ATENEO DE DAVAO UNIVERSITY School of Business and Governance In partial fulfillment of the requirements for Fin324 CAPITAL STRUCTURE DECISION OF SMALL AND MEDIUM SIZED ENTERPRISES A Case Study of All Systems Logistics, Inc. Phil Submitted by: Bijis, Dean Victor 3BM-A Submitted to: Ma. Grace M. Baysa Fin324 Teacher Abstract Firms need capital in order to run their respective businesses, do necessary investments and eventually, grow larger. These actions and decisions are combined with high costs where both internal and external financing might be appropriate.
Capital structure is the relation between debt and equity. In this case, I have focused on the decision behind the capital structure of All Systems Logistics, Inc. I have focused on the industry and I have tried to find out how management reason about their decision. The purpose of this case is therefore to describe and analyze its decision of capital structure within its industry. Emphasis is put on the different aspects that influence the capital structure decision and to what extent this is a strategic issue colored by personal beliefs.
To fulfill the purpose, mainly a qualitative approach with primary data from structured interviews has been used. The interview was conducted face-to-face with owner and/or manager. One theory explains that firms, especially SMEs, prefer to finance their businesses with internally generated funds. Focus of the theoretical part is on theories of what factors that affect the capital structure decision, how this can be argued to be a strategic question for SMEs, how risk affects the capital structure decision and how this decision is made in a family business.
These theories are presented to shed light on the capital structure decision making process of SMEs. From this study it is found that the majority of the companies prefer internal financing i. e. reinvested earnings, and as a second alternative to use debt in form of bank loans. The study also shows that the reasons behind this preferred order are the will of being independent, previous experience and managements’ risk-taking propensity. I believe that these factors combined with beliefs about debt and realized need for debt works as a base for how a capital structure strategy is discussed, formed and developed.
From this study it can also be concluded that risk indirectly affects the capital structure decision. Last, the study concludes that even though the studied firms prefer to finance with retained earnings they all use debt more or less. Table of Contents 1Introduction………………………………………………………………………… 1 1. 1 Background………………………………………………………………… 1 1. 2 Problem………………………………………………………………………… 1 1. 3 Purpose………………………………………………………………………… 3 1. 4 Definitions………………………………………………………………… 3 2Capital Structure Theories ………………………………………………………. 4 2. 1 Foundation of capital structure decision theories……………………. … 4 2. 1. 1 M&M Theorem………………………………………………………… 4 2. 1. 2 Information Asymmetry………………………………………………… 5 2. 2 Pecking Order Theory………………………………………………………… 5 2. 3 SMEs strategic capital structure decision theories………………………… 6 2. 4 Risk………………………………………………………………………… 9 2. 5 Characteristics affecting capital structure………………………………… 9 2. 5. 1 Special characteristics of family businesses………………………… 10 3Empirical Findings and Analysis ……….. ………………………………………….. 10 3. 1 All Systems Logistics, Inc. ………………………………………………….. 10 3. Analysis of M&M theorem………………………………………………….. 11 3. 3 Analysis of the Pecking Theory ……………………………………………. … 12 3. 4 Analysis of SMEs strategic capital structure………………………………. …. 12 3. 5 Analysis of Risk………………………………………………………………….. 13 3. 6 Analysis of firm characteristics………………………………………….. 13 3. 6. 1 Analysis of special characteristics of family business………….. 13 4Conclusion………………………………………………………………………….. 14 1 Introduction In order for every company to grow and expand the business they have to invest money in different assets such as personnel, machinery and buildings.
These investments are often combined with high costs and the cash-flows generated from previous years are rarely enough to finance all the investments needed. For companies to finance larger investments like those for new premises, machineries or vehicles they can either issue new shares or turn to different banks or venture capitalists. Large corporations often obtain credit in the public debt markets, while small firms often have to rely on commercial banks. Capital structure, the subject of this study, is about the choice between the different financial alternatives that a company faces or the combination of debt and equity. . 1 Background The issue of capital structure, the relation between debt and equity, is constantly debated and never the less current. Capital structure is a complex issue of financial research. It is important to bear in mind that there are two different ways to finance the assets of the firm; through equity and debt. Furthermore, there are several different kinds of equity and debts, such as common stock, preferred stock and retained earnings (untaxed reserves) as well as bank loans, bonds, accounts payable and line of credit.
The relation between debt and equity, often measured with the debt proportion ratio, represents the capital structure of a firm. There are many factors influencing the decision on capital structure, some companies are not able to receive bank loans, some have enough retained earning to undertake their desired investments without taking any loans, and some does not want to undertake any debt by principle. 1. 2 Problem How to finance and structure the capital of a company is a problematic and important question. Without capital the firm would be unable to run, grow and expand their business.
I have described and analyzed the capital structure decision making of All Systems Logistics, Inc. I have described and analyzed whether or to what extent the theories are applicable on the company’s decision making process of capital structure. I wanted to test if the manager/owner reason about capital structure in financial terms with the aim for certain debt proportions; if the firm reason about debt as a cheaper alternative towards equity or if they neglect those academic concepts and simply let their personal values and beliefs affect the capital structure decision.
I believe capital structure to be a financial complex issue. Copious of research have been done, but yet there is no magic combination of equity and debt for companies to apply. This study makes no effort in trying to solve this issue, but instead trying to shed some light on the capital structure decision issue within a specific industry in order to find out how executives reason about the area under discussion. The problem discussed lead to the formulation of the following research questions; • What financial sources do the interviewed company prefer and why? How is management’s risk-taking propensity affecting the capital structure decision? • Is capital structure decision a strategic and/or a financial issue? • What factors influence the capital structure decision? 1. 3 Purpose The purpose of this study is to describe and analyze the decision of capital structure of All Systems Logistics, Inc. Emphasis is put on the different aspects that influence the capital structure decision and to what extent this is a strategic issue colored by personal believes. 1. 4 Definitions
This section explains some frequently used key terms in order to facilitate the reading process. Capital structure is defined as the relation between debt and equity that is used to finance a firm’s assets (Moyer, McGuigan & Kretlow, 2001; McMenamin, 1999). The optimal capital structure “is the mix of debt, preferred stock, and common equity that minimizes the weighted cost to the firm of its employed capital, the capital structure where the capital cost is minimized and the total value of the firm’s securities are maximized” (Moyer et al. , 2001 p. 52). SME is an abbreviation for small and medium sized enterprises. We used the term SME in this case according to the European Commissions definition from 1996 (Nutek, 2005): “The category of micro, small and medium-sized enterprises is made up of enterprises which employ fewer than 250 persons and which have an annual turnover not exceeding 50 million, and/or an annual balance sheet total not exceeding 43 million. Family business has no general definition but we have adhered the definition presented by Gallo and Sveen (1991) cited in Mustakallio (2002, p. 7): “A business where a single family owns the majority of stock and has total control. Family members also form part of the management and make the most important decisions concerning the business”. 1 Capital Structure Theories This chapter starts by introducing some general theories of capital structure and then theories of relevant theories for SMEs capital structure decisions are presented. 2. 1Foundation of capital structure decision theories
For me, it would be unwise and remarkable not to start this theoretical framework with introducing the most cited publication as far as we are concerned; Modigliani and Miller’s (1958) theory of optimal capital structure and theories on information asymmetries. Therefore, before presenting the most important theories in this study, the optimal capital structure is presented. It serve as a base presenting how the capital structure ought to be according to pure financial issues in contrast to later presented theories explaining how, in reality, the capital is structured in most SMEs. 2. 1. 1 M&M Theorem
The original ideas presented by Modigliani and Miller (1958) are very theoretical and assumes conditions that do not fit with the real world e. g. all firms have a constant cash-flow, there exist no taxes and all investors and businesses can borrow and invest to the same risk-free rate. However, Modigliani and Miller’s famous theorem (M&M theorem) has made a great contribution to the field of finance as several authors have further developed their original theory. This has resulted in a formula showing why the proportion of debt financing is positively correlated with the return on equity.
Today the formula is better known as the leveraging effect. A firm that chooses to issue some debt e. g. takes a bank loan, will increase its return on equity since the cost of lending money from a bank is cheaper than “lending” money from the shareholders. It is cheaper due to the fact that long-term debt normally has lower administrative/issuing costs, debt interests are normally tax deductible and the pre-tax interest rate on debt is invariably lower than the required return of shareholders since debt usually demands assets as securities.
This implies that an increasing proportion of debt financing, to a lower interest rate than the required return of shareholders, will increase the return on equity and thereby the wealth of the shareholders. An alternative way of looking at this phenomenon is to consider the weighted average cost of capital (WACC). In connection to the modified version of M&M proposition with corporate tax, one can derive that an increased proportion of debt financing, to a lower interest rate than the required return of shareholders, will either reduce the cost of capital (see Figure 3. ) or increase the return to shareholders. In the latter situation, the cost of capital remains constant as the benefits of using cheaper debt is exactly balanced by the increase in the cost of equity. This leaves a net tax advantage with the conclusion that firms should use as much debt as possible. However, the debt interest rate is only lower than the return on equity to a certain point since creditors demand premiums for the risk they take when lending money. 2. 1. 2Information Asymmetry Information asymmetries are frequently debated in capital structure literature.
Information asymmetry means that the people inside the organization possess more information than what investors do. This can lead to the firm’s equity being incorrectly priced by the market and thus a greater risk for the business. The asymmetric information problem is greater between small firms and the banks than for large companies and their external providers of capital. Lenders will be unwilling to lend long-term loans to owner-managed businesses due to the risk of asset substitution and small businesses therefore have to rely on short-term loans instead.
According to Hutchinson (1995) information asymmetry are present within owner-managed firms because family and friends will find difficulties in trying to understand the problems with the investments. 2. 2Pecking Order Theory The pecking order theory is about what firm’s management prefer; a pecking order of alternative sources of finance that firm faces: First, firms chose internal finance, i. e. using profits from previous years. Second, if there is no internal finance available, will firms chose to lend money from credit institutions such as banks. Third, only as a last option will firms issue new shares.
Basically, the pecking order theory says that management favors internal financing to external financing. The pecking order theory tries to explain why most profitable firms use internal financing; the easy reason for this is that they do not need to make use of external funding. The other extreme, less profitable businesses do not possess enough internal capital and have to seek for external funding (Myers, 1984). Hutchinson (1995) points out that profit retention has an opportunity cost. The more business owners are willing to risk, the higher the possible profits.
The pecking order approach is relevant for small businesses since costs associated with external financing are higher for small firms than for large businesses. Sogrob-Mira (2005) argues that the pecking order theory could easily be applied on SMEs since managers usually are at the same time shareholders and they do not want to lose control of their businesses. SMEs will prefer internal financing to external resources since it will allow them to continue to be independent. If SMEs need external funds, they will choose an alternative that do not diminish the managers/owners operability.
Further, Sogrob-Mira (2005) concludes in his article How SME uniqueness affects capital structure that companies use the pecking order theory are successful, since more profitable SMEs tend to use less debt when financing their businesses. Chittenden et al. (1996) argue that one of the reasons why small firms avoid the use of external funding is that it would lead to less control by the present owner/managers. 2. 3SMEs strategic capital structure decision It is argued that capital structure is not just a financial question but also a strategically issue that the company faces.
Barton and Matthews (1989) presented in their article ”Small firm financing: implications from a strategic management perspective” a concept suggesting that corporate strategy plays an important role that might be more influential than a traditional finance perspective in explaining small firms financing decisions. Capital structure is not just a financial issue of trying to find the optimal level of debts and taxes or a question that firms prefer internal financing due to shareholder’s interest and transaction costs.
Barton and Matthew (1989) instead argue that the most important factors affecting the capital structure is influenced by the company’s vision, risk aversion and internal constraints. Barton and Matthews (1989) present five different propositions in their article on what affects SMEs financing decisions: “Top management’s risk-taking propensity affects the firm’s capital structure”. The amount of debt that top managers feel is manageable affects the overall debt ratio of the firm since the owners most often have to personally guarantee the loan in order to acquire one.
It argues that owners attitude towards risk seem to influence the choice of capital structure. As debt increases the risk inflate, hence, a risk averse organization will probably use debt to a less extent than a risk-willing organization. This proposal about top management’s risk awareness affecting capital structure is supported by Levin and Travis (1987) (cited in Barton & Matthews, 1989) who claim that SMEs’ equity level plays impact of their owners’ attitudes towards risk.
In case SMEs need external financing they will prefer short-term debt before long-term debt since the latter reduce management’s operability and short-term debt do not include restrictive covenants. “Top management’s goals for the firms will affect the firm’s capital structure”. Not all managers strive for profit maximizing; growth can sometimes be considered more important. This idea is strengthened by Levin and Travis (1987) who argue that SMEs not follow the same patterns and policies as larger companies do. In fact, SMEs choose debt on personal and managerial preference than what larger firms are able to do.
This is supported by Romano et al. (2001) who argue that capital structure processes should be analyzed by the impact of owner/manager’s personal reference and values of the firms’ characteristics. “Top management would prefer to finance firm needs from internally generated funds rather than from external creditors or even new stockholder”. Top mangers have a preference to remain as free as possible and do not want to become restricted by debt agreements. This idea goes in line with the pecking order theory (Myers, 1984).
Hutchinson (1995) argues that this could lead to an under-investment problem where high-quality, low risk project are rejected to be undertaken due to lack of equity and the unwillingness to external financing. “The risk propensity of top management and financial characteristics of the firm affect the amount of debt lenders are willing to offer and on what terms”. Credit institution’s willingness to lend money to different organizations is risky from their point of view; they always estimate how well they consider the organization’s ability to pay back when providing a bank loan. Financial characteristics moderate the ability of top management to select a capital structure for the firm”. The financial risk and flexibility of a firm tend to affect what the management’s willingness change their capital structure. The main incentive to increase the level of debt in a firm’s capital structure is when the interest costs are tax deductible. Matthews et al. (1994) argue similar to Barton and Matthews (1989) that capital structure is an issue of strategic choices and beyond what they refer to as the finance paradigm.
Information asymmetry theories have contributed to our understanding of the capital structure issue but they do not address the details of analyzing the managerial choice of the capital structure decision. In order to understand privately held businesses’ capital structure we need to apply a strategic perspective. Business leaders in small privately held business are less likely to be challenged by others and their personal characteristics will play a more dominant role in the decision making phases (Matthews et al. , 1994).
Beliefs about debt differs from attitudes towards debt in the way that a manager can dislike debt as a form of financing, but still possess the knowledge that debt might sometimes be needed as a part of the companies’ capital structure. 2. 4Risk Barton and Matthews (1989) argue that the amount of risk a company could bear is one of the greatest explanations to how capital is structured. In general, when discussing risk there are two different forms; operational risk and financial risk. Operational risk is the uncertainty concerning decisions: on the market, prices, personal, organization, business cycle and similar.
Financial risk is the risk a company faces when choosing the amount of debt and equity; the capital structure of the firm. 2. 5Characteristics affecting the capital structure There are several other factors influencing companies’ choice of capital structure. Petersen and Rajan (1994) argue that there are more relevant and suitable measures to use when analyzing the capital structure of an organization. Business size, age and cash flow is according to Petersen and Rajan (1994) important factors. • The larger the company is, normally the debts are too. The age of a company affects the capital structure. As the company matures debt decreases. Young companies are more or less forced to finance through bank loans while older have had possibilities to build capital from previous revenues. • A company with a solid cash flow has fewer problems to pay interest and to amortize than a company with a volatile cash flow, due to these reasons they can handle a larger amount of debts. Hutchinson (1995) presented an idea why small firms may not choose to increase its debt in capital in line with the capital structure that would maximize the value of the firm.
He suggested that small firms move towards a more conservative look upon debt; an equity ratio which decreases the effect from financial risk and, as a result, decreases the cost of equity. Hutchinson (1995) explains the phenomenon of owner/managers aversion to new equity capital to purely be due to the desire to remain independent and in total control over the business. 2. 5. 1Special Characteristics of family businesses Businesses run by families are dissimilar to non-family businesses in many aspects.
The aim for family businesses is stability compared to the non-family firms’ aim of maximizing future stock price. The goal for the family businesses is to care for the assets and the reputation of the family distinguished from non-family businesses’ goals of meeting investors’ expectations. The most vital stakeholders for family business are employees and customers. 3Empirical Findings This chapter outlines the findings for the interviewed company, All Systems Logistics, Inc. followed by financial ratios comparing the company to the industry and finally an interview with a credit officer is presented. . 1 All Systems Logistics, Inc. All Systems Logistics, Inc. was founded in 1996 by a group of dynamic individuals with the vision to be recognized as a genuine customer and service oriented company. As a young 100% Filipino-owned freight forwarding/logistics Company with an edge in marketing, ALL SYSTEMS is well placed to offer what the markets require from transportation partners in the national level. Through their extensive local network and with the full cooperation of its network of agents in the country, All Systems Logistics, Inc. nd its partners can only look forward to a bigger, brighter and stronger tomorrow. The diagram above shows that All Systems Logistics, Inc. has proportionally much long-term debt, even more than what it has short-term debt and equity together. All Systems Logistics, Inc. does not rent nor lease any of their trucks, all of them are owned. Previously, Its CEO took bank loans finance their trucks. Today, the CEO has increased their line of credit in order to finance their trucks by short-term debt. It is lower interest rate on the loan for properties compared to loans on ehicles and that is the major reason to why they have focused on amortizing the loans on the trucks and instead increase the loans on the premises. Another reason is of course that trucks decrease in value over time whereas the premises most certainly increase in value. The owner prefers internal financing and as a second alternative bank loans. He has a long-term view of growth. CEO declares that he has no desire to expand the business as rapid as possible but instead he prefers the company to grow slowly in order to remain the control of the business which he means has to do with his risk awareness.
When the company recently invested in new properties The CEO applied for a loan from the bank for the entire amount. However, he had to invest some internal capital later on as his calculations of the building costs were a bit optimistic. The dream is to be totally independent of the bank and its Transport’s policy is to own all assets, and not to lease or rent anything. As far as it is possible he tries to finance without external financing from the bank. 3. 2 Analysis of M&M Theorem It seems that All Systems Logistics, Inc. oesn’t seem to consider such an optimal capital structure presented by Modigliani and Miller (1958) but rather follow the theory presented by Barton and Matthews (1989) which suggest that SMEs do not seek to maximize the owner’s wealth. 3. 3 Analysis of the Pecking Theory All Systems Logistics actively choose to finance with internal capital in order to be able to act fast which is perfectly in line with Myers (1989) ideas. Hutchinson (1995) argues that the pecking order theory is valid for SMEs since they have a more restrictive approach towards debt.
According to the pecking order theory, firm management will only as a last alternative issue new shares. This was exactly the case in the empirical findings where the firm’s owner claimed that he did not considered any other alternatives to finance investments than through retained earnings or by taking loans from creditors. 3. 4 Analysis of SMEs strategic capital structure I could clearly identify Barton and Matthews (1989) ideas about capital structure decision being a strategic rather than a financial issue. All Systems Logistics, Inc bought, built or extended properties, mostly financed through debt.
This shows that demand for services in the road freight industry is ballooning. It only desires to finance with internally generated funds from previous year profits, but more or less, it used debt. My empirical findings appear to confirm Matthews et al. (1994) and Romano et al. (2001) ideas that the personal characteristics of the managers and owners play a dominant role in the decision of the capital structure. Hence, capital structure decisions should be analyzed by the impact of owner/manager’s personal reference and values of the firm’s characteristics.
All Systems Logistics, Inc strives for total independence from the bank and appreciates to be debt free. This is what Matthews et al. (1994) refers to as beliefs about debt. Even though it prefers to not issue any debt at all, none of it is financing solely through internally generated funds. The firm has chosen to undertake a bank loan to finance their new properties although it would have preferred to finance by internally generated funds. 3. 5 Analysis of Risk The desire and willingness to let the business grow, and management’s need for achievement is considered to affect the risk level a company chooses (Delmar & Davidsson, 1993).
All Systems Logistics, Inc prefers a slow and organic, internally funded, growth over a rapid and externally funded growth. Hence, it seems to be a clear connection between slow growth and management’s risk-taking propensity. According to Delmar and Davidsson (1993) the risk level a company take on is affected by competence of managers and the awareness of present risk taken, this goes very close with self realization about how much risk they can bear. All Systems Logistics, Inc believes that careful investments and slow growth is a superior strategy compared to rapid externally financed growth.
In my opinion, the experiences it possesses from the recession make them more restrictive towards the risk of undertaking bank loans. 3. 6Analysis of firm characteristics All Systems Logistics, Inc didn’t claimed they had a plan or written policy about how to structure their capital. It is hard to analyze whether this affects their amount of debt but I believe that they use less planning since they rely on previous experiences and personal beliefs which is something you normally not put in print. 3. 6. Analysis of special characteristics of family businesses All Systems Logistics, Inc CEO claims that he never had the desire for the business to grow rapid, it is more important to remain the control of the company and avoid unnecessary risk taking. This can be referred to what Hutchinson (1995) argues, i. e. that entrepreneurs as long as possible wants to stay independent and therefore tend to use retained profits not to involve outside participants. Further more this is because of their goal to stay in full control of their business. 4 Conclusion