Small Business Finance: Incident Command System (Essay Sample)

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CAPITAL STRUCTURE
INTRODUCTION.
Capital structure is the mix of equity, debt and firms retained earning. The theories tend to play an important role in identifying which source is cheap and how can the three be mixed to maximize the benefit at the same time minimizing the cost. And it is evident that small business enterprise prefers using debt financing. The test was carried on the outside financing and it was realized that Small business enterprises received a lot of attention than large financing in determination of credit worthiness of the business to repay the debt back "Freedman, j. and Godwin, 1994, incorporating the micro-business”
The growth of the firm is also considered in understanding capital structure and how expensive it will be to use certain mix at a particular stage of the business. In addition the efficiency of the financial system also dictate what choice the firm will prefer using" Booth, L.,Aivazian, V., & Demirgue-kunt, A. (2001). Capital structure in developing countries.”
CAPITAL STRUCTURE THEORIES
* Cassar and Holmes (2003)
It describes three theories of capital structure. They include;
a. Pecking order theory- It advocated that funding capital structure depend on a certain criteria that is, the firm has to use its internal finances before looking for debt and lastly using firms equity as the option of the last resort.
The weakness to this theory is that some small medium businesses don’t insist on this order but it uses equity directly without considering using borrowing debt from financial institutions such as banks.
Static trade-off theory – It is the benefit arising from the tax shield due to use of debt to finance capital structure in comparison to the cost of using such debt that is; bankruptcy cost and agency cost.
Bankruptcy cost arises when the firm becomes unable to pay off its debt or insolvent and it is suppose to be liquidated in order to pay off the debt. The cost incurred in the process is called bankruptcy cost.
Agency cost is the cost incurred in monitoring the use of such debt and it is always instituted in order to protect the interest of debt-holder and business owner. Therefore when the monitoring cost is high the relationship or possibilities of default of such debt is high.
Tax shield is the tax benefit the business get due to use of debt and is always calculated by multiplication of the tax with the debt.
Static trade-off theory is arrived by:
Benefit= TD – FD.
Where; T is tax imposed to the business.
D is the amount of debt used.
F is proportion of bankruptcy cost or agency cost incurred when certain level of debt is used.
The theory proposes that the firm can increase the amount of debt used as the benefit increases to a point where it stagnate, further increase beyond this point will lead to decrease of the benefit of using debt to even a negative value.
Information asymmetry theory- This proposes that there is difference in the information between the potential debt-holder and the business that is, the firm has enough knowledge on the future of the firm and it might consider using its internal equity for example retained profit to avoid the risk of using debt and also the debt-holder might have high expectation thus fixing high interest rate which will make the use of debt more costly than firms equity. This theory opposes the pecking order theory in some ways since pecking state that firm will consider using debt then equity will be the last option.
* La Rocca, La Rocca and Cariola (2011)
Pecking theory- it state that early stage the business will use its internal fiancé which is readily available to them in relation to equity and debt finance. At growth stage the firm consider important to use equity since more potential shareholders have confidence in the growth of their share due to higher growth rate in returns of the firm (information asymmetry problem). At maturity stage the shares will not be attractive to investors since growth stagnate and due to asymmetry problem resolved. Therefore, the business will consider using debt capital other than the rest sources of funding capital structure.
* Qui and La (2010)
The journal puts weight on pecking order theory, bankruptcy theory and signaling theory but differ with tradeoff theory.
Pecking order theory- Thought it agrees with the preference order of the capital structure mix in firms finance, followed by debt and lastly equity but future state that the cost of capital depend on the length of the duration of the debt for example long term debt will be based on the firm difference in the earning power that is, new business will find long term debt capital costly. Also short term source of capital is based on debt ratio when debt ratio is high the cost of capital will also increase due to increase in contingency cost such as bankruptcy and agency cost.
Signaling theory- This is the information that public or potential investors have in mind. For example a business with robust growth, high profitability or when company pay no or lower dividends because they might have invested their profits. All this information makes the shares attractive and hence making it competitive because everybody is certain that their share will grow and earn higher dividends.
SAMPLE DATA
* Cassar and Holmes (2003)
The Business longitudinal Survey selected approximately 13,000 businesses which include those which they had previously taken survey in 1994-1995 as sub-sample.
The firms were required to avail financial statement analysis for a period of 4 years. And only those which had profit and active business were chosen, also the firms must have had assets of value more than $500 and less than $25,000,000 and lastly only firms with leverage less than 100% were include. This brings the sample of study to 1,555 business units.
* La Rocca, La Rocca and Cariola (2011)
The study was carried out strictly on medium sized and small business as recognized by EU. It had the following characteristics: it had employees not more than 250, sales not more than 40million pounds but not less than 2 million pounds.
The study was made on 10,242 small and medium-sized non-financial Italian firms and the variables were taken from books of accounts of at least 5 years.
* Qui and La (2010)
The data was collected from the Australian listed businesses on stock exchange but they didn’t include financial institutions, banks and insurance firms.
In 1992 they used 65 businesses and in the year 2006 they used 412 firms.
The data were collected from books of accounts it included; Earning before tax and interest (EBIT), value of Non-current assets, ordinary equity, preferred stock, debt with interest and market value of equity capitalization.
FINDINGS FOR CAPITAL STRUCTURE
* Cassar and Holmes (2003)
It was found out that: long-term leverage, transaction cost and information asymmetry had a positive correlation which limits debt attractiveness.
Short-term and non-current assets had inverse relationship where the period between were consistently matched by the business.
Banks had more impact on the business since it used fixed asset as a remedy to reduce agency cost than any other financial lender.
Regression of growth was positive to the five variables examined in the study.
It was noted that the level of debt also used was determined by the risk exposure too. The higher the exposure the lower the small business used debt.
* La Rocca, La Rocca and Cariola (2011)
Findings made were: That some firm had higher tax shield benefit through other sources other than debt for example having large amount of asset and actively buy and sell them thus contradicting with tradeoff theory.
The age of the business proved negative as a determinant of the leverage level since firms didn’t base on age.
The growth and leverage ratio also had negative correlation and it second the pecking theory that is true and can be used in making capital structure mix decision.
Correlation between size of the firm was also negative thus can use any level of leverage irrespective of the size of the firm. Therefore, proving pecking order theory.
It also confirmed positive correlation between the leverage ratio and liquidity of the firm for example the firm with high liquidity will stabilize by increasing leverage level.
* Qui and La (2010)
After the study it was found out that: For the long term debt source of finance growth coefficient is important but for short term debt coefficient for ownership, size of the firm, tangibility and level of profitability of the business played a very important role because both had positive coefficient at the end of the result.
It was also noted that leverage level and growth had negative correlation.
Also large businesses with high dividend payout preferred debt capital than small businesses arrived by the positive signaling coefficient.
With the short-term debt it is considered to bring about positive ownership coefficient due to its short period which reduces level of conflict.
Short-term debt resulted to negative coefficient of profitability since short term debt proves to b...