The examples above reflect how transaction costs are a significant element in such examples of capital structures. We can say that when the transaction costs is null/zero, the best capital structure will be chosen by the management under the forces external pressures. On the other hand, if the cost of the transaction is high, the mistakes by the management are simply impossible to point or correct from the team of outsiders.
The reason is served by the fact that outsiders are not just enough when it comes to purchasing or selling the shares of the corporate. The possible action in terms of purchase and selling of shares will require a proper procedure of acquiring shares enough from the firm and then following the procedure by forcing the management in order to improvise the situation of the firm. The market on the other hand may not correct itself if the external pressure is not disciplined enough. Under such a situation, the investors along with managers would likely commit a mistake which may lead to either too much debt or too much equity.
One can say that transaction costs are vital in playing a direct role too. For an instance, the 1933 securities act which imposed the liabilities as well as reporting requirement for the equity traded in public can result into a much higher and larger than the borrowed figure in private. As a matter of fact, the costing of publicly traded equity is even further higher under the recent act of Sarbanes-Oxley Act. Furthermore, it has been noticed that when a new equity is issues, it has a direct costs of transaction which is between 5-15% around the issue. Such a cost of equity, in fact, for small companies is considered large enough in order to warrant the structure of capital which will consist of private securities and debt of bank exclusively and NOT public equities.
We can understand the effect of transaction costs on individual structures of capital through another instance which does not cover certain markets. Considering institutes which are legally not allowed to carry or hold securities which consists lower credit rating. In fact, the large commercial market of paper cannot be touches by the firms which have a lower credit rating than BBB.
Such a scenario can give a rise to a situation where the capital of debt can dramatically rise when the firm is reflected with too much of debt. Furthermore, we can say on the most basic level that trading a particular corporate debt of a company for the investors in retail can result is even a cheap option. Mutual funds, on the other hand, are unable to facilitate such accessibility; the serious issues against cost of issues debt will be raised.
In the other section, we discussed the relationship between behavioral finance and costs of transaction. The behavioral finance plays a significant role when the costs of transactions are high. Such a situation is pretty clear and common in the context of corporate finance. Therefore, we can say that it becomes too risky and expensive to take over a company or a firm just to correct the structure of capital which reflects debt of 10% more.
We can understand the same with an example. We all agree that managers are motivated with their peers, and in turn try to imitate them a lot of times. But, on an unfortunate incidence one cannot comment anything of the behavioral finance of the firm until and unless a specific behavioral mistake is considered. In other words, one cannot understand the factors that helps in guiding the behavioral finance theory guided to the managers that help in deciding the optimal structure of capital.
And therefore, it is said that behavioral finance is a new hope and direction in corporate finance. But where and how does this factor help the management is a too soon judgment to make. Although, there are few very common behavioral mistakes which are noticed in the early insights of a corporate. Over optimism and over confidence, for example, are noticeable traits which are considered under the biggest behavioral mistakes in the corporate management. And these two traits are generally noticed in the investors which make poor decision affecting the overall financial figures of the corporate as well as public markets.
Links of Previous Main Topic:-
- What matters
- The role of personal income taxes and clientele effects
- Operating policy behavior in bad times financial distress
- Operating policy agency issues and behaviour in good times
- Bondholder expropriation
Links of Next Financial Accounting Topics:-
- Static capital structure summary
- The effect of leverage on costs of capital and quoted bond yields
- Valuation formulas with many market imperfections
- Capital structure dynamics