Capital Structure Decisions
A Case Study of Listed Swedish High Growth SMEs
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Capital Structure Decisions
A Case Study of Listed Swedish High Growth SMEs
Introduction/Background
Capital structure is a complex area in making financial decisions. This is because it has a significant impression on the profitability of the company. However, financial managers’ most challenging task is determining the optimal capital structure to apply in their business, especially when funding new projects. To address this issue, several theories have been provided to help managers in the decision-making process. Pecking order theory provides that financing should start with retained earnings, and if this is not sufficient, then the firm should seek funds from debt, and if still not work, then new equity should always be the last resort (Arnold, 2016). The cost of capital will differ from one firm to the other, depending on their capital structure. Taking an example of two firms in the same industry, say firm A and firm B with a leverage ratio of 65% and 40%, respectively, firm A will have to incur higher fixed costs than firm B to pay for the interests charged on its debt. Therefore, this will imply that the firm will have a lower profit margin compared with firm B.
Capital leverage is associated with the fixed cost of financing. Therefore, the amount of leverage in a firm’s capital structure would increase its risk and lower its profitability (Gitman and Zutter, 2015). Debt and external equity increase the cost of capital. However, a firm may decide to fund their new projects with this external equity or even debt. Therefore, capital structure decisions are based on various factors, including revenue reliability, tax incentive, risk management, and management preferences (Gitman and Zutter, 2015). For example, a firm may prefer using debt rather than its reserve to enhance tax planning. This is because the interest charged on debt is tax allowable, and hence this will help reduce the firm’s tax liability.
Managers need to consider not only quantitative factors but also qualitative factors. Qualitative issues involve the factors that may directly impact the choice of the firm’s capital structure (Arnold, 2016). Some of these factors include organizational culture, total quality management, market share, organization goals/objectives, market condition, and organizational environment, among others (Gitman and Zutter, 2015). Qualitative factors play a significant role while making capital structure decisions. For example, a firm policy may provide that all its projects should be financed 50% from external sources. This implies that the decision-maker is limited to this policy while making capital structure decisions.
Sometimes, capital structure decisions are limited by the agency problem (Arnold, 2016). Finance managers act as agents of the stockholders. Their primary role is to mediate between the business owner (the stockholders) and the lenders. However, an agency problem may arise whereby the managers try to serve their interests, contrary to their principals or the owners (Gitman and Zutter, 2015). For example, a manager can favor a particular lender for his interest but not to the firm’s benefit. Managers tend to engage in such activities to increase their benefits in the form of agency costs. Therefore, capital structure decisions can be influenced by agency problems.
The practical implications of the investigation of the strength of determinants of capital structure and the capital structures on SMEs listed in Sweden are increasing the understanding people have on the factors valued most by companies regarding capital structure decisions (Martinez et al., 2019). As a result, this has the potential of giving a partial explanation of how companies perform in Sweden. Additionally, how the listed companies in Sweden perform may reflect the company performance and the capital structure in a broader sense. In some aspects, Sweden is termed a pioneer regarding corporate structures and business life. According to Kostyuk et al. (2018), the models of corporate governance used in Sweden are a combination of the European model that emphasizes value for the stakeholder and the shareholder model of Anglo-Saxon, emphasizing wealth maximization of the shareholder.
Taking into account the position Sweden has of being a pioneer regarding the structure of corporate governance and the performance of the country in the recent downturn in economic growth, it indicates that the results of this case study can be broadly applied to other countries other than Sweden only (Martinez et al., 2019). How the results of this case study can be applied concerning companies’ capital structures should thus be of great interest among active stakeholders in global markets. This is due to Sweden’s environment, as described by Kostyuk et al. (2018), being a leader, which is becoming the norm in many countries across the world. Although one should not give a generalization of the results to other groups apart from the population being studied, the case study’s practical implication will act as an indicator to other nations and firms, apart from the listed ones in Sweden.
This research paper’s primary purpose is investigating whether there exist any contradictions between the pecking order theory among listed SMEs and empirics and view on capital structure. The aim is studying if the basic theory can be applied to complex situations, which an SME may find being faced with in real life, and verifying the strength of impact and the comparative importance of flexibility in financial matters on preferences of capital structure, together with the impact tax shield advantage has. The role played by control and ownership.
Research Design
The research method used in the case study was quantitative. A deductive approach was used whereby propositions were taken from theories and then tested on SMEs listed on the Equity market of NGM. A quantitative research method is applied in describing, measuring, or explaining a certain phenomenon and interpreting and understanding such a phenomenon (Queirós et al., 2017). This method corresponded to the case study’s aim to describe the factors influencing decisions of capital structure and if the pecking order in the Swedish economy corresponded to the theoretical one. Intending to describe the listed high growth SMEs in Sweden, the research target group used was the Equity market of NGM. This population was suitable for the study since it fulfilled the requirements of being a unique target group with ease of accessibility. The Equity market of NGM is a stock market that is authorized, whereby the companies listed are high growth SMEs that are Nordic (Selin and Wigartz, 2020).
The case study used questionnaires that consisted of closed-ended questions, whose analysis of data collected is usually more straightforward than data from open-ended questions. The questionnaires were relatively brief and consisted of only nine questions, allowing focus on the specific area of study and increasing the possibility of having high response rates. They allowed a clear empirical picture regarding preferences companies had concerning the hypothetical way of describing the pecking order. SPSS software was used in analyzing the data, allowing encoding, analysis, and creation of charts from the gathered data. Testing of statistical significance was not appropriate for the study and thus was not conducted. This is because it may not have been statistically applicable to make generalizations on similar firms due to the companies being presented on the Equity market of NGM being few.
Results
As per the results of the case study, the population that was being studied fulfilled the requirement of being defined as an SME according to the European Commission. Twenty-three companies gave their response, showing they had employees ranging from 1 to 237, giving 58.15 as the mean. Concerning the average growth of the companies in the past three years, the average company on NGM had a rate of growth near the growth rate that was average within the industry. This indicated that the listed SMEs on the NGM had not experienced extraordinary growth in the last three years. On the management of the capital structure, the results showed that, on average, companies have a great concern on the management of the capital structure, with the determination of the equity and debt levels being rational. Active involvement of the management in the capital structure decisions showed that it was essential to examine closely the factors that contribute to the decision of funding, whether flexibility in financial matters, the tax shield advantage, control of ownership, or other factors (Kostyuk et al., 2018).
Regarding debt management, most of the respondents indicated having active maintenance of debt at an optimum level, with the rest showing a lack of concern in the maintenance of a particular debt level or altogether avoiding the use of debt. On financial flexibility in capital structure decisions, a majority of the companies (19) indicated that financial flexibility was essential to the companies in the case study regarding capital structure decisions. On tax advantage regarding the deductibility of debt interest, most companies viewed this as not being important. Ownership control in the capital structure decisions showed that this aspect was very important to most of the companies. Concerning external equity, external debt, and equity, most of the case study companies had more preference on equity, with external equity and external debt being preferred in equal measure. On external and internally generated funds, most of the firms indicated they had a preference for internally generated funds.
Discussion
The case study results gave a more in-depth insight into the practical application of the management of the capital structure. The assertion that companies are not having access to numerous sources of funds was supported. Concerning the interconnection between equity and debt issues, it appeared that the use of equity and debt was commonly balanced. To have accessibility to debt markets, there is a need for equity holders that are creditworthy, among firms that experience small growth. In the preference of equity to debt, there was still use of debt, keeping it at an optimized level by most companies to remain financially flexible. This means that most firms have an equal preference regarding equity and debt. Additionally, there was an indication of greater importance being placed on control of ownership and financial flexibility compared to the tax advantage brought by the deductibility of debt interest.
According to the results, no evidence could support an assertion that listed SMEs with high growth in Sweden prefer raising equity compared to getting into debt. Firms do not tend to have a specific order of preference regarding how external funds are raised, with equity and debt having an equal preference. Such a similar priority indicates that there was no support for the pecking order theory since there was no inclination towards external debt compared to external equity that could be demonstrated in the case study. What was supported by the case study was the preference of funds that were internally generated over those that were externally generated, which the theory of pecking order suggests (Martinez et al., 2019).
Companies in the case study had a preference for financial flexibility. According to Pendar et al. (2019), many companies prefer having financial flexibility. In the case study, firms that were inclined to external equity instead of external debt showed that financial flexibility was of high importance. Regarding the tax advantage factor brought by the deductibility of debt interest, most companies did not value it, showing a minimal effect on capital structure. The results supported the assertion that control of ownership impacted the financial structure of firms (Pendar et al., 2019).
It was found out that control of ownership and financial flexibility were two factors that influenced the capital structure of listed Swedish high growth SMEs. However, the effect of the two factors on decisions regarding capital structure was different. Having financial flexibility means that a company can retain a certain extent of debt capacity preserved for a flexible response to threats and opportunities that might arise. On the other hand, control of ownership is seen as a highly important factor because small firms tend to have a large dependence on their owners. The case study showed that control of ownership was seen as an essential aspect for a company to have accessibility to debt markets compared to retaining ownership control.
Conclusion
The results of this case study can be broadly applied to other countries other than Sweden because of the position the country has in being a pioneer regarding the structure of corporate governance. The results presented by the descriptive statistics indicate that there is no evidence to support a particular pecking order regarding external funds. This suggests that there is a need for the theory to be revised. Debt and equity appeared to have a close equal preference, with the overall findings suggesting that listed SMEs on the Equity market of NGM lacked financial strategy. Being flexible in financial matters appeared to have the most significant effect on influencing the financial structure, followed by control of ownership. The least important factor appeared to be the tax advantage brought by the deductibility of debt interest.
References
Arnold, G. (2016). Corporate financial management. Pearson Education.
Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. ISBN13: 9780133507690.
Kostyuk, A., Mozghovyi, Y., & Govorun, D. (2018). Corporate governance, ownership, and control: A review of recent scholarly research. Kostyuk, A., Mozghovyi, Y., & Govorun, D.(2018). Corporate governance, ownership, and control: A review of recent scholarly research. Corporate Board: Role, Duties, and Composition, 14(1), 50-56.
Martinez, L. B., Scherger, V., & Guercio, M. B. (2019). SMEs capital structure: trade-off or pecking order theory: a systematic review. Journal of Small Business and Enterprise Development.
Pendar, M., Tayar, H., & Karimeh, S. (2019). The impact of financial flexibility on capital structure decisions: Some empirical evidence. Management Science Letters, 9(1), 133-138.
Queirós, A., Faria, D., & Almeida, F. (2017). Strengths and limitations of qualitative and quantitative research methods. European Journal of Education Studies.
Selin, R., & Wigartz, S. (2020). Nordic IPOs and Private Equity affiliation.