Introduction
The following is an essay on the cross sectional differences in corporate capital structures. The first part of this discussion entails the background and the origins of corporate capital structures, how they came to be and the disparities in these corporate capital structures. The other part incorporates analysis of the empirical evidence, which has been supplied by previous studies on econometrics and corporate capital structures.
Explanation on the cross sectional differences in corporate capital structures
Corporate capital structure refers to the characteristics of a firm’s capital in reference to its equity (mostly the preferred and common stock), debts (which include bonds and loans), and hybrid securities (convertible debt and preferred shares.) (Allen, Bradley & Stewart 2008).
Equity financing usually refers to the capital which has been contributed or brought about by the owners of the companies who are the shareholders. Debt financing on the other hand refers to the capital which has been sourced from the banks or from the people who have company’s bonds.
The corporate capital structure is an indicator of the firm’s liabilities and assets as it unearths who has acclaim in the company’s assets and whether the claim is a debt claim or an equity claim. The proportion of the company’s equity in relation to the company’s debt is the ratio of leverage (Allen, Bradley & Stewart 2008).
The corporate capital structure is quite intriguing because; there are various types of equity and debt financing. For instance, a debt can be held privately or publicly. A debt can also be a secured debt or an unsecured debt. The debt can also vary in regard to its maturity period either long term or short term.
The capital structure can also be taken to be an illustration of how a corporation organizes its cash flow and how it sources its financial resources with which it operates. Different businesses have got different kinds of capital structures geared towards meeting the internal and external needs and for return on shareholders’ capital. A balance sheet is one of the clear examples of the internal and external capital structure of every company. As indicated in the balance sheets the corporate capital structures are derived from three vital bocks.
One of those blocks is the long term debt, which refers to the financial obligations or resources supplied to the company but they will not be due or repaid within the next twelve months. This debt mostly constitutes of resources such as bonds, capital lease obligations as well as mortgages (Baker & Wulgler 2002).
The second block is the preferred stock which is a representation of the of the ownership interests in the company. The preferred stock is usually static and the owners of this stock are not allowed to share the capital gains which have been made by the company when it grows. The third and the most important block is the common stockholders’ equity. This is a demonstration of the underlying investment made by the shareholders of the company. This equity is made up of values assigned to the shares of the stupendous stock, the capital gains made by an increase in the value of the existing stock, and the retained profits which are portions retained by the company after issue of dividends to its stock holders. Therefore, common stock equity is the total worth of a company when all the liabilities are deducted from the total assets indicated on the balance sheet.
The cross sectional differences in corporate capital structures arise as a result of the conflict between the management and the stockholders. This is because; when organizing the corporate financial structure the management usually looks forward towards the lowest cost of capital whereas the shareholders or the investors aim at obtaining the greatest return possible. This usually conflict especially with the shareholders who feel that the management is not doing enough to increase the worthy of their stock.
However, this conflict can be abated through leverage, which is the percentage of debt in comparison to the shareholders equity. Whereas leverage is good it is also risky in that it limits the flexibility of the corporation in terms of its operations meaning that the company cannot change its operations overnight. It also makes the company to be in the risk of bankruptcy. It leads to limited accessibility to the capital markets especially in periods when the credit is tight. The management is also forced to look for new ways of raising capital rather than look for ways in which to boost their operations. Because of the challenges which every corporation had to face in managing the shareholders equity as well as use leverage provided by the debts, there was a dire need to come up with theories which will affect the performance of the corporations in a positive manner (Baker & Wulgler 2002).
One of such theoretical framework on corporate capital structures was formulated by Modigliani and Miller and it is known as Modigliani and Miller theorem. This theorem states that if the tax, bankruptcy costs, misinformation, and in an efficient market the company’s value is not influenced by its methods of financing irrespective of whether the corporation’s capital is made up of equities, debt, or a mixture of both equity and debt. This Modigliani Miller theorem is also called the capital structure irrelevance principle (Myers & Majluf 1984).
There are a number of tenets which underlie in this theory and one of such assumptions is that there is no taxation. The founders of this theory explain that if there are no taxes, an increase in leverage will have no bearing in regard to the value creation. However, when taxes are brought into consideration then benefits such as interest tax shield or tax breaks which accrue as a result of huge or large debts leads to an increased leverage.
The theory also assumes that if the shareholders were to buy shares from two identical companies, one which is leveraged with debt and the other is not leveraged, the shareholders are not likely to buy the stock based on the leverage but on the company’s returns or its capability to generate revenues, which is important.
However, in reality both of the assumptions will not be realized but the theorem is advantageous because, it puts emphasis on the importance of the capital structure. By application of this theorem the economists are in a position to obtain the determinants of maximum capital structure and see how the shareholder management differences can be contained.
The theorem has got its limitations in the sense that it justifies unchecked leverage to boost economic and financial growth in the corporations as well as in the country. However, the recent economic meltdown and the debt ridden economies which countries have found them into is the result of this unlimited leverage ratio.
The following part discusses empirical evidence in regard to the cross sectional differences in corporate capital structure. There is an analysis of a survey which was carried out in sixteen European countries on managers of corporations concerning the determinants of capital structure. This survey came into a conclusion that financial flexibility and earnings per share are some of the major concerns of the corporate managers whenever they are taking a debt or issuing out new stocks. The survey also found out that due to this cross sectional differences in capital structures the managers put a lot of value in hedging considerations. One of the breathtaking finding of this survey is that although most of the interviewees thought that the country’s legal environment is an important factor in determining the debt policy, it had little or no bearing in the policies on the common stock (Stewart 1991).
This augurs well or it reaffirms the theory of Magdilioni and Miller that taxes and other legalities have got no bearing on the value of the common stock. This survey examines the theory of corporate finance by comparing the cross sectional differences in corporate capital structures in various European countries. They look into how a number of aspects in corporate finance of a particular country affect the managerial views on the determinants of corporate capital structure. The countries where the samples were taken from are Belgium, Austria, UK, France, Norway, Portugal, Netherlands, Germany Spain, Denmark, Sweden, Switzerland, Finland, Italy, Greece and Ireland.
This study carried out an investigation to determine whether the policies in a particular country are self determined by the country or they are influenced by other institutions outside the country. It also sought to see whether the mangers views were influenced by their countries policy or they were independent. The survey was done by asking mangers on their views about what are the determinants of debt, equity, convertibles, as well as methods of raising foreign capital in their firms.
The first hypothesis is that the European firm managers make their decisions on their corporate capital structures using factors which are alike. They argued that the common law system provided them with a better kind of shareholder protection system compared to the civil law systems. Those from Germany and Scandinavian countries were of the view that their legal systems were better than those of France. However, they argued that the country can compensate for the effect of having a deficient legal system in regard to banks and their regulation (Myers & Majluf 1984).
The second hypothesis was that the cross country differences identified by the managers concerning the cross sectional differences in capital structures were affected basically by the home county’s legality. This means that their views were based on their country’s legal system.
The survey was done by supplying a questionnaire with a similar design to that of Graham and Harvey but it was modified for some of the questions to suit various countries in Europe. The questionnaires were also reviewed by several academics and it was revised to incorporate their suggestions (Stewart 1991). The revised questionnaire had one hundred questions and it was made up of nine topics.
In regard to sampling, the sample was derived from two places. The first source had all non French firms listed in La Tribune to provide daily information on stock and trading companies. The total number of firms listed on this source was six hundred and twenty one firms. They also added one hundred and sixteen French firms to make the survey complete. However, seventeen of the non French firms did not have correct addresses so they were not included in the mailing list. This brings in seven hundred and twenty as the total number of firms which were sent the questionnaire by mail. Out of this, only eighty seven companies responded, which was fifteen per cent of the total sample.
In regard to the methodology which the authors of these study used it was challenged from the start because rather than having a definite source of their sample they chose to prejudge the sample by classifying whether the firm is non French or whether it is a French company. In an ideal sampling the samples should be taken from firms within a particular country. If it is firms in Norway they should be considered and then from the samples random companies should be selected as a representation of firms in Norway. This should have been done for all countries. Another problem was posed by the methods used to take the sample.
Questionnaires which are generalized are not likely to be the best way of obtaining the correct responses and from the right person. One cannot be assured that the responses gotten were filled in by the manager or by a junior officer in the company.
In an ideal experiment when such surveys are done there should have been prior communication to the manager especially via telephone informing him or her about the incoming questionnaire such that when it finally gets to him it will not end up in the trash, which is clearly what happened to most of the questionnaires in this study.
In an ideal experiment the questionnaires need to be brief, one hundred questions are too many for a busy executive to spend quality time to answer unless they have a direct interest in the outcome of the survey (Stewart 1991). Otherwise, the questions in a questionnaire should be kept to the minimum possible to ensure that the respondent is not bored by the myriad questions.
The study irrespective of having various loopholes managed to make significant findings such as most of the cited tax deductibility on interest was one of their major concerns. They also indicated that another issue of concern to them was that of credit rating by banks. They wanted their firms to be ranked as some of the credit worthy corporations so as to ensure that they can easily get funds whenever necessary.
Conclusion
The above survey is one of the indicators of the cross sectional variance in corporate capital structures. It also gives an explanation on how those differences come to be. However, in carrying out a survey to bring out the determinants of such differences the methodologies used have to be well specified. This especially has to do with the methods of data collection whether it will be questionnaires or one on one interview. The samples have to be chosen randomly to create a proper variance and to ensure that the work done is at the right timing. The questionnaires have to be short enough to ensure that they do not exhaust the respondent’s enthusiasm (Stewart 1991). Having analyzed the case study above there are also various theorems which have to be analyzed for instance in the example above it did not completely show how the legal aspects are not absolute determinants of the performance of the value of the common stock.
References
Allen, F, Bradley, R & Stewart, M 2008, Principles of corporate finance 9th ed, McGraw-Hill/Irwin, Boston
Baker, M & Wurgler, J (2002), Market timing and capital structure, Journal of Finance vol. 57, no. 1, pp.1–32.
Myers, S & Majluf, N 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, vol. 13, no. 2, pp. 187–221.
Stewart, B 1991, The quest for value: A guide for senior managers, Harper Business, New York.