2. Capital Structure and Financial Life Cycle
The notion that firms evolve through a financial growth or life cycle is well-established in the
literature. However, there is disagreement concerning sequential financing choices and the debt/equity
ratio. Moreover, the growth-cycle paradigm does not fit all small businesses (Berger and Udell 1998),
and differences exist not only for management determination but also regarding different industry
affiliation and institutional environment in which firms operate (Harris and Raviv 1991, Beck et al.
2002, Rajan and Zingales 2004, Utrero-González 2007). In their review of the capital structure
literature, Harris and Raviv (1991) noted that it is generally accepted that firms in a given industry will
have similar leverage ratios, which overtime are relatively stable, while leverage ratios vary across
industries. Specifically, industry is a significant determinant of leverage,
that alone has been found to
explain up to 25% of within-country leverage variation (Bradley, Jarrell and Kim1984). Moreover, the
institutional environment has also a crucial influence on capital-structure decisions, as recently
documented by Titman et al. (2003) for large companies and by Gaud et al. (2005) for small firms.
More than the type of financial system (market-based or bank-based), it is the efficiency of the
financial system (Rajan and Zingales 1995, Wald 1999, Booth et al. 2001, Zingales et al. 2004) and of
the general institutional context (Petersen and Rajan 1994 and 1995, Berger and Udell 1995) that determine the financial growth of firms affecting capital structure decisions. Therefore, hypotheses on
capital-structure determinants must take into account industry affiliation and the institutional
environments. This is particularly the case for firms that are opaque and affected by asymmetric
information.
2.1 Financial Life Cycle: Theory and Hypothesis
Several hypothesis, as synthesized in table 1, can be proposed to consider the life-cycle in
explaining firms financing behavior.
Table 1 – Main hypothesis
Hypothesis Description of the hypothesis
H.1 (pecking-order theory): Myers
(1984), Holmes and Kent (1991),
Chittenden et al. (1996), Michaelas et
al. (1999).
Financial managerial preferences depends on the costs of information asymmetries and of transaction costs,
pushing for the utilize at first place of retained earnings, then debt and at last equity.
The level of debt in a
firm’s capital structure is adjusted in response to difference sensitivity to financial needs of the firm over its
growth cycle. More-profitable firms will retain earnings and become less leveraged.
H.2.a (financial life cycle): Fluck
(2000), Kaplan and Stromberg 2003,
Carey et al. (1993), Helwege and Liang
(1996)
A life-cycle pattern of firm financing assumes that small firms, that are particularly sensitive to asymmetric
information problems, will use outside equity first (such as venture capital finance) and retained earnings,
issuing debt at last to satisfy their subsequent financing needs.
H.2.b (reputational effect): Fluck,
Holtz-Eakin and Rosen (1998),
Diamond (1989)
Young firms, without past experience and a track record, have a low debt capacity. A reputation argument
supports the convenient use of debt only in the maturity stage.
H.3.a (reverse financial life cycle):
Petersen and Rajan (1994), Hamilton
and Fox 1998
Young firms rely on the closest sources of financing, i.e., family capital and bank capital based on family
pledges. Firms rebalance their capital structure at the maturity stage. As the firm grows, internal selfgenerated financial resources substitute debt and the fraction of borrowing declines as the firm matures.
H.3.b (reputational searching effect):
Diamond (1991)
Young firms seek to obtain certification of their quality and acquire credibility in the product market by
submitting themselves to monitoring by banks. In an actively growing firm and, especially, in a mature one,
monitoring becomes secondary, as the track record signals both quality and reliability, the debt level declines.
The use of internal resources as a substitute for external finance must be acknowledged, as in the
pecking-order theory, as these reflect the severity of asymmetric information problems. Accordingly, in
this study, hypothesis 1 deals with the role of profitability and the preferences regarding internal
resources vs. debt. Hypotheses 2 and 3, each of which is further divided into two formulations, address
the different theoretical financial preferences during the life cycle of a firm. Hypothesis 2.a attempts to
describe the financial life cycle with respect to the age of a firm, while hypothesis 3.a is the reverse
formulation. Hypothesis 2.b attempts to describe the financial life cycle with respect to the role of a
firm’s reputation, while hypothesis 3.b is the reverse formulation. Finally, due to the fact that the
previous mentioned effects can be heterogeneous for different industries and for firms operating in
different institutional context, we explicitly take into account for industries affiliation and for the
context of analysis.
Hypothesis 1 (pecking-order theory): The main approach to interpret capital-structure choices
from the asymmetric information point of view is the pecking-order hypothesis (Myers 1984), which suggests that firms finance their needs in a hierarchical fashion. Myers (1984) and Myers and Majluf
(1984) pointed out the role of managerial preferences in the choice of financing resources. These
choices are made by considering the relative costs of the various sources of finance due to information
asymmetries and of transaction costs. The pecking-order theory proposes that firms prefer to use
internal sources of capital, relying on external sources only when the internal ones are exhausted. As a
result, firms prefer to use less information-sensitive securities, with retained earnings being the most
preferred financing source, followed by debt, and then equity capital7
.
This implies that more-profitable
firms will retain earnings and become less leveraged, while less-profitable firms will become more
leveraged, thus demonstrating an inverse relation between profitability and financial leverage. The
pecking-order theory seems particularly relevant for small and medium-sized firms due to their typical
features and limited access to external finance (Holmes and Kent 1991). In particular, the pecking order
hypothesis provides an instrumental tool to analyze the strategic financing problem of firms along the
life cycle (Rocha Teixeira and Coutinho dos Santos 2005). It states that no optimal level of debt
becomes “objectively” evident; instead it becomes apparent as a firm’s situation changes over time.
Thus, the proportion of debt in a firm’s capital structure is adjusted in response to the impending
financial needs of the firm over its growth cycle. Empirical evidence from previous studies that
examined small and medium-sized firms (Chittenden et al. 1996, Michaelas et al. 1999) was consistent
with the pecking-order argument, since leverage was found to be negatively related to profitability.
Therefore, the empirical model employed here included profitability, defined as earnings before
interest, taxes, depreciation, and amortization (Ebitda) to capital (Sogorb-Mira 2005, Fama and French,
2002, Michaelas et al. 1999).