SIZE AND OTHER DETERMINANTS OF CAPITAL STRUCTURE IN SOUTH AFRICAN MANUFACTURING LISTED COMPANIES

By:

NOSIPHO MGUDLWA

DISSERTATION

Submitted in partial fulfilment of the requirements for the MASTER OF TECHNOLOGY IN COST AND MANAGEMENT ACCOUNTING (MTECH: CMA)

at the NELSON MANDELA METROPOLITAN UNIVERSITY

SUPERVISOR: PROF. P PELLE

Submission: November 2009

DECLARATION:

I, the undersigned, hereby declare that the work contained in this thesis is my own original work and that I have not previously, in its entirety or in part, submitted it at any university for a degree.

---------------------------------Signature

------------------Date

ACKNOWLEDGEMENTS

I wish to express my sincere thanks and gratitude to the following people:

Prof. Pieter Pelle for his professional supervision and guidance during the study. My colleagues Chris Mkefa and Stanley Sithole for their assistance and valuable support. My son, Bantu, for his encouragement and love. My family and friends for their encouragement, understanding and support. Last but not least to the Almighty for giving me the strength to carry on.

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ABSTRACT
The importance of the capital structure as a measure of company growth and performance has been at the core of vigorous debate for many years. With the threat of the recession and global competitiveness to the survival of organizations, what constitutes an optimal capital structure had to be interrogated. The focus of the study is to investigate the factors (with more

emphasis on size) that influence the capital structure of manufacturing firms in general and South African manufacturing firms in particular. The aim is to

advance recommendations on policy formulation so as to improve the financial performance of the manufacturing sector in South Africa, a developing economy.

The study is explained within the theoretical framework which relates elements purported to have an influence on the capital structure to the use of leverage/debt by organizations. Leverage is seen to increase the shareholders interest whilst being exposed to financial risk. The size of the organizations as a comparative element defines the extent of accessing the borrowed funds, hence the distinction between the Small, Medium and Micro Enterprises (SMMEs) and large sized enterprises (LSEs). The research evidence indicates that SMMEs are

characterized by lower liquidity, use more short-term debt instead of use of longterm debt, and are generally low in debt and basically capital intensive. contrary LSEs are highly leveraged. On the

The selected research design is triangulated, with a combination of a case study which is of a qualitative and interpretive nature, as well as a quantitative type survey by means of a structured questionnaire. Twenty five ratios were

computed from information derived from the financial statements of organizations and means and medians were determined for comparative reasons. The

questions were directed to chief financial officers or managers responsible for the compilation of the financial statements, mainly to expand on the debt policy of iii

their respective organizations. The findings confirmed the correlation between gearing and size, asset structure and growth with the exception of profitability. On the relevance of financial policy regarding debt, two factors were proven to be influential to capital structure decisions: the theory and practice of capital structure and the impact of the debt policy, both of which relate to financial flexibility. The study concluded that as much as there are

similarities/consistencies between the two size groups, there are fundamental differences confirming that size significantly impacts on the capital structure choice specifically the use of debt. It is, therefore, recommended that the South African government should review its policies with regards to the financial support towards SMME viability.

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TABLE OF CONTENTS
DECLARATION

ACKNOWLEDGEMENTS

ABSTRACT

PAGE NO.: CHAPTER 1: INTRODUCTION AND RESEARCH METHODOLOGY

1.1 1.2 1.3

INTRODUCTION AIM OF THE STUDY RESEARCH METHODOLOGY 1.3.1 Research approach and design 1.3.2 Sample and data collection 1.3.3 Methodology 1.3.4 Data 1.3.5 Measurement 1.3.6 Analysis

4 7

8 8 9 10 12 12

1.4

RESEARCH STRUCTURE 1.4.1 Chapter 1: 1.4.2 Chapter 2: 1.4.3 Chapter 3: 1.4.4 Chapter 4: Introduction and Research design Literature review Findings Recommendations and Conclusions 13 14 14 14

PAGE NO.: CHAPTER 2: THEORETICAL FRAMEWORK AND LITERATURE REVIEW 2.1 2.2 2.3 INTRODUCTION CAPITAL STRUCUTRE VS FIRM VALUE KEY THEORETICAL CONCEPTS 2.3.1 Capital Structure 2.3.2 Weighted Average Cost of Capital 2.3.3 Leverage (debt) ratio 2.4 LITERATURE ON CAPITAL STRUCTURE (THEORIES) 2.4.1 Static Trade-off theory 2.4.2 Information Asymmetry 2.4.3 Pecking Order model 2.4.4 Agency cost theory 2.4.5 Other theories 2.5 THEORETICAL DETERMINANTS OF CAPITAL STRUCTURE CHOICE (FIRM CHARACTERISTICS) 2.5.1 Size of the firm 2.5.2 Asset structure 2.5.3 Profitability 2.5.4 Growth opportunities 2.6 CONCLUSION 25 26 27 27 28 20 22 23 23 23 17 18 20 15 15

CHAPTER 3: FINDINGS 3.1 3.2 3.3 INTRODUCTION DATA AND METHODOLOGY EMPIRICAL RESULTS: 3.3.1 Financial Performance findings 3.3.2 Relevance of financial policy regarding debt 3.3.3 Theory and practice of capital structure 3.4 CONCLUSION 2 32 37 39 42 30 31

PAGE NO.: CHAPTER 4: CONCLUSION AND RECOMMENDATION 4.1 4.2 4.3 4.4 SUMMARY OF FINDINGS IMPLICATIONS OF EXISTING THEORY RECOMMENDATIONS SCOPE FOR FUTURE RESEARCH 44 50 51 53

BIBLIOGRAPHY

APPENDICES A-C:

Appendix A: Appendix B: Appendix C:

Survey questionnaire Tables I and II Permission approval letter from the supervisor

CHAPTER 1

1.1

INTRODUCTION

Research suggests that for a firms survival, especially in very difficult circumstances, capital structure is essential to measure growth and performance (Voulgaris, Asteriou and Agiomirgianakis 2004: 247). Large companies are

exposed to increasing competition not only within South Africa but in the Southern African Development Community (SADC), the African Union and globally. A number of South African companies are listing internationally. For Small, Medium and Micro Enterprises (SMMEs) survival is further complicated by additional issues like size and reputation. players in the countrys economy. For this reason the South African

government is doing its best to support the SMMEs as they are important roleSMMEs maintain competition, thus keeping

the large size enterprises (LSEs) highly competitive. Voulgaris et al. (2004: 248) are of the view that LSEs are necessary to achieve economies of scale in production, research and marketing. The authors further state that economic progress of countries specifically developing (transitional) economies (like South Africa) depends on the research and development aspect. Chen (2004:1342) agrees that not much work has been done to further knowledge on capital structure within said economies. The abovementioned

statements have necessitated this study within the South African context.

Over the years there has been experimenting and intervention by authorities of different countries and corporations. Market reform programmes aimed at

curbing economic decline have been introduced, intending to generate sustainable growth and development (Boateng, 2004: 56). Four key reform

programme components, namely: liberalization of the foreign direct investment regulatory framework; infrastructure upgrading; economic stabilization (including fiscal deficits); privatisation, rationalization and restructuring the state-owned

enterprises have been suggested in Boateng (2004: 56). According to Jerome (2004: 12-13) South Africas approach to restructuring and privatisation has been unique to other models applied worldwide. Referred to as partial privatisation by Jerome (2004:14), the objectives include attracting foreign investment; reduction of public borrowing requirements and assisting in the fuelling of an economic growth. The author concedes that not much has been achieved by the

programme.

Voulgaris et al. (2004: 248) are of the opinion that LSEs tend to take advantage by commercializing resources that have been initiated by SMMEs. There are policies formulated to address specifically financing SMMEs for their

sustainability. When sustained, SMMEs lead in employment creation as they are more labour intensive and more flexible than LSEs (Voulgaris et al., 2004: 248). In South Africa ownership, procurement and mentoring based on the Broad Based Black Economic Empowerment Act, Act 53 of 2003 (BBBEE) principles are favourable for these small enterprises. Despite the promotion and support

by authorities, SMMEs have not managed to progress as much as the LSEs, especially in the manufacturing sector, as Ortigvist, Masli, Rahman and Selvarajah (2006: 278) advance the reason that SMMEs are unable to secure adequate sources of capital. The authors refer to the argument put forth by Ang (1991) that SMMEs are also limited in raising capital by means of shares or even in long-term loans. The financial constraints are attributed to performance as well as the capital structure choice of SMMEs, which according to Voulgaris et al. (2004: 248) is, in comparison to LSEs, characterized by: lower and more variable profitability (lower liquidity) lower use of long-term debt lower leverage higher short-term debt

Debt or leverage has featured a number of times when capital structure is debated such that both terms have been used synonymously, as witnessed in the 5

characteristics presented in the Voulgaris et al. 2004 study. Both terms have been equated to the value of the firm.

When articulating industry dynamics, Miao (2005: 2644) states that firms without debt financing (which results in not taking advantage of tax shields and instead financing by means of equity) have a firm value that is lower than that of firms with debt financing.

The focus of this paper is to investigate the factors (with more emphasis on size) that influence the capital structure of South African manufacturing firms. Classifying firms into manufacturing and non-manufacturing will assist in designing more appropriate and effective policies that will encourage expansion of each type of the firm according to size, SMME or LSE (Voulgaris et al., 2004: 249). Both the manufacturing and the non-manufacturing sectors are vital for the growth of the South African economy, an economy in transformation. South African firms, especially those in manufacturing, face the tough challenge of competing for survival during critical times like the current global meltdown. Important is that elements key to the survival of the companies in the manufacturing industry are identified. The elements should be the basis of the optimal capital structure. Delcoure (2007: 400) argues that despite extensive research on what factors determine optimal corporate capital structure, there has been no consensus on a universal model applicable to the real business world. Existing literature on

capital structure of South African companies has so far not extensively investigated the role of firm size and the effect of other determinants on capital structure. Use of leverage/debt ratios to alternate industry classifications for example manufacturing has not been sufficiently explored either. Much remains to be understood as to whether different institutional features do influence

leverage choices (Bancel and Mittoo, 2004: 3). These aspects have prompted this study with a view to provide additional evidence and insights.

1.2

AIM OF THE STUDY

MAIN PROBLEM: To investigate factors which determine the capital structure and size of firms in order to make recommendations on policy formulation so as to improve the financial performance of the manufacturing sector in South Africa.

SUB PROBLEMS: To recommend a model in which optimal capital structure and debt maturity are jointly determined.

To suggest basic grounds on which detailed evaluation could be based, also hoping to answer the following: Whether and how closely do the determinants of capital structure support the theory that the determinants of capital structure and/or ratios have evolved?

HYPOTHESES:

The following research hypotheses have been formulated: size is positively related to gearing; asset structure (acting as collateral) is positively related to gearing; profitability is negatively related to gearing; growth is positively related to gearing

1.3

RESEARCH METHODOLOGY

1.3.1 Research approach and design

A research design is a set of guidelines that connect theoretical paradigm to the inquiry strategies and empirical material collection methods to address research problems (Mouton 1996: 107). Mouton (1996: 175) further suggests that a

research design consists of a plan on how research participants are obtained and how information is to be collected, which Welman & Kruger (2001: 46) confirm.

This study is triangulated in that it will combine a case study which is of a qualitative nature, as well as a quantitative type survey. The case study will follow an interpretive approach, assuming an understanding derived from intrusive methods on how text is interpreted. Ryan, Scapens and Theobald

(2002: 147) understand the purpose of an interpretive research to be the development of a theoretical framework that explains the holistic quality of observations and practices, socially. The authors are of the view that the model is appropriate for dynamic processes in which relations between variables are constantly changing. Structured interviews, comprising of short questions

directed to managers (mainly chief financial officers) regarding the theory and practice of capital structure, will be conducted.

Both the case study and the survey will attempt to explain reasons for observed accounting practices as highlighted by the financial statements.

1.3.2 Sample and data collection The sample to be used in this study will be collected from the population of listed companies in South Africa for the years 2003 to 2008. Manufacturing firms and the data used are randomly selected from the Financial and Business Information Service company data which is a database including annual reports for all South African manufacturing companies and where the companies (fiscal) financial 8

information has been tracked for the recent five years. From the manufacturing companies listed on the Johannesburg Securities Exchange between 2003 and 2008 several are excluded. Reasons for exclusion include: unavailability of the necessary data in the consecutive periods due to nonreporting for one or several of the years studied; firms without complete record of all accounting items, such as long-term debt, gross and net fixed assets, sales and operating profits are also omitted from the dataset. These items are required for the construction of variables; financial sector firms because they have a different structure (in terms of liabilities and capital structure) and might be missing a characteristic essential in observing some of the variables; firms with negative capital ratios. The final sample size is the manufacturing listed companies within the Gauteng province, the industrial hub of South Africa.

1.3.3 Methodology

The sampled companies will be stratified according to size. The size according to which a firm is defined, either as an SMME or an LSE, can be determined using a variety of variables for example employment, sales volume, assets or qualitative factors such as independent ownership or management (Voulgaris et al., 2004: 251). Employment numbers will be used as an indicator of size.

The survey will focus primarily on the determinants of the capital structure policy of firms but will also include some questions on topics that are closely related to the capital structure. The questions will be relevant in the South African context regarding the financial policy. Respondents to the telephonic interviews and e9

mailed surveys will be the managers (chief financial officers) of the sampled companies. The same questions will be asked by the same interviewer during the interviews. The e-mailed survey questionnaires will also comprise the

questions as in the interviews (see Appendix A). Because the questions are standardized, every respondent responds to the same questions in the same order (Ndlangamandla, 2005: 41). limited to 2 pages. The length of the survey questionnaire is

1.3.4 Data

The dataset is based on financial data which is collected from the statements of financial position (balance sheets) and statements of comprehensive income (income statements) of the manufacturing listed LSEs and SMMEs in Gauteng. Descriptive statistics of the data will be extracted from the tables of means and medians of both dependent and explanatory variables, separately for SMMEs and LSEs.

The financial data are extended to a period of 5 years so as to take into account growth variables (for instance percentage change in sales, total assets and profit) also including accounts such as capital stock, net worth, short- and long-term debt, total assets, fixed and current assets, inventories, sales turnover, depreciation, gross and net profit (Voulgaris et al. 2004: 251).

Twenty five financial ratios will be calculated based on the South African financial framework: Generally Accepted Accounting Principles (GAAP), as proposed in the 1978 Courtis equivalent. The selected set of ratios includes:

X1 X2 X3 X4

Current assets to current debt Quick assets to current debt Net working capital to total assets Net fixed assets to total sales 10

X5 X6 X7 X8 X9 X10 X11 X12 X13 X14 X15 X16 X17 X18 X19 X20 X21 X22 X23 X24 X25

Long-term debt + net worth to net fixed assets Long-term debt to total debt Total debt to total assets Net worth to long-term capital Short-term debt to total assets Inventory x 360 (days) to sales Creditors x 360 (days) to sales Accounts payable x 360 (days) to sales Sales to net fixed assets Sales to net working capital Sales to total sales Sales to net worth Net profit to gross profit Sales to number of employees Net profit to sales Gross profit to sales Net profit to net worth Net profit to total assets Percentage change in sales Percentage change in total assets Percentage change in net profits

The ratios are divided into classes which address solvency, managerial performance, profitability and growth, assuring relative independence of each other. The ratios completely cover a firms profile. Book value will be used for calculating variable where applicable.

Responses to questions will be used as the basis of comparison between the different institutions capital structure choice. Comparative tables according to size, will be drawn.

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1.3.5 Measurement

The variables used in this study are adopted from the research conducted by Voulgaris et al. (2004: 250-256), carried out on manufacturing firms.

The dependent variables, short- and long-term debt ratio are measured as the ratio of short- and long-term debt to total assets (leverage).

Explanatory or independent variables are profitability, asset structure, size and growth. Profitability is measured as a ratio of pre-tax income to sales turnover. Asset structure is measured as a ratio of fixed assets to total assets. Size is measured as the total assets in thousand rands. Growth is measured as the percentage increase of sales turnover last four years in established firms.

Descriptive data on key variables for the five years, also taking into consideration the different corporate factors, should indicate the financial performance of the size groups SMMEs and LSEs. A comparison is made between SMMEs and LSEs, in terms of liquidity, capital intensiveness, and use of short-term debt or long-term debt for capital.

1.3.6 Analysis

According to De Vos et al. (2002: 340) the qualitative data analysis process is a search for general statements about relationships among categories of data, building grounded theory. The process involves an inseparable relationship

between data collection and data analysis. The data will be analysed on the basis of financial performance of the two size groups and in terms of: solvency/liquidity is looked at on short- and long- term basis, with ratios X1 to X3 covering the short-term and X5 being a long-term ratio

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managerial performance is assessed in terms of: o asset structure (ratios X4, X6, X7; X8 and X9); o inventory (ratio X10) o credit policy (ratios X11 and X12) o administration (ratio X18) profitability is classified into: o capital turnover (ratios X13, X14, X15 and X16) o profit margin (ratios X17, X19 and X20) o return on investment (ratios X21 and X22) growth (in established firms) is denoted by ratios X23, X24 and X25 (Source: Voulgaris et al. 2004: 252)

The importance of each factor (in the questions), will be ranked according to importance on a scale of 0 to 4 and a mean rank will be determined. The highest mean rank will represent the most important factor.

1.4

RESEARCH STRUCTURE

1.4.1 Chapter 1:

Introduction and Research design

Chapter 1 introduces the topic, encompassing the purpose, the objectives and motivation of the study. The aspects of research design are provided, entailing the methodology, sampling and data collection and analysing procedures. Definitions of key concepts are also expanded on.

The research design includes the research methodology followed in obtaining, processing and analysing data. A sample of the structured questions applicable is included. The design also outlines and discusses practical applications,

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challenges encountered and delimitations of the study. Ethical considerations are also advanced.

1.4.2 Chapter 2:

Literature review

The theoretical background provides information and models which have been the basis of previous research. To contextualize the theory and models, more literature has to be reviewed, especially the most recent views.

1.4.3 Chapter 3:

Findings

This chapter includes an outline of detailed discussions on the research findings. An analysis and interpretation of data from the ratio calculations is presented. The researcher will also try to collate the responses from the questionnaire with the financial data. Comparisons between the literature review and the findings from the study will be conducted, without bias.

1.4.4 Chapter 4:

Recommendations and Conclusions

Closing comments which entail a report and discussion on the summary of findings are made. Recommendations and conclusions are put forward. This is then followed by the list of sources used in informing the study and the subsequent appendices if any.

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CHAPTER 2

2.1

INTRODUCTION

There are three main theoretical areas that inform the present study, namely capital structure as against the firm value, capital structure theories and firm characteristics. Firstly, the study attempts to establish whether a link exists

between capital structure and firm value. Contention and analysis by various researchers is referred to in this regard. Secondly, the study refers to the

theoretical models proposed in a number of studies, making them the basis of this paper. To understand the different interpretations of capital structure choice, it is important to reflect on the theories. This chapter also discusses firm

characteristics previously identified as being influential in determining an optimal capital structure. The significance of the influence is measured against the

results which are supported by evidence. Several key theoretical concepts used throughout the paper have been explained.

2.2 CAPITAL STRUCTURE VS FIRM VALUE

While carrying out capital structure research, corporate finance researchers have suggested that a link exists between a firms value and capital structure, such that one cannot isolate the terms from each other. Voulgaris, Asteriou and

Agiomirgianakis (2004: 249) believe capital structure to be a crucial aspect in a firms performance, a statement that has occupied financial researchers. De Wet (2006: 1) views this statement as a focal point that financial managers (and researchers alike) still grapple with in their endeavour to maximize shareholders wealth. Hatfield, Cheng and Davidson (1994: 1) entered the fray, referring to the considerable debate on whether there is an optimal capital structure for an individual firm. Whilst articulating on optimal capital structure, the authors

brought up another dynamic, questioning whether debt usage is irrelevant to the 15

individual firms value.

In linking optimal capital structure, debt usage and firm

value Eriotis, Vasiliou and Ventoura-Neokosmidi (2007: 322) start by justifying that employment of debt is crucial in achieving the optimal capital structure. The authors explain this by showing how tax benefits (tax shields contributing to firm value) should be balanced with the costs of debt financing (as part of a capital structure). De Wet (2006: 2) strongly believes that the impact of the capital structure on the value of the business is of paramount importance.

However, other researchers have a different view point on the impact of capital structure on the value of the firm. Frielinghaus, Moster and Firer (2005: 9) argue that the research on why capital structure matters and how it contributes to the overall value of the firm, has proven inconclusive, hence the vigorous, ongoing debate. In Kyereboah-Coleman (2007: 271) the Modigliani and Miller (1958)

study is analysed based on the contention that capital structure is irrelevant to firm value as capital structure does not affect a firms cash flow. Cheng and Shiu (2007: 30) also interpret this contention as suggesting that firm value is independent of firm capital structure. Both studies term the Modigliani and Millers basis as restrictive and unrealistic. Kyereboah-Coleman then proposes that the assumptions be adapted to more realistic expectations which will prove that capital structure decisions do, in fact, affect a firms value.

According to De Wet (2006: 1-2), what baffles financial managers in determining an optimal capital structure, is the question whether it is the sources of capital used that affect the value of a company and to what extent . The author lists some of the factors that influence the way in which a company raises finance, including the: existing level of operating leverage (fixed costs relative to variable costs); cost of the particular source of capital used; impact of this form of financing on the control of the company; risk attached to the source of finance and various tax implications and financial distress costs. 16

De Wet concedes that the factors do play some role but the emphasis should be on the target capital structure which impacts on the value of a business. Defining the target (optimal) capital structure, he refers to the combination of equity and debt that will maximize the value of the firm, with all things being equal.

Researchers have also tried to extend the influence of capital structure beyond the firm value. In addressing concerns of an optimal capital structure existence for an individual firm as well as irrelevance of the proportion of debt usage to individual firm value, Hatfield et al. (1994: 2) scrutinize the relationship between the industry and capital structure. The authors conclude that the industry to which a firm belongs, may be influential to that firms capital structure. Delcoure (2006:400) examines capital structure choices in different foreign markets, finding some similarities and differences suggesting further interrogation in this regard. Chui, Lloyd and Kwok (2002: 100-101) complement previous studies by Grinblatt and Keloharju (2000), Stonehill and Stitzel (1969) and Sekely and Collins (1988) which examine specific cultural dimensions on capital structure.

2.3

KEY THEORETICAL CONCEPTS

The following are the concepts used in this study.

2.3.1 CAPITAL STRUCTURE

In Kyereboah-Coleman (2007: 271) capital structure is defined as the relative amount of debt and equity used in financing the operations of a firm.

Boateng (2004: 57) provides a definition of the capital structure as a ratio of total debt to total assets at book value. In dispelling the Modigliani and Miller theory, Boateng (2004: 58) concludes by pointing how much the capital structure matters in reality, especially in cases where banks have to finance projects with debt capital. 17

Correia, Flynn, Uliana and Wormald (2006: 535) refer to optimal capital structure as, debt-equity ratio that is applied by a company to have the lowest Weighted Average Cost of Capital (WACC).

Lambrechts (1990: 510) simplifies capital structure by referring to as the liability side of the balance sheet, made up of the shareholders interest and the borrowed capital of a firm. Interestingly the same authors use the term Financing Structure interchangeably to capital structure, suggesting the composition of forms of financing in terms of the required ratio between debt and shareholders interest. The author advances aspects to be considered when financing policy guidelines are formulated, including: differentiation between shareholder capital and debt as financing forms; differentiation between fixed and current assets as well as permanent and variable capital requirements; limitations of the discussion on the management of manufacturing industry as public companies; profitability, liquidity, solvency and control.

2.3.2 WEIGHTED AVERAGE COST OF CAPITAL (WACC) The Weighted Average Cost of Capital is the common way in which the cost of capital is expressed and has two main components: debt and equity and their relative weightings. affected. Where tax calculations are applicable, they should be

WACC assumes that when an entity raises finance, the cash raised is added into the pool of funds. When a potential investment project is identified, the project is assumed to be financed from the pool (a mix of equity, debt and preference shares). Should this mix remain constant over time, the discount rate applicable would be the cost of the pool funds, that is, the WACC. The WACC can be 18

derived by calculating the cost of each long-term source of finance weighted by the proportions of finance used (CIMA: Financial Strategy: 2006: 157-159).

In Vigario (2006: 68-70) as well as in www.costofcapital.net, there are other factors that are suggested regarding WACC: Use of market values of the various components when weights are determined and in the absence of market values (or where specifically requested), book values should be used. Vigario (2006) notes that that WACC calculated at book value has little value. There are instances where a target structure (that is, the sequence and the proportion in which the structure is proposed by each company) is suggested, it is recommended that such target structure be fulfilled. When the WACC is used as a discount rate in incremental projects, the assumption is that the new project has the same risk profile than existing projects. WACC can be used as a cut-off or discount rate for calculating the net present values (NPVs) of projected cash flows for new investments provided: the capital structure is reasonably constant. if the capital structure changes, the WACC calculation will change as this will alter the required return characteristics due to the change in risk. the new investment is marginal (relatively small in relation to the total capital structure) to the entity. Lower WACC means higher value whereas a higher WACC is equal to lower value. WACC is expressed as a percentage. WACC technique may be the most relevant approach for gearing purposes.

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Correia and Cramer (2008: 46) concluded that the determination of a companys weighted average cost of capital requires a firm to determine a relevant capital structure. The weighted average cost of capital represents a composite rate of return that can be used to undertake firm valuations (Correia and Cramer, 2008: 34).

2.3.3 LEVERAGE (DEBT) RATIO

Voulgaris et al. (2004: 249) define leverage as the amount of foreign capital (liabilities) reflected on a companys balance sheet, which is expected to grow as the company size grows, particularly if the lender is no security risk (that is it can be able to pay the debt).

Correia et al. (2006:534) maintain that leverage/gearing is the relative use of debt in the capital structure, intended to increase the return on shareholders funds in exchange of greater financial risk.

2.4

LITERATURE ON CAPITAL STRUCTURE (THEORIES)

Reference has repeatedly been made to prior theories, with the 1958 Modigliani and Miller model being the pioneer. Pagano (2005: 237-246) reviewed most theorems on the basis of the Modigliani and Miller model and their relevance todate. Of interest from the reviews is what informs the arguments of this research.

2.4.1 Static Trade-off Theory

The Modigliani and Miller model started by debating that the market value of any firm is independent of its capital structure, based on the premise that capital structure does not affect a firms cash flow (Kyereboah-Coleman, 2007:271). 20

When interpreted, the argument shows that the capital structure is not expected to vary from company to company. Barclay & Smith (2005: 8-9), following on their preceding 1995 and 1999 papers, justify this invariance argument by trying to understand the conditions under which it was developed. The authors

conclude that the conditions could be deliberately artificial and could be excluding information costs, personal or corporate taxes, contracting or transaction costs, and a fixed investment policy. In 1963 Modigliani and Miller revised their initial stance that the financing decisions of firms do not affect their value, suggesting that firms with higher profits should use more debt, thus substituting debt for equity to take advantage of interest induced tax shields. Kyereboah-Coleman (2007: 271) sources Myers (1984) as advancing the static trade-off theory. The theory explains how a firm decides on the debt-to-equity ratio on the assumption that some optimal capital structure exists, enabling the firm to operate efficiently and ensuring external claims on cash flow are reduced. Miller (1988: 100) contends this to imply that

firms are encouraged to increase their debt levels. For this reason, Voulgaris et al. (2004: 249) argue that a trade-off between tax gains and increased bankruptcy costs increases a firms cost of capital. In highlighting limitations to optimal level of firm debt, Voulgaris et al. consider the arguments of the Stiglitz 1974 and 1988 papers; that bankruptcy costs increase as the firms level of debt increases. Myers & Majluf (1984: 219-220) proposed that firms should attempt to achieve an optimal capital structure that maximizes the value of the firm by balancing the tax benefits with bankruptcy costs which are associated with increasing levels of debt.

Since the evolution of the trade-off theory, debate has raged with researchers adapting the assumptions to more realistic expectations and analysis (Kyereboah-Coleman, 2007: 271). One amongst some identified shortcomings, is that in reality high profitable companies tend to have less debt than less profitable companies as the former utilize the profits for financing.

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Warner (1977: 345) pointed that bankruptcy costs are much lower than the tax advantages of debt, implying much higher debt than predicted. The Pinegar & Wilbritch (1989) study is quoted in Ortqvist et al., (2006: 279), as encouraging the use of debt with minimum costs increases the amount of resources available for growth and expansion.

2.4.2 Information Asymmetry

In 1977 Ross developed the Information Asymmetry theory which sought to remove another underlying assumption from the Modigliani and Millers 1958 model value invariance theory. The theory suggests that full information about activities of firms can be known to external stakeholders. Information in managers possession regarding firms future prospects (which the market does not have) might be exposed by the capital structure choice of these managers. The market is given an indication by some pointers within the financing structure. The reasoning behind that would be that when leverage is increased, the value of the firm would subsequently be increased, thus signalling the size and stability of future investments. However, Fama and French (2002: 7), with reference to the Myers (1984) study, contradict the Ross argument. The authors believe that increasing debt actually signals poor prospects for future earnings and cash flow, as there will be less internal financing available to fund development. Voulgaris et al. (2004: 249) noted the view from a Binks and Ennew 1996 study, that information asymmetry implies there is a positive relationship between debt and asset structure in terms of high fixed asset ratio. In simple terms, the higher the value of assets, the higher the loan amount extended. Voulgaris et al. (2004:

249) in defining leverage, further affirms the prospects of the liability growing with size. Ross points out that firms use more debt to overcome information

asymmetry.

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Myers & Majluf (1984: 209) observed the sequence in which firms finance tangible assets growth - relying on internally generated funds first, followed by debt and external equity issue, respectively. Reasons advanced by Voulgaris et al. (2004: 249) are that internal funds are considered to be cheap and there is no outside interference from the funder. Chen (2004: 1342) points out that in such a case there is no need to issue security in terms of fixed assets.

2.4.3 The Pecking Order model

Contrasting the static trade-off theory, Myers & Majluf (1984: 194-195) discuss the rational of the Pecking Order model (POT) of corporate leverage, which was later supported by amongst others Chen (2004: 1342). The model is explained by what has been observed in companies, which is the tendency of not issuing stock (shares) and instead, holding large cash reserves. Myers & Majluf

conclude that this is unnecessarily holding financial slack as a consequence of possible conflict of interest by managers as well as between old and new shareholders. Chens (2004: 1342) view is that only when forced by

circumstances do companies resort to external financing, using debt before equity. To highlight the contrast Kyereboah-Coleman (2007: 271) explains the pecking order theory to be suggesting that the profitability of a firm does influence its financing decisions. The study elaborates the contention that firms which have not predetermined their debt and equity mix, prefer internal to external financing. An observation is that the pecking order framework tends to overlap the asymmetric information and the agency cost theories.

2.4.4 Agency cost theory Kyereboah-Coleman (2007: 271) interrogates the identification of an optimal capital structure and its explanatory variables. The author starts by asking what motivates the selection of a debt and equity mix. As a result, the agency cost theory is proposed and explained as when managers have the information

23

regarding the prospects of the company, use that information for their own interests which are different from those of shareholders. Subsequently, firms use more debt in their capital structure especially when management is pressurized by the shareholders to use funds efficiently so as to be able to pay out future cash flows (for example dividends) (Kyereboah-Coleman, 2007:271). Barclay and Smith (2005: 11) refer to this theory as signalling signalling a firms (in)ability to meet its obligations. Barclay and Smith (2005: 11) confirm the notion by Jensen (1986) that agency costs give enough reason for firms to increase the amount of debt in their capital structure. The authors suggest increasing debt as a credible signalling mechanism. Other than that, agency costs become higher

when the organization generates substantial free cash flow (surplus cash after expenses including investments have been paid). There is a further assumption that debt is less effective in rapidly growing organizations.

2.4.5 Other theories In addition to the previously cited theories/models, Voulgaris et al. (2004: 249) also refer to the theory of finance on capital structure and the debt structure. The paper outlines the process of testing of the theory of finance on capital structure, empirically and separately on the different types of firms (which are manufacturing and non-manufacturing firms in this instance). The process entails the development of models containing factors that are expected to influence the debt ratio of the different firms. After comparing the results, policy measures are accordingly formulated. A firm debt structure is characterized by size,

profitability, asset structure, collateral, liquidity, age, access to capital markets, risk and growth.

Chen (2004: 1342) summarized the effect of capital structure theories with the empirical evidences on the relationship of capital structure determinants with leverage has also been confirmed by the results of this study.

24

2.5

THEORETICAL DETERMINANTS OF CAPITAL STRUCTURE CHOICE (FIRM CHARACTERISTICS)

Based on theories of capital structure and previous empirical literature, a variety of variables have been identified as potentially responsible for determining capital structure decisions in companies.

Cheng and Shiu (2007: 34) chose five characteristics that might be correlated with leverage which included growth opportunities, firm size, profitability, asset structure and business risks. Mazur (2007: 499) listed ten factors, adding

liquidity, product uniqueness, non-debt tax shields, dividend policy and effective tax rate to Cheng and Shius factors.

This study is hypothesized around the following four variables:

2.5.1 Size of the firm

Size is considered a variable that determines the differences in leverage among firms (Eriotis, Vasiliou and Ventoura-Neokosmidi, 2007: 325). A number of

researchers agree that larger firms tend to be more diversified and as a result they are less likely to become bankrupt. Kyereboah-Colemans (2007: 274) input is that these firms are able to absorb risk, have lower probability of default, tend to have easy access to credit and have more diluted ownership. The more

diversified, the lower the variance of earnings, enabling the firms to use more debt, tolerating high debt ratios as Abor and Biekpe (2005: 39) put it. Mazur (2007: 501) supports the notion of easier access to the market adding that the firms can also borrow at better conditions, thus reducing transaction costs and tax rates. According to Eriotis et al. (2007: 325) large firms will more easily attract a debt analyst to provide information to the public about debt issue.

Cheng and Shiu (2007: 35) link the size characteristic to some of the theoretical models. The authors point out that the diversification of large firms and the 25

subsequent lower financial distress costs are resultant of the static trade-off model. This model predicts a positive relation between firm size and leverage.

The size of the firm is also used mainly in finance literature, representing valuable information to potential investors, creditors and credit markets (Cheng and Shiu, 2007: 35). The extent of the asymmetric information can have an impact on the association between size and leverage, as previous research suggests.

2.5.2 Asset structure

An asset structure is often suggested as an explanatory determinant as it includes fixed assets which can serve as collateral (Mazur: 2007: 499). Kyereboah-Coleman (2007: 274) concurs with Mazur in that the security feature (in terms of debt) is consistent with the trade-off theory. A suggestion is that more of the assets should be tangible so as to derive greater liquidation value when accessing finance (Abor and Biekpe, 2005: 40). The authors warn though that this could lead to higher debt or outside financing in the capital structure. Tangibility is measured as a ratio of fixed assets to total assets (Cheng and Shiu, 2007: 35). The Abor and Biekpe study confirms other papers conclusion that a significant positive relationship exists between asset tangibility and firm debt specifically in large firms.

However, a negative relationship is identified as coming through the pecking order theory, also a prediction that firms holding more tangible assets will be less prone to asymmetric information problems. This means such firms are less likely to issue debt (Mazur, 2007: 499).

26

2.5.3 Profitability

The existence of a relationship between firm profitability and capital structure can be explained in terms of the pecking order theory (Abor and Biekpe, 2005: 40). The theory assumes that because of information asymmetry between insiders and outsiders firms prefer to finance using internal funds rather than external finance (Cheng and Shiu, 2007: 35). Availability of internal funds depends on profitability as well as liquidity (Mazur, 2007: 500). According to Mazur profitable firms are more likely to generate internal funds and it is expected that firm leverage would decrease due to profitability affirming the pecking order hypothesis of a negative correlation between profitability and capital structure.

Linking profitability to the static trade-off theory, Cheng and Shui (2007: 35) advance the theory contention that more profitable firms will use more debt as these firms have better ability to take on debt. High debt levels attract tax

shields, implying a positive relationship between profitability and debt (Mazur, 2007: 500).

Kyereboah-Coleman (2007: 274) bases the inverse relationship between capital structure and profitability on the theory of agency cost which compels managers to be disciplined when considering debt. The importance of shareholders wealth is emphasized.

2.5.4 Growth opportunities

In Ortqvist, Masli, Rahman and Selvarajah (2006: 282) growth is expressed as a proxy of risk, implying that the higher the growth, the higher the risk. The paper also points to other arguments that growth does not necessarily generate income that needs to be covered by debt - meaning that growing ventures have lower debt ratios. Accordingly, research findings expose a negative relation between growth and capital structure. However, other authors have proposed a different 27

view, prompting another group to suggest that the relation will differ depending on whether the focus is on short-term or long-term debt ratio. Hall, Hutchinson and Michaelas (2000) (quoted in the Ortgvist et al. paper) hypothesise that longterm debt ratio would be negatively related to growth regards to SMMEs, while short-term debt ratio would be positively related to growth within the same context.

Mazur (2007: 501) refers to a common argument that growing firms have more opportunities to invest in risky projects at the expense of creditors, resulting in an inverse association between leverage and growth opportunities.

Due to inconclusive findings, Abor and Biekpe (2005: 41) base their input on the pecking order hypothesis, suggesting that growing firms place a greater demand on the internally generated funds of the firm thus capturing higher debt ratios. The authors also highlight the existence of a relation between the degree of previous growth and future growth. Future opportunities are predicted to

positively relate to leverage. Cheng and Shiu (2007: 34) caution highly levered firms as they are more likely to pass up good investment opportunities compared to their counterparts with less debt.

According to Eriotis et al. (2007: 325) growth is measured in terms of the change in annual earnings whilst Mazur (2007: 501) advance average growth rate of total assets, average growth rate of revenues from sales and long-term investment to total assets as proxies of growth opportunities.

2.6

CONCLUSION

This chapter has introduced the linkage of capital structure to shareholders value which is on its own vital. Capital Structure models have also been engaged as

the basis of analysing the four envisaged determinants of the capital structure. 28

This study predominantly draws on the latter approach. The study also shows the importance of leverage (debt) or the debt/equity ratio as a concept that is synonymous to element(s) of capital structure and its role within the analysis of the structure.

The next chapter entails the computation and interpretation of the ratios, the analysis of the responses to the questions on the survey questionnaire, their linkage to the determinants as well as the findings in relation to the existence of relationship(s) between determinants and the theories.

29

CHAPTER 3

3.1

INTRODUCTION Whether and how closely do The chapter also attempts to

This chapter aims to answer the question: capital structure and/or ratios have evolved?

determinants of capital structure support the theory that the determinants of

explain reasons for the observed accounting practices, specifically in terms of the Generally Accepted Accounting Practices (GAAP) and the International Accounting Standards, which are highlighted in financial statements (Ryan et al., 2002: 144).

The chapter presents an analysis of the determined twenty five (25) ratios in relation to the dependent variables (short- and long-term debt ratio), addressing solvency or liquidity of the different size enterprises (SMMEs and LSEs) and explanatory or independent variables (profitability, asset structure, size and growth). The latter variables seek to address managerial performance,

profitability and growth within the groupings. Published financial statements of five SMME and five LSE firms were obtained electronically. The sampled ten companies (confirming the same characteristics), five SMMEs and five LSEs, were provided the survey questionnaire.

The structured questionnaire was e-mailed to the ten enterprises and an additional one to a subsidiary of one of the LSEs. Telephonic interviews were also conducted as means of following up and soliciting responses on the questions (from those companies who had not replied to the e-mail) based on debt policy applied by the different enterprises. A comparative analysis of the responses is presented in Appendix B: Table II: Survey Report. The report includes a percentage of the important response as well as means of responses to the questions, separately for SMMEs and LSEs.

30

3.2

DATA AND METHODOLOGY

Challenges experienced by Bancel and Mittoo (2004:25), in the survey data and methodology include (i) response validity that is, whether the respondents have truthfully answered the questions asked in the survey and (ii) non-response bias that is whether the respondents are representative of the population studied, were also of concern to the researcher. On examining the extent the responses reflect the reality in the field, the author ended up being comfortable with highlighting the importance of financial flexibility and the reasonability of the responses as suggested by Bancel & Mittoo (2004:25). The author also noted the timing of the survey, conducted during

recession, a period of uncertainty and low market liquidity which could influence responses to financial flexibility. The author also expected the data (extracted from the financial statements including responses from the management of these enterprises) would relatively vary as a result of the economic down turn during year 2008. Acknowledgements of the envisaged effects of the recession have

been made in the analysis throughout the study. The proportions of the respondents across manufacturing listed companies within the Gauteng province met the criteria of the initial sample. All the sampled

companies are in the manufacturing industry with a fair spread in diversified operations and mining. By the nature of the sampled firms characteristics, the

author is confident that the firms are representative of the manufacturing enterprises across Gauteng.

From the data in the financial statements, twenty five ratios were computed, enabling the determination of means and medians for both the dependent and explanatory variables for SMMEs and for LSEs. The statistics show the average indicators of variables computed from the financial statements (Abor & Biekpe, 2005: 43). Different classes, including solvency, managerial performance,

profitability and growth, with relative independence of each other assured, are 31

reflected (see Appendix B: Table I: Summary statistics of dependent and independent variables and Tables A1 to A4 for SMMEs and LSEs tables of means and medians) (Voulgaris et al., 2004: 251).

Six out of the eleven company managers (approximately 55%) were able to provide precise responses to all the questions in the questionnaire. The

respondent firms represent 50% (two out of four) of the surveyed SMMEs and 60% (four out of six) of the surveyed LSEs. 80% (four out of five) of the LSEs on which a case study had been conducted, responded.

3.3

EMPIRICAL RESULTS

3.3.1 FINANCIAL PERFOMANCE FINDINGS

An analysis of the financial performance of the two size groupings shows how South African SMMEs fare compared to LSEs in terms of liquidity, capital intensiveness, use of short- or long-term debt, reliance on inventory and suppliers credit as well as profitability. The analysis asserts the fact that SMMEs are characterized by lower and more variable profitability (lower liquidity), lower use of long-term debt, lower leverage and higher short-term debt (Voulgaris 2004: 248). The observation is made on the basis of Tables I and II. Growth and size of the enterprises also feature in the analysis.

Short-term solvency and liquidity

Solvency/liquidity ratios represent the extent to which an entity can pay its shortand long-term (by way of interest payments) financial obligations which is measured by the liquidity ratios (Berry, De Klerk, Doussy, Du Plooy, Jansen van Rensburg, Ngcobo, Rehwinkel, Sceepers, Swanevelder & Viljoen: 2007: 345).

32

In addressing the dependent variables: short-term, long-term debt and total debt, the liquidity ratios below were computed. Current assets to current liabilities, denoting the current ratio, resulted in the mean of SMMEs at 1:1, concluding that, in the short-term, SMMEs are in a position to settle their debts within the limits of a cash cycle (flow of cash in and out of the business as a result of normal trading operations) (CIMA 2008:360). The inventory holding period (inventory/cost of sales x 360 days), another element of the cash cycle, averages 77 days for SMMEs which could if regarded as excessive, is a negative attribute. In compensating for the length of holding inventory, accounts payable/creditors are delayed by a shorter 54-day period. In comparison LSEs current ratio mean of 2:1 indicates more than adequate liquid assets to cover short-term debt and in turn compensates the longer inventory turnover period of 83 days. LSEs. Accounts payable are delayed by 84 days by the

Investing in working capital is another element considered in the cash The higher average

cycle and SMMEs had invested 21.7% LSEs 15.7%.

investment in capital for SMMEs concurs with the argument that SMMEs tend to rely on more capital than debt due to the lack of collateral and subsequently restrained to access credit (Voulgaris et al. 2004: 250). At the same time LSEs payment period (credit policy) is extended due to their ability in securing debt based on their liquidity and extended asset structure.

Quick assets to current debt: CIMA (2008: 361) recommends a quick/acid test ratio of 0,8 which has not been matched by either entity, with means of 1:2 for SMMEs and 1:1 for LSEs respectively. The SMMEs situation is not comfortable as, with the exclusion of

inventory, current assets are less than the current liabilities, an indication of not being able to cover short-term debt. The SMMEs longer period of inventory turnover could also be a negative factor. The mean of the LSEs also indicates an impact of the high built-up inventory levels. Without a receivables collection period, no definite deduction can be made on the liquidity of the firms.

33

Net working capital (current assets less current liabilities) to total assets: The means of 1:5 and 1:45 for SMMEs and LSEs respectively indicates that the remainder of working capital is approximately 20% of total assets for both smaller and larger entities. For SMMEs the working capital means long-term funds which consist mainly of a firms own funds (profit and capital) (Voulgaris et al. (2004: 256). In both size firms, the deduction is that the organizations are

revolving the same debt. The large total asset portion of the LSEs can also be attributed to extensive use long-term debt in acquiring the assets. Long-term debt plus net worth to net fixed asset is concerned with how much the company owes in relation to its size (CIMA, 2008: 356.) The ratio is a measure of long-term debt (payable) from non-current assets. The exclusion of current liabilities from equity highlights indebtedness which, when out of control results in liquidation (CIMA 2008: 357) or non-qualification in accordance with the National Credit Act in the South African context. The mean of SMMEs is 2:1 and for LSEs is 1:1. The LSEs ratio falls within the acceptable limit according to CIMA

(2008:357).

Independent/explanatory variables are addressed by looking into the classes of profitability, managerial performance and growth. According to Berry et al. (2007: 342), profitability ratios measure a firms profit for a specific period relative to sales, assets or equity for that period. The ratios include: Capital turnover is measured in terms of sales as a percentage of either net fixed assets or net working capital or total assets or net worth (equity), to assess whether capital has been invested appropriately in terms of generating enough sales. The averages for SMMEs are (in the respective sequence) 271%, 417%, 117% and 191% and for LSEs 202%, 288%, 107% and 255%, respectively. For both groups there is an actual increase or constant investment in assets between 2004 and 2006 declining in 2007. The scenario changes from 2008, highlighting 34

possible revenue change. The fluctuation can be attributed to the global downturn. The mean percentages for SMMEs are significantly higher than those of the LSEs in all but one aspect which is net worth. The same deduction of more use of long-term debt (which inflate total assets) by LSEs compared to SMMEs and concentration in investing in capital by SMMEs, can be made. Return on investment (ROI) indicates the rate of return earned on funds invested in an entity by the owners (Berry et al., 2007: 343). The ratio calculates net profit as percentage of the net worth (which is equity excluding borrowings). SMMEs, the exclusion of borrowings bears a higher mean of 22%. For In

comparison, the average return on total assets ratio (ROA) is 10% for SMMEs. The inclusion of borrowings prompts the suggestion that SMMEs rely mainly on capital employed rather than debt, with a possible consequence of limited access to borrowed funds. For LSEs the mean for ROI is 16% whereas for ROA is 8%. Under-valuation of non-current assets resulting in unrealistically low capital employed can be attributed to a low ROA (CIMA 2008: 353). Profit margin ratios express net profit (for the period) as a R1 of sales (Berry et al. 2007: 344). The authors contend that these ratios indicate managements ability to operate an entity with sufficient success in recovering the cost of inventories, operating expenses, interest obligations as well as owners interests. For both groupings the ratios show more or constant expenditure patterns until 2007, with a significant turn-around for LSEs in 2008. The average ratios are 10% for SMMEs and 8% for LSEs. The low ratio implies low sales prices and high expenditure in cost of sales and period costs resulting in depressed sales revenue (CIMA, 2008: 355). The other ratios are gross profit to sales and net

profit to gross profit which yield means of 16% and 39% for SMMEs and 20% and 41% for LSEs. CIMA (2008: 355) highlights a trade-off between profit margin

and asset turnover (a measure of how well the assets are being used to generate sales). The trade-off expresses the notion that profit margins tend to be higher when the asset turnover is lower, whilst a fall in profit margins is compensated by a higher asset turnover. 35

Managerial performance is assessed on the asset structure and the management of inventory, the credit policy and administration. Solvency; shortand long-term is also part of the assessment but has been addressed as a criterion on its own. Inventory turnover and the credit policy have also been referred to under solvency, above.

The asset structure ratios include the ratio: long-term debt to total debt which yields a mean is 1:3 for both SMMEs and LSEs. The ratio indicates that the equity of the entities have generated enough profits to cover interest obligations on the debt (Berry et al. 2008: 349). Capital as a portion of equity is measured

by comparing net worth to long-term capital and is 1097:1 for SMMEs, reflecting capital intensiveness of SMMEs in comparison to LSEs which have a mean of 104:1 (Voulgaris et al. 2004: 250). For each grouping one firm had very high proportions of net worth which could be as a consequence of changes (possible increase) in retained earnings or an increase due to revaluations. Short-term debt to total assets yields respective means of 1:3 and 1:6 each grouping, showing how much the short-term debt is covered by the assets, this in securing collateral. SMMEs have proven to own less assets to secure debt than LSEs, affirming the theories on collateral. Management of administration reflects the contribution of each employee of the entity towards sales revenue. In SMMEs each employee contributed an average of R434 952 whilst an employees contribution in LSEs averages R715. The differences are due to the difference in numbers of employees in the different sized establishments, with more employees in LSEs than in SMMEs.

Growth is measured as the percentage change (increase) in sales, a change which could be as a result of a change in the quantity supply or in the price. The average (mean) change between years 2004 and 2007 is equal to 26% for SMMEs and 20% for LSEs. Generally, an average increase of 20% and more in sales (revenue) equates positive growth. A change in total assets is attributed to either acquisitions of assets or a change in retained earnings. SMMEs have a 36

mean of 35% (with a significant increase of 57% in 2007) whilst LSEs have a mean of 19%. An increase in retained earnings rather than asset acquisition could be attributed to the higher SMME average percentage whereas the inverse could be applicable to LSEs. A change in net profit implies a change in revenue

in relation to assets. The means for SMMEs and LSEs are 43% and 54% respectively. The traded-off theory suggested by CIMA (2008: 355), of a higher profit margin and a lower asset turnover, has an influence in the reasoning for the change.

3.3.2 RELEVANCE OF FINANCIAL POLICY REGARDING DEBT

Responses of chief financial officers and or managers who were asked about their opinion on various factors that are likely to influence capital structure policies, are examined and aligned to factors interrogated in the survey questionnaire (Bancel & Mittoo, 2004: 8). Two sets of factors are selected based on (i) the implications of theory and practice of the capital structure and (ii) debt policy. Both sets relate to financial flexibility in as far as how debt and or equity issues impact on the capital structure changes.

The summary of responses, as tabled in Table II, and subsequent implications thereto are discussed below. On the theory and practice of the capital structure, maintaining a target debt-to equity ratio was regarded as the most important at 100%, a mean of 1 for SMMEs and a mean of 2 for LSEs. Use of long-term debt for LSEs could be

influential on the decision. On fund activities, the respondents concurred that is it is very important to consider whether recent profits are sufficient, at 100% with an SMME mean rank of 1 and 1.67 for LSEs. Fairing close behind is the managers timing of debt or equity issues as a very important factor likely to influence a firms capital structure policies. 67% of the managers regard the factor important with a 1 mean ranking for both small and large organization. The

37

extent to which different stakeholders influence the firms financial decisions and other factors including capital structure theories and capital structure changes on financial statements, is regarded less important, all scoring 33% on importance with mean ranks of 1 for both SMMEs and LSEs. The inability to obtain funds

using other sources is considered least important by 17% of the managers (mean rank 1 for both groups). No manager puts any importance on stock being the least risky source of funds (mean 1 for SMMEs and 1.25 for LSEs).

On the debt policy, the factors that affect how the appropriate amount of debt is chosen and the tax advantage of interest deductibility are the most important at 100% and mean ranks of 2 and 4 for SMMEs and LSEs respectively. Tax

advantage of debt and the timing of debt/equity issue are also of importance to the firms with 100% of the managers confirming this, yielding means of 1 for the different size groupings on both factors. Matching the maturity of debt with the life of assets is 67% important in choosing between short- and long-term debt (mean: SMME = 1 and LSE = 2). The question of issuing short-term while

waiting for long-term market interest rates to decline, was also responded to by 67% of managers (mean: 2 for SMMEs and 4 for LSEs). Ensuring that upper

management works hard and efficiently is considered by another 67% in the choice of appropriate amount of debt (1 and 1.33 mean for small and large firms respectively). Only 50% respondents consider the choice between short- and long-term debt and the potential costs of bankruptcy as important with means of between 1 and 1.33. 33% of managers rate issuing of debt when the firm has accumulated profits as important (1 is the average for both groupings). Borrowing short-term to reduce the chance of taking on risky projects and issuing long-term debt to minimize the risk of financial bad times are both ranked important by 17% mangers (mean: 1 for SMMEs and 1.67 for LSEs). No

respondent considers the issuing of debt when recent profits are not sufficient for funding activities as a factor of debt policy (1 SMME mean and 1.67 LSE mean).

38

3.3.3 THEORY AND PRACTICE OF CAPITAL STRUCTURE

In the literature review, the Voulgaris et al. (2004) and other studies made reference to different capital structure theories such as the static trade-off theory, the information asymmetry theory, the pecking order theory, the agency cost theory, the theory of finance on capital structure and debt structure that have been empirically tested separately on SMMEs and LSEs by developing models containing the factors that are expected to influence debt ratios. Only 33% of the chief financial officers (managers) think capital structure theories are likely to influence a firms capital structure policies. However, the results show significant scale effects from the ratios, specifically the gearing/debt ratios, also indicating positive effects from variables such as size (measured as total assets) and the percentage change in total assets as argued by Voulgaris et al., (2004: 248). These results also prove that the other hypotheses (in this paper) are testable with the asset structure (acting as collateral) being positively related to debt, profitability being negatively related to debt and growth being positively related to debt.

Size (measured as total assets) is positively correlated with total debt.

Net

working capital (current assets less current liabilities) to total assets yielded means of 1:5 for SMMEs and 1:45 for LSEs (20% of total assets); the long-term debt plus net worth to net fixed assets ratio means were 2:1 and 1:1 for the respective size groups and the indication of the asset structure (short-term debt to total assets) means were 1:3 and 1:6 for SMMEs and LSEs respectively). This is in line with the Ross 1977 information asymmetry theory (information about activities of firms and future prospects known to managers is disseminated by these managers to external stakeholders, exposing the managers capital structure choice). The assertion that the larger enterprises have better access to bank financing than their smaller counterparts (as indicated by more fixed assets acquired and generally extended total assets) is confirmed. Banks are able to

access the information divulged by managers on application for debt or when 39

financial statements are published and subsequently assess the enterprises future prospects. When asked about what drives the choice between short- and long-term debt, 67% of the managers responded, rating the matching the maturity of debt with the life of assets (very) important with means of 1 and 2 for SMMEs and LSEs, respectively. This also confirms the importance of the asset structure. However, the 33% importance rating on the extent to which different stakeholders influence the firms financial decisions shows that the managers consider information asymmetry to be of a lesser significance.

The static trade-off theory explains how a firm decides on the debt-to-equity ratio on the assumption that some optimal capital structure exists, which according to Miller (1988: 100), encourages firms to increase their debt levels. On the factors that affect the appropriate amount of debt chosen by the firm, 50% of the respondents to the questionnaire rated the potential costs of bankruptcy as important whilst all the managers thought the tax advantage of interest deductibility is very important. 100% of respondents also confirmed the tax The argument by

advantage of debt as an influencing factor to debt policy.

Voulgaris et al. (2004: 249) that a trade-off between tax gains and increased bankruptcy costs increase a firms cost of capital is, therefore, affirmed by the responses. The increase of debt is one of the factors associated with the growth (measured as a percentage change in total assets) of a firm. The average change for

SMMEs is 35% whilst being 19% for LSEs. The change has been found to significantly affect total debt through higher use of short-term debt than long-term debt, especially by SMMEs (Voulgaris et al., 2004: 255). The authors reasoning is that SMMEs lack sufficient earnings to finance their needs due to difficulties in accessing the capital market, hence the higher use of short-term debt in spite of the maturity matching principle of finance. correlated to gearing. Growth is, therefore, positively

The Pecking Order theory has been aligned with growth

in that companies tend to hold large cash reserves instead of issuing stock (Myers & Majluf, 1984: 194-195). The Kyereboah-Coleman (2007: 271) study 40

explains the theory to mean that firms prefer internal to external funding in terms of the debt-equity mix. The high average 43% and 54% change in net profit for the respective groupings is an indication of firms holding high retained income to issue shares. This notion is supported by the responses when managers are asked what factors affect the firms decision when considering issuing equity. For inability to obtain funds using other sources 17% thought it important whereas no manager views stock the least risky source of funds. At the same time the Myers agency cost theory is also highlighted within the aspect of selecting debt to equity. Because the managers are in possession of information on the firms future prospect, they tend to use the information for their personal interests. When under pressure from shareholders and creditors, the managers submit into using more debt. future cash obligations. This signals the inability of the entities to meet

Profitability, measured as net profit to assets (return on assets) is a low 10% for SMMEs and 8% for LSEs, was found to have a significant effect on short-term and total debt (Voulgaris et al., 2004: 255). The effect is highlighted when a comparison is made with the return on investment which is higher than the return on assets due to the inclusion of borrowings in the latter. This negative

correlation to gearing is explained by the pecking order theory, which in the case of SMMEs accessing debt and external equity would be very costly (Voulgaris et al., 2004: 255). In case of LSEs the pecking order theory suggests that the firms use debt only when additional finance is essential, with the trade-off theory not holding (no unnecessary increase of debt). Gross and net profit margins do not seem to affect short-term debt at 16% and 39% for SMMEs and 20% and 41% for LSEs. Voulgaris et al. (2004: 256) point out that they would have significant effect in long-term borrowing as they are determinants of this type of debt. It

should however, be noted that during the period under study, South African interest rates were very high. The National Credit Act was also introduced in June 2007 and as such firms were constrained in terms of accessing credit facilities. 41

In line with the pecking order theory, net working capital to total assets, a proxy for liquidity, was found to have a significant negative effect on total debt leverage ratio (Voulgaris et al., 2004: 256). At 1:5 and 1:45 for SMMEs and LSEs

respectively, the remainder of working capital is too low and would not be sufficient to cover debt.

The high employee contribution to sales production and higher total assets growth is found to affect short-term borrowing. This signals the importance of labour productivity and short-term debt for South African manufacturing SMMEs (Voulgaris et al., 2004: 256). Empirical evidence, indicating the importance of

short-term finance to SMMEs, completes a number of papers with a Sunday Times (2009-09-20: 10) article encouraging SMMEs to make use of appropriate financial instruments to achieve their goals.

The significance of positive effects are also observed on long-term debt in terms of liquidity, asset structure (fixed assets to total assets) and sales growth as expected (Voulgaris et al., 2004: 256).

The Chen (2004: 1342) summarised effect of capital structure theories with the empirical evidences on the relationship of capital structure determinants with leverage has also been confirmed by the findings of this study.

3.4

CONCLUSION

This chapter has tabled the computations of the twenty five ratios which had been determined in highlighting the dependant (short-term and long-term debt) and independent (profitability, growth, assets structure and size) variables. These ratios have been analysed and interpreted in relation to their respective means (averages).

42

Responses from the chief financial officers (managers) of the sampled organizations were also analysed in relation to the variables. The empirical

results were then linked to the theories on capital structure to determine whether there is correlation between the theories and the capital structure determinants also to determine whether the correlation is of a positive or negative nature.

From the findings, the researcher has observed the existence of barriers to longterm financing, especially for SMMEs. However, in the SME Survey 2009,

financial institutions are said to have had a relook into assisting SMMEs in terms of opportunities, funding and advice (for example managing money collection, streamlining stock holdings and negotiating better terms with suppliers (Sunday Times, 2009-09-20: 10). The article further points out to initiatives focusing on

SMMEs in manufacturing and other sectors that are regarded as significant roleplayers in the economy.

The next chapter on recommendations and conclusion will provide closing remarks, commenting on, discussing and reporting the findings.

Recommendations on the way forward and policy proposal will be advanced. This is then followed by the list of sources used in informing the study and the subsequent appendices.

43

CHAPTER 4

4.1

SUMMARY OF FINDINGS

Several important conclusions can be drawn from the findings of this paper in as far as the aspects of an entitys financial performance are concerned. In this study the organizations financial profile has been adequately substantiated, over and above the published financial information. also referred to as the firms value. A companys financial profile provides an indication of the companys viability in the short-term and long-term, In expanding the understanding of the Central to the application of the

financials, ratio analysis has been applied.

analysis are the capital and leverage structures of the entities, hence the focus on both throughout the study. A comparison, in terms of financial performance

between Small, Medium and Micro Enterprises (SMMEs) and large size enterprises (LSEs), features in the analysis. Overall, the analysis confirmed previous researchers observations that size plays a role in liquidity, capital intensiveness as well as indebtedness. SMMEs financial performance analysis revealed low solvency levels and low usage of debt in general and long-term debt in particular. This size group leans on capital availability which limits the group in accessing funds from lending institutions. Effectively, the capital intensiveness of SMMEs results in these firms acquiring less debt in comparison to LSEs which utilise the leverage (long-term debt). The larger entities are able to secure credit as their extended asset structures stand as collateral, widening the scope for more credit facilities. Net working

capital to total assets (a solvency/liquidity ratio) confirmed the points alluded to above, also highlighting common attributes of revolving the same debt and acquisition of assets on credit.

The analysis comprised of twenty-five ratios, grouped into clusters looking into solvency/liquidity; profitability; managerial performance and growth. Of the

44

four computed solvency/liquidity ratios, three (current, quick (acid-test) and longterm indebtedness) addressed the dependent variables: short- and long-term debt as well as total debt. Profitability, managerial performance and growth,

representing explanatory (independent) variables, encompassed the rest of the ratios. Profitability was measured in terms of three ratio categories: capital

turnover, profit margin and return on investment. Managerial performance was assessed in terms of asset structure, inventory (holding periods), credit policy and administration (personnel productivity). changes in sales, total assets and net profits. Growth was denoted by relative

A holistic view of solvency/liquidity was expressed within a cash cycle context, with the flow of cash linked with trading operations. SMMEs current ratio

showed ability of meeting short-term obligations, the inventory holding period averaged higher than expected, accounts payable were delayed in lesser period in comparison to that of the LSEs. LSEs in turn had a current ratio which

indicated that in the short-term current assets could easily cover current debt, compensating for the longer inventory turnover period and accounts payable delay of almost three months. With quick (acid-test) ratios, the analysis could not provide a conclusive indication with the unavailability of accounts receivables collection periods, proving the importance of not isolating any of the elements of the cash cycle. The exclusion of (the high levels of) inventory in currents assets

(in the quick ratio calculation) could be the reason for downward change in meeting the short obligations by both size groups. SMMEs quick ratio indicated total inability to cover short-term debt whilst LSEs situation was better in that they could just pay the short-term debt, though not as comfortably as recommended. Net working capital remains at 20% of total assets for all the enterprises. The remainder explained the retention of capital and profit in the case of SMMEs whilst pointing to the extended use of credit in acquiring assets for LSEs. Else

both size groups are revolving the same debt. Long-term debt plus net worth to net fixed assets proved that SMMEs long-debt would not be payable from non-current assets and are susceptible to liquidation whilst the different sized 45

LSEs would be in control of the situation. The exclusion of current liabilities from equity warns on the extent of indebtedness which could explain the state of SMMEs, The LSEs fixed assets, obtained by means of long-term debt, provides a balance this ratio to acceptable limits, yet SMMEs do not enjoy the luxury of collateral in exchange of extended credit.

Profitability assesses profits in relation to sales generated, assets and equity within the same period. Appropriate capital investment percentage of sales to net fixed assets or working capital or total assets or equity (capital turnover), proved to be higher for SMMEs than for LSEs in 75% of the ratios, an indication of the latters high use of long-term debt in contrast to the formers investment in capital. Whether borrowings are included or not, return on

investment of SMMEs was higher than the LSEs, also confirming the reliance on capital by SMMEs versus reliance on borrowed funds by LSEs. Profit margin

ratios averaged low for both SMMEs and LSEs at 10% and 8%, respectively, an attribute to low sales prices, high cost of sales and period costs as well as the probable effects of the recession in the latter years. The argument is

substantiated by the subsequent gross profit to sales and net profit to gross profit ratios which were higher, more for LSEs. The LSEs low profit margins could be traded off against the higher asset turnover assets acquired by means of long-term debt, yet the SMMEs are limited in accessing debt finance, hence the lower asset turnover.

Managerial performance was guided by a larger number of classes, including solvency/liquidity. These classes covering asset structure, inventory, credit

policy and administration, were measured by means of nine ratios, with the asset structure and administration being the only classes not already discussed in solvency/liquidation above. Long-term debt to total debt, as a measure of

the asset structure was the same for both size groupings, securing interest coverage by the generated profits. Findings of more ratios within this category

reflected the same arguments in terms of capital intensiveness of SMMEs 46

(capital to equity), high at 1097:1 and LSEs collateral theories in terms of the short-term debt to total assets fairing higher than that of SMMEs. Different employment figures impacted on the administration productivity analysis for the different sized organizations, with the expected conclusion that the LSEs ratios would be significantly different to those of the SMMEs.

Growth

The significant increases in sales, total assets and net profits signalled positive growth in both the SMMEs and LSEs. Findings showed an above average

(+20%) upward trend of 26% and 20% sales respective increases in spite of profit margins. The element of change in total assets was as a consequence of asset acquisitions (LSEs), as evidenced in asset structures as well as a change in retained earnings (SMMEs). Net profit change was caused by the revenue changing relative to assets. The trade-off argument, that when profit margins are high asset turnover is lower and vice versa, therefore, fitted in this respect.

Also found to be relative are two main considerations which, according to the facts, have been proven to influence capital structure decisions of the surveyed chief financial officers (managers): the theory and practice of capital Both considerations entail

structure and the impact of the debt policy.

financial flexibility, a key factor for the managers in accessing external financing whatever the economic outlook. The experience of the recession has

strengthened the need to investigate the use of leverage by companies. Empirical evidence on the role of the determinants of capital structure, documented in a number of studies, had to be reviewed within the context of the credit crunch.

47

Relevance of financial policy regarding debt:

Recognising that taking financial decisions are their sole responsibility, chief financial officers or managers strongly supported the aspects of maintaining target debt-to-equity ratios, considering whether recent profits are sufficient and the timing of debt or equity issuing. The three points sought to address the theory and practice of the capital structure, funding activities and factors likely to influence capital structure policies for which these managers have to account. As a result, the managers neither regard stakeholder influence in financial decisions as effective nor do they think the inability in obtaining funds is much of a deterrent. funds. Stock/inventory could not be taken to be the least risky source of

Amongst the criteria of debt policy, regarded as very important, was the

choice of an appropriate amount of debt, taking advantage of interest in terms of tax shields and the timing of the debt/equity issue. Not only does this principle

make good business sense but it also underscores good management practices, one of the variables in the analysis. Regarded as less important was the

matching of debt with asset life span (in the short-term) as well as the issuing of short-term to delay long-term debt obligations. This papers findings reflected not only the impact of the recession but also the transitional nature of the South African corporate environment, exposing the lack of adequate legislation in support of the ultimate growth and sustainability of the companies, especially the SMMEs. Suggesting the re-visitation of legislation To

around the SMMEs, guarding against isolating the LSEs, was necessary.

reserve resources, it has been important to first identify commonalities and differences, if any, between the two size groups.

Panel data of the sampled SMMEs and LSEs from the manufacturing sector of the Gauteng province, South Africa, were used in testing the hypotheses and answering the research question. Empirical evidence from the case study

undertaken suggest that the determinants of capital structure of the two size 48

groups do differ whereas there are also factors that are consistent.

Among the

latter, having been acknowledged by previous works, were the following: debt / leverage (dependant variable) increases with size (the main explanatory variable). The analysis suggests that LSEs employ more long-term debt and debt in general, in comparison with their smaller counterparts. The latter prefer short-term finance hence the lower

amounts of long-term debt. Significant institutional differences such as ownership and financial constraints in the banking sector are factors that influence firms leverage decisions. debt has a negative relationship with profitability as assumed in the pecking order theory framework, implying that high profitable firms generate high internal cash flows to finance their investments. growth (percentage increase in total asset) shows a higher utilisation of total debt, specifically through higher short-term debt. Entities with high growth require more external financing to finance their growth, displaying higher leverage. term debt. As witnessed in the elements listed above, leverage has featured as a key element on which the optimal capital structure is based, which is consistent with the view that without debt financing a firm value is regarded as lower than that of firms with debt financing. The firms use more total liabilities but use less long-

Fundamental differences between small and large firms have also been identified, confirming that size significantly impacts on the capital structure choice specifically the use of debt. Now and then evidence emerged in favour of the existence of leverage constraints for long-term financing, especially for SMMEs.

49

Other differences summarised, include: Liquidity not affecting LSEs debt leverage as opposed to SMMEs. LSEs have assets as collateral to secure debt, compared to their counterparts. Also in relation to debt leverage, the LSEs accumulation of assets does affect the amount of their financial liabilities, which is not the case with SMMEs. The size of fixed assets and employee productivity has not indicated significance as determinants of LSEs capital structure, as in SMMEs. Inventory management, which reflects on management (in)efficiencies are found to be determinants of debt only for SMMEs.

4.2

IMPLICATIONS OF EXISTING THEORY

The literature had shed light in terms of the theoretical framework tabled by previous researchers. The findings of this study concur with the fact that there is a linkage between the variables prescribed in this study (dependant and explanatory variables) and the theorems. The existence of a relationship

between firm size and total leverage, based in the information asymmetry theory, is realised when information privy to managers is utilised by the financing institutions, hence the discrepancies in lending facilities. Exposure of LSES

asset structures gives these enterprises more advantage with regard to funding. In pursuit of growth, firms have been found to be increasing their debt levels (with the subsequent debt-to-equity ratio), as the static trade-off theory predicts. The benefits of debt (in tax deductibility) outweighed the transactional costs (interest payable), as submitted by respondents to the questionnaire, concurring that the factor was influential to the debt policy. Arguments on the pecking order theory,

the agency cost theory, the theory of finance on capital structure and debt structure have also been confirmed in the tests. Also in terms of growth

opportunities, the pecking order model implies the reluctance by organizations 50

in issuing stock preferring to issue debt. An overwhelming percentage of chief financial officers (managers) concurred with the idea.

However, the notion of the pecking order model contradicts the desire for financial flexibility as the interests of the firms owners are not positively served (in terms of dividends). This highlights the theory on agency costs which is

also consistent in that managers are conflicted in choosing debt over equity. The asset structure is also collated positively to debt as it signals the companys ability to meet its credit obligations, allowing the financier to provide more credit. Signalling also affects capital structure choice.

The opposite is evidenced when it comes to profitability, with results showing a negative correlation between this independent variable and aspects of the theory of finance on capital structure and leverage.

4.3

RECOMMENDATIONS

The empirical results presented in this study have some implications for policymakers (within and outside of the entities), as some theoretical underpinnings of the observed correlations remain unresolved. In order to assist South African manufacturing firms obtain optimal capital structure, the following policy measures are suggested: Change the attitude of banks towards small sized firms so that they provide easier access to long-term bank financing. This will encourage growth of the SMMEs and the subsequent expansion of the manufacturing industry as a whole. Support government support as required in terms of financing by reviewing the existing restrictions which are detrimental to SMMEs, providing assistance in raising capital, capital schemes and loan subsidies. Growth and sustainability of these entities is vital for the economy.

51

Support government support as needed in terms of services: information measures in support of co-operation of both size groups, locally, regionally and internationally. Exposure of these firms expands their networks, resulting in global competitiveness. State guarantees for SMME investment in new technology should be provided. This will enhance the competitiveness, facilitating growth and export. SMMEs should be encouraged to use alternative financial instruments to broaden access to finance even beyond the country. Transparent trading operations expand markets. Benchmarking of national policies in support of the Broad Based Black Economic Empowerment strategies which are intended to empower SMMEs. Review of tax laws in terms of tax rates decreases and tax alleviation enabling smaller firms to be self-sufficient and be debt healthy. Promulgation of policies aiming at supporting all firms in research and development, marketing and promotion, nationally and internationally. Policies that will assist South African firms in corporate governance to achieve a stronger capital structure. Inefficient corporate governance

structures exacerbate the prevailing agency problems, with managers taking advantage of the situation. Measures directed towards deregulation of markets and restrictions of the public sector which would result in an increase in economic activity improving efficiency of South African firms. These flexible by-laws should be applicable in instances of disasters where the economy needs to be boosted afterwards. An example of such legislation is government

intervention by means of bail-outs to companies.

52

Ensuring effectiveness and efficient implementation of the policy formulation suggested above in order to improve the financial performance of the manufacturing sector in South Africa.

Internally, companies should use retained income in financing new investments and operational costs. With the current financial crisis in mind, South African firms must increase their cash generating capacity through more efficient asset management; increase competitiveness within the continent and global markets; increase cash generating capacity; establish good and steady bank-firm relations; provide highly trained managerial personnel, trained in technologies in personnel in accordance with the new global trends.

4.4

SCOPE FOR FUTURE RESEARCH

Although this study has not been based on action research, there are important implications regarding academic curricula hence the recommendations below to academia and potential researchers. Restructuring of academic programs in the country is essential. The

programmes should be diverse and focused especially in areas specialising in financial management. Designing a model in which optimal capital structure and debt maturity are jointly determined.

This paper has laid some groundwork to explore size and other determinants of capital structure of South African listed manufacturing companies upon which a 53

more detailed evaluation could be based. Further work can be undertaken in order to develop new hypotheses for the capital choice decisions in (with regards to leverage) these South African firms and to design new variables to reflect the institutional influence(s).

54

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Delcoure, N. 2007. The determinants of capital structure in transitional economies. International Review of Economics and Finance, 2007:16 De Vos, A.S., Strydom, H., Fouche, C.B. & Delport, C.S.L. 2002. Research at grass roots for the social sciences and human service professionals. 2nd edition. Pretoria: Van Schaik. De Wet, JHvH. 2006. Determining the optimal capital structure: a practical contemporary approach. Meditari Accountancy Research, 14 (2). Eriotis, N., Vasiliou, D. & Ventoura-Neokosmidi, Z. 2007. How firm characteristics affect capital structure: an empirical study. Managerial Finance, 33 (5). Fama, E. & French, K. 2002. Testing tradeoff and pecking order predictions about dividends and debt. Review of Financial Studies, 15. Frielinghaus, A., Moster, B. & Firer, C. 2005. Capital Structure and firms life stage. South African Journal of Business Management, 36 (4). Harris, M. & Raviv, A. 1990. Capital Structure and the Informational Role of debt. Journal of Finance, 45 (2). Harris, M. & Raviv, A. 1991. The Theory of Capital Structure. Journal of finance, 46 (1). Hatfield, G.B., Cheng, L.T.W. & Davidson, W.N. 1994. The Determination of Optimal Capital Structure: The Effect of Firm and Industry Debt Ratios on Market Value. Journal of Financial and Strategic Decisions, 7 (3): Fall. Jensen, M.C. 1986. Agency costs of Free Cash Flow, corporate Finance, and Takeovers. American Economic Review, 76. Jerome, A. 2004. Privatisation and Regulation in South Africa. An Evaluation. Available on http://www.competion-regulation.org.uk/conferences/South Africa Kyereboah-Coleman, A. 2007. The determinants of Capital Structure of Microfinance Institutions in Ghana. SAJEMS NS, 10 (2). Lambrechts, I.J. 1990. Financial Management. Pretoria: Van Schaik. Mazur, K. 2007. The determinants of capital structure choice: evidence from Polish companies. Int Adv Econ Res, 13. Miao, J. 2005. Optimal Capital Structure and Industry dynamics. The Journal of finance, LX (6). Miller, M. 1988. The Modigliana-Miller Propositions after Thirty Years, Journal of Economic Perspectives, 2 (4). Modigliani, F. & Miller M.H. 1958. The cost of capital, corporation finance and the theory of investment. American Economic Review, 48 (3).

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Modigliani, F. & Miller, M.H. 1963. Corporate Income taxes and the cost of capital: a correction. American Economic Review, 53, June:433-443. Mouton, J. 1996. Understanding social research. Pretoria; Van Schaik. Myers, S.C. 1984. The capital structure puzzle. Journal of Finance, 34 (3). Myers, S.C. & Majluf, N.S. 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13 (2). Ndlangamandla, C. 2005. Sex sells or does it? Responses to the construction of youth identities in print advertisements. University of the Witwatersrand.

Ortiqvist, D., Masli, E.K., Rahman, S.F. & Selvarajah. 2006. Determinants of Capital Structure in New Ventures: Evidence from Swedish Longitudinal Data. Journal of Developmental Enterpreneurship, 11 (4). Pagano, M. 2005. The Modigliani-Miller theorems: a cornerstone of finance. Banaca Nazionale del Lavoro Quarterly Review, Jun-Sep: 58. Ryan, B., Scapens, R.W. & Theobald, M. 2002. Research Method & Methodology in Finance & Accounting. 2nd edition. London: Thompson. Stiglitz, J.E. 1974; On the irrelevance of corporate financial policy. The American Economic Review, 64 (6). Stiglitz, J.E. 1988. Why financial structure matters. Journal of Economic Perspectives, 2 (4). Vigario, F. 2006. Managerial Finance. 3rd edition. Durban: LexisNexis. Voulgaris, F., Asteriou, D. & Agiomirgianakis, G. 2004. Size and Determinants of Capital Structure in the Greek Manufacturing Sector. International Review of Applied Economics, 8 (2). Warner, J.B. 1977. Bankruptcy costs: some evidence. The Journal of Finance, 32 (2). Welman, J.C. & Kruger, S.J. 2001. Research Methodology for the Business and Administrative Sciences. 2nd edition.

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APPENDIX A (Survey Questionnaire) NAME: COMPANY NAME: DESIGNATION:

A. 1. 2. 2.1 2.2 2.3 3. 3.1 3.2 3.3 3.4 B. 4. 5. 5.1 5.2 6.

THEORY AND PRACTICE OF CAPITAL STRUCTURE: The extent to which different stakeholders influence the firms financial decisions Factors likely to influence firms capital structure policies: Capital structure theories Managers timing of debt or equity issues Capital structure changes on financial statements When your firm considers issuing equity, what factors affect its decisions about equity?: Maintaining a target debt-to equity ratio Whether recent profits are sufficient to fund activities Inability to obtain funds using other sources Stock is the least risky source of funds DEBT POLICY: How the appropriate amount of debt is chosen for the firm Factors that influence debt policy: Tax advantage of debt Timing of debt/equity issue Choice between short-term and long-term debt 0 0 0 1 1 1 2 2 2 3 3 3 4 4 4 0 1 2 3 4 0 0 0 0 1 1 1 1 2 2 2 2 3 3 3 3 4 4 4 4 0 0 0 1 1 1 2 2 2 3 3 3 4 4 4 0 1 2 3 4

58

Very important

Unimportant

Important

Irrelevant

Neutral

Please rate on a scale of 0 (irrelevant) to 4 (very important). Circle the number that best reflects your choice

Unimportant

7. 7.1 7.2 7.3 7.4 8. 8.1 8.2 8.3 8.4 9. 9.1 9.2

What drives the choice between short-term and longterm debt?: Matching the maturity of debt with the life of assets Borrowing short-term to reduce the chance of taking on risky projects Issuing long-term debt to minimize the risk of financial bad times Issue short-term while waiting for long-term market interest rates to decline What factors affect how the appropriate amount of debt is chosen for the firm? Financial flexibility The tax advantage of interest deductibility The potential costs of bankruptcy Ensuring that upper management works hard and efficiently What other factors affect your firm debt policy? Debt is issued when recent profits are not sufficient for funding activities Debt is issued when the firm has accumulated profits 0 0 0 0 1 1 1 1 2 2 2 2 3 3 3 3 4 4 4 4 0 1 1 0 0 1 1 2 2 2 2 3 3 3 3 4 4 4 4

0 0

1 1

2 2

3 3

Important

Irrelevant

Neutral

Please rate on a scale of 0 (irrelevant) to 4 (very important). Circle the number that best reflects your choice

4 4

(Adapted from: Bancel & Mittoo, 2004)

59

Very important

APPENDIX B
Table I:
Summary statistics of dependent and independent variables: 2004 - 2008 SMMEs Mean Median SOLVENCY/LIQUIDITY Short-term debt: Current ratio Quick ratio Net working capital total assets Long-term debt + net worth to net fixed assets MANAGERIAL PERFORMANCE Asset structure: Long-term debt to total debt Total debt to total assets Net worth to long-term capital Short-term debt to total assets Inventory to sales (in days) Accounts payable to sales (in days Administration GROWTH % change in sales % change in total assets % change in net profit LSEs Mean Median

1:1 1:2 1:5 2:1

1:1 1:1 1:6 1:1

2:1 1:1 1:45 1:1

1:1 1:1 1:9 1:1

1:3 1:2 1 097:1 1:3 77 54 R434 952

1:1 1.2 1:2 2:1 63 51 R219 527

1:3 1:2 104:1 1:6 83 84 R715

1:1 1:2 1:2 1:1 64 62 R644

26% 35% 43%

20% 29% 37%

20% 19% 54%

19% 15% 51%

PROFITABILTY Profit margin: Net profit to gross profit Net profit to sales Gross profit to sales Return on investment: Net profit to net worth Net profit to total assets Capital turnover: Sales to net fixed assets Sales to net working capital Sales to total assets Sales to net worth

39% 10% 16% 22% 10% 271% 417% 117% 191%

25% 6% 17% 19% 9% 199% 276% 107% 260%

41% 8% 20% 16% 8% 202% 288% 107% 255%

39% 6% 21% 11% 4% 116% 280% 80% 274%

60

Table A1 SOLVENCY
Mean Short-term: Current assets to current liabilities 2004 2005 2006 2007 2008 Quick asset to current debt 2004 2005 2006 2007 2008 Net working capital to total assets 2004 2005 2006 2007 2008 Long-term: Long-term debt + net worth to net fixed assets 2004 2005 2006 2007 2008 1 2 1 1 1 : : : : : 1 2 2 1 1 1 1 1 1 1 1 1 1 1 1 : : : : : : : : : : : : : : :

SMMEs
Median 1 1 1 3 1 2 1 2 1 1 2 2 3 1 15 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 : : : : : : : : : : : : : : : 1 1 1 1 1 1 1 1 1 1 4 4 5 2 17 2 1 1 1 2 1 1 1 1 1 1 1 1 1 1 Mean : : : : : : : : : : : : : : :

LSEs
Median 1 1 1 1 1 1 1 1 1 1 17 -9 13 7 142 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 : : : : : : : : : : : : : : : 1 1 1 1 1 1 1 1 1 1 6 7 12 13 6

1 1 1 1 1

1 1 1 1 1

: : : : :

1 1 1 1 1

1 1 1 1 1

: : : : :

1 1 1 1 1

1 1 1 1 1

: : : : :

1 1 1 1 1

61

Table A2 GROWTH SMMEs Mean Median Percentage change in sales 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 19.4% 8.3% 39.2% 38.2% 17.8% 9.0% 23.9% 69.6% LSEs Mean Median 9.9% 21.2% 6.7% 40.9% 10.8% 16.5% 22.1% 29.3%

Percentage change in total assets

23.8% 34.2% 57.0% 24.6%

23.5% 27.6% 30.1% 53.3%

13.8% 17.8% 17.9% 27.2%

3.4% 17.8% 22.7% 13.5%

Percentage change in net profit

65.2% 24.9% 8.9% 72.1%

65.0% 28.2% 3.7% 46.5%

20.2% 117.4% 644.6% 25.6%

50.5% 83.3% 5.6% -18.8%

62

Table A3 PROFITABILITY: Capital turnover: Sales to net fixed assets 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

SMMEs Mean 420.9% 379.0% 195.3% 186.5% 172.8% 340.6% 357.0% 316.4% 838.7% 234.3% 143.5% 138.1% 107.6% 100.2% 95.3% 344.1% 293.0% 251.5% 265.9% 299.5% Median 226.1% 238.5% 199.4% 186.0% 191.4% 299.3% 321.4% 276.2% 232.0% 233.4% 122.4% 122.0% 107.0% 102.4% 91.0% 346.0% 271.5% 221.6% 259.6% 216.9%

LSEs Mean 201.3% 206.0% 192.4% 188.7% 221.0% 256.8% 270.8% 308.5% 295.1% 310.0% 105.4% 110.2% 108.1% 97.4% 115.2% 257.9% 249.9% 241.9% 235.8% 288.6% Median 107.7% 115.9% 105.0% 120.2% 149.4% 267.3% 246.4% 279.8% 319.0% 317.1% 80.0% 83.6% 76.1% 79.5% 88.3% 227.8% 298.2% 274.0% 221.7% 324.4%

Sales to net working capital

Sales to total assets

Sales to net worth

63

SMMEs Mean Profit margin: Net profit to gross profit 2004 2005 2006 2007 2008 20.2% 48.1% 54.5% 37.4% 36.7% 20.2% 48.1% 54.5% 25.0% 20.9% Median

LSEs Mean Median

35.3% 18.2% 43.2% 67.5% 40.9%

30.1% 35.8% 38.9% 55.5% 27.1%

Net profit to sales

2004 2005 2006 2007 2008

6.2% 9.2% 9.8% 8.0% 14.3%

6.0% 8.6% 10.8% 5.2% 4.3%

4.8% 3.9% 9.0% 9.1% 13.3%

4.1% 5.9% 10.0% 8.6% 4.1%

Gross profit to sales

2004 2005 2006 2007 2008

8.3% 12.9% 10.9% 19.6% 30.3%

0.0% 12.5% 8.9% 25.0% 21.3%

18.0% 18.3% 20.8% 17.7% 25.4%

12.6% 16.8% 21.0% 22.3% 16.0%

64

SMMEs Mean Return on investment: Net profit to net worth 2004 2005 2006 2007 2008 18.8% 20.4% 19.6% 16.5% 34.2% 17.2% 22.6% 19.1% 17.4% 21.4% Median

LSEs Mean Median

12.5% 10.9% 18.7% 17.8% 18.7%

6.5% 4.6% 12.6% 11.9% 11.3%

Net profit to total assets

2004 2005 2006 2007 2008

8.0% 10.1% 9.1% 7.3% 13.2%

8.5% 9.3% 9.8% 5.9% 5.3%

5.3% 5.9% 9.6% 8.4% 10.1%

4.0% 2.1% 6.6% 5.7% 7.7%

Inventory: Inventory to sales (days) 2004 2005 2006 2007 2008 55 81 85 87 70 55 82 85 63 58 84 83 68 64 116 64 58 67 53 75

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SMMEs Mean Credit policy: Accounts payable (creditors) to sales 2004 2005 2006 2007 2008 Administration: Sales to number of employees 2004 2005 2006 2007 2008 307 822 339 112 359 303 491 996 679 530 211 256 219 527 288 476 479 701 28 802 919 968 1 071 1 175 1 482 47 43 53 67 62 49 51 46 63 58 118 116 71 60 56 Median Mean

LSEs Median

64 61 69 62 48

504 572 644 786 1 071

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TABLE A4 MANA MANAGERIAL PERFOMANCE Assets structure:

Current assets to current liabilities 2004 2005 2006 2007 2008 Long-term debt to total debt 2004 2005 2006 2007 2008 Total debt to total assets 2004 2005 2006 2007 2008 Net worth to long term-capital 2004 2005 2006 2007 2008

SMMEs: Mean

Median

LSEs: Mean

Median

1 2 2 1 1 1 1 1 1 1 1 1 1 1 1 769 965 1330 1131 1292

: : : : : : : : : : : : : : : : : : : :

1 1 1 3 1 5 3 2 3 3 2 2 2 2 2 1 1 1 1 1

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 3 2 12

: : : : : : : : : : : : : : : : : : : :

1 1 1 1 1 3 3 2 3 2 2 2 2 2 2 1 1 1 1 1

2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 3 3 5 56 456

: : : : : : : : : : : : : : : : : : : :

1 1 1 1 1 3 4 3 3 3 2 2 2 2 2 1 1 1 1 1

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 1 2

: : : : : : : : : : : : : : : : : : : :

1 1 1 1 1 2 5 2 2 2 2 2 2 2 2 1 1 1 1 1

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Short-term debt to total assets

2004 2005 2006 2007 2008

1 1 1 1 1

: : : : :

3 3 4 3 3

1 1 1 1 1

: : : : :

3 3 3 3 3

1 1 1 1 1

: : : : :

5 4 5 5 5

1 1 1 1 1

: : : : :

3 3 3 3 3

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Table II:
SURVEY REPORT Respondents are asked to rate on a scale of 0 (irrelevant) to 4 (very important). The report is on the mean of the different size groups; SMMEs and LSEs, as well as percentage (%) of respondents that answered 3 and 4 (important and very important).

Survey question

Important or very important %

SMME Mean

LSE Mean

A. THEORY AND PRACTICE OF CAPITAL STRUCTURE: 1. 2. The extent to which different stakeholders influence the firms financial decisions Factors likely to influence firms capital structure policies: 33% 67% 33% 1 1 1 1 1 1

33%

2.1 Capital structure theories 2.2 Managers timing of debt or equity issues 2.3 Capital structure changes on financial statements 3. 3.1 3.2 3.3 3.4 When your firm considers issuing equity, what factors affect its decisions about equity?: Maintaining a target debt-to-equity ratio Whether recent profits are sufficient to fund activities Inability to obtain funds using other sources Stock is the least risky source of funds

100% 100% 17% 0%

1 1 1 1

2 1.67 1 1.25

Survey question

Important or very important %

SMME Mean

LSE Mean

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B. 4.

DEBT POLICY: How the appropriate amount of debt is chosen for the firm? 33% 3 1.5

5. Factors that influence debt policy: 5.1 Tax advantage of debt 5.2 Timing of debt/equity issue 6. 7. 7.1 7.2 7.3 7.4 Choice between short-term and long-term debt What drives the choice between short- and long-term debt?: Matching the maturity of debt with the life of assets Borrowing short-term to reduce the chance of taking on risky projects Issuing long-term debt to minimize the risk of financial bad times Issue short-term while waiting for long-term market interest rates to decline

100% 100% 50%

1 1 1

1 1 1.33

67% 17% 17% 67%

1 1 1 2

2 1.67 1.67 4

8. What factors affect how the appropriate amount of debt is chosen for the firm?: 8.1 What factors affect how the appropriate amount of debt is chosen for the firm? 8.2 The tax advantage of interest deductibility 8.3 The potential costs of bankruptcy 8.4 Ensuring that upper management works hard and efficiently 9. What other factors affect your firms debt policy?; 0% 33% 1 1 1.67 1 100% 100% 50% 67% 2 2 1 1 4 4 1 1.33

9.1 Debt is issued when recent profits are not sufficient for funding activities 9.2 Debt is issued when the firm has accumulated profits

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APPENDIX C

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