A credit crunch has been used to refer to the situation in an economy where there is a decline in the supply of credit because, although the banks are less willing to lend, lending rates do not rise. It is an inefficient situation in which credit-worthy borrowers are unable to obtain credit at all, or cannot get it at reasonable terms, and lenders show excessive caution which may or may not be traceable to regulatory distortion, leaving would be borrowers unable to fund their investment projects (Green & Oh, 1991). These credit crunches may have several causes such as regulatory pressures and overreaction to bank asset values and profitability. Under ordinary circumstances, the market may induce a decline in the supply of credit by hiking the interest rates. A credit crunch will however occur when banks become more risk averse even where the interest rates remain the same. The spiral effect is that the interest rates becomes infinitely high for the majority of the borrowers, which in effect makes it more difficult to fund investment decisions, which conversely slows down the economy, making it even harder for lenders to lend.
For the firm and corporations, credit crunches will ultimately affect their corporate capital structures, due to the effects on the cost of capital. It has been advanced that this will be dependent on the characteristics of the firms. This paper will therefore analyze the impact of the recent credit crunch on the cost of capital for firms with the financial theories, and more so the capital structure theory. Specifically, the paper discusses how the recent credit crunch affects the cost of capital and how the firm’s characteristic affects the costs of capital under the circumstances.
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How does the recent credit crunch affect the cost of capital?
The theories of capital structure attempts to provide an explanation between the mix of securities and financing sources that may be employed by corporations to finance their real investments. Most of these theories have focused on the proportions of debt vs. equity as observed on the right-hand sides of the firms’ balance sheets. Several theories have been advanced on the debt-equity choices without one being universally accepted. For example, the trade-off theory suggests that firms seek debt levels that will provide a balance between the tax advantages of additional debt against the cost of possible financial distress. The pecking order theory on the other hand advances that a firm will borrow, rather than issue equity, when internal cash flows are not sufficient to fund capital expenditures, suggesting that the amount of debt will reflect on the firms cumulative need for external funds. The free cash flow theory on the other hand proposes that dangerously high debt levels will increase value, notwithstanding the threat of financial distress, when the firms operating cash flow significantly surpasses its profitable investment opportunities. The latter theory has been designed for mature firms that are more inclined to over-invest (Armstrong, 2007).
The surveys of the optimal capital structure all seem to step from the Modigliani and Miller (1958) assertions that financing doesn’t matter in the case of perfect capital markets. According to his model, the market values of the firms’ debt and equity, D and E should add up to the total firms value given that V is a constant. This proposition assumes that the assets and growth opportunities on the left hand side of the balance sheet have been held at a constant. This assumption results, to a large extent, in generalization of the mixes of the securities issued by the firm. For example, the debt period (whether long term or short term, callable or call-protected, straight or convertible etc) are not factored in the equations. This would also suggest that each firms cost of capital stands at a constant regardless of the debt ratio. Unfortunately, the capital markets are not sufficiently perfect. This is more so when we consider the effects of credit crisis in an economy.
How Firms select their Capital Structure
How firms select their capital structures is a question that has been severally asked and analyzed without a definite answer being arrived at, given the economic realities of the specified times. This will essentially bring forth the issue of capital structures of companies that are operating under credit constraints. These environments are typically and characteristic of centrally planned, transition and emerging economies but as Kornai (2003) has noted the relevance of the credit constraints syndrome has gained profound acknowledgement in for the market economies as well. This has come about from the misconception that, since most of the theory is not concerned with the relationship between the financing and production, then a standard assumption that production are unconstrained should be a fallacy. But, considering that there is a direct link between financing and production, then it would not be prudent to ignore the fact that investments affects the capital structures of corporations as a direct consequence of budget constraints (Harris & Raviv, 2001). It has been noted that in perfect and complete capital markets, the firm’s capital structure is irrelevant to the making of investment decisions. However, these capital structures may become poignant to the investment decisions for firms facing very uncertain prospects and operating within budget constraints with varying levels of hardness such that the relative cost of external capital varies accordingly to that of the internal capital (Modigliani & Miller, 1958).
Good Capital Structure for Firms
An analysis of what would constitute a good capital structure points to a structure that results in a low overall cost of capital for a firm i.e. a low overall rate of return that must be paid back for the funds provided. This is structured around the understanding that when the cost of capital is low, the discounted value of future cash flows accruing to the firm is high which translates into higher overall value of the firm. Conversely, firms strive to find a capital structure that provides the overall cost of capital and, by extension the highest firms value (Armstrong, 2007). Assuming that a firm is financed through debt and equity, it has been advanced that borrowing will have a lot of implications on the firms cost of capital.
The chief reason why firms borrow seem to aggregate towards the fact that debt has a cheaper direct cost to equity and there are two distinct reasons for this; that is, debt is less risky to the investor than equity (low risks results in a low required return) and secondly, interest payments are allowable deductions against corporate taxations whereas dividends wont be. This does not mean that borrowing doesn’t have its limitations chief among which is the fact that it causes shareholders to suffer increased volatilities of borrowing of earnings, or what is commonly referred to as financial leverage. The implications of this are that borrowing may cause the cost of equity to rise and thus offsetting the cheap direct cost of debt. The other disadvantage is that too much borrowing may result in a firm going bankrupt. At reasonable levels of gearing this effect may be imperceptible, but becomes more poignant for highly geared companies as it may result in a range of risks and costs which have tendency to increase the company’s cost of capital.
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Considering the case of a firm that has been financed by debt and equity alone, the company weighted average cost of capital (WAAC) will be computed using the cost of equity, the cost of debt and the market value of equity and debts as weights. Borrowing from the traditional view of capital structure, it has been suggested that when a firm starts to borrow, the advantages will outweigh the disadvantages. This is because the cheap cost of debt plus the tax advantage will cause the WAAC to fall as borrowing increases. However, as the gearing rises, the effects of the financial leverage cause shareholders to increase their expected rates of returns. At very high gearing the cost of debts also rises since the risk of the company defaulting on the debt rises in tandem, meaning that at higher gearing, the WAAC will increase. All these assumptions hold for perfect operating markets and where the risk free rate, company beta and cost of debt follow financial market fluctuations. However, significant variations will be discernible due to the magnitude of changes that have been triggered by the current credit crunch.
Financial markets require firms to hold capital as a cushion against contingencies and to protect creditors from agency costs of debts. In the context of this capital structure theory, a firm will hold that level of capital that will maximize the value of the firm within the unique advantages and constraints it may face (Athavale, Bland & Trimm, 2002). In making these investment decisions, and while focusing on particular utilities, three factors appear to reign supreme, i.e., the high levels of uncertainties in the estimation of the forward-looking financial figures, the increasing costs of access to debt financing, including that of reputable and stable institutions and the unusual effects difficult to factorize with the traditional approaches (Armstrong, 2007).
The high level of uncertainties in the estimation of forward-looking financial figures stems from the problems of estimating accurate values for the risk free rate, the corporate bonds credit spread and the corresponding gearing ratios. The increasing cost of debt also in the case of stable and reputable institutions has resulted from the shortage in credit supply and the lack of cheap financing sources. This has made it more difficult for the firms to determine the optimal capital structures from the traditional approach, largely due to the increases in risk aversions and the more extreme positions that are being taken by different stakeholders. This has meant that a lot of firms are struggling to arrive at the optimal cost of depth and capital structures.
Generally, the WAAC measures the firms cost of equity and debt financing on the basis of 4 elements, that is gearing ratio, which assesses the financial leverage of a firm by comparing owner funds and creditor funds, the cost of equity, the cost of debt and the effective tax rate. In making long-term investment decisions, firms must accurately estimate the forward-looking figures. However, this is becoming increasingly difficult to arrive at given the effects of the credit crisis. For example, the gearing ratio should accurately reflect the optimal capital structure in order for a firm to enter into the necessary investments that will enable for business operations in future. Due to the prevailing credit crunch, firms are no longer able to access new funds at reasonable costs, leaving the firms with no other options other than cutting down their investment projects. This will, conversely have a direct impact on the gearing ratio, which can no longer be computed as a figure optimized according to business rationales alone. All the growing constraints need to be factored into the analysis. In any case, the risk free rate, which is the starting pillar for both the equity and debt cost computations, becomes more and more difficult to configure.
Despite the impact on the cost of equity as a direct consequence of the risk free rate, it is the cost of debt that has been impinged more by the credit crunch. This is because the spread over risk free assets would appear to skyrocket for stable utilities as well as seen from the fact that even large financial institutions are more averse to or even less capable of availing finances (Armstrong, 2007). Other factors come to the fore when these issues are dissected in detail. For example the privately held equities that are not backed up by the government have been viewed as experiencing increasing levels of vigilance by their own shareholders, and more so in the emerging markets. Consequently, investors are less inclined to take any additional forms of risk and are more prone to react to modifications of their operating conditions such as the license terms. But it should be borne in mind that the lending conditions during the license renewal period are also prone to higher volatility impulses, while the interest rates offered by the banks rising significantly on the appending of the signatures. This despite the fact that prices are expected to drop shortly afterwards. Another important consideration is that, going by the widely accepted concepts, the higher risks involved in the realization are questioned by the utilities themselves. Essentially, this implies that, despite the volatility of demand, pricing and the level of service threaten utilities performance from the distribution side (Athavale, et al 2002).
The above scenario present firms with major headaches in the ascertainment of the costs of debts and what should be their optimal capital structure. It has been advanced that firms should consider multiple scenarios in an attempt to arrive at the optimal capital structure for their businesses, which should provide three different degrees of outcomes-optimistic, base and pessimistic (Armstrong, 2007). The drivers to be taken into account should ideally vary as an attribute of the varying situations such as additional premiums required, market conditions and the interest rates. These should be tailored to capture the underlying business issues and concerns for the key stakeholders. It has been advanced that elaborating on the intrinsic values of the firms and overall business risks in the long term and capturing the same in forward-looking figure can provide a solid background on the basis of which solid capital structures can be anchored.
How do firm’s characteristics affect its cost of capital under the circumstance?
It has been ascertained that credit crunches affects the corporate capital structure decisions for a firm. The frictions in the credit creation process have been found to result in fluctuations in the supply of bank loans. These imperfections could result from monetary shocks, bank assets devaluations, and regulatory changes. All of these acts as precursors of credit crunches (Armstrong, 2007). The presence of informational asymmetries has also been advanced as resulting in variations in firms’ access to non bank capital sources (Leary, 2005). An in-depth delineation of the effect of the cost of debt and capital structure therefore points at a cross-sectional variation in the firms financial structures that reflect differences in firms’ characteristics and credit crunches impacts. These will largely depend on whether a firm is bank-dependent or not.
Basically, changes in supply frictions in the case of credit has impacts on the leverage ratio, issuance choice and the mix of debt sources of small bank-dependent firms as contrasted with firms that have public market access, following positive or negative supply chokes (Leary, 2005). For example, Leary (2005) has demonstrated that the use of public debt by firms that have access to public markets increases relative to that of small firms following the 1996 credit crunch. This would cement the underlying believe that bank loan supply movements are important determinants of variations in firms placement of their debt and by extension, capital structures. This believe has been buttressed by the findings of Brav (2005) and Faulkender and Petersen (2005) who have empirically demonstrated that access to public financial markets do have considerable impacts on the leverage ratios. Their findings point to the fact that bank-dependent firms on average have lower leverage ratios than firms that have public market access, although Leary (2005) has intoned that the magnitude of this is more a consequence of the tightness of the credit market conditions.
Leary (2005) has pointed out that the impacts and implications of the capital structure of the firms, as either bank or non-bank-dependent, to be influenced by the relationship between the interest rates and the debt sources or debt issuance timing. It has been advanced for example that the ratio of the bank to non bank debt to be related to the interest rates (Diamond, 1991), yet when its considered that interest rate movements are associated with changes in the availability of bank loans (Stein, 1998), then the ratio of bank to non bank debt should be positively correlated with interest rates over the sample period as a whole (Cantillo and Wright 2000). It should however be noted that in the accompanying interest rates upsurges following credit crunches, the ratio of bank to non bank debts falls for small firms relative to large firms.
It is seen that the bank-dependent firms bear the costs of intermediation, but fluctuations in the bank’s access to loanable funds results in further variations in the firms financing decisions. It should also be noted that the effect of credit crunches is viewed to primarily affect the short term investment decisions (Leary, 2005). Kashyap, Stein and Wilcox (1993) as cited by Leary (2005) has for example demonstrated that monetary policy shocks affects the mix of outstanding short term debt between bank loans and commercial paper as well as the inventory investment of small firms relative to larger ones. However, these credit crunches do impact on the long term investment decisions by firms, such as fixed investment, and automobiles purchases. These will definitely impact on the cost of capital. Armstrong (2007) has advanced that one of the determinants of such investments is the size of the firm.
Thus, it can be noted that another differences in characteristics of firms, i.e., the size of the firm will also be impacted differently, notwithstanding whether its bank dependent or not (Leary, 2005). The exact mechanism through which this occurs can be explained as follows; if a loan market clears by price, then a deposit outflow will lead to an increase in the interest rate on bank loans relative to that on no-bank debt. In this case, small firms will borrow less, since they face a higher cost of debt of capital as contrasted to the larger firms who will be less affected as they possess the ability to substantiate towards relatively less expensive public debt. Conversely, if adverse selection and moral hazard costs are increasing in the interest rate charged, loan markets may clear through quantity rationing. In this case, a decrease in loan supply will increase the degree of rationing for the marginal risk class of firms. Consistent with the conclusions of Holmstrom and Tirole (1998), bank loans will then be less available for small firms, while the loan availability for the largest firms, which are perceived as least risky, will be relatively unaffected.
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What is important to note is that small firms may experience more difficulties in gaining access to credit during credit crunches, given their less intense asset bases, that is required as collateral in the issuance of loans. As a result, smaller firms may actually not be highly dependent on bank loans, largely because they fail to meet loaning requirements from the financial institutions. Their capital structure may therefore be fewer banks dependent. Conversely, it may be argued that the effects of credit crunches bear more significance on the larger, bank dependent firms (Armstrong, 2007). It has also been advanced that managers in firms will time the issuance of public debts to periods when interest rates are low relative to recent historical rates (Leary, 2005). This is usually done, largely in part due to the limited availability of bank loans. It should be noted though that only large and publicly owned firm can be able to raise more capital through equity.
From the above sentiments, it can be ascertained that the current credit crunch will have profound bearings on a firms cost of debt and the subsequent capital structure. However, it should be noted that the degree of effect will vary based on the characteristics of the firm, chiefly among which are whether the firms are bank dependent or non-bank dependent. Relative to firms with public debt market access, the leverage ratios of bank dependent firms either decrease or increase following a contraction or expansion, relatively, of the bank credit. Conversely, these firms will shift the composition of their financing sources in response to the tight credit conditions created by a credit crunch. Thus, it can be adjudged that bank dependent firms or corporations will tend to shift towards equity financing following bank debts scarcity. On the other hand, non bank dependent firms tend to shift between bank debt and public debt markets. It can therefore be ascertained that the leverage ratios and debt placement structures are not wholly determined by the changes in firms demand for capital structures. It would appear that supply frictions in the credit market are also important determinants of firms capital structures and more so for the bank dependent firms (Leary, 2005). This would imply that the same capital market imperfections that create linkages between the banking sector and the economic growth also create linkages between credit conditions and firms financial structures.
The discussions presented in this paper have shown that credit crunches will have an impact on the cost of debts as assessed by the capital structure theories of firms. It is has been established that the impact, to a large extent will be moderated by the characteristics of the firms. These will largely depend on the impact of shifts in the availability of bank loans on the capital structures for the bank-dependent firms relative to firms with access to public debt markets. The frictions in credit supply impacts on the flow of capital through the banking system are seen as having considerable impacts as ascertained by the time series and cross-sectional variation in debt placement structures and leverage ratios. The availability of bank loans following the periods of credit crunches results largely in the leverage ratios for the bank dependent to increase relative to the firms with public market access. These have been ascertained as occurring as a result of the convergence of the constrained access to bank debts and the associated reliance on equity financing by the smaller firms in the periods of credit crunches as well as the substitution from private to public debt by the larger firms.