How Financial Crisis affect Firms’ Capital Structure (Essay Sample)
Economic Crises are a natural phenomenon in the economic system. one would expect that firms'capital structure would need to adapt to financial crises. you are asked to critically analyze how finanacial crises affect capital structure. your arguments should take into acctout that firms are heterogenous. provide references to support your argumentssource..
How Financial Crisis affect Firms’ Capital Structure
Financial crises may affect the capital structure of organizations in diverse ways. All through the financial crisis, anticipated returns always decline, risks rise, and uncertainties also increase. As a result, the creditors and debtors become unwilling to lock in the capital in long-term investments (Gürkaynak & Wright, 2012). Based on lenders' perspective, given the increase in default probabilities during the financial crisis, the term premium they want to lend to firms increases, thereby making long-term lending much less attractive in proportion to short-term lending (De Vries, 2013). The financial intermediaries that have a balance sheet that is impaired may take a step of strengthening their lending margin. Additionally, they can increase their premium even more, when the uncertainties and risks upsurge and business predictions become more indeterminate throughout the economic crisis. The majority of the companies that cannot commit to a cumulative maturity structure, in turn, reduce their loan maturity and leverage.
Brunnermeier & Oehmke (2013) deploy a "rat race" capital structure model to explain the effect of the economic crisis on a firm's capital structure. They suggest that high volatility during a financial crisis increases the firm's incentive, thus shortening the loan maturity, regardless of the high roll-over costs related to short-term loans, since doing this adulterates the long-term investors' pay-offs. These authors suggest that financial crisis leads to volatile economic conditions, thus forcing firms to value financial flexibility. As a result, these firms will likely enter into long-term agreements with covenants, leading to a decrease in the demand for long-term loans. This suggests that the new issuance of a long-term loan to firms decreases during the financial crisis. Correspondingly, any new firm's loan issues may have shorter maturities.
Every financial crisis has three periods, the pre-crisis, crisis, and post-crisis period. The leverage ratio of corporations’ upsurges significantly from the pre-economic crisis to the crisis period of the financial crisis (Iqbal & Kume, 2014). An upsurge in the leverage ratio occurs due to short-term and long-term loans and a significant increase in debt rather than equity. Correspondingly, the economic crisis also affects the leverage ratio of private corporations. This occurs because a financial crisis usually hurts the financing channels, thus forcing private companies to hold money and issue equity for circumventing the adverse impact of inconsistency (Akbar et al., 2013). Based on the dynamic theory of capital structure, the ideal capital structure of corporations is adversely affected by the financial crisis. After the 1997 Asian economic crisis, Kim et al. (2005) research found a decrease in the mean adjustment speed, which indicated that corporations and LLC faced financial difficulties after the economic crisis.
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