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Literature review on capital structure

Updated on March 8, 2015

Abstract

Capital structure involves an analysis of the composition of the shareholder equity and liabilities section in a corporation’s balance sheet. In contrast, capital budgeting involves the process of evaluating investment prospects. Capital structure and capital budgeting should be aligned to ensure that the business receives enough cash to undertake necessary investments. Business organizations may fail if there is a failure to match cash needs to cash sources may be disastrous for any business. In the most extreme cases, the failure may result in bankruptcy. The problem of capital structure and capital budgeting is a significant part of the management function. The majority of businesses cannot afford to invest in profitable projects. Instead, the investments are determined by the availability of funding. The lenders and shareholders have a responsibility of looking at the capital structure before deciding to mandate the project to proceed. The process involves an analysis to determine how the successful implementation or failure of the investment will change the capital structure. In some cases, the project may have to be scaled back or terminated until there is a match between the funding available and the cash that must be invested. The success of banks depends on their ability to maintain a positive capital structure.

Introduction

The risks involved in a particular project plays a significant role in determining whether financing through shareholders or lenders is viable. If the risk involved is high, the business should rely on the shareholder funds to finance it as opposed to loans. The move is informed by the fact that a failure to earn the projected cash could result in far worse consequences if the money had been acquired through loans. A failure to pay the creditors could give them an opportunity to sue the business and confiscate the assets. In extreme cases, the move can result in bankruptcy. In contrast, the worst case scenario that can happen if the shareholders fail to realize the projected gains of the project is to vote the board of directors out of office during the annual shareholders meeting.

Brealey and Allen state that Capital structure involves how a business is financing its operations1. The capital structure can be quantified as the ratio of shareholder equity to total debt on the balance sheet. In spite of the size of an enterprise and its scope, all companies have access to two basic sources of financing; equity and lenders. The retained earnings from a past financial period can be referred to as shareholder equity. The term can be attributed to the fact that the profits belong to the shareholders. In contrast, liabilities involve a wide variety of loans such as bank loans, funds received from bond investors and the financial obligations to suppliers.

Capital structure and capital financing is more important in some industries than others. The observation can be attributed to government regulation. For instance, the government has passed policies that govern the capital structure of insurance companies. The organizations are required to meet a certain financial threshold. Similarly, financial institutions are required to ensure that they have a healthy financial position at all times. Consequently, capital budgeting and capital structure for these institutions is governed by the law.

The paper will focus on capital budgeting in financial institutions. The financial sector includes banks, hedge funds and insurance companies. The health of the national economy depends on the success of these businesses. Consequently, there is a need for leaders in the financial sector to ensure that their organizations are in good financial health so as to avoid undermining the national economy. For instance, they have to ensure that they have to maintain a balance between the amount of loans that they give to their clients and the amount of cash reserves that they have. Similarly, they have to ensure that their cash reserves do not reflect a deliberate desire to hoard cash.

The capital structure is determined by the risk management of the organization. Some organizations may have a greater appetite for risk as compared to others. In addition, it can also be determined by the stage that the company is in. An organization that is pursuing an expansion or growth strategy would lean towards investing a lot of money into achieving its objective. As a result, it would seek for funds from shareholders and external lenders. The move would have a negative effect on its financial position in the short-term. However, it can benefit the organization in the long-term once it has honored its financial obligations.

Understanding capital structure in the financial industry will lead to a better understanding of the policies of the banking sector. The ease of obtaining loans is dependent on the capital structure adopted by the banks. Although banks have a responsibility to ensure that their customers have access to capital, they have to ensure that the investments do not undermine their financial position.

Body

In ‘Bank capital structure and credit decisions’, Inderherst ad Mueller argue that banks must have a lot of leverage for them to have the ability of issuing risky loans2. The argument is against the popular belief that excessive leverage tends to lead to an increased appetite for risk. The article argues that banks are informed lenders whose actions are guided by prudence and a well thought formula. The argument is based on two key assumptions about banks. First, banks provide financing for projects that they do not own. As a result, their profit participation is often limited. Second, banks are expected to perform a credit risk analysis before they issue new loans. Besides, the two authors reveal a model that can be used to explain why the banks take more unsecured loans than they should. In addition, the model reveals why banks and other financial institutions have similar leverage ratios. The observation is unexpected since the other financial institutions are not subjected to similar regulations. The government has different regulations for deposit takers and the other financial institutions.

Baker and Chinloy have addressed two significant aspects of capital structure in banking institutions. In the first part, the book focuses on the impact of credit lines on the capital structure of REITS. The second part involves a focus on the bank credit lines and the REITS. The purpose of this literature review is to focus on the first part. A bank line of credit refers to a loan commitment that a prearranged and legally binding contract that enable firms to access extra capital when they capital. The advantage of this arrangement is that it enables the banks to access funding in a quick manner to enable them to make acquisitions or investments3. The feature has made it attractive for industrial banks. The text also analyzes the impact of bank debt usage and this banking relationship on the capital structure of REITS. An evaluation of the text shows that the balance of power shifted from mortgages and other traditional sources of funds into public capital matters. The banks have played a significant role in the evolution of REITS. The observation can be attributed to the fact that the REITs with strong banking relationships receive a favorable long-term debt rating. In addition, the REITS tend to avoid secured debt.

Baker and Gerald have focused on the banking sector in the developing countries. In ‘Capital structure & corporate financing decisions theory, evidence, and practice’, the authors state that there are three factors that affect the capital structure of the banking sector4. First, the development of the capital markets. Countries with a strong capital market have banks with strong financial positions. However, in some cases the ease of access to capital may make the banks to take on a significant amount of debt. Second, the effectiveness of the legal system in the country. A country with a strong legal system will provide the mechanisms for the government to enforce regulations. Developing countries with weak legal institutions have created a problem that involved poor performance of loans. Consequently, banks in these countries are often faced with poor capital structures. Third, the strength of the banking sector. Countries with a strong banking sector are characterized by banks with strong capital structures. In contrast, those with a weak banking sector are characterized by banks with weak capital structures.

In ‘The euro financial crisis impacts on banking, capital markets, and regulation report of the international workshop in Potsdam on July’, Hummel states that China should focus on improving the capital structure of its banks5. The government should encourage the banks to promote capital structure adjustments. They can achieve this by strengthening the management of its internal economic capital. In addition, they should adjust the assets structure according to the risk tolerance of their capital. Furthermore, they should transform the profit growth model. Moreover, they should focus on increasing the operational efficiency of their capital. The author shows that the country still experiences problems in the incomplete deductions. They also have unqualified debt instruments. An evaluation of the financial data in the country shows that a majority of the banks prefer equity capital as a form of financing. However, the move is not a sustainable source of funding in the long-term. The dependence on equity financing can be attributed to the high cost of external financing in China. The dependence on equity financing is bound to limit the ability of the banks to expand in the future.

InCapital Structure Determinants in the Nigerian Banking Industry: Financial Managers’ Perspectives’, Iwarere and Akinleye focus on the factors that should be considered when determining the appropriate amount of equity and debt capital in Nigeria6. They use a lot of data gathered through a survey that had been conducted. They state that the findings show that the credit rating, volatility of cash flow, financial distress, transaction costs and financial flexibility play s significant role in determining the appropriate amount of debt that a bank should have. In addition, they reveal the factors that play a role in the making of equity issues. They include the ownership structure and management control. They proceed to recommend that banks should adopt an appropriate mix source of fund. In addition, they should reduce debt issue. Banks should invest more in liquid assets through the creation of tangible assets.


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The capital structure decision poses a significant problem to firms. The most critical strategic decision that firms such as banks are faced with is the determination of the appropriate mix of equity and debt7. A wrong mixture of the two could lead to the collapse of the bank. For banks to achieve the aim of wealth maximization, deliberate steps must be taken to identify the appropriate mix in a timely and effective manner. The article focuses on the development of a model that enables the corporate managers in capital structure decisions.

In ‘Capital Structure Determinant’s of North American Banks and the Compensation Executive Program-An Empiric Study on the Actual Systemic Crisis’, Nascimento, Almir and Fishlow have focused on the factors that banks consider when determining their capital structure. For instance, they should consider the requirements for minimum regulatory capital that were established by the Basel agreements. Although there is a belief that this consideration plays a significant role in determining the capital structure, there are other things that they consider. The factors include; size, profitability, measurable benefits and growth opportunity. In addition, the payment of dividends influences the amount of leverage in the banks. The authors sought to determine if the same factors apply to America. The broad study involved 30 banks and was conducted over the 2003 to 2006 period8. The 2007-2010 period was also included. The inclusion of the later period is informative due to the fact that banks were facing a systematic crisis. The variable of compensation also plays a significant role in determining the capital structure.

Niresh states that capital structure has elicited a lot of debate in academic circles9. However, the banking industry has failed to give it the attention that it deserves. In an attempt, to correct this mistake Niresh has focused on examining the impact it had on ten listed banks in Sri-Lanka. The capital structure of a bank plays a significant role in determining its long-term success. In Sri Lanka, the total debt of a bank is a critical determinant of its success. The study reinforces the existing theoretical framework on the subject. Her findings demonstrate that there are three things that the banks should adopt. First, they should maintain an appropriate mix of capital structure. Second, the management should ensure that they make prudent financial decisions. Financial missteps are difficult to correct in a competitive banking industry. Third, the banks should not only focus on the increasing the amount of deposits that they receive but they should also focus on utilizing those resources in an effective manner.

Although most scholars focus on the capital structure with regard to the balance between the debt and equity, there is another more important aspect. From a tactical perspective, the capital structure has a lot of influence on the strategy of the organization. The capital structure influences the risk profile of the bank. In addition, it will determine the ease of getting capital for future growth and investment. The customers will also be affected because it determines the ability of the bank to give out loans. The cost of the funding that a bank will receive will depend on its capital structure. The return for its investors will also be affected by the capital structure. Consequently, it is a critical factor in the determination of the viability of a bank for a merger and acquisition. Market analysts can use the capital structure to determine the possible return that investors can receive. The move shows that it is an important part of the stock trading process. Moreover, the capital structure determines the degree of insulation that the bank has from both microeconomic investment decisions and the external environment.

Conclusion

In conclusion, it is evident that capital structure is an important process in an investment decision. The term determines the ability of a bank to issue new loans. A failure to apply due process in the evaluation of the capital structure may undermine the financial health of the organization. The 2008 recession could be partly attributed to the fact that banks and other financial institutions had failed to act appropriately on the issue. Most of them had made investments that placed their industry and the global economy at risk. The government regulations that were introduced sought to force them to ensure their capital structure does not undermine their business. The relevant financial institutions should ensure that the regulations are followed. In addition, there should be a deliberate attempt to increase awareness about the importance of capital structure. The move would ensure that all the organizations benefit from the application of prudent financial practices.

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Bibliography

  1. Brealey, R., Myers, S. & Allen, F. 2013, Principles of Corporate Finance, 11th ed, New York: McGraw-Hill.
  2. Inderherst, Roman and Mueller M Holger. Bank capital structure and credit decisions. Journal of Financial Intermediation. vol 17 (21 March 2008): 295-314.
  3. Baker, H. Kent, and Peter Chinloy. Public Real Estate Markets and Investments. 2014.
  4. Baker, H. Kent, and Gerald S. Martin. 2011. Capital structure & corporate financing decisions theory, evidence, and practice. Hoboken, N.J.: John Wiley & Sons. http://site.ebrary.com/id/10456211.
  5. Hummel, Detlev. 2013. The euro financial crisis impacts on banking, capital markets, and regulation report of the international workshop in Potsdam on July 20/21, 2012. Potsdam: Univ.-Verl. **94058.
  6. Iwarere H. T and Akinleye G. T. Capital Structure Determinants in the Nigerian Banking Industry: Financial Managers’ Perspectives. Vol 7, no 3. Pakistan Journal of Social Sciences. (2010): 205-213.
  7. 7. Kennedy Prince Modugu. Capital Structure Decision: An Overview. Journal of Finance and Bank Management, Vol 1(1):14-27.
  8. Niresh, N, Aloy. Capital Structure and profitability in Sri-Lankan banks. Global Journal of Management and Business Research. Vol 12, No 13 (2012).

8. Juca, M. N., Almir F. S & Fishlow, A. Capital Structure Determinant’s of North American Banks and the Compensation Executive Program-An Empiric Study on the Actual Systemic Crisis. Vol 7, no 17(2012).

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