The systems that are a governing factor of change in equity and debt ratio something known to everyone. But, not many people have an answer to the question “why a company uses them”. You might think that learning how to issue drive net debt is the most important because it is considered as an essential aspect of changes in the structure of the capital. This is followed by the phenomenon of issuing the net equity and that again is followed by the act of issuing net debt and finally arrive the issue of veritable debt and dividends. These are necks through which all other mechanisms operate.
The six bottle necks which are in question:
- The parameters which change the non-financial liabilities
- Things that make a firm issues debt
- Aspect which are responsible for a firm’s retire debt
- Parameter responsible for a firm issuing equity
- On what grounds a firm will pay dividends
- Effects a firm will have on corporate performance of value.
Each pointer will raise a pertinent question of the foundation of a capital structure. So, you will not be able to decipher the mechanisms of capital structure from its bottle necks. But you can be sure to get a wider angle of the structure keeping aside all its instruments. Another thing you should know is that if one variable has an impact on the neck then it will have an over impact on the entire structure of the capital. All the activities are directly related to each other. See an example here; if solar fluxes have to churn debt of market then you can expect solar flux to bring in significant changes in the upper limit of firm’s ratio of equity and debt respectively. Although,that is not always a mandatory outcome. In case solar flux had a positive impact on debt or ratios of equity through one neck but negative impact through another then its positive effect will have ultimately have no impact in the capital structure as a whole. Also, as u must have learned earlier that a variable can be explanatory for many equity issues, but they will not have any considerable impact on mainstream equity and debt ratios. The firms which are directly affected by these variables, they are most likely 100% financed by the overall equity and also will stay as an all-equity firm. Sometimes the complete opposite can be the case. This is how; if a variable has a weak impact on every neck, it will naturally be considered a weak link but if this weakness proves worthy for all the 6 necks then it will have a positive impact on the entire debt/equity ratios.
22.4 A COMPREHENSIVE EMPIRICAL STUDY
A broad and factual examination of the theory was done by “HOT” (Hovakimium, Opler, and Titman) in the year 2001 about how different variable exert an impact on 4 of the above mentioned necks over a period of 1 year. According to the authors there are hosts of variable that apparently have a statistically significant role. Note: -All these variables are just a small fraction of the all the variants seen in a capital structure across various companies. Only a tiny portion of the firm’s behavior which is the driving force of their corporate financial choices is explained in this chapter.
The study considered the initial necks which are also known as non-financial liabilities and sometimes the end neck which are known as stock returns.
But it did skim through the other necks as well:
The debt issuing channel: This is the second neck in the sequence so HOT so they established that firms generate more long-term debts if they have high market ratios. On the other hand they will have decent recent stock performance if they have a chunk of their debt coming in soon. They also established that firms issue debt over really tiny periods if they experience below average performance in the stock market.Also, if they have negligible debts over tiny periods then they will appear prominently in the industry. These can only explain 2% to 3% of the overall representation of the variables which is termed as R2- a diminutive quantity. So, by far is not clearly known why companies issue debt on firms.
The debt retirement channel: Now comes the third neck in the sequence. For this neck HOT established that firm decrease their overall debt if they are above there industry counterparts in terms of current stock market performance and debt ratios nut also poor accounting performance. You would be surprised to know that these choices are completely opposite to those that would be chosen to rebalance the existing ratio of equity and debt. Now the question arises on the importance of all these choices. So a decent 12% with R2 as miniscule proportion can be achieved. It’s not that great but it is passable.
The equity issuing and retiring channels: These are the 4thand the 5th neck in the sequence and all academic researches revolve around these two necks. There are 3 main reasons for this which you need to know. First reason, there are cogent theories involved in this section. Especially of the order of pecking which has a consistent ground due to some existing evidence around it. Now the second reason, the declaration of issuing equity which have a direct relation with the market and also the movements of the dividend has a significant role for the overall financial thrust. Finally, the third reason, there is a lot of easily available data found here. The phenomena of issuing equity and the complex act of retirement of debt will essentially remain unknown in the times to come.
HOT seems to be implying towards the fact that firms did not like the act of issuing too much equity in the first place. This concept is consistent in orders that are pecking. When companies did declare that they are open to issuing at least some equity then it would most likely face an adverse return on the stocks that are withstanding. In case a firm had good stock performances and bad accounting performances then the firms inclines towards issuing equities rather than debts on balance. Note: – Firms also have a tendency to issue more debt as a response to positive stock market performance; if evidences are to be believed then the tendency of issuing equity would also become stronger and firm mangers would try to time the stock market according their convenience. This trend was seen in firms which had a higher rate of tax obligation and they had to issue more equities. The author only explained 3% of the different variations in the companies attempt to again buy preowned equities and 15% of the act of buying fresh equity. Compiling all the evidences together here is an overview of the factors that play a crucial rule in impacting the outcomes of the overall structure of the capital.
Here they are in an order of significance:
Direct stock performance influence: If return of stock are considered are as the root rather than instrument then it can easily become the most important variable in a company that essentially has a physical value and the reason for this is that companies do not curb stock returns and companies that have an above average price of stock performance can end up with negligible ratios of debt whereas companies with below average performance in the stock market will end up with higher ratios of debt.
Equity issuance avoidance: A common practice in firms is that they make an active effort to avoid the act of issuing any kind of equity. Any firm that offers equity is close to being extinct. Moreover, it is mostly seen outside and M & A transaction. The reason for this avoidance is the high cost of equity even during negative market reaction and this will not come as a surprise for you if follow the behavior.
Peer similarity: There are times when firms seem to mirror the activities of their capital structure to their respective industry counterparts. But they also have a tendency to become a striking mirror image in the phenomena of issuing or simply retiring equity or debt to come close to their counterparts. Although, there are some existing industries which absolutely avoid debt financing.
Corporate income taxes: Companies which usually have really high corporate tax income tax rate also have a tendency to issue debt and retire equity. They do this to increase their overall debt ratio.
This being the case, many firms which pay sky high taxes have comparatively low ratios of debt. You might ask “how is this possible?” The answer to this is good performance doesn’t only churn high profits which result in high taxes of the corporate firms but also into high level performance by the price of stock. So, the latter automatically reduces the firms’ debt ratio. But the end result of this can be composite on an average. In such cases net issuing activity is not sufficient to control or undo the adverse effects that returns of direct stocks have in a firm.
Accounting performance: Another fascinating trend of firms is that they prefer issuing net debt over issuing net equity provided they have more decent accounting profitability than previous time and more tactile assets (it can easily be insured). Whit taxes a perfect profit margin form accounting is observed has a firm collaboration with greater prices of stock and that in turn is directly proportional to really low ratios of debt.
M & A activity: Ample amount of equity and debt are issued in relation to M & A activity; however you will experience that more debt is generated in comparison to those of equity. So, almost all non-financial firms that are doing reasonably well should give credit to M&A activity for not ending with zero debt. But you should also know that firms normally start acquiring other firms after they note decent stock performances, in that case the overall structure of the capital can get a be difficult to comprehend. If the performance of the entire operating system is fairly desirable then it will bring down the debt and aggravate the value and also it will significantly raise the ratio of overall debt through the process of possession of asset.
Financial distress: Firms that are on the verge of a crackdown have no other choice but to retire their debts. In times like this firms will have a firm ground to hold debts but that will not prove fruitful to them in the future. This is mostly the case with companies which are about to face bankruptcy.
Credit ratings: It is important for companies to have easy and direct access to market papers that have commercial value and maintaining credits ratings that are fairly equitable is extremely important. The firms need to make sure they borrow less more so when they are nearing the margin because having less debt will most likely have a huge impact on the overall debt ratio of the company. Also, firms need to earn good positions in BBB rating or maybe even AA- OR A+ rating.
Active market timing: Firms that have seen decent stock price increase often have tendency to issue maximum security and they do this through equity and debt, in this the structure of the capital outcome does not have a strong payoff. Also these firms end up paying more dividends, so the concept of issuing net equity is not all that clear. But when a survey was conducted CFOs made a announce that they keep a close eye on their values of the stock market and file responses accordingly to it and sometimes even try to tally the timings. Whatever the case maybe, active timings of the market is something interesting and calls for exploration. Which researches standing as testimony, you might get to know that it never got its due importance over the time.
Uncertainty: Companies that have more unstable latent assets will have strikingly low debt in their overall structure of the capital
It is believed that managers of various old, huge, companies that are commonly traded are the once in which the corporate governance have come cracking down, These companies will have equity in their overall structure of capital even when it is not favorable for the company. This is only because managers have an affinity towards equity and not debts. But it is not a cakewalk to measure if these firms actually have a lot of equity because of the crackdown of corporate governance as a result of high amount of equities.
22.4 B Theory Versus Empirics
Though the above mentioned variables are intriguing what the theory demands. Say for example; an interest coverage ratio is considered as a stand-in to amount contiguity financial distress; but this not really the identical financial distress. Few firms have a suffering financial stress but then again some companies have high interest sum financially secure. Most of the times, variables have a fate of being compromised between empirical accessibility and theoretical build up. But an interpretation is drawn from the angle of theories to establish empirical findings. Next, few variables whose identities are not known so the circle still remains a mystery. Check these examples; what is the reason for firms not to counteract market impact vehemently; do firms get attracted to capital structures that are more or less a replica of industry counterparts? You might find answers in future researches.
It is behavior which will require fair time to comprehend and it has a lot idiosyncrasies attached to it. Variables have statistical significance but do not serve the purpose of wide explanations. You can decipher this situation as follows:
- Variables do not substance abundant but they are weak stand-in to theoretical build-ups (for bankruptcy costs and tax savings). So, with further research better stand-in can be established to get a comprehensive understanding of the entire set up of the capital.
- Some theories which are still unknown and most likely they are much more relevant as compared to that ones that are existing now.
- The Management people may focus on a lot of aspects such company horoscopes and predictions or book-market ratio but they will have negligible value consequences.
- Management can act in a way which will have a positive impact on their personal interest and not the company as a whole but cannot actually prevent this.
The idiosyncrasies of the managerial behavior which is apparently important as manage misbehavior of any kind. Although, this set up still remains an intriguing field which attracts a lot of research work. Evident progress is seeing in the learning process of how managers react to situations and how to curb their detrimental behavior. It is going to be a long journey to reach the terminal point.
22.4 C Managerial Lessons
The pertinent question that arises is what CFOs can learn from all the existing empirical evidence. The answer to this is “they have a lot to learn”. For starters, the evidence partly states that which most like a long standing one is. What conclusion can be drawn here?
- Do bosses never re-balance the sizes and debt and equity ratios which can be used as evidence to their wrong decisions in the future? Certainly that’s not the case. In such a situation, Management may breathe a sigh of relief because of the capital structures. It could be that restructuring such as these can be quite expensive as compared to the cost. So, in case like this, managers will not be very comfortable with their set up of capital. Again, this might not bring in any kind of profit to the firm if they make an attempt to redress the same.
- There is possibility that it may or may not necessarily have to be this way. At certain companies, the miscapitalization by managers is fairly objectified. But for other firms, there is no such assurance. A lot of controversy revolves around the particular interrogation.
- Does it intend to signify that worries regarding the structure of Capital and accurate corporate scale are not valid? The answer to this question is “certainly not” although there are some managers’ resort to passive ways that doesn’t mean you will also have to do the same. You can always choose to do what needs to be done! Your choices should always remain authentic as well as energetic.
- It signifies that you cannot gauge the capital structure of your company depending on the set up of peer companies. The answer to this is most likely yes. Other companies will have capital structure which does not have indicators of essential designs as opposed to historical performances.
Links of Previous Main Topic:-
- Introduction of corporate finance
- The time value of money and net present value
- Stock and bond valuation annuities and perpetuities
- A first encounter with capital budgeting rules
- Working with time varying rates of return
- Uncertainty default and risk
- Capital structure patterns in the united states
- Empirical capital structure patterns
- Mechanisms versus causes
Links of Next Financial Accounting Topics:-