Are the Implications of the Financial Growth Cycle Confirmed for Spanish SMEs?
Sanchez-Vidal, Javier, Martin-Ugedo, Juan Francisco, Journal of Business Economics and Management
Capital structure is a recurrent topic in the financial literature. After the seminal work by Modigliani and Miller (1958), which argued that under perfect market conditions the decision about financing would be irrelevant, many studies have analysed the influence of tax considerations (Modigliani, Miller 1963; Miller 1977, among others) and financial distress (Baxter 1977; Warner 1977, among others) on the financial structure of companies. Following Jensen and Meckling (1976), many other studies considered the influence of information asymmetry and agency costs on firms' financial structures. The information asymmetry problem, in relation to financing decisions, refers to the fact that external investors have poorer information about the firm than managers and internal shareholders. A prime contribution on information asymmetry in capital structure theory is the Myers and Majluf (1984) model. Myers and Majluf argued that the empirical evidence is not consistent with the idea that companies adopt a financial policy that is determined by a trade-off of advantages and disadvantages of debt. Rather, companies' financial policies seem to be better explained by the behaviour described by Donaldson (1961). He established a hierarchy describing company preferences for internal funds over external funds. In the case of external funds, a company prefers debt over the issue of equity.
To explain this behaviour, Myers and Majluf (1984) construct a model based on the assumption that a firm's managers act on behalf of the current shareholders. If companies have enough financial slack, they will make all the investments that have a positive net present value. If external funds are needed to finance new investments, the market will interpret equity issues as evidence that company shares are overvalued and thus issue announcements have a negative impact on share price. Thus, Myers and Majluf (1984) argue, if the company does not have enough funds to finance new investments, it will issue equity only when there are very profitable investments that can neither be postponed nor financed through debt, or when managers believe that the stock is sufficiently overvalued that shareholders will be disposed to tolerate the market penalty.
However, the Myers and Majluf (1984) model has some limitations. The first is that it applies to markets like the American market where shares are offered mainly through commitment underwritings and not through rights issues, which is the flotation method that prevails in most other markets. In an underwritten firm commitment, shares are offered simultaneously to the public at large. Thus, if shares are overvalued, there will be a wealth transfer from new to current shareholders. In rights offerings, current shareholders enjoy priority in the purchase of new shares, which minimizes the possibility of wealth transfers (1).
A major problem in SME financing, especially in non-Anglo-Saxon countries, is limited access to capital markets (a finance gap) (Holmes, Kent 1991). As a consequence, long-term financing is usually reduced to internal financing and bank loans, and this is particularly the case for SMEs. These factors (different issuance methods and finance gap) imply a similar hierarchy for SMEs in non-American markets to the one described by Myers and Majluf (1984). That is, the company would make use of retained earnings in the first place, then debt (bank loans) and, as a last resort, equity issues. In addition, Cressy and Olofson (1997) propose an alternative explanation for the pecking order hypothesis for European SMEs in which the management tries to minimise interference and ownership dilution, and in which trade debt and internal sources are employed first. As previously noted, the information asymmetry problem refers to the relatively poorer information that is available to external fund providers compared to the economic agents involved in the management of the enterprise. …