To show some of the possible determinants of firms’ capital structure, further describe why SME’s face a more problematic financial situation, and describe some of the benefits and costs with different financial choices, capital structure theory is being adopted. This par-ticular body of literature was originally a result from studies on large manufacturing com-panies (Ang, 1991), but has during the last two decades also been exposed to thorough test-ing and consequently supplemented to fit an SME reality. Below the development of this particular literature is described, only considering the main contributions with emphasize on SME’s.
However, whilst capital structure analysis reflects past aggregated data at a moment in time, it has no power to predict the future or render a deeper understanding of the process of growth and it’s financing. Hence, growth strategies, financing possibilities and associated trade-offs relevant for SME’s to consider within this context are presented.
To grow with profitability you also need to manage the effects of growth. Hence the costs of growth along with relating areas of current thinking carrying a potential to enligh-ten and further depict the phenomena in focus will be presented. Towards the end of every section of the theoretical framework, the theories will be operationalized into questions ex-plaining its fit and usage within the investigation process.
Modigliani and Miller (M & M) laid the foundation to what was to become the theory of firms’ capital structure. Their first ‘irrelevance theorem’ (1958) stated that in a perfect mar-ket a firm’s choice of finance does not affect its value, since the effect of cheaper debt will be matched by an equal increase in cost of equity resulting in an unaffected cost of capital. The message was for management not to spend any time examining the right side of the balance sheet, but instead focus on the value adding left side. Since they outlined where capital structure theory is irrelevant, others were inspired to explore when and how it in fact is relevant (i.e. in non perfect markets). Even M & M modified their own theory in 1963 when they described the ‘tax shield’ as an advantage of debt finance that could elevate firm value, since interest is tax deductable. Why then, are firms not a 100% debt financed?
The first cost associated with debt finance are bankruptcy costs; the additional legal expenses, decreasing sales, increasing costs of production, and losses in value due to forced fire sales, that comes with a firm’s bankruptcy or reorganization. These costs make firms less benevolent towards leverage and financial institutions more careful lending (Robichek and Myers, 1965). More recent studies all agree that these costs relatively decrease with firm size, making bankruptcy costs more severe for SME’s (Van der Wijst and Thurik, 1991). Myers continued on his own to describe another cost, called underinvestment caused by debt overhang (1977). Highly levered firms will find it hard to finance positive net value projects (NVP’s) since existing creditors deny further lending to limit exposure, and junior creditors (in a negative scenario) will only finance the repayment of more senior debt. To generalize, firms primarily valued on its expected future cash flow will find the cost of un-derinvestment to be substantial, and mature firms with limited growth opportunities will find the benefit of the tax shield to outweigh this cost. The choice between the benefit of debt (tax shield) and cost of debt overhang (underinvestment) is called the static trade-off.
In 1976, Jensen and Meckling portrayed the principal-agent relationship as another cost affecting firms’ choice of finance. These so called agency costs arise from management not always performing in a value maximizing way (emphasizing reinvestment of free cash flow to increase power instead of dividend), forcing creditors to invest in monitoring d e-vices to supervise and control their behavior. Due to the elusive nature and opaque appear-ance of a smaller firm, with less financial control and historical records, these costs are comparatively higher for SME’s (Chittenden, Hall and Hutchinson, 1996). Myers and Ma-jluf (1984) found evidence of the static trade-off being a second hand concern, behind the ‘pecking order theory’ (POT). Here a firm prefers using its internal funds, before trying to obtain debt finance, and only see new equity issues as a last resort. The behaviour was ex-plained by information asymmetry, leading to unwanted market reactions. Without full di s-closure of firms’ future prospects, the market will interpret new issues as management con-sidering the equity to be overvalued, and thus in response lower its value. The same logic explains why initial public offerings (IPO’s) are found to be underpriced for smaller firms, and when carried through associated with higher cost of equity for a given risk, making ex-ternal equity more expensive for SME’s (Buckland and Davis, 1990). Following the POT logic profitable firms will choose internal funding and less profitable will be forced to choose external. Additionally, it entails that growth might be limited to match firms’ gen-eration of internal funds.
Before moving on to SME growth considerations, it can be intuitive to see how their financial situation limit and affect them through a life-cycle perspective. Early on firms are seen as almost entirely dependent on owners’ equity which limit their chances of really seiz-ing all opportunities and grow. After surviving the first years of underinvestment they can start making use of trade credit and short-term debt6. However, due to lack of long term debt7 and stock market quotation, rapid growth at this stage could severely hurt the liquid-ity of the firm (Weston and Brigham, 1981). Michaelas et al. (1999) take a similar stand-point when they identify the lack of long term debt to decrease a firm’s chances of handling late payments on receivables, and thus as a result increase their dependence on short-term debt. This theoretical section will be utilized in the following way:
Determinants of SME capital structure:
Size – due to agency costs
Age – due to agency costs
Profitability – due to the ‘pecking order theory’ Asset structure (as a proxy for collateral) – due to agency costs Growth – due to the static trade-off
- What benefits and costs of debt have they experienced?
- What are their preferences between: internal equity, short/long term debt, and external equity?
SME growth and its financing
Capital constraints are uniformly considered to be the main obstruction for SME growth (Becchetti and Trovato, 2002; Riding and Haynes, 1998), but are not entirely conclusive. Bartlett and Bukvic (2001) find institutional bureaucracy to be almost as important, al-though not particularly in Western Europe but from a global perspective. The field of stra-tegic management turn to the entrepreneur himself for explaining SME growth. If not re-stricted by his perception of what is possible, his capabilities, his ability to delegate, then his desire in form of unwillingness to grow could be the true barrier (O’Farrell and Hitchens, 1988). However, when a firm is growing there are certain trade-offs that should be consid-ered, closely tied to the overall strategy and financial ability of a company; that is how to grow, with what speed, and how to finance it?
Organic growth means that a firm grow without buying other existing companies, licences or products, meaning they increase/expand production or establish new plants on their own (Ansoff, 1965). Non-organic growth can for SME’s take the form of mergers and ac-quisitions. In acquisitions one company ‘swallow’ another company and have the possibility to completely change its structure and processes. In mergers on the other hand, two com-panies normally of the same size unites under the control of one management (Gaughan, 2002). Although most literature on mergers and acquisitions (M&A) have its origin in large companies a recent study by Weitzel and McCarthy (2009) on SMEs’ M&A behaviour found that: a) M&A is a more popular growth strategy among SME’s than for larger firms, SME’s are performing better in M&A deals, and c) the pecking order only partially ex-plains SME behaviour when found that they, in comparison to large firms, use more stock and less debt and cash to pay for their M&A. The choice between organic and non -organic growth is according to Ansoff (1965) driven by cost and time. With organic growth the de-velopment of new products, the construction of new facilities, and changes to the structure of the organization are all additional costs. The same costs are associated with the non – organic growth, which also bring transaction- and acclimatization costs but it is considera-bly faster achieved.
2 Problem statement
3 Theoretical framework
3.1 Financial situation
3.2 SME growth and its financing
3.3 Managing the effects of growth
4.1 Abductive method
4.2 Mixed method approach
4.3 Financial situation
4.4 Growth, it’s financing and possible effects of growth
4.5 Problems and weaknesses
5 Findings and analysis
5.1 Financial situation
5.2 Growth and its financing
5.3 Managing the effects of growth
7 Evaluation and further research
List of references
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OVERCOMING CAPITAL CONSTRAINTS AND CHALLENGES OF FAST GROWTH AS AN IT SME