Debt Equity for Funds Essay Example Pdf

The generation of fund is one of the most important decisions for firms. When the firm is unable to generate enough internal funds to invest in various projects then firm take a decision to issue debt or equity for funds. The objective of study is to determine the financial characteristics that lead firms to choose Equity or Debt. This study helps to predict the choice of firms for funds through the Multiple Discriminant Analysis on the basis of their distinctive financial characteristics. In this study financial characteristics like Leverage, Profitability, Liquidity, Market Price of common stock, Firm Size, Dividend Policy, Sales growth and variability and variables relate to specific firms ratios with Industry norms (average) will be analyzed to predict the future firm's decision for funds.

INTRODUCTION

The selection of debt or equity is basic issue for the financial management of company. The decision of firms to issue debt or equity might depend on the following variable like leverage, liquidity, profitability, dividends market price, firm size, sales growth and variability. Generally it is predicted that company or firms with low leverage ratios as compare to industry average tend to issue debt rather than equity. In the same way company will issue debt rather than equity if it possesses the higher profitability and liquidity ratios. There is no any specific rule to conclude that if the firm is issuing debt or equity having low or high payout ratios but more possibility is that if the firm issues equity under certain characteristics its payout earnings will be lesser as compare to those firms which are issuing debt. The price earnings ratio of debt issuing firms are lesser than of equity issuing firms, likewise larger the firm size issues debt and lower firm size issue equity. The firms having high sales growth and variability prefer to issue equity rather than issuing debt( John D. Martin and David F. Scott, Jr. 1974). In this study only the sample of firms is taken which are issuing debt or equity in the financial year 2008 and firms are used to analyze the distinctive financial characteristics. In this study the dependent variable is choice of debt or equity and several independent variables are Leverage, Profitability, Liquidity, Market Price of common stock, Firm Size, Dividend Policy, Sales growth and variability and variables relate to specific firms ratios with Industry norms (average). With the help of financial characteristics (independent variables) of Company the Choice for funds will be predicted by using Multiple Discriminant Analysis technique.

Literature Review

Main Article- A Discriminant Analysis of the Corporate Debt-Equity Decision

This study was conducted in USA (Standard and Poor's Standard Corporation Descriptions), by Martin and Scott, in 1971 to determine the general financial conditions actively affecting the debt-equity decision of industrial firms. This study conducted during the time period between 1971 and 1972, total one hundred and twelve firms qualified for this study out of one hundred and twelve firms sixty two firms were those which were issuing bond and remaining fifty firms were issuing equity. The hypothesis here is that companies choosing to issue debt instead of common equity (or vice-versa) possess distinctive financial characteristics. Discriminant analysis methodology used for the prediction of the Choice of firms for issuing debt or equity. A linear discriminant function is used to distinguish between two types of firms on the basis of their financial characteristics which are issuing debt or equity. Capital structure is the combination of debt and equity used in the firm's operations. In this study the dependent variable is Choice and the other independent variables used to predict the choice for debt or equity are Leverage, Profitability, Liquidity, Market Price of common stock, Firm Size, Dividend Policy, Sales growth and variability and variables relate to specific firms ratios with Industry norms (average). The empirical findings of this study are the group means analysis of the above variables is showing the equity issue firms are smaller on balance than the firms issuing debt and those firms which are issuing common stock during test period displayed greater profit ability, interest coverage ratios and price earnings ratios. Similarly the firms which are issuing equity maintained lower dividend payout rates and showing higher debt ratio than debt issuing firms. Firms with larger asset bases and lower price earnings ratio have tendency to issue debt. Article-2

The Choice between Equity and Debt: An Empirical Study

This study was conducted in UK by Marsh, to find how companies actually select between financing instruments at a given point in time. The sample for this study is taken from UK companies over the period from 1959-70 and total sample of 748 firms issue equity and debt, the holdout sample of one hundred and ten firms were taken from the year 1971 to 1974. The hypothesis is a company's choice of financing instrument is a function of the difference between its current and target debt ratios. Logistic analysis and descriptive model of the choice between equity and long term debt is used in this study. The variables which were used long term debt, short term debt, Market Price of Common Stock, asset composition, Firm Size, payout ratios, Return on investment. The results of this study are as First, it exhibits that companies are heavily influenced by market conditions and the past history of security prices in choosing between equity and debt. Second, this study provides proof that companies do appear to make their choice of financing instrument as though they had target levels in mind for both the long term debt ratio, and the ratio of short term to total debt. Finally, the results are consistent with the notion that these target levels are themselves functions of company size, bankruptcy risk, and asset composition. Article-3

The Debt-Equity Choice

This study was conducted in UK by Hovakimian, Opler, and Titman. The sample for this study is taken from UK companies over the period from 1979 to 1997 and total sample of 39387 taken and equity issuance and repurchase are identified from the statement as change in cash flows reported in compustat. The hypothesis tests (1) Firms tend to move toward a Target Debt ratio when They either raise new Capital or retire or repurchase existing capital. (2) Leverage deficit will be related to the firms' issuing choices as long as there is a tendency for firms to move toward their target debt ratio. (3) Firms with high NOLC (net operating loss carry forward) have low target leverage. Regression analysis is used in this study. The variables used (leverage) target debt ratio, Market Price of Common Stock, NOLC (net operating loss carry forward), ROA, Ret, and M/B. The results of this study since observed debt ratios are Likely to deviate from the optimums suggested by these static models. Furthermore the study suggest that the past profits are an important predictor of observed debt ratios firm often make financing and repurchase decisions that offset these earnings-driven changes in their capital structures. Article-4

Investment, Capital Structure, and Complementarities between Debt and New Equity

This study was conducted in UK by Stenbacka, and Tombak to demonstrate theoretically and empirically the important interaction between different instrument of external financing and impact of these interactions on the investment of financially constrained firms. The sample for this study is taken from 3119 Publicly Traded manufacturing and telecommunications corporations from 1982-1992. The Propositions are (1) when restricted to debt as the only instrument for external finance, debt-financed investment is an increasing and concave function of the firm's net worth with a positive intercept. (2) When restricted to new equity as the only instrument for external Financing, the firm's equity-financed investment is an increasing and concave function of internal funds. (3) There are complementarities between new equity and debt as instruments of external financing. These complementarities are functions of the firm's incumbent equity. Furthermore, the product of these complementarities ((dD**/dK) x (dK**/dD)) is less than one. The variables which were used Long term debt, retained earnings, Common stock ranking, interest rates, Sales of Common and preferred Stock. The results of this study are in the presence of capital market imperfections, the complementarities between debt and new equity as instruments of external finance are particularly important for small firms facing severe financial constraints in relationship to their available investment projects. Finally it is concluded that policies enhancing the exploitation of complementarities will be more significant with the Higher the degree of imperfections prevailing in the Capital market. Article-5

The Determinants of Capital Structure Choice

This study was conducted in USA, in 1988 by Titman and Wessels to enhance the empirical work on capital structure theory in different ways. The data for the firms is taken from Annual compustat industrial files and U.S department of Labor Bureau of Labor Statistics. The variables included in the sample for the study were analyzed in different time periods of 1974 to 1982 and in these period total 469 firms were analyzed. The hypothesis here is that significant coefficient estimates for either the market value or book value equations are consistent with debt ratios being chosen randomly. Factor analytic technique is used for this study. The variables used in this study are Collateral Value of Assets, Non-Debt Tax Shields, Growth, Uniqueness, Industry Classification, Size, Volatility, and Profitability. The firms with unique or specialized products posses low debt ratios and as compare to large firms the small firms use more short term loans.

Methodology

Hypothesis: The Distinctive Financial Characteristics have significant impact to choose the Debt instead of Equity or to choose Equity instead of Debt. Technique: Multiple Discriminant Analysis Sample: All textile industry firms which are only borrowing long-term debt or issuing equity in 2008. The 70% of the sample will be used for prediction and the remaining 30% will be holdout sample and will also be used for prediction of choice of decision.

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