How do firms finance themselves in theory and in practice?

The primary goal of corporate finance is to maximise shareholder value while at the same time ensuring that the firm’s financial risks are managed in a satisfactory manner. Generally speaking the sources of finance that a corporation relies upon fit into two independent categories, internal and external sources. Internal finance consists of capital generated by the firm itself in the form of retained earnings while external sources refer to debt and equity attributed to outside investors. The financing of a corporation is the concern of the chief financial officer and it his/her responsibility to make the necessary capital budgeting and capital structure decisions required to ensure long-term financial stability. The manner in which firms finance themselves in theory is not always consistent the practical application of finance theory and there has been a considerable number of empirical research studies conducted that attest to this disparity. The role of company characteristics such as size, leverage, industry and credit rating are undeniable components in the irregularities and disparities that occur between theory and real world practice. Of note is the fact that capital budgeting in corporations tends to be aligned relatively close to academic theory, following notable techniques such as the renowned Discounted Cash Flow and Net Present value to weigh up potential investments. On the other hand capital structure decision making does not necessarily follow a prescribed path as finance theory would suggest. As I endeavour to examine in greater detail during the latter parts of this piece, capital structure decisions are often made at the discretion of the chief financial officer and the rules of thumb that he/she dictates as an informal benchmark.

There are two main theories that dominate corporate structure decision making in the corporate realm. The first of these is the trade-off theory (Kraus and Litzenberger 1973) which stipulates that the respective level of debt and equity chosen by a firm is decided by weighing up the relevant costs and benefits. The result is an optimal debt to equity ratio that finds a balance which facilitates financial flexibility and maximises earnings per share. Early forms of theory highlighted the benefits of taking on debt, including the tax deductibility of interest sustained upon debt. In more recent examinations of the theory Jensen’s free cash flow hypothesis has been incorporated to create a more rounded theory. The hypothesis states that ‘managers endowed with free cash flow will invest it in negative net present value investments’/projects rather than pay it out to shareholders in the form of dividends (Jensen 1988). This is particularly relevant for mature firms that have the benefit of a sustainable free cash flow and have already invested in suitable positive net present value investments in the course of their expansion.

The trade-off theory has been criticised for its inaccuracy and none more staunchly than Stewart C. Myers who argued that the theory does not match reality because it suggests corporations take on more debt than they actually do. In its place he proposed the second of the aforementioned theories that dominant corporate structure theory. The Pecking-order theory states that firms order their sources of finance according to preference as per the principle of least resistance/effort. Accordingly the preferred option for corporations would be to utilise internal sources that are self-generated but if this proves impossible then debt would be issued and when this option proves to be unviable then equity is issued as a last resort. The decision to issue further equity is not generally taken lightly because of the transaction costs that are involved and the signals that it would send to the markets. A stock issue is often interpreted as a sign that management view the stock as overvalued thus leading to a decline in the price of the stock upon announcement. However if the management in reality is forced to issue stock that is already at a fair value out of necessity then the subsequent decline would be detrimental to investor interests. Equally if a stock is over-priced the decline following an issuance would actually help to correct the disparity between the fair value and the market value.

A notable difference between finance theory and practice is in the calculation of ratios and in particular those that pertain to leverage. Theory would suggest that it is expedient to calculate leverage as a percentage of the market value of the firm while in reality it is common practice to actually work these ratios using the book value of assets. A practice that is also used by the very rating agencies that assess the risk attached to company credit. The frequent rebalancing that is required and the transaction costs that go with it in the use of market values makes it an unfeasible option, especially if accuracy is to be attained. Similarly empirical research in the field suggests that there is little evidence supporting the Pecking-order’s claim that information disparities has a significant role in the decision making process (Graham and Harvey 2002). The role firm size plays in defining the difference between theory and practice is considerable. While theory does appear to be very consistent with large companies in practice it does not fit as well with small and medium companies. The unsophisticated and unstandardized decision making process often taken my small firms does not bode well with the assumptions of finance theory.