Leary (2008) suggests two reasons that the leverage ratio of larger and more transparent companies are unaffected by changes in banks’ funding constrains. Firstly, bank’s lending to small and risky businesses may be more sensitive in terms of providing credits compared to their lending to larger businesses. Secondly, it is much easier for larger companies to substitute toward non-bank public debt sources in response to changes in the bank debt’s availability or cost.
In addition, Korajczk and Levy (2003) find that both macroeconomic conditions and firm-specific factors, such as the nature of the companies’ assets, profitability, the existence of alternative tax shields and size, have impacts on the business’s financing choices. Furthermore, they also state that both financially constrained and unconstrained companies have different manner of choosing the capital structure. However, the macroeconomic conditions, such as changes in the relative pricing of asset classes, can lead a company to choose different capital structure at different points in time and other things would be the same. Therefore ‘macroeconomic conditions play a smaller role in both target leverage and issue choice for constrained firms than for unconstrained firms’ (Ibid, 2003, p.106).
According to Lemmon and Roberts (2006), constraint on the financing and investment of firms can be impacted by ‘the fluctuations in the supply of financial capital or the limitations on the amount of intermediary capital’. Businesses may face capital rationing that could be due to either there is an adverse selection concerns arising from information asymmetry between company and capital suppliers, or moral hazard concerns arising from private benefits of control. Holmstrom and Tirole (1997) write that companies face a moral hazard problem that manager can take out private benefits through an appropriate choice of projects. Intermediaries will try to lessen the moral hazard problem through costly supervision, which in sequence creates a moral hazard problem for the intermediaries. The moral hazard problem faced by the intermediaries requires them to inject their own capital into the firms under their supervision. Thus, this could cause the capital supplier unwilling to provide the capital to a company. Furthermore, Lemmon and Roberts (2006) find that those firms with low net worth firms or firms requiring high-intensity monitoring are most likely to be affected by fluctuations in the supply of intermediary capital because of monitoring acts as a substitute for collateral.
It is said that debt market segmentation may put constraints on some firms’ ability to borrow. In a segmented capital market, other than risk, the cost of capital is different across different sources of finance, such as bank debt, public debt or equity for reason (Lemon and Roberts, 2006). Gorton and Pennachi (1990) also write that segmentation can arise from the preference of shareholder and from the existence of the same frictions that make capital rationing. Therefore, shocks to the supply of capital can also impact the financing and investment behaviours of a firm in so far as segmentation makes switching sources of capital costly.
According to Roberts and Sufi (2009), ‘incentive conflicts’ between business and their creditors have a large impact on corporate debt policy. They show that ‘financial covenant violations’ give rise to a huge and constant decrease in net debt issuing activity by giving creditors with limited rights to influence financial policy via altering the conditions of the credit agreement. Furthermore, they find two reasons to why the financing response to ‘covenant violations’ is stronger. Firstly, various actions can be taken by the existing creditors to decrease the acceptable borrowings in order to moderate the supply credit such as increase interest rates. Secondly, the access of borrowers to alternative sources of finance is either limited or rather costly. Therefore, covenant violations play a key role in affecting the flow of capital to companies due to their ability to assign control rights to capital supplier in a state-contingent way.
Furthermore, Dichev and Skinner (2002) find that managers tend to take actions to avoid debt covenant violations especially the managers of healthy company. Since any review of the operations of a company by outsiders is expected to be costly, the managers would prefer to avoid it. For example, the administrative time, the need to generate updated financial reports, and the need for management to explain and justify its forecasts and strategy. Consequently, it is likely that even managers of company with good performance will try to find the way to avoid violations, in particular if they can do so at rather low cost.
Trade off Theory
In the trade off theory, the benefits of increased the level of debt are weighted against the costs of increased leverage. This can be explained as there would be a tax benefits on debt and the reductions in agency costs since the interest payments of company's firm is tax deductible and hence this would encourage firm to take on debt, but, too much debt would raise the possibility of bankruptcy. However, DeAngelo and Masulis (1980) argue that interest tax shields may be irrelevant to businesses with other tax shields such as deprecation.
Korajczyk and Levy (2003) find that target leverage is positively related to firm size and not the profitability of companies such as the level of non-interest tax shields, the level of taxes paid, the level of intangible versus tangible assets and the market-to-ratio. Additionally, larger firms and those with more tangible assets tend to have higher leverage whereas companies with unique assets tend to have lower leverage. Furthermore, companies with large depreciation tax-shields have lower target leverage. In addition, firm with high levels of tangible assets will likely to be able to provide security for debts than the company with lower levels of tangible assets. If the company with high levels of tangible assets defaults on the debt, the assets will be held but the company may be in a situation to avoid bankruptcy. Therefore, firms with high levels of tangible assets are expected to take on reasonably more debt since they are less likely to default consequential in a positive relationship among tangibility and financial leverage. Similarly, both of the empirical studies in developed countries by Titman and Wessels (1988) and Rajan and Zingales (1995) discover that there is a positive relationship among tangibility and leverage, but the empirical studies in developing countries is not the case, mixed relationship is found among those two.
Pecking order Theory
In the pecking order theory, external financing is more expensive for riskier securities. This could be due to informational asymmetries between managers and security holders. Therefore, companies prefer to finance first with internal funds rather than with debt and lastly with equity. Moreover, in pecking order theory, the insiders know more about the future prospects of the firms than the outsiders. Myers (1984) suggests that issuing debt secured by guarantee may reduce the costs in financing related to asymmetric information . The difference in information put between the parties concerned may lead to the moral hazard difficulty or diverse selection. Hence, debt secure by security may lessen asymmetric information related expenditure or cost in financing. Therefore, a positive relationship between tangibility and financial leverage may be expected. Furthermore, Bevan and Danbolt (2002) declare that less debt will be held by the more profitable company since internal funds are provided by high levels profits.
According to Korajczyk and Levy (2003), their studies show a consistent with the pecking order theory in which there is a negative relation between profitability and target leverage. Furthermore, they find out that the unconstrained companies would fit the pecking order theory a lot better than the constrained companies. This is because the constrained companies have ‘pro-cyclical leverage’ (debt issues) whereas the unconstrained companies have counter-cyclical leverage (equity issues).
Um (2001) argues that growing companies’ funding pressure for investment opportunities is likely to exceed their retained earnings and, according to the ‘pecking order’ are likely to choose debt rather than equity. Booth et al (2001) argue that this relationship between financial leverage and growth is generally positive in all countries in their sample, except for South Korea and Pakistan. Pandey (2001) finds a positive relationship between growth and both long-term and short-term debt ratios in Malaysia.
Myers (1984) suggests that issuing debt secured by security may lessen the asymmetric information associated costs in funding. The difference in information sets between the parties involved may give rise to the moral hazard problem or diverse selection. Hence, debt secured by security may ease asymmetric information associated cost in funding. Thus, it is expected that a positive relationship between tangibility and financial leverage.
Conclusion
To sum up, the findings of this paper contribute toward a better understanding of to what extend does the capital structure of companies depend on the availability of particular source of funds. There are many factors that have impacts on the capital structure of a company. For example, the macroeconomic condition, firm specific factors such as nature of alternative tax shields and the size of a firm, and the leverage ratio of a company. Furthermore, it has been found that the incentive conflict between firm and their creditors have also had a large impact on corporate dept policy. Lastly, the supply of capital also has an impact on the firm’s capital structure. In conclusion, small firm is found to be more constrained than biggest firm. The findings from the literature suggest that both the trade-off theory and the pecking order theories of capital structure are pertinent theories.
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