

External Sources

 

Retained Earnings

Market Finance

Bank Finance

Alternative Finance

 

(%)

(%)

(%)

(%)

High income

60

6

16

17

Upper middle income

64

2

18

16

Lower middle income

61

4

18

17

Low income

72

3

14

11

_____________________________________________________________________________________________

Source: International Finance Corporation (IFC), World Bank Group.

Despite all these information we collect from data at Table 1.1 I have to say there are some limits because the level of firm financing is reported to be similar across the same income group level. Table 1.2 given below, on the other hand, shows important heterogeneities within countries with similar income level. For example, the ratio of bank finance to all sources of finance goes from 5% in Argentina to 30% in Chile. The ratio of alternative finance to all sources of finance goes from 9% in Greece to 52% in China. Moreover, Table 1.2 indicates that alternative finance is more important than bank finance in 18 out of the 40 largest economies reported in the World Bank surveys. Alternative finance for SMEs in China seems to be more important than in any other countries, and it accounts for more than 25% of all firms financing in Argentina, Brazil, Czech Republic, and Indonesia.

Table 1.2 – Firms financing channels, 2002-2010

 

Internal Sources

External Sources

 

Retained Earnings

Market Finance

Bank Finance

Alternative Finance

Country

(%)

(%)

(%)

(%)

Argentina

69

1

5

25

Brazil

74

3

6

17

Chile

52

2

30

17

China

15

12

20

52

Czech Republic

55

7

9

29

Greece

71

6

13

9

India

58

1

28

13

Indonesia

42

1

16

40

Ireland

49

1

28

23

Mexico

73

0

7

19

Portugal

66

1

14

19

Russia

82

0

6

11

Spain

60

2

22

16

Turkey

58

12

16

14

Venezuela

30

28

28

14

_____________________________________________________________________________________________

Note: This table presents firms financing channels for selected countries around the world. Financing channels include: retained earnings, market financing (from public or private entity), bank financing (from local and foreign commercial banks), and alternative finance (leasing, trade credit, credit cards, loans, investments funds, informal sources, etc.). The countries in bold corresponds to countries in which alternative financing is higher than bank financing.

Source: International Finance Corporation (IFC), World Bank Group.

There are many reasons why alternative finance in many emerging countries is more used than bank finance. The most important is that, in many emerging markets, the banking sector is limited and vulnerable to banking crises and equity and bonds are solely available for large and consolidated firms in a small number of industries. Thus, firms make use of alternative forms of financing since bank financing is not feasible.

To better understand this point I examine the proportion of firms having a line of credit or a loan from a financial institution and the proportion of firms identifying access to finance as a "severe" obstacle to the development of their business. A high proportion of firms in both developed and developing economies do not have access to credit from any financial institution, and the difficulty in access to such credit is more pronounced in less developed economies, and especially for small firms. Only 17% of the small firms from developing economies have bank credit, as compared to 66% of the large firms from developed economies. The table also reports that 44% of the small firms from developing economies that identify access to credit as a "severe" obstacle for the development of their businesses, which is against 18% of the large firms from developed economies.

Table 1.3 – Firms with Access to Bank Credit, 2002-2010

Income Level

Large Firms

Medium Firms

Small Firms

Firms with a line of credit or loan (%)

High

66

60

45

Upper middle

65

54

38

Lower middle

51

39

25

Low

46

33

17

 

Firms identifying access to finance as "sever" obstacle (%)

High

18

18

22

Upper middle

20

25

29

Lower middle

23

28

31

Low

30

39

44

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Note: The top panel of the table reports the proportion of the firms in the formal sector with a line of credit or a loan from a financial institution. The bottom panel reports the proportion of the firms identifying access/cost of finance as a "severe" obstacle to the development of their business. Firm size levels are the following. Small firms have between 5 and 19 employees, medium firms have between 20 and 99 employees, and large firms have more than 100 employees.

Source: International Finance Corporation (IFC), World Bank Group.