Capital Structure Decisions During a Firm's Life Cycle

Abstract

The study reported here examines the financing choices of small and medium-sized firms, i.e., those most vulnerable to information and incentive problems, through the lens of the business life cycle. We argue that the controversy in the empirical literature regarding the determinants of capital structure decisions is based on a failure to take into account the different degrees of information opacity, and, consequently, firms' characteristics and needs at specific stages of their life cycles. The results show that, in a bank-oriented country, firms tend to adopt specific financing strategies and a different hierarchy of financial decision-making as they progress through the phases of their business life cycle. Contrary to conventional wisdom, debt is shown to be fundamental to business activities in the early stages, representing the first choice. By contrast, in the maturity stage, firms re-balance their capital structure, gradually substituting debt for internal capital, and for firms that have consolidated their business, the pecking-order theory shows a high degree of application. This financial life-cycle pattern seems to be homogeneous for different industries and consistent over time.

This is a preview of subscription content, log in to check access.

Fig. 1

Notes

  1. 1.

    Zingales (2000) also has emphasized the fact that “…the attention shown towards large firms tends partially to obscure (and often ignore) firms (of small and medium size) that do not have access to the (public) financial markets…”.

  2. 2.

    Large firms use a variety of financing instruments, both public and private, while small firms typically use bank loans and private equity, mainly based on the financial support of the entrepreneur and his or her family. Moreover, small businesses do not issue securities that are priced in public markets.

  3. 3.

    According to Berger and Udell (1998), the opportunities to invest in positive net present value projects may be blocked if potential providers of external finance cannot readily verify that the firm has access to a quality project (adverse selection problem), ensure that the funds will not be diverted to an alternative project (moral hazard problem), or costlessly monitor use of the revenue by the firm they invest in (costly state verification).

  4. 4.

    Beck et al. (2002) showed that small firms are the most credit-constrained by underdeveloped institutions.

  5. 5.

    Moreover, this topic is also of particular interest in the valuation of the firm, considering that capital structure decisions, which differ throughout the stages of the life cycle of the firm, directly affect the opportunity cost of capital and the market value of the firm.

  6. 6.

    Pinegar and Wilbricht (1989), in their survey, observed that external debt is strongly preferred over external equity as an approach for raising funds.

  7. 7.

    Furthermore, since small businesses are usually owner-managed, the owner/managers often have strong incentives to issue external debt rather than external equity in order to retain ownership and control of their firms (Berger and Udell 1998); indeed, venture capitalists seek to take part in corporate decisions.

  8. 8.

    The availability of external finance to small business is likely to be highly dependent upon the institutional environment (Demirgüç-Kunt and Maksimovic 1996). An information-poor environment, characterized by a weak system of investor protection and poorly developed mechanisms for information sharing, will lack venture-capital markets and has only a limited ability to sustain small business without collaterals.

  9. 9.

    In a second scenario, Diamond (1989) observed that the institutional environment, in which incentive and informational problems can be more or less severe, influences the use of debt funds; if moral hazard is sufficiently widespread, then firms will build their reputation by being monitored by a financial intermediary.

  10. 10.

    It appears that firms can raise finance more easily as the financial system develops because physical collateral becomes less important, while intangible assets and future cash flows can be financed. As the financial system develops, it should be possible to easily appreciate the soundness of the firm’s projects and of its managerial behaviors (Rajan and Zingales 1995).

  11. 11.

    Judicial enforcement is important because the financial system and the regulations governing it work in the interests of investors, protecting creditors only to the extent that the rules are actually enforced.

  12. 12.

    Several outliers were deleted from the dataset in order to reduce their impact on the results. All firm-year observations for which variables used in the estimation were below the 1st percentile or above the 99th percentile were deleted.

  13. 13.

    With regard to the variable Age, which was used to proxy reputation, we would like to comment that we followed what was indicated by Diamond (1989), who considers reputation to mean the good name a firm has built up over the years, and Petersen and Rajan (1994), who found that older firms, which ought to be of higher quality, have higher debt ratios. In particular, Diamond (1989) suggests that the “reputation of the enterprise” may be measured as a function of variables such as age and/or length of service.

  14. 14.

    In the empirical analysis, other functional forms were tested, but they did not add relevant significance to the model.

  15. 15.

    Overall, we examined the values for adjusted R 2, F test, T tests and Durbin–Watson test to assess the statistical significance of the model. The regression models were always statistically significant (p value of the F test < 0.01) with a relevant adjusted R 2, indicating that the variables accounted for a substantial part of the variation in leverage across companies. From the Durbin–Watson value, which was generally close to 2, an absence of autocorrelation was observed.

  16. 16.

    Although young firms do not have as many tangible assets that can be easily evaluated or pledged as collateral and have little repayment history or record of profitability upon which external suppliers of funds can rely, they resulted in being directly in need of debt to grow.

References

  1. Alessandrini, P., & Zazzaro, A. (1999). A “Possibilist” approach to local financial systems and regional development: The Italian experience. In R. Martin (Ed.), Money and the space economy. New York: Wiley.

    Google Scholar 

  2. Ang, J. (1992). On the theory of finance for privately held firms. Journal of Small Business Finance, 1(1), 1–13.

    Google Scholar 

  3. Banca d’Italia. (2008). L’economia delle regioni italiane nell’anno 2007. Economie Regionali 1.

  4. Beck, T., Demirgüç-Kunt, A., & Maksimovic, V. (2002). Financing patterns around the world: The role of institutions. World Bank policy research working paper, 2905. Washington DC: World Bank

  5. Beck, T., Demirgüç-Kunt, A., & Maksimovic, V. (2005). Financial and legal constraints to firm growth: Does size matter? Journal of Finance, 60(1), 137–177.

    Article  Google Scholar 

  6. Berger, A., & Udell, G. (1995). Relationship lending and lines of credit in small firm finance. Journal of Business, 68(3), 351–382.

    Article  Google Scholar 

  7. Berger, A., & Udell, G. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of Banking & Finance, 22(6/8), 613–673.

    Article  Google Scholar 

  8. Bianco, M., Japelli, T., & Pagano, M. (2005). Courts and banks: Effect of judicial enforcement on credit markets. Journal of Money Credit and Banking, 37(2), 223–244.

    Article  Google Scholar 

  9. Bonaccorsi di Patti, E., & Dell’Ariccia, G. (2004). Bank competition and firm creation. Journal of Money Credit and Banking, 36(2), 956–970.

    Article  Google Scholar 

  10. Booth, L., Aivazian, V., & Demirguc-Kunt, A. (2001). Capital structures in developing countries. Journal of Finance, 56(1), 87–130.

    Article  Google Scholar 

  11. Bradley, M., Jarrell, G., & Kim, H. (1984). On the existence of an optimal capital structure: Theory and evidence. Journal of Finance, 39(4), 857–878.

    Article  Google Scholar 

  12. Brewer, E., I. I. I., Genay, H., Jackson, W., & Worthington, P. (1996). How are small firms financed? Evidence from small business investment companies. Economic Perspectives, 20(6), 1–18.

    Google Scholar 

  13. Carey, M., Prowse, S., Rea, J., & Udell, G. (1993). The economics of private placements: A new look. Financial Markets, Institutions and Instruments, 8(2), 1–67.

    Google Scholar 

  14. Carpenter, R., & Petersen, B. (2002). Is the growth of small firms constrained by internal finance. Review of Economics and Statistics, 84(2), 298–309.

    Article  Google Scholar 

  15. Cassar, G., & Holmes, S. (2003). Capital structure and financing of SMEs: Australian evidence. Accounting and Finance, 43(2), 123–147.

    Article  Google Scholar 

  16. Cheng, S., & Shiu, C. (2007). Investor protection and capital structure: International evidence. Journal of Multinational Financial Management, 17(1), 30–44.

    Article  Google Scholar 

  17. Chittenden, F., Hall, G., & Hutchinson, P. (1996). Small firm growth, access to capital markets and financial structure: Review of issues and an empirical investigation. Small Business Economics, 8(1), 59–67.

    Article  Google Scholar 

  18. Chiu, T., Fang, D., Chen, J., Wang, Y., & Jeris, C. (2001). A robust and scalable clustering algorithm for mixed type attributes in large database environment. In: Proceedings of the Seventh ACM SIGKDD International Conference on Knowledge Discovery and Data Mining. San Francisco, CA.

  19. De Miguel, A., & Pindado, J. (2001). Determinants of capital structure: New evidence from Spanish panel data. Journal of Corporate Finance, 7(1), 77–99.

    Article  Google Scholar 

  20. Demirgüç-Kunt, A., & Maksimovic, V. (1996). Stock market development and financing choices of firms. World Bank Economic Review, 10(2), 341–370.

    Google Scholar 

  21. Demirgüç-Kunt, A., & Maksimovic, V. (1998). Law, finance and firm growth. Journal of Finance, 53(6), 2107–2137.

    Article  Google Scholar 

  22. Diamond, D. (1984). Financial intermediation and delegated monitoring. Review of Economic Studies, 51(3), 393–414.

    Article  Google Scholar 

  23. Diamond, D. (1989). Reputation acquisition in debt markets. Journal of Political Economy, 97(4), 828–862.

    Article  Google Scholar 

  24. Diamond, D. (1991). Monitoring and reputation: The choice between bank loans and directly placed debt. Journal of Political Economy, 99(4), 689–721.

    Article  Google Scholar 

  25. Dow, S., & Montagnoli, A. (2007). The regional transmission of UK monetary policy. Regional Studies, 41(6), 797–808.

    Article  Google Scholar 

  26. European Commission and Eurostat. (2001). Enterprises in Europe, 6th report (199 pp.). Luxembourg: Eurostat.

    Google Scholar 

  27. Fama, E., & French, K. (2002). Testing trade-off and pecking order predictions, about dividends and debt. Review of Financial Studies, 15(1), 1–33.

    Article  Google Scholar 

  28. Fluck, Z. (2000). Capital structure decisions in small and large firms: a life-time cycle theory of financing. Working paper. New York: Stern School of Business.

  29. Fluck, Z., Holtz-Eakin, D., & Rosen, H. (1998). Where does the money come from? The financing of small entrepreneurial enterprises, Working paper. New York: Stern School of Business.

  30. Gaud, P., Jani, E., Hoesli, M., & Bender, A. (2005). The capital structure of Swiss companies: An empirical analysis using dynamic panel data. European Financial Management, 11(1), 51–72.

    Article  Google Scholar 

  31. Giannetti, M. (2003). Do better institutions mitigate agency problems? Evidence from corporate finance choices. Journal of Financial and Quantitative Analysis, 38(1), 185–212.

    Article  Google Scholar 

  32. Gregory, B., Rutherford, M., Oswald, S., & Gardiner, L. (2005). An empirical investigation of the growth cycle theory of small firm financing. Journal of Small Business Management, 43(4), 382–392.

    Article  Google Scholar 

  33. Guiso, L. (2003). Small business finance in Italy. In: Europe’s changing financial landscape: The financing of small and medium-sized enterprises. EIB Papers, 8(2), 120–151.

  34. Guiso, L., Sapienza, P., & Zingales, L. (2004). Does local financial development matter? Quarterly Journal of Economics, 119(3), 929–969.

    Article  Google Scholar 

  35. Hall, G., Hutchinson, P., & Michaelas, N. (2000). Industry effect on the determinants of unquoted SME’s capital structure. International Journal of the Economics of Business, 7(3), 297–312.

    Article  Google Scholar 

  36. Hall, G., Hutchinson, P., & Michaelas, N. (2004). Determinants of the capital structure of European SMEs. Journal of Business Finance and Accounting, 31(5), 711–728.

    Article  Google Scholar 

  37. Hamilton, R., & Fox, M. (1998). A profit analysis of the change in the financial characteristics of newly quoted small firms. International Journal of Entrepreneurial Behaviour & Research, 4(3), 239–248.

    Article  Google Scholar 

  38. Harris, M., & Raviv, A. (1991). The theory of capital structure. Journal of Finance, 45(1), 297–355.

    Article  Google Scholar 

  39. He, Z., Xu, X., & Deng, S. (2005). Scalable algorithms for clustering large datasets with mixed type attributes. International Journal of Intelligent Systems, 20(10), 1077–1089.

    Article  Google Scholar 

  40. Helwege, J., & Liang, N. (1996). Is there a pecking order? Evidence from a panel of IPO firms. Journal of Financial Economics, 40(3), 429–458.

    Article  Google Scholar 

  41. Hirshleifer, D., & Thakor, A. (1992). Managerial reputation, project choice and debt. Review of Financial Studies, 5(3), 437–470.

    Article  Google Scholar 

  42. Holmes, S., & Kent, P. (1991). An empirical analysis of the financial structure of small and large Australian manufacturing enterprises. Journal of Small Business Finance, 1(2), 141–154.

    Google Scholar 

  43. Hyytinen, A., & Pajarinen, M. (2008). Opacity of young businesses: Evidence from rating disagreements. Journal of Banking & Finance, 32(7), 1234–1241.

    Article  Google Scholar 

  44. Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behaviour, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360.

    Article  Google Scholar 

  45. Jordan, J., Lowe, J., & Taylor, P. (1998). Strategy and financial policy in UK small firms. Journal of Business Finance & Accounting, 25(½), 1–27.

    Article  Google Scholar 

  46. Kaplan, S., & Stromberg, P. (2003). Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. Review of Economic Studies, 70(2), 281–315.

    Article  Google Scholar 

  47. Kumar, K., Rajan, R., & Zingales, L. (1999). What determines firm size? Working paper NBER 7208. Cambridge, MA:National Bureau of Economic Research.

  48. La Porta, R., Lopez de Silanes, F., Shleifer, A., & Vishny, R. (1999). Corporate ownership around the world. Journal of Finance, 54(2), 471–518.

    Article  Google Scholar 

  49. Levine, R. (1997). Financial development and economic growth: Views and agenda. Journal of Economic Literature, 35(2), 688–726.

    Google Scholar 

  50. Lopez-Garcia, J., & Aybar-Arias, C. (2000). An empirical approach to the financial behaviour of small and medium sized companies. Small Business Economics, 14(1), 55–63.

    Article  Google Scholar 

  51. Lopez-Iturriaga, F., & Rodriguez-Sanz, J. (2008). Capital structure and institutional setting: A decompositional and international analysis. Applied Economics, 40(14), 1–14.

    Article  Google Scholar 

  52. Martin, R. (1999). The new economic geography of money (Chap. 1). In R. Martin (Ed.), Money and the space economy. New York: Wiley.

    Google Scholar 

  53. Michaelas, N., Chittenden, F., & Poutziouris, P. (1999). Financial policy and capital structure choice in UK SMEs: Empirical evidence from company panel data. Small Business Economics, 12(2), 113–130.

    Article  Google Scholar 

  54. Myers, S. (1984). The capital structure puzzle. Journal of Finance, 57(3), 575–592.

    Article  Google Scholar 

  55. Myers, S., & Majluf, N. (1984). Corporate financing and investment decision when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187–221.

    Article  Google Scholar 

  56. Petersen, M., & Rajan, R. (1994). The benefits of lending relationships: Evidence from small business data. Journal of Finance, 49(1), 3–37.

    Article  Google Scholar 

  57. Petersen, M., & Rajan, R. (1995). The effect of credit market competition on firm-creditor relationships. Quarterly Journal of Economics, 110(2), 407–443.

    Article  Google Scholar 

  58. Petersen, M., & Rajan, R. (2002). Does distance still matter: The information revolution in small business lending. Journal of Finance, 57(6), 2533–2570.

    Article  Google Scholar 

  59. Phillips, B., & Kirchhoff, B. (1989). Formation, growth and survival: Small firm dynamics in the US economy. Small Business Economics, 1(1), 65–74.

    Article  Google Scholar 

  60. Pinegar, J., & Wilbricht, L. (1989). What managers think of capital structure theory: A survey. Financial Management, 18(4), 82–91.

    Article  Google Scholar 

  61. Pollard, J. (2003). Small firm finance and economic geography. Journal of Economic Geography, 3(4), 429–452.

    Article  Google Scholar 

  62. Rajan, R., & Zingales, L. (1995). What do we know about capital structure? Some evidence from international data. Journal of Finance, 50(5), 1421–1460.

    Article  Google Scholar 

  63. Rajan, R., & Zingales, L. (2004). Saving capitalism from the capitalists. Princeton, NJ: Princeton University Press.

    Google Scholar 

  64. Robb, A. (2002). Small business financing: Differences between young and old firms. Journal of Entrepreneurial Finance and Business Venture, 1(2), 45–65.

    Google Scholar 

  65. Rocha Teixeira, G., & dos Santos, C. (2005). Do firms have financing preferences along their life cycle? Working paper Social Science Research Network.

  66. Romano, C., Tanewski, G., & Smyrnios, K. (2001). Capital structure decision making: A model for family business. Journal of Business Venturing, 16(4), 285–310.

    Article  Google Scholar 

  67. Showalter, D. (1999). Strategic debt: Evidence in manufacturing. International Journal of Industrial Organization, 17(3), 319–333.

    Article  Google Scholar 

  68. Sogorb-Mira, F. (2005). How SME uniqueness affects capital structure: Evidence from a 1994–1998 Spanish data panel. Small Business Economics, 25(5), 447–457.

    Article  Google Scholar 

  69. Storey, D. (1994). Understanding the small business sector. London: Routledge.

    Google Scholar 

  70. Titman, S., Fan, J., & Twite, G. (2003). An international comparison of capital structure and debt maturity choices. Working paper. Austin: University of Texas.

  71. Titman, S., & Wessels, R. (1988). The determinants of capital structure choice. Journal of Finance, 43(1), 1–19.

    Article  Google Scholar 

  72. Utrero-González, N. (2007). Banking regulation, institutional framework and capital structure: International evidence from industry data. Quarterly Review of Economics and Finance, 47(4), 481–506.

    Article  Google Scholar 

  73. Van der Wijst, N., & Thurik, R. (1993). Determinants of small firm debt ratios: An analysis of retail panel data. Small Business Economics, 5(1), 55–65.

    Article  Google Scholar 

  74. Wald, J. (1999). How firm characteristic affect capital structure: An international comparison. Journal of Financial Research, 22(2), 161–188.

    Google Scholar 

  75. Weinberg, J. (1994). Firm size, finance and investment. Economic Quarterly, 80(1), 19–33.

    Google Scholar 

  76. Weston, J., & Brigham, E. (1981). Managerial Finance. Hinsdale, IL: Dryden Press.

    Google Scholar 

  77. Williamson, O. (1988). Corporate finance and corporate governance. Journal of Finance, 43(3), 567–591.

    Article  Google Scholar 

  78. Zingales, L. (2000). In search of new foundations. Journal of Finance, 55(4), 1623–1653.

    Article  Google Scholar 

Download references

Author information

Affiliations

Authors

Corresponding author

Correspondence to Maurizio La Rocca.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

La Rocca, M., La Rocca, T. & Cariola, A. Capital Structure Decisions During a Firm's Life Cycle. Small Bus Econ 37, 107–130 (2011). https://doi.org/10.1007/s11187-009-9229-z

Download citation

Keywords

  • Capital structure
  • Financial growth cycle
  • Financing decisions
  • Small and medium-sized firms
  • Source of finance

JEL Classifications

  • G30
  • G32