ESTIMATING THE COST OF CAPITAL AND ITS DETERMINANTS IN SMALL AND

MEDIUM ENTERPRISES

1 Introduction
1.1 Background
Smallandmediumenterprisesarebecomingincreasinglyimportantintheeconomy.They
playanimportantroleinpromotingeconomicdevelopment,creatingjobsandincreasing
economicdiversity.Duetotheirrateofflexibilityandversatility,SMEsareabletoadjustto
changesineconomicenvironmentbetterthanbiggerorganisations.AccordingtoPadoan,Arzeni
andOrganisationforEconomicCooperationandDevelopment(2010),therewere
approximately4.6millionSMEsin2010andforms99.9%ofallbusinessesbynumber.This
comprisedofmorethanhalfofemploymentintheprivatesectorandhalfoftheentireturnover
intheprivatesector.ThecontributionandsignificanceofSMEstowardstheeconomyhas
evolvedovertimeastheoperatingenvironmentchange(Carboni2010).Inmostcases,itisthe
SMEsthatenteranewindustryfirstbeforethelargerfirmsidentifytheimportanceoflargescale
operationinthenewindustry(Padoan,Arzeni&OrganisationforEconomicCooperationand
Development2010).
AccordingtoAng(1991),SMEsaresmallandmediumenterprise,managedbytheowner,
ratherthanaprofessionalmanageronbehaveofthebusinessshareholders.MostSMEhaveless
than100workers,theyarelegallyindependentandownaverysmallshareofthemarket.
IntheUK,SMEscontributelargelytoeconomicgrowthandtransformation.Overtime,
theyhavecreatedpositivevaluetotheeconomyandcontributedtowardsbalancedand
sustainableeconomicgrowth,socialstabilityandemployment.AlthoughtheSMEsinUKplay
animportantroleintheeconomicgrowth,theaccesstofinancehasalwaysbeenlimitedevenin
theglobaloperation(Carboni2010).Inmostcases,theaccesstofinanceforSMEsvaries
dependingonanumberoffactorssuchasavailabilityoffinancechannels,management

experience,marketingcapabilities,thedevelopmentofagivenjurisdictionandpersonal
connectionbetweentheownersandfinanciers.
Duringthestartupstages,promotersoftheSMEsoftenrelyontheirowncapitalsuchas
personalcreditcards,savings,loansorequityfromfamily,friends,banksandotherfinancial
institutions(Chuietal2002:Claudioetal.2001).Inadditiontoventurecapitalists,creditaccess
canbealsobeavailedbysuppliers.AccordingtoBloomfield(2008),thechallengefacedby
SMEsinaccessingfinancehasbeenamplifiedbytheincreasedeffectsofglobalfinancialcrisis,
whichledtothecurrentreformsinfinance.Thesechangesincludetheintroductionofstrict
capitalrequirementsforfinancialinstitutionsrelatedtoBaselIII.Strengtheningthefinancial
institutionsandthebankingsectorhashadtheeffectofdecreasingtheeffectofintermediationas
banksbecomemoreriskaversewhenextendingcreditespeciallytotheSMEs(Roche&Great
Britain1998).Thus,ithasbeenmadeimportanttoexamineallthepossiblealternativesof
accessingcreditfortheSMEs.Raisingcapitalthroughorganised,transparentandreliablemarket
canprovidereliablesourcesoffinanceatarelativelylowercost.
Itisimportanttonotethatalthoughthecriteriausedbythebanksinlendinghavebeen
tightened,variouseconomicrecessionshaveincreasedtheunderlyingcreditriskforSMEs
(Berger,KlapperandUdell2001).Thisismainlyduetosalesdeclineandgreateruncertainties.
AccordingtoFraser(2009),rationofthenumberofbusinesswithlowprobabilitytodeclined
droppedby48%between2004and2008.However,71%ofthebusinessesdidnotmake
unauthorisedexcessontheoverdraftfacilities.Thisexplainssomeoftheincreaseddifficulties
theSMEsexperienceintheireffortstoraisecapital.ThecurrentEurozoneturmoilhascaused
uncertaintiesintheentireglobaleconomy.Althoughthereisevidencethatbothbanksand

businessesarebecomingmorepreparedtohandletheeconomicshock,adefaultoflargeEuro
zonecountrycauseresulttomajorfinancialcrisisduetoUKbanksexposuretothemarket.
Therefore,identifyingthemostsuitableestimatingthecostofcapitalandcapitalstructure
ofSMEsisveryimportant.Asuitablecapitalstructurecanhelpanorganisationtomaintaina
competitiveadvantageinthemarketandprovidepositiveeffectonthecountryseconomy
(Bloomfield2008).Themainobjectiveofanyfirmiswealthmaximisationandobtainingthe
rightcostofcapitalshouldprovidedirectionsonhowafirmplanstofunditsprojectsandmeet
theobjectives.Inthisregards,theabilityofanSMEtoaccessfinanceshelpsinfacilitatingstart
upofnewbusinesses,fundingbusinessinvestmentandensuringthebusinessachieveitsgrowth
potential.

1.2 Rationale for the Study

Mostbusinesseshavebeenabletoobtainfinancialaccessastheyneedbuttherearevarious
structuralandmarketfailuresaffectingthesupplyofequityanddebtfinancingtotheSMEs.This
hasresultedtoadiscriminativedenialofaccesstocapitaltopotentiallysuccessfulbusiness
ideas.Thesemarketfailuresarerelatedtoasymmetricalinformation.Thesefailuresexacerbates
duringuncertaineconomicsituationswhenbanksandotherlendersbecomemoreriskaversedue
toincreaseduncertainties.
Understandingthemarketuncertaintiescanhelptheresearcherinunderstandingthe
existingundersupplyofequityfinancetoyoungbuthighlypotentialbusinesses.Thisisdueto
thefactthatinvestingininnovativebusinessduringthestartupstagecanleadtoanumberof
positivespillovereffects.Thiscanincreasetherateofknowledgetransferandinnovativenessto

otherpartsoftheeconomywhichfinancialsectorfailstoconsiderwheninvestinginventure
capitals.
Theproblemdiscussionshallreviewallrelevantliteratureinregardstothestructureof
capital.AccordingtoBeltrame,CappellettoandToniolo(2014),moststudiesfocusonthecapital
structureamongthetopcompaniesorthoselistedinthestockmarket,thusoverlookingthe
capitalstructureofSMEs.Differentempiricalstudiesonthecapitalstructurehavegathereddata
frombusinessescategorisedaslargebusinesses.AsillustratedbyHunterandTan(2007),the
existingresearchonthecapitalstructureofSMEsindicatesthatthereisabigdifferencebetween
theircapitalstructureandthatofthelargerbusinesses.

1.3 Research Problem

DespitetheroleplayedbySMEsintheUKeconomy,thefinancialconstraintsfacedduring
operationhaveanegativeeffectondevelopmentofthebusinessandpotentialgrowthtothe
nationaleconomy(Ang1991).Thisisaworryingtrendforafirstworldcountrywiththe
requisiteinfrastructureandtechnologytoaccessmorefundsatalowcost.MostSMEsinthe
countrydonothavethecapacityintermsofexposureandtechnologicalknowhowtomanage
theiractivitiesinmostofthehighlycompetitiveindustries(DeGeeter,2010).Consequently,the
businessesareunabletorecordthesamequantityofoutputascomparedtothebiggerfirmsand
withnoauditedfinancialstatements(anessentialrequirement);theyarenotabletoaccesscredit
fromfinancialinstitutions(Coleman2000).Therefore,thedetailsofSMEsfinancialconditions
maybeinaccurateorincompletemakinglendersdenythemcreditorofferingthecreditatvery
highcostduetotherisksinvolved.

TheotherissuethatmakescreditinaccessibleforSMEsinUKisinadequatecapitalbase.
Anorganisationisrequiredtomeetacertaincapitalthresholdinordertobeconsideredforcredit
lending(Hunter&Tan2007).Inthissituation,mostSMEsareunabletoprovidethecollaterals
oftenendingupwithlittleaccesstofundsthatareadequatetoforthedevelopmentoftheir
projects.
Eurozonecrisisandeconomicdepressionhavealsoaffectedthefinancialpolicies.The
financialcrisisof200809happenedbecausebankswereabletomaketoomuchmoney.The
bankswereabletoincreasethehousingpricesthroughspeculationinthefinancialmarkets.
Lendingtoomuchmoneymadeexistingloansunpayableandfinancialmarketalmostbecame
bankrupt(DeGeeter,2010).Afterthecrisis,banksrefusedtolendunlesstoinvestmentsthey
weresuretheywillbepaid,thuslimitingtheiroveralllending.Thisdecisiononplayersinthe
financialmarketaffectedeventheinnocentSMEswhoonlyrequiredrelativelysmallamountof
capitalfortheirbusiness.

1.4 Research Hypotheses

Thestudywillbebasedonthefollowinghypothesis;
H0: There is no relationship between the cost of capital and the success of SMEs in the
UK.
H0: The SMEs are not able to adjust their cost of capital during and after thefinancial
crisis

1.5 Aims and objectives of the study

Thisresearchaimstoidentifytheestimatedcostofcapitalanditsdeterminantinsmalland
mediumenterprisesintheUnitedKingdom.TheresearchwillseektounderstandhowtheSMEs
managedtoadjusttheirfinancialandcapitalrequirementsduringdifferentphasesofthefinancial

crisis.Thestudyismodelledinamannerwhichtheimpactofcapitalestimationdeterminesthe
successofsmallandmicrobusinesses.Themodelinvolvescontrollingbusinessspecific
variablessuchasmanagementstyles,thesizeoftheSMEsandtheperiodofoperation.The
studywillcontributetotheexistingliteratureonaccesstofinanceforSMEsandthesuccessof
respectivebusinesses.ThefindingswillcontributeinformingalinkbetweenSMEsaccessto
capitalandtheirperformanceinaneconomicallyturbulentenvironment.Forthisreason,this
studywillattempttofillthegapbyextendingtheknowledgeofcreditaccessforSMEsinUK
despitevariousglobalfinancialcrisesthathaveshapedfinancialpoliciesintheEurozone.Itwill
beimportanttoanalysehowtheeconomicenvironmenthaveaffecteddevelopmentofpoliciesin
thefinancialinstitutionwhichinturnhashadsomeimpactsoncapitalaccesstotheSMEs.The
aimofthisresearchistoassesshowthecostofcapitalhasaffectedtheperformanceofSMEsin
economicdevelopment,innovationandjobcreation.Thestudywillalsoseektoestablishhow
theSMEshaveadaptedtothechangesinoperatingenvironmentespeciallyonthelending
policiesandchangesincostofcapital.

1.6 Research Questions

Thestudywillseektoanswerthefollowingresearchquestionsonthefactorsaffecting
SMEscostofcapital:
1. What are the factors affecting the cost of capital for SMEs in the UK?
2. How did SMEs adjust their cost of capital during and after thefinancial crisis?
Theobjectivesofthisstudywillseekto;
1. To establish the factors that affects the cost of capital for SMEs in the UK.
2. To evaluate how the SMEs adjust their cost of capital during and after thefinancial
crisis

2
2.1

Literature Review

Introduction
The discussion on the cost of capital dates back to Modigliani and Miller (M&M, from

now on) theorem proposed four decades ago. Researchers propose some theories such as
leverage relevance theories as alternatives to the MM theorem. Existing studies categorise capital
structure theory into three main groups: agency cost theories; tax-based theories; asymmetric
information and signalling theories. This section provides a brief overview of how SMEs
compute their cost of capital based on the capital structure theories. The value of the firm value
is the discounted stream of its expected cash flows. Investors hold claims on the firm's cash
flows. In particular, debt holders claim regular repayment of principal and interest while equity
holders lay claim on firms residual stream of cash flows. In essence, equity claims are riskier
because there is no guaranteed payment on equity.
SMEs utilise a combination of both debt and equity funds in their capital structures. By
taking into consideration of the various constraints within each firm, firms tend to differ in their
proportion of firm, each firm attempts to have the right combination of debt and equity to
maximise value. Capital structures define how firms finance investment projects. In essence,
capital structure determines the manner in which firms divide profit between owners of the firm
and creditors. Ross et al. (2008) notes that deciding on the right combination of debt and equity
is a critical issue for firms. Issuing equity is an expensive undertaking as compared to debt, but
debt generates higher riskparticular in periods of rising cost of borrowing. As a result, the
main concern is to find the best proportion of debt and equity in a firms capital structure
(Modigliani & Miller, 1958).To maximise firm value, the general approach is to minimise the
cost of capital by using more of the cheaper between debt and equity. Modigliani and Miller
(1963) notes that increasing leverage tend to increase the interest tax shield, which in turn

enhances a companys value. On the other hand, increasing the level of debt tends to increase a
firms financial distress cost, thereby decreasing a companys value. In another study Bradley et
al. (1984) defines the optimal capital structure as the level of leverage that provides the best
combination of the tax benefit and financial distress cost.
2.2

Capital Structure Theories

Firms capital structure of firms is a puzzle because it is difficult to find the ideal

financing structure for projects. As mentioned in the previous section, the literature on the cost
of capital is based on the seminal work of Modigliani and Millers (1958). It is imperative to note
that these studies majorly focus on large corporations leaving out SMEs.
There are various studies that have looked at SMEs capital structure approaches for SMEs.
The papers use empirical methodologies that are empirically testing the models developed for
large entities. Later studies attempt to take into consideration the special features of SMEs.
Entrepreneurs' personal wealth mainly influences SMEs capital decisions, and there tends to be
no clear separation between personal and business risk. Another issue highlighted in literature for
SMEs is information asymmetry faced by financers (Heyman et al., 2007). In essence, the lack of
proper information on SMEs tends to create funding barriers. Hence, the financing decisions are
constrained by big information asymmetries (Berger et al., 2001). Psillaki and Deskalakis (2009)
note that SMEs cost of capital is country specific and affected by asset structure (rtqvist et al.,
2006).
When firms are mature and become informationally transparent, can they be able to gain
access to public debt and equity funding (Gregory et al., 2005). As a result, Holmes and Kent
(1991) uses a restricted form of the pecking order theory and posit that equity funding is
expensive for SMEs. In another study, Ang (1992) posits that SMEs owners fund then using a

mix of personal and firms wealth. Raising capital using equity implies a dilution of shares,
something that family-owned SMEs may not be willing to take. Family owners are very
concerned about losing control over their firm because they want to pass to the next generation.
2.3

Components of Capital Structure

2.3.1 Equity Financing

A firm that does not use debt financing is often referred to as the levered firm (Bradley &
Roberts 2004). This phenomenon brings about business risk. Business risk refers to the potential
and imminent risk that a firm is exposed to if it does not use debt financing. The return on
investment in firms that do not use debt financing is measured by return on equity which is
represented as the shown below:
Return on Equity (ROE) = Net income to common stock holders/Common equity
This ratio shows that the business potential risk of a firm that does not use debt financing
is the measure of standard deviation of its ROE as Brigham and Houston (2007) posited.
2.3.2 Debt Financing
A firm that resorts to debt financing to service its operation is referred to as the levered
firm. Brigham and Houston (2007) asserted that firms resort debt financing due to the financial
risk they face. The financial risk arises from the additional risk that common stock holder face
upon resorting to use debt financing. In other words, the financial risk is the likelihood that the
firms earnings will not be improved due to the method of financing opted. Brigham and Houston
(2007) further observed that the financial risk arises from the fact that debt has a mandatory call
of the firms cash-in terms of interests-which must be paid periodically before the shareholders
can share the earnings.

2.3.3 Cost of Capital

Since the choice of capital structure affects the cost of capital, firms influence their cost of
capital through various ways. Brigham (2004) asserted that equity capital-providing investors are
often in more risky position as opposed to debt providers. This is because owners are the ultimate
claimants of the net cash flows of a firm. In particular, equity holders receive returns through
dividends while debt holders receive interest on debt before the equity holders can claim their
dividends. As such, cost of capital refers to the cost attached to different sources of financing
(Shyam-Sunder & Myers, 1999). According to him, the shareholders are often not in a position to
make explicit the return on their capital contribution in the case of equity financing. However,
capital raised through debt financing has a predefined rate of interest on the principal amount
attached to it which forms the overall cost of capital for an organization. Therefore, it is
imperative to understand that levered firms depend on debt financing for financial capitalization
which increases the risk of debt payment and the return to shareholders. Importantly though,
Brigham and Houston (2007) in his study of capital financing noted that both equity and debt
financing require higher returns to bear the risk. According to Shyam-Sunder & Myers, 1999),
among the two popular forms of financing, debt financing is preferred to other capital financing
options because it looks cheaper. Other scholars who have advance the argument for the
utilization of debt financing to other financing options cited the advantages such as the effect of
tax shields on corporate financing (Modigliani & Miller 1958). On the other hand, Myers (2001)
warned of the possible danger and imminent risk associated with debt financing citing financial
distress and indirect or direct bankruptcy costs which arise whenever shareholders exercised their
rights to default. As such, the choice of capital financing has a bearing on the overall
performance of a firm.

2.4

Determinants of Capital Structure

Since the 1960s, the subject of capital structure has become one of the most productive

yet misunderstood areas of research in the field of corporate finance, giving rise to a multitude of
theoretical and empirical studies. Early researchers in the field of capital structures proposed that
choices of finance are irrelevant in typical markets (Modigliani and Miller, 1958). Subsequent
theoretical contributions cited that firms can maximize their respective market value by using the
associated tax benefits to debt financing before increasing their respective cost of bankruptcy.
Jensen & Meckling (2006) embarked on the capital structure decision puzzle by citing that
although employees are employees are hired to further owners objectives, they end up becoming
biased towards preserving their own private interests. Consequently, the agency cost was
included in the capital structure equation as an important variable that could eliminate agency
problems that arise from information asymmetries between the investors and the managers
(Jensen & Meckling 2006). In the subsequent research, the pecking order theory was design.
According to Myers and Majluf (1984), pecking order theory states that that information
asymmetries causes firms to opt to finance their activities through internal financing or perhaps
debt issuance but on rare occasion resorts to issue of new equity. Most recently, the Equity
Market timing theory has been widely applied in the field of capital financing that proposes that
firms should resort to issue new equities whenever there is a difference between its market value
and accounting value.
Notwithstanding, the existing body of literature on capital structure suggest that very few
authors have embarked on investigating the financing decisions of small and medium enterprises.
This limitation often arises because SME data are often scarce and in most cases unreliable. This
is because SME are typically owned private entities which, under statutory laws or otherwise, are

not required to disclose detailed information or audit their reports. At the same time, it is often
presumed that privately owned small or medium enterprises would eventually transform to
become publicly traded companies; besides, very few SME issue publicly traded securities or list
their shares on stock exchange market.
2.5

Determinants of Financial Performance in SMEs

Cashflow,liquidity,costofcapitalandleveragemeasurescoverthecapitalstructureofa

firmandtheabilityoftheorganizationtoserviceitsliabilitiesinatimelyway.Eachofthethree
categoriesrelatesignificantlytofirmsperformance.Leverageisameasureofafirmsfinancial
structureandincludessuchmeasuresasdebttototalassets,debttoequityandtimeinterest
earned.Liquiditymeasuresprovideelaboratedescriptionoftheabilityofafirmtoconvertassets
tocashandincludesuchmeasuresascurrentratioandquickratio.Cashflowmeasuresprovide
descriptionsoftheamountofcashafirmcangeneratebasedonthesourceofthecashrelativeto
thecashdemandinthefirm.Inthissubsection,particularattentionisfocusedonleverageand
thecostofcapital.
2.5.1 Leverage and Firms Performance
Leveragemeasuresdescribeafirmsfinancialstructure.Inotherwords,financialleverage
referstotheextenttowhichoperatingassetsarefinancewithdebtversusequity(Pennman
2001).Thismeasurebringsforththeconceptofcostofcapitalintermsofinterestswhose
impactontheperformanceofsmallandmediumsizeenterprisesisbeinginvestigatedinthe
currentpaper.Debtobligationsgenerallyencompassthepaymentofinterestandtheprincipal
amountonaperiodicbasisbutwithinaparticularperiodoftimeusingafirmscashgenerating
initsoperations.Ontheotherhand,commonequitydoesnotnecessitatetheperiodicreturnsto
capitalprovidersorfortheretirementofcapitalinvestmentofequityholdersinafirm.Assuch,

equityholdersreceivereturnsafterallothercreditorobligationsaresatisfiedwhiledebtholders
receivefixedpayment.Penman(2001)arguedthatiftheamountofafirmsprofitexceedsthe
costofborrowedcapital,theexcessbecomesadditionalprofitfortheshareholders.Conversely,
ifafirmearnsprofitinshortageofthecostofborrowedcapital,theshareholdersshouldersthe
shortagewhilethedebtholderscontinuetoreceivetheirreturnintermsofinterests.Therefore,
whenevertheratioofcapitalobtainedthroughborrowingtothecapitalprovidedbyequity,the
higherthecostofcapitalwhichcreatespotentiallossesfortheequityholders.Assuch,the
higherthecostofcapital,theperformanceofthesmallandmediumsizefirmdeteriorates.Brush,
BromileyandHendrickx(2009)notedthatthemanagersinSMEshavelimitedstrategicchoices
tochoosefrominhighlyleveragedfirmsduetotheirinabilitytoraiseadditionaldebtcapitalor
theexcesspressurerequiringthemtousedcostlyequityfinancing.Overall,thecostofcapital
affectstheoverallperformanceofsmallandmediumsizefirms.
2.5.2 Cost of Capital and Firms Performance
Erasmus(2008)notedthat,thecostofcapitalforafirmisusuallydeterminedby
computingitsweightedcostofcapital.Theweightedaveragecostofcapitalincorporatesthecost
ofequityaftertaxandthecostofotherdifferentformsofdebtaftertax.AccordingtoModigliani
andMiller(1963)studyoncapitalstructuresandfinancialperformance,itbecomeapparentthat
whenacompanyusesdebtfinancinginitscapitalstructure,theaveragecostofcapitalreduces
whileprofitabilityisenhanced.Withprofitabilityasanimportantmeasureoffinancialand
overallperformanceofafirm,Pandey(2005)notedthatcostofcapitalhasasignificanteffecton
financialperformancewhichcaneitherbenegativeorpositive.

2.6 Impact of Financial Crisis on SMEs Cost of Capital

During the recent global financial crisis, the level of credit issuance to non-financial firms
was considerably reduced. The impact was severe in advanced markets countries, notably the US
and UK. Nonetheless, there is no definitive evidence that firms excessive leveraging led to the
financial crisis. In a study by Kayo and Kimura (2011), the authors analysed 40 countries, using
firm-level factors and market timing efforts as factors affecting firms capital structure decisions.
Also, they show that non-financial firms in advanced markets were unable to take full advantage
of lucrative financing schemes. Potentially, there are many significant changes in the financial
system that triggered the recent global financial crisis. It is imperative for researchers to examine
the effect of these changes further before making definitive conclusions.
The severity of the recent financial crises left firms in a financially constrained position.
As a result, a majority of the financially constrained firms had their funding sources limited in
capital markets while the cost of borrowing rose significantly. Also, firms faced difficulties in
issuing or renewing credit lines. Additionally, the financially constrained firms were had to
forego lucrative investment opportunities given the constrained funding sources. In this regard,
some of the financially constrained firms were forced to offload their assets to fund their
activities (Campelloet al.,2010).Given that asset declines can significantly affect firms ability to
raise debt, it is likely that firms may be forced to adjust their capital structure tomanage the
severe circumstances during a financial crisis. Overall, researchers assume that capital market
conditions before the financial crisis tend to be positive than during and after the financial crisis.
According to Doukaset al.(2011), the aspect of adverse selection related to equity
issuance has significant effects on capital structure choices. If equity is more expensive than
debt, then firms will take more leverage to finance their activities. The use of debt increases

when debt markets are more favourable as compared to equity markets, irrespective of the costs
associated with an adverse selection that a firm may be facing. Furthermore, the authors
demonstrate that the impact of adverse financial conditions on debt-financing can endure for
more than five years after the year of issuing. They do not find evidence of the trade-off theory
of capital structure in the capital structure decisions of the sampled firms. The underlying
argument is that even before a financial crisis, in times of favourable capital markets, trade-off
theory cannot fully explain firms capital structure decisions. Choeet al.(1993) notes that
financial managers are expected to minimise the cost of issuing equity. The authors find that in
periods of economic growth, firms face lower costs of adverse selection, resulting in more equity
issuance as compared to debt. Dittmar and Dittmar (2008) corroborates this finding, noting that
during a period of economic expansion, the cost of equity significantly reduces as compared to
the cost of debt. For this reason, equity financing activities increase in times of economic
expansion, significantly affecting firms activities.

2.7 Factors That Inhibit Ease Of Accessing Finance for SMEs in the UK
As of May 2013, UK financial institutions total outstanding amount of lending to SMEs
was approximately 170 billion (Hussain,etal.,2006). Approximately 17 billion of the amount
was obtained in form of over drafts. SMEs lending by financial institution in the UK represent
approximately 35% of total amount lending to non-financial organizations. However, despite the
high percentage of lending, SMEs in the UK experience obstacles when looking for finance. UK
lenders such as banks rely on the security guaranteed by existing assets of the business and track
records to get assurance on the ability of the business to pay the loan. These factors enable
lenders simply and reduce the cost of conduction a detailed financial assessment of every SME
in the UK. Unfortunately most SMEs are new and small businesses, they may not have the

required track record, history or existing asset base to give potential lending firms their
assurance. Approximately 38% of all loan applications by SMEs that are not more than 5 years
old are rejected by UK banks (Darvas,2013). In comparison, only 19% of all loan applications
by SMEs more than five years old are rejected (Berry,Grant&Jarvis,2004). BIS commissioned
research reported that 27% loan application for firms with an annual turnover of less that 1
million are rejected compared to 16% for businesses with a turnover of over 1 million. The
research also highlights on the rejection rates of term loans and overdraft to have been
significantly high between 2008 and 2009 which reflect constraints by banks on the supply of
credit (Hussain,MillmanandMatlay,2006). Lack of tract record and existing capital base are
some of the factors that inhibit SMEs in the UK from accessing finance easily. Since most SMEs
are small and newly opened, the year factor plays an important role in determining the ease with
which they access finance by banks and other lending institutions.

2.8 Summary of Literature

The literature review synthesised various papers on capital structure theories and related
empirical results. Overall, the conventional opinion is that capital structure significantly affects
firms financing decisions. Thus, it is envisaged that reasonable use of leverage can help to
increase firm value through the reduction of the cost of capital. Literature shows that, when
leverage increases beyond an optimal level, the cost of capital increases more than the increase in
firm value. There is no universal identification on the optimal capital structure. Evidently, there
is no consensus on the most appropriate capital structure theory and what depicts an optimal
capital structure in the application. Nonetheless, there a sample evidence of correlations between
firm-level factors and capital structure decisions. Additionally, some previous studies utilise
balanced panel data, which limits the inclusion of all obtainable data in a panel regressions.

Thus, the use of unbalanced panel regression procedure can allow researchers to overcome this
limitation. For the paper to analyse the impact of the financial crisis on firms capital structure,
the present study will incorporate the effects of the 2007-2010 financial crisis on SMEs cost of
capital. It is imperative to control for the period of the recent global financial crisis (2007-2010)
and use firm-specific variables to model capital structure determinants in the context of UK
listed non-financial SMEs.

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