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The Implications of the Trade-off Theory
This means that there are two categories of firms: firms whose values mainly consist of assets in place (those that Stewart et al. (2005:39) call value firms), and those whose values consist of growth options. The financing policies of these two categories of firms would be expected to be different, as the firms have different business plans.
Firms whose values mainly come from assets in place tend to be large, mature and profitable firms with stable cash flows. As their assets are less risky, these firms have larger debt capacities due to increased collateral available. Value firms face lower financial distress costs, which in turn lower their borrowing costs. Furthermore, these firms have lower stock of growth options. This implies that their capital expenditures are predictable, as they mainly relate to asset replacements. Stewart et al. (2005:40) argued that the financing policy of these firms is primarily driven by the need to maximise the interest tax shield. The firms have adequate profits to fully capture the increased debt interest, and this means that they can move to the optimal capital structure hypothesised by the static trade-off theory. These firms will therefore be highly leveraged (Brealey et al., 2008:520; and Shivdasani & Zenner, 2005:30).
On the other hand, firms whose values mainly come from growth options tend to be small, risky and fast-growing firms which are less profitable. These firms have lower stocks of tangible assets in place and therefore have reduced debt capacities.
Because of their lower profitability, these firms cannot fully capture the increased debt interest and will therefore use less debt. They also face high financial distress costs due to lower quality collateral. According to the trade-off theory, these firms will therefore have lower optimal leverage than value firms. Their financing policies are mainly driven by the need to achieve and maintain financial flexibility, which is key to exercising their growth options. According to Stewart et al. (2005:39), growth firms will have lower leverage so as to build and maintain financial flexibility. This financing approach enables them to exercise a higher proportion of their growth options.
How do mature value firms achieve high target levels? Stewart et al. (2005:40) suggested that they have two options. The first option may be to return excess capital to shareholders by means of increased dividends and/or share buybacks. If firms exercise this option, they are expected to show generous dividend payment patterns or increased share buybacks (Barclay & Smith, 2005:10). This distributed capital is then replaced with debt capital, and the net effect is to increase both leverage and deductible debt interest. The second option is to adopt a policy of financing all future investments with debt until the firm reaches the desired level of leverage.
In growth firms, the target capital structure is achieved by paying low dividends or no dividends so as to preserve the retained earnings and use these to finance the growth options. This internal equity can be supplemented with external equity. The theory therefore predicts that growth firms will issue more equity than debt, since they have low debt capacities deriving from poor profits and asset qualities.
These financing policies of both value and growth firms fully reconcile with the predictions of the agency theory. This theory is discussed in Section 3.4.3. It deals with the use of financing mechanisms to avert the agency costs of overinvestment in value firms and underinvestment in growth firms. Is the static trade-off theory practical? Are firms expected to maintain a rigid leverage point? Ju, Parrino, Poteshman and Weisbach (2005:279) and Hovakimian et al. (2001:24) argued that this approach to corporate financing is impractical, as it entails a firm‟s continuously issuing or redeeming securities in order to achieve the optimal target leverage. Zero target deviation is therefore impossible. They argued that the static trade-off theory can be replaced by the more relevant dynamic trade-off theory which contends that even if firms have target leverage ratios, these are rarely static. As the cost of deviating from the target is very small (about 0.5% of firm value), the observed leverage ratios fluctuate around the target within an acceptable range. If the ratios deviate from the range, they are brought back through the manipulation of financing means (Fischer, Heinkel & Zechner, 1989:39 and Leland, 1994:1248-1249). This is a more realistic model than the traditional trade-off theory. Firm conditions change over time, and the debt ratios behave in a similar way. Firms would therefore have a dynamic target range debt ratio as opposed to a static ratio.
The dynamic trade-off theory, however, does not specify whether the target is optimal or not. Is this adjustment towards the target capital structure frictionless, and how frequently does it occur? At what speed do firms adjust their ratios towards the target?
If the adjustment process were frictionless, then firms would not deviate from their chosen targets. But empirical work by Leary and Roberts (2005: 2613) points to the presence of adjustment costs, and presents evidence that regardless of these adjustments costs, firms still actively rebalance their capital structures. Flannery and Rangan (2006:472) argued that due to the presence of market frictions, firms will partially and infrequently adjust their capital structures towards the target capital structure. The presence of information asymmetry, transaction and adjustment costs prevents frequent and full adjustment towards the target leverage ratio. There are two approaches that can be adopted in testing for the target adjustment behaviour of corporate financing. The first type uses the debt or equity issuance decisions to test for target adjustment (Hovakimian et al., 2001:7; Jalilvand & Harris, 1984:131; and Marsh, 1982:127). The central argument for this test is that firms will issue equity to move their leverage ratios towards their target and will issue (retire) equity or debt to bring down their leverage ratios towards the target.
The Pecking Order Theory
The pecking order theory was first proposed by Myers (1984:576) and further developed by Myers and Majluf (1984:219). This theory rejects the idea of a target or optimal capital structure. It asserts that firms do not have leverage targets (Hovakimian, Opler & Titman, 2002:25). Myers (1984:588) argued that capital structure decisions still remain a puzzle and cannot be explained by the trade-off
theory, but rather by the pecking order theory. According to this theory, the main determinant on capital structure is the firm‟s need to build and preserve its financial flexibility or financial slack (Brealey et al., 2008:521). The firm places a premium value on creating and maintaining financial flexibility, and this flexibility is viewed as a “real option” to the firm (Shivdasani & Zenner, 2005:31). The optimal capital structure is therefore defined as the point where the firm‟s financial slack is optimised. This may mean a point where the firm has zero leverage or where the firm has sufficient internal funds to finance all its available growth options. The theory places les emphasis on tax benefits of debt and financial distress costs. According to Baskin (1989:33), taxes and bankruptcy costs play a less significant role in the determination of leverage. Pinegar and Wilbricht (1989:89), in their survey of what managers think of capital structure theory, concluded that financial managers are more likely to follow the pecking order theory than the trade-off theory of corporate financing. The survey done by Graham and Harvey (2001:232) on US firms also confirms the value chief financial officers (CFOs) attach to financial flexibility when designing the firm‟s financial structure.
Myers and Majluf (1984:219) base their theory on the existence of asymmetric information between managers and investors. This information asymmetry in turn creates a preference ranking on how firms raise additional funds (Leary & Roberts, 2010b:351). They argue that financing choices signal the firm‟s quality or the expected earnings quality, and firms can use their capital structures to signal their quality. Good quality firms signal their quality by relying more on internal funds to finance growth options, and poor quality firms rely on external equity. This argument is plausible. Given market frictions in raising external capital, firms would only approach capital markets if they faced an internal funds deficiency. Myers and Majluf (1984:219) contend that good quality firms prefer internal financing to external financing. Thus, for good quality firms, the financing hierarchy descends from internal funds to debt and lastly to external equity (Chirinko & Singha, 2000:424).
When faced with an internal funds deficit, the managers of good quality firms would follow the external finance hierarchy. This hierarchy starts with the safest and cheapest source of external capital, which is exhausted before moving on to the next source. The hierarchy followed is: pure debt first, then hybrid debt, and lastly equity, which is the riskiest source of capital and very expensive to raise (McGuigan, Kretlow & Moyer, 2009:453).
1. INTRODUCTION
1.1 INTRODUCTION
1.2 THE OBJECTIVES AND QUESTIONS OF THE RESEARCH
1.3 CONTRIBUTIONS TO THE BODY OF KNOWLEDGE
1.4 STRUCTURE OF THE STUDY
2. OVERVIEW OF THE SOUTH AFRICAN CAPITAL MARKET
2.1 INTRODUCTION
2.2 A REVIEW OF THE SOUTH AFRICAN MACRO-ECONOMIC ENVIRONMENT
2.3 A REVIEW OF THE STRUCTURE AND PERFORMANCE OF THE JOHANNESBURG STOCK EXCHANGE (JSE)
2.4 THE JSE DEBT MARKET
2.5 MACRO-ECONOMIC CHANGES AND CAPITAL STRUCTURE DYNAMICS
2.6 SUMMARY
3. A STUDY OF THE CAPITAL STRUCTURE LITERATURE
3.1 INTRODUCTION
3.2 EARLY BEGINNINGS OF CAPITAL STRUCTURE THEORY
3.3 CAPITAL STRUCTURE IN PRACTICE
3.4 DEPARTURE FROM MODIGLIANI AND MILLER THEORIES: THE MODERN CAPITAL STRUCTURE THEORIES
3.5 THE LEADING CAPITAL STRUCTURE THEORIES
3.6 WHICH ARE THE RELIABLE DETERMINANTS OF CAPITAL STRUCTURE?
3.7 THE FIRM-SPECIFIC DETERMINANTS OF CAPITAL STRUCTURE
3.8 THE COUNTRY-SPECIFIC DETERMINANTS OF CAPITAL STRUCTURE
3.9 THE COUNTRY-SPECIFIC DETERMINANTS OF CAPITAL STRUCTURE: TESTS ACROSS THE GLOBE
3.10 THE IMPLICATIONS FOR SOUTH AFRICAN FIRMS
3.11 CORPORATE FINANCING, CAPITAL STRUCTURE AND FIRM VALUATION
3.12 CAPITAL STRUCTURE THEORIES: A CRITICAL COMMENT
3.13 SUMMARY
4. RESEARCH METHODOLOGY
4.1 INTRODUCTION
4.2 THE NATURE OF PANEL DATA
4.3 REVIEW OF PANEL DATA ESTIMATORS
4.4 THE CURRENT RESEARCH
4.5 SUMMARY
5. RESULTS ANALYSIS: TRADE-OFF VS. PECKING ORDER THEORY
5.1 INTRODUCTION
5.2 VARIATIONS IN THE BDR AND MDR OF MANUFACTURING, MINING AND RETAIL FIRMS: 2000-2010
5.3 THE FINANCING PATTERNS OF THE MANUFACTURING, MINING AND RETAIL FIRMS: 2000-2010
5.4 PANEL 1: FULL SAMPLE SUMMARY STATISTICS
5.5 PANEL 1 EMPIRICAL RESULTS: TRADE-OFF VERSUS PECKING ORDER THEORY
5.6 SUMMARY
6. RESULTS ANALYSIS: CAPITAL STRUCTURE AND KEY FINANCIAL PERFORMANCE VARIABLES
6.1 INTRODUCTION
6.2 PANEL 2 SAMPLE: SUMMARY STATISTICS
6.3 PANEL 2 SAMPLE RESULTS: KEY FINANCIAL PERFORMANCE VARIABLES
6.4 A NEW MODEL FOR LEVERAGE DETERMINATION
6.5 SUMMARY
7. RESULTS ANALYSIS: DISCOUNTED VALUE PREMIUM
7.1 INTRODUCTION
7.2 THE DISCOUNTED VALUE PREMIUM SAMPLE: SUMMARY STATISTICS
7.3 EMPIRICAL FINDINGS: THE DISCOUNTED VALUE PREMIUM
7.4 SUMMARY
8. CONCLUSION AND RECOMMENDATIONS
8.1 INTRODUCTION
8.2 TRADE-OFF AND PECKING ORDER THEORIES
8.3 TARGET SPEED OF ADJUSTMENT
8.4 KEY FINANCIAL PERFORMANCE INDICATORS AND CAPITAL STRUCTURE
8.5 DISCOUNTED VALUE PREMIUM
8.6 CORRELATIONS, SPEED OF ADJUSTMENT AND THE DISCOUNTED VALUE PREMIUM: A NEW CAPITAL STRUCTURE THEORY?
8.7 LIMITATIONS AND RECOMMENDATIONS FOR FUTURE RESEARCH
9. LIST OF REFERENCES
