Debt and Equity choice for funds in east africaAbdifitah Mohamed Jama Deer
Institute : Finance –International Finance
Course :Seminar —FINAL PROPOSAL
The main aim of my research is to get answer these questions
What is the correlation if interest rate increase or decrease and capital structure in the company in east African firms?
Not only East African country beyond these countries, what are the determinants of capital structure choice of fund whole the continental
If we use all theoretical framework does help to explain all variances
The purpose of Research
In this research paper , different theories will used in order to reach empirical result of debt-equity choice. The sample of the population in this research will be 80 east African Companies in downstream (fuel stations) .
Furthermore , I will focus in my research how the interest rate fluctuation and equity-debt are related last ten years. The models that I will use are trade-off agency and pecking.
(Hoesli, Gaud, & Bender, 2007) their study and determination in related to these three factors The first finding is adjustment to the target ratio about debt, The second one was performance about operating and and final one was market efficiency in financing choice that are not change when the leverage book is used and they tested some of European firm Hoestli & Bender reported the main factors of CAPM policies in the EU is Debt ratio, Operating Performance and marker Performance.
Their paper, the maturity was over 12 (years) when they examine the debt and equity choice applying case of European companies more than five hundred.
This research paper is interested because of my topic choice debt and equity in Africa Gaud, Hoestli & Bender also their research is European countries and they find when the managers of the companies prefer to issue debt so as to increase dividends of shareholder that means when the projects has profitable that is best debt disciplines of the managers.
The theory of the MM (Modigliani-Muller Theory)
Trade off Theory
The MM (1958) model is criticized, mainly because it has very unrealistic assumptions and fails when taxes, bankruptcy costs, or asymmetric information were introduced. In their later paper, MM (1963) introduced taxes to their model.
The amount of debt used is positively related with firm value this theory developed by (MM, 1963). Also we can say if manager use the theory about maximizes debt 100% choice of funds by specified as linear function of debt and equity radio also where is positive relation with firm value and debt. In this model, they assume that there is no bankruptcy cost. However, there exists an offsetting cost of debt which avoids this extreme choice. There is an increasing stress of bankruptcy with increasing usage of debt. Therefore, bankruptcy is the balancing factor for the extreme situation shown by MM in 1963
Myers (1984) changed the concept of MM (1963) and static trade off theory. By claiming the benefit of using tire off and debt and the financial distress that occurs in the likelihood of bankruptcy and increase the use of debt. According to Myers (1984), its trading outlook has been limited to the company’s limited credit rating and the establishment of the capital structure of the company.
Pecking direct hypothesis
Agency viewpoint is emerged from moral hazard and conflict of interest between principal and agent. It suggests that agents of a company have a tendency to take actions which are not best for the company because the benefits are higher than costs as such costs are shared between shareholders.
The literatures use symmetric date base on demand and suppler. If demand and suppler can get to various data (not good) the inventory are more likely to be selected. In a setup like Modigliani and Miller (1958), where efficient market hypothesis holds and all of the members of the market has a chance to reach same information under equal conditions, there would not exist any problem related with asymmetric information and all sources would be equally preferable. However, in real world, because of the asymmetric information problems, firms prefer to obtain financing from sources where there exist lowest amount of information asymmetry problems.
The main idea behind the pecking order theory which is, normally, owner of an overvalued company prefers to sell equity while owner of an undervalued company uses equity financing only as a last resort only company shareholder have to know the true about how the managers deal to maximize value of the stock in market by the company. However, an outsider can only guess these values. Therefore, people react suspiciously when shareholder tries to sell equity. Therefore, the announcement of an equity issue will decrease the value of shares of a company (Ross, 1977). On the other hand, using retained earnings or riskless debt will not cause any change in the value of the shares.
(Berens ; Cuny, 1995) states that a firm follows a preference order if it prefers internal financing retained earnings to external financing and if it prefers debt to equity at external financing. (Berens ; Cuny, 1995) also indicates that if it is possible, using a riskless debt should be equally preferable as internal financing. However, if debt is available but risky, it should be placed somewhere between retained earnings and equity which actually creates the pecking order.
Capital Structure of SMEs in Several Countries
(Ang, 1991) Indicates that theories of capital structure were not developed with thinking SMEs in first place so they may not be directly appropriate for them. However, the validity of capital structure theory for SMEs are tested empirically in many countries. In addition to size, there are two main factors
That differentiate SMEs from large firms (Bhaird and Lucey, 2010). The first one is the SME owners’ desire for keeping their independence and control. The second one is the fact that SMEs are having more severe information asymmetry problems in financing decisions. These following ways are the types of the affect capital structure decisions: In order to keep control, SME managers tend to not allow to increase debt, even for projects with positive net present values (Holmes and Kent, 1991). Also, because of information asymmetry problems, lenders are unwilling to provide finance to SMEs. For example, another literatures show that, small and young firms have shorter banking relationships, pay higher interest rates and are more likely to pledge collateral to borrow money.
(Hall, Hutchinson, & Michaelas, 2004) there are several studies of the factors affecting the CAPM of the structure of SM Enterprises in more countries. Hall, Hutchinson & Michaelas says that there are differences in the factors that affecting capital structures of small and medium enterprises, around twenty four years Mr. Van der Wijst & Thurik (1993) works on financial data average of more than 20 different shops by date analysis on Germany small enterprises that operating in the retail sectors, they find that there is significant effects of the tangible assets, sales and ROI however literature are not use sales indeed. Furthermore, they observe that, non-debt tax shields, measured by depreciation expenses, have no significant influence on debt ratios. The variables that they use have an influence on maturity structure of debt rather than total debt. So, the effects on long term debt and short term debt have a tendency to cancel out. They observe that both industry characteristics and time specific effects have significant impact on capital structure of firms.
Chittenden et al. (1996) analyze a U.K. database for a sample of both listed and unlisted SMEs with an emphasis on growth and being quoted in stock market. Using OLS regression, they find that tangible assets, profitability, size and being listed have significant effects on financial structure of small firms.
They find that collaterals are used by lenders to solve information asymmetry problem widely, especially for small unlisted firms. Moreover, the importance of collateral decreases with the increase in size. Furthermore, long term debts provided to small companies are mostly based on collaterals. They conclude that financial barriers to enter stock markets for small firms needs to be reduced and innovative solutions are needed to solve agency problem between small firms and lenders.
Like Chittenden et al. (1996), Hashemi, R. (2013). also analyze a U.K. database for SMEs. Using panel data methodology, they find that size, asset structure, profitability, growth, future growth opportunities, age, stock turnover and net debtors have significant effect on short term debt and long term debt levels. They find that tax rate has an insignificant effect. Moreover, their results indicate that average short term debt ratios of SMEs increase during periods of economic recession and decrease as economic conditions improve. However, long term debt ratio is positively associated with economic growth.
Cassar, G., & Holmes, S. (2003) also examine Kenyan Small and medium enterprises . Using OLS regression, they recorded that the performance, the capacity, growth of assets and asset tangibility are essential elements to identify the capital structure of the Small and medium enterprises. Moreover, what is different in their study is that, they examine if there is a difference between financing and firm characteristics of small firms and relatively larger firms in the sample. They divide their sample into two using sample median for total assets. They discover that, the effects of these factors on capital structure are homogenous across both small and large firm.
In another research done by Sorgob F.(2005). tests in what way the firm characteristics affect small medium enterprises capital structure in Spain. Their data consists of 6,482 firms over the period between 1994 and 1998. Using panel data analysis, he found that the debtless tax protectios and profibility have negative relationship with leverage , on the other hand the capacity , growth and the structure of the asset has a positive relationship with the leverage . . The results support maturity matching principle. That is, Kenyan companies are demanding their short run assets with short term credits and their long run assets with long term credit.
In 2007, a research done by P.,Kappert &H. Degryse, . Studied capital structure of Dutch SMEs. They employ a panel data analysis in their investigation. Their outcomes are mostly similar with the order theory of pecking. which is, size, asset tangibility, growth of assets and growth opportunities are positively associated with leverage. Furthermore, they observe that SMEs prefer to use their revenues to decrease their credit and loan levels. Also they recorded that the industry that the firm operates in is also important factor for the capital structure of Dutch SMEs. They also support the maturity matching principle.
Examine the capital structures of debt maturity choices of 39 developed and developing countries including United States and Turkey. They calculate the total of leverage as the proportion of total debt to the market value of the company. Market value of companies is defined as the market value of common equity added by book value of preferred stock and total debt. Moreover, they use long term debt to total debt ratio as indicator of debt maturity. Turkey and USA are found among five countries which have lowest amount of total debt in their capital structures. However, when debt maturity is observed, USA is found as the fourth country which has highest long term debt ratio while Turkey is the thirty seventh. This difference stems from being a developed economy or not. Hence developed economies have more debt with long term in structure of capital. In order to investigate the difference between nations, they use some country specific measure like usage of common law, level of corruption, existence of an explicit bankruptcy code, existence of deposit insurance. They provide such measures from sources including International Country Risk Guide and Corruption Perception Index. In general they find that, being a developed economy, common law and low level of corruption are associated with lower leverage and higher long term debt. Related with USA they posted the proportion of the tangible assets to the average assets., profitability and size is positively and market-to-book ratios of firms are negatively related with both leverage and debt maturity.
Research Design And Sampling Method.
In order to find the best equity and debt choice for fund In East African firms in the last ten year period, this thesis study we will use both qualitative and quantitative research designs.
Due to variability of features among items in the population, we applied probability sample design in the sample selection process to reduce the distortion view risk of the population and made inferences about the population based on the information from the sample survey data. Only the sampled population will be subjected to the data gathering exercise to provide the necessary information to the study.
The two kinds of data collection will be utilized as a part of this research which are the primary and secondary data. primary data acquired by distributing surveys to the examined firms through drop and pick later and in a few cases the examiner talked about the substance of the poll with the respondents and left them to be filled at their own opportunity. Secondary sources will be utilized to give data and information from distributed yearly reports and financing wellsprings of firms spreading over five years. In this investigation poll and reflection strategies will be utilized as a part of data collection. Primary data was utilized to gather information straightforwardly from respondents. It comprised of inquiries on skill and the mentality of best administration. Abstract technique was utilized to gather primary information from distributed reports and articulations gave by examined firms. Keeping in mind the end goal to build the reliability of the research, a blend of Data from Primary and Secondary sources will be utilized.
Regression will be used to establish the relationship and differences between the independent factors (profitability, ,firm size, tax implications & structure of asset) and the dependent factors of debt and equity. measurement of the data will be usd SPSS. a software was used in the work on quantitative data. Outcome from the annual financial reports and other articles will be posted in form of,, graphs, charts , tables and narrative statements.
The Regression Components
= Equity of a firm
= debt of a firm
= A constant
= Profitability of a firm
= Tax effect of a firm
= Asset structure
?= Standard error
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