Capital structure has always been one of the main topics among the studies of finance scholars. Its importance derives from the fact that capital structure is tightly related to the ability of firms to fulfil the needs of various stakeholders. The last century has witnessed a continuous developing of new theories on the optimal debt to equity ratio. The first milestone on the issue was set by Modigliani and Miller, whose model argued on the Irrelevance of the capital structure in determining firms’ value and future performance (1958). However, many authors have successively proved that a relationship between capital structure and firm value actually exists (e.g., Lubatkin and Chatterjee, 1994). The same Modigliani and Miller (1963) asserted that their model was not effective anymore if tax was taken into consideration. They demonstrated that the existence of tax subsidies on interest payments cause the value of the firm to increase when equity is traded off for debt.

Since the publication of Modigliani and Miller’s (1958) paper on capital structure, much of the debate has focused on the Pecking Order Hypothesis (POH), which has become one of the most influential theories of corporate leverage. The work on agency theory (Jensen and Meckling, 1976), information asymmetry (Myers and Majluf, 1984) and signalling theory (Ross, 1977), Myers (1984) proposed that firms prefer internal to external finance and when external funds are necessary, firms prefer debt to equity finance. This hierarchy stems from information asymmetry between managers and investors with the result that, in attempting to raise external capital, investors face an adverse selection problem and demand a premium that raises the required rate of return on external capital. Firms are better off if they meet financing needs from internally.

Structure of Literature Review

Section 2.1 Theoretical Review

capital structure theories, mainly, Trade Off Theory (TOT), Agency Theory, Information Asymmetry and Pecking Order Hypothesis.

Section 2.2 Empirical Evidence

Discussion on the Empirical Evidences, Mainly on the different factors and studies, which many researchers have been considering, using some of the Theories above.

THEORETICAL REVIEW

Section 2.1

Capital Structure Theories:

Many theories have attempted to explain the variation in debt ratios across firms. The theories suggest that firms select capital structure depending on attributes that determine the various costs and benefits associated with debt and equity financing. The explanations vary from the irrelevancy hypotheses (Modigliani and Miller, 1958) to the optimal capital structure, where the cost of capital is minimized and the firm value is maximized, hence, maximizing the wealth of the shareholders. However, these theories have been developed to explain financing preferences focusing on large listed firms. The issue of whether these findings are valid for other firms, especially SMEs, has received limited attention. Three of the most popular explanations of capital structure are the trade-off, the agency costs, and the pecking-order theories. Below a brief overview of these theories are elaborated.

Section 2.1.1 The Trade-off theory (TOT)

The TOT claims the existence of an optimal capital structure that firms have to reach in order to maximize their value. The focus of this theory is on the benefits and costs of debt. The former include essentially the tax deductibility of interest paid Modigliani and Miller (1958), while the latter are originated by an excessive amount of debt and the consequent potential bankruptcy costs, Kraus and Litzenberger (1973). Thus, firms set a target level for their debt–equity ratio that balances the tax advantages of additional debt against the costs of possible financial distress and bankruptcy.

Section 2.1.2 Agency theory

The agency theory concept was initially developed by Berle and Means (1932), who argued that due to a continuous dilution of equity ownership of large corporations, ownership and control become more and more separated. This situation gives professional managers an opportunity to pursue their own interest instead of that of shareholders (Jensen and Ruback, 1983).

In theory, shareholders are the only owners of a company, and the task of its directors is merely to ensure that shareholders’ interests are maximised. However, Jensen and Meckling (1976) observed that mangers do not always run the firm they work for to maximise shareholders’ wealth. From this observation, they developed their agency theory, which took into account the principal-agent relationship as a key determinant in determining firm performance. According to their definition, “An agency relationship is a contract under which one or more persons (the principal[s]) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent”.

The problem is that the interest of the principal and the agent are never exactly the same, and thus the agent, who is the decision-making part, tends always to pursue his own interests instead of those of the principal. It means that the agent will always tend to spend the free cash flow available to fulfil his need for self-aggrandisement and prestige instead of returning it to shareholders as argued by Jensen and Ruback, (1983). Hence, the main problem faced by shareholders is to ensure that managers will return excess cash flow to them (e.g. through dividend payouts), instead of having it invested in unprofitable projects as explained by Jensen, (1986).

Nevertheless, recent research has discovered that capital structure can somewhat cope with the principal-agent problem without substantially increasing agency costs, but simply by trading off equity for debt as explained by Pinegar and Wilbricht (1989). Lubatkin and Chatterjee (1994) argue that firms can discipline managers to run businesses more efficiently by increasing their debt to equity ratio. Debt creation ensures contractually that managers will return excess cash flow to investors instead of investing it in project with negative Net Present Values. This is due to the fact that high degrees of leverage entail high interest expenses, which force managers to focus only on those activities necessary to ensure that the financial obligations of the firm are met.

Hence, by having less cash flow available, managers of highly leveraged firms see their ability of using the firm’s resources for discretionary – and often useless – spending, dramatically reduced. Therefore, firms which are mostly financed by debt give managers less decision power of those financed mostly by equity, and thus debt can be used as a control mechanism, in which lenders and shareholders becomes the principal parties in the corporate governance structure. Managers that are not able to meet debt obligations can easily and promptly be displaced in favour of new managers that can better do stakeholders’ interests. Leveraged firms, therefore, are somehow better for shareholders because they ensure them that manager do not have the ability (and the cash) to waste the company’s resources in useless expenses. The ultimate outcome of debt creation is thus to transfer wealth from the organization and its managers to the investors (Jensen, 1989).

This reasoning may lead to the conclusion that debt financed firms are always better for investors than equity financed firms. It is logical, therefore, to wonder why not all the firms are mostly financed by debt. The answer lays in the fact that debt financing increases the cost of capital and other costs: highly leveraged firms are more likely to face cash problems, which increases their likelihood of bankruptcy, and thus increases also all the costs related to bankruptcy. Moreover, highly leveraged companies, which are generally considered risky companies, tend to be low-rated by rating agencies. This classification as risky companies increases their overall cost of capital, since they must guarantee higher returns than those guaranteed by well-rated firms if they want to attract investors.

Section 2.1.3 Information Asymmetry

The introduction into economics of the explicit modelling of private informa­tion has made possible a number of approaches to explaining capital struc­ture. In these theories, firm managers or insiders are assumed to possess private information about the characteristics of the firm’s return stream or investment opportunities. In one set of approaches, choice of the firm’s capital structure signals to outside investors the information of insiders. This stream of research began with the work of Ross (1977) and Leland and Pyle (1977). In another, capital structure is designed to mitigate inefficiencies in the firm’s investment decisions that are caused by the information asymme­try. This branch of the literature starts with Myers and Majluf (1984).

They showed that, if investors are less well-informed than current firm insiders about the value of the firm’s assets, then equity may be mis-priced by the market. If firms are required to finance new projects by issuing equity, under pricing may be so severe that new investors capture more than the NPV of the new project, resulting in a net loss to existing shareholders. In this case the project will be rejected even if its NPV is positive.

This underinvestment can be avoided if the firm can finance the new project using a security that is not so severely undervalued by the market. For example, internal funds and/or risk less debt involve no undervaluation, and, therefore, will be preferred to equity by firms in this situation. Even (not too) risky debt will be preferred to equity. Myers (1984) refers to this as a “pecking order” theory of financing, i.e., that capital structure will be driven by firms’ desire to finance new investments, first internally, then with low-risk debt, and finally with equity only as a last resort.

Strictly speaking, Myers and Majluf (1984) show only that debt whose value is not sensitive to the private information is preferred to equity (e.g. risk less debt). Moreover, if such debt is available, the theory implies that equity never be issued by firms in the situation of extreme information asymmetry they model. Consequently, the “pecking order” theory requires an exogenous debt constraint in the Myers and Majluf model. Note also that there can be a pooling equilibrium in which all firms issue securities, because the project’s NPV exceeds the worst under pricing. This equilibrium would not have the properties of the separating equilibrium mentioned in the text.

Section 2.1.4 The Pecking Order Hypothesis (POH)

The “Pecking Order” Theory postulated by Myers and Majluf (1984) states that the existence of asymmetric information between managers and investors causes the financial assets issued by the firms to be undervalued, which increases the cost of external financing as compared to internal, making the second one preferable as a financing method. At the same time, the transaction costs derived from the external financing are avoided. For that reason, this Theory establishes that the firms leverage is a consequence of the need for external financing, since the internal financing for making profitable investments has run out Myers and Majluf, (1984) and, therefore, the existence of target debt ratios is not considered. The changes at the leverage level come from the need for external financing since the internal financing has run out and there are still profitable investment opportunities, but not with the aim of reaching a certain leverage level. Thus, the capital structure is the result of a “hierarchical” financing of firms throughout the years.

The existence of a preference for internal financing as a main capital structure determinant of firms has an important empirical support in the reverse relation that different empirical studies state between leverage and profitability (Kester, 1986; Titman and Wessels, 1988; Rajan and Zingales, 1995). The reverse relation between economic profitability and leverage is in accordance with the firm’s preference for internal financing that the “Pecking Order” Theory proposes. In this way, considering the side of the debt demand, a reverse relation between profitability and debt seems reasonable, since the greater generation of internal financing expected in the most profitable firms makes it less necessary to resort to debt.

It must be emphasized that the relation between debt and economic profitability that the “Pecking Order” states is contrary to the Trade off Theory and to the usefulness of leverage as a financial signal Ross(1977) and as a mechanism to reduce the agency conflicts Jensen (1986). In all these cases, the best financial situation and prospects we can associate with greater economic profitability predicts a direct relation between leverage and profitability.

The negative valuation of equity issue announcements by the financial markets Myers (1984) is also consistent with the “Pecking Order” Theory, and contrary to the existence of a search for an optimal debt ratio by the firms. This would imply that any change at the leverage level, whether an increase and decrease, should cause an increase in value, since those changes in the capital structure would follow the optimal ratio, that is, the one that maximizes a firm’s value.

EMPIRICAL REVIEW

Section 2.2

Introduction

The capital structure theories just described above allow the identification of various factors as determinants of a firm’s capital structure choice. Indeed, the famous seminal paper by Modigliani and Miller (1958) had set the stage for numerous propositions that have been developed to provide the theoretical underpinnings of this crucial concept. Theoretical advancement with emphasis of shaping capital structure models based on tax balancing and information asymmetry, product market, corporate governance have aided in understanding the financing behaviour of corporate entities.

Section 2.2.1 Developing versus Developed

Generally, SMEs and entrepreneurial activities are said to be important to economic development Hamilton and Harper, (1994). The few empirical studies on the capital structure of SMEs have tended to concentrate mainly on developed economies with varied and inconclusive results for instance Chittenden et al., (1996); Cressy and Olofsson (1997); Jordan et a., (1998), Michaelas et al (1999); Esperanc¸a et al., (2003); Hall et al.,(2004); Sogorb-Mira (2005).

The case in mauritius

The differences in institutional arrangements and financial markets between developed and developing countries actually merit the need to look at the issue from the perspective of developing economies, especially within the context of Africa such as Mauritius. SMEs in Mauritius may show a different capital structure with limited access to external finance due to the under developed nature of the financial market. What influences SMEs’ capital structure decisions still remains unexplored in the Mauritian context. This is the focus of the project.

Section 2.2.2 On one hand – why to use debt financing

The introduction of Tax Benefits

Argument amongst others has been centred on the determination of an optimal capital structure for a specific firm and also as to whether the quantum of debt usage in relation to equity is irrelevant to a firm’s worth. After their initial presentation stating that capital structure is irrelevant to firm value, Modigliani and Miller in 1963 revised their position by incorporating tax benefits as determinants of capital structure. In this new dimension, the essential characteristic of taxation is the recognition of interest as a tax-deductible expenditure. To strengthen this argument, Modigliani and Miller explain that a firm that honours its tax obligation benefits from partially offsetting interest called “tax shield” in the nature of payment of lower taxes. This therefore is a tacit admission that capital structure influences firm value. They, thus, state that firms should use as much debt as possible in order to maximize their value.

Liquidation and Cashflow

Subsequent to this, several studies have looked at the linkage between capital structure and firm value and more especially after the paper by Jensen and Meckling in 1976. There is the argument that greater financial leverage has the possibility of affecting managers and reducing agency cost through the threat of liquidation which causes personal losses to managers’ salaries, reputation, perquisites etc. (e.g. Grossman and Hart, 1982; Williams, 1987), and also through pressure to generate cash flows to pay interest expenses (Jensen, 1986).

Mitigation of Conflicts

Emanating from the foregoing discussion, higher leverage is considered an appropriate method to employ in order to mitigate conflicts between shareholders and managers concerning the type of investment to undertake, (Myers, 1977), the amount of risk to undertaken, (Jensen and Meckling, 1976; Williams, 1987), the conditions under which the firm is liquidated, (Harris and Raviv, 1990), and even decisions regarding dividend policy, (Stulz, 1990).

Section 2.2.3 On the other hand – The Problem with Debt Financing

The Issue of Agency Cost

Berger and Bonaccorsi di Patti (2005), argued that increased leverage may reduce the agency costs of outside equity, the opposite effect may occur for the agency costs of outside debt arising from conflict between debt holders and shareholders, and that when leverage becomes relatively high, further increases may generate significant agency costs of outside debt from risk shifting or reduced effort to control risk that result in higher expected costs of financial distress, bankruptcy, or liquidation.

The Issue of Liquidity and Cashflow

Such agency costs leads to higher interest expenses from firms to be able to compensate debt holders for their expected losses. Thus, capital structure which is defined as total debt to total assets at book value, impacts on both the profitability and riskiness of a firm as explained by Bos and Fetherston (1993), and when a firm exhibits greater gearing, it has a higher possibility for failure in the event that cash flows fall short of the required volume to honour debt obligations.

Section 2.2.4 Agency Cost Contradiction

According to Jensen and Meckling (1976), the influence of leverage on total agency cost is expected to be non-monotonic. Therefore, at low levels of leverage, increases will produce positive incentives for managers and reduce total agency costs by reducing agency costs of outside equity.

Berger and Bonaccorsi di Patti (2006) show however that at some point where bankruptcy and distress become more likely, the agency costs of outside debt overwhelm the agency cost of outside equity, and therefore further increases in leverage lead to higher total agency cost. In all this debate, one important conclusion that has emerged is the fact that the structure of a firm’s capital has implications for its operations and impacts on its performance. Though much of the debate on capital structure has centred on the determination of an optimal composition of debt and equity for firms, it lacks theoretical foundation and that empirical results show that firms with diverse idiosyncrasies require what is considered an acceptable level of debt and equity mix taking into consideration their peculiar characteristics and the environment within which they operate for effective operation and to deal with agency cost.

Section 2.2.5 Structure of Capital Determinants

There have been a number of studies investigating the determinants of capital structure of firms in different businesses such as, joint venture ships (Boateng, 2004), manufacturing sector (Long and Malitz, 1985; Titman and Wessels, 1988), electricity and utility companies (Miller and Modigliani, 1966), the non-profit hospitals, (Wedig et al. 1988) and in agricultural firms Jensen and Langemeier, (1996). In these studies, one of the main findings is that industrial classification is an important determinant of capital structure. Thus, firms in different sectors employ different mix of debt and equity financing for their operations.

Section 2.2.6 Profitability

However, there are fewer studies that emphasizes on linkage between capital structure and performance. For instance, Berger and Bonaccorsi di Patti (2006) using data on commercial banks in the USA show that higher leverage or lower equity capital ratio is related to higher profit efficiency, and Abor (2005) on capital structure and profitability of SMEs in Ghana, show that short-term debt ratio is positively correlated with return on equity.

In a similar study, Chiang Yat Hung et al. (2002), on capital structure and profitability of the property and construction sectors in Hong Kong conclude that while high gearing is positively Microfinance institutions 59 related to asset, it is negatively related to profit margins. The separation of ownership and management of any corporate entity leading usually to divergent objectives raises questions on how much debt and equity should be employed. A clear case of agency costs which could be viewed from different perspectives by management and owners. From the foregoing analysis, it is clear that agency cost and capital structure is an important research agenda.

Section 2.2.7 The Pecking Order Hypothesis

The pecking order hypothesis generated funds and, when it is necessary to resort to external financing, the least risky claim is best and, therefore, debt is preferable to equity finance. While empirical evidence on the POH does not offer convincing support (see Klein et al., 2002, and Barclay and Smith, 2005 for a summary and discussion, respectively) its simplicity, predicting the priorities with which firms choose their means of financing, has given it a wide appeal.

Does it apply to Small Firms?

A small number of researchers (e.g. Berggren et al., 2000; Chittenden et al., 1996; Holmes and Kent, 1991; Howorth, 2001; Norton, 1991a, 1991b; Scherr et al., 1993) have sought to establish whether the POH applies to small firms. As is the case with large companies, empirical evidence about the applicability of the POH to small firms is mixed. For example, Norton (1991a) found evidence of the POH in high growth companies whereas Chittenden et al. (1996) found that small firms especially seem to develop structures that have a minimum, rather than a maximum, amount of debt.

Howorth (2001) found evidence of truncation with owners refusing to contemplate external equity finance. Moreover, a body of evidence has highlighted a variety of other factors that determine the financial capital preferences in small firms, for example, life style preferences. The confusing picture of the financial preferences of small firms may stem, at least in part, from the wide variety of ventures studied. These range widely both within and between studies making comparison difficult. They used a sample that includes firms that range in size from 60 to three employees; Chittenden et al. (1996) defines small firms as employing up to 100 staff while Holmes and Kent (1991) use a cut-off of 20 employees.

Moreover, as Ang (1992) points out there may be confusion over the use of the terms equity and debt due to the financial intertwining of owners and their businesses that is characteristic of many small firms. Berger and Udell (1998) suggest that in small firms much external debt is not external in an economic sense. Many lenders to small businesses require personal guarantees and, from the perspective of the entrepreneur, it can be argued that the debt is more appropriately considered a personal liability. This confusion adds to the difficulty of assessing the applicability of the POH to small firm financing.

In relation to start-up firms in particular, the majority of studies that have empirically investigated start-up financing have tended to be descriptive and shied away from testable implications (Cassar, 2004). The issue of information asymmetry, which underpins the POH, is particularly acute in new ventures. At this stage of their development, businesses are informationally opaque (Hall et al., 2000; Schmid, 2001) and assets are often intangible and knowledge-based. Moreover, many of the ways in which owners of established businesses facilitate more efficient transactions by signalling information about the quality of their goods through, for example, an established track record and product branding are often not available to business start-ups.