Academic journal article Australasian Accounting Business & Finance Journal

A Survey of the Relation between Capital Structure and Corporate Strategy

Academic journal article Australasian Accounting Business & Finance Journal

A Survey of the Relation between Capital Structure and Corporate Strategy

Article excerpt

ABSTRACT

This paper responds to the general call for integration between finance and strategy research by examining how financial decisions are related to corporate strategy. In particular, the paper focuses on the link between capital structure and strategy. Corporate strategies complement traditional finance paradigms and extend our insight into a firm's decisions regarding capital structure. Equity and debt must be considered as financial instruments as well as strategic instruments of corporate governance (Williamson 1988). Debt subordinates governance activities to stricter management, while equity allows for greater flexibility and decisionmaking power.

The literature on finance and strategy analyzes how the strategic actions of key players (managers, shareholders, debtholders, competitors, workers, suppliers, etc) affect firm value and the allocation of value between claimholders. Specifically, financing decisions can concern value creation process (1) influencing efficient investments decisions according to the existence of conflict of interest between managers and firm's financial stakeholders (shareholders and debtholders) and (2) affecting the relationship with non-financial stakeholders, as suppliers, competitors, customers, etc.

To summarize, the potential interaction between managers, financial stakeholders, and nonfinancial stakeholders influences capital structure, corporate governance activities, and value creation processes. These in turn, may give rise to inefficient managerial decisions or they may shape the industry's competitive dynamics to achieve a competitive advantage. A good integration between strategy and finance dimensions can be tantamount to a competitive weapon.

Keywords: Overinvestment; underinvestment; risk-shifting; capital structure;corporate strategy.

1. Introduction

This paper responds to the general call for integration between finance and strategy by examining how financial decisions are related to corporate strategy (Kochhar and Hitt 1998). With relatively few exceptions, strategic management and finance appear to be in schizophrenic tension, if not in direct opposition (Ward and Grundy 1996). Bettis (1983) argued that modern financial theory and strategic management are based on very different paradigms, resulting in opposing conclusions. The conflicting state of these two knowledge systems might not matter if managers were able to make the linkages between strategy and finance with ease in practice (Grundy 1992). But the few (empirical) studies available suggest that the general managers do not find these linkages at all easy to make.

The polarity between finance and strategy, two areas of research that traditionally are studied separately, is just apparent, instead, these two areas present many connections, and it is relevant to understand the way in which these areas function individually and interrelate.

In particular, the link between financial decisions and strategy is largely unexplored. An extremely relevant topic, notoriously controversial, to the academic and business communities relates to capital structure decision and their effects on firm's creation of value. A firm's capital structure refers, generally, to the mix of its financial liabilities. In analysing capital structure we focused on the type of funds, debt or equity, used in the firm for financing. Debt and equity are the two major classes of liabilities, with debtholders and shareholders representing the two types of investors in the firm. Each of these is associated with different levels of risk, benefits, and control. While debtholders exert lower control, they earn a fixed rate of return and are protected by contractual obligations with respect to their investment. Shareholders are the residual claimants, bearing most of the risk, and, correspondingly, have greater control over decisions.

In the past, financial theorists suggested that, in perfect and efficient market, financing decisions may be "irrelevant" for firms strategy (Modigliani and Millet 1958); however, in the real world such choices may differentially affect firm value, explicitly because there are several imperfections (Myers and Majluf 1984). …

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