According to Pérez J.A. et. al. (2019), the studies about capital structure consider that a company finances its assets through a combination of equity and debt, which determines the composition of its structure and net liability. Nevertheless, those studies have exclusively focused on the relation of this structure with a company’s value and in those accounting components that maximize share prices. However, its has been demonstrated that factors like agency costs, taxes and asymmetry of information affect the value of a company.
About, in the context of behavioral finance and the recent paradigm named cognitive finance, the aforementioned study mades use of a 44-item questionnaire applied to a group of CFOs from different companies in order to validate the dimensions comprising the capital structure and compare them to the traditional financial theory. This instrument was aimed to verify its capacity to form properly the construct of capital structure with the intention to add value to the study of cognitive biases involved in the corporate financial decision-making process.
1.1. Behavioral finance.
The behavioral finance hypothesis (BFH) questions the scientific knowledge of conventional economic theory—the efficient markets hypothesis (EMH)—because of the existence of cognitive reasoning and different human psychological biases. As proven in some documented cases, the traditional financial paradigm is complemented by another approach that contemplates the psychological attributes that explain certain financial anomalies. This focus assumes that the use of sophisticated and thorough mathematical models is insufficient to completely explain the current financial paradigm, where a market’s efficiency can be measured according to social behavior.
In contrast, the EMH approach is based on rational assumptions of an efficient market and the maximization of profit (Fama, 1970). This theory is centered on objective situations of the financial market; however, it is often unable to explain the chaotic phenomena involved in the current market.
Empirical evidence points out that the current investigation approach in the financial field involves human prejudices as these are directly interconnected with financial decision-making, and which can explain investors’ behavior and its relation with market anomalies. Therefore, corporate decision-making is affected by human behavior that underlies in the financial environment of a company. This involves unconscious deeds affecting, to a greater or lesser extent, the selection, occurrence and importance of variables in a company’s financial analysis. According to Pérez et. al. (2019), studying those variables at a construct level is an opportunity to understand the intervention of the variables in the valuation of the capital structure, as discussed later in this article.
According to Bunge (1973), a construct is like a non-observational concept, in contrast with observational or empirical concepts, that cannot be demonstrated. These concepts cannot be directly manipulated, but can be inferred from behavior. A construct is a non-tangible phenomenon that, by means of a certain process of categorization, manifests in a variable that can be measured and studied through different indicators. Taking the theory of capital structure at a construct level represents a valuable opportunity to verify fundamental approaches of corporate financial theory. Specifically, this new approximation allows for verification in terms of cognitive biases involved in the decision-making process.
Capital structure is the specific mix of long-term debt and equity that a company uses to finance its operations. The CFOs of a company determine the right balance between debt and capital looking for the least costly sources of funds for the business. The most important challenge for a CFO, therefore, lies in managing value and knowing how to create value at different corporate levels to benefit shareholders.
According to Pérez J.A. et. al. (2019), the optimal capital structure is the one that maximizes the shares price and this tends to demand a lower debt ratio that maximizes the expected earnings per share. This means that the capital structure that maximizes the price it is also the one that reduces, to the minimum, the WACC.
2. Applied Techniques.
2.1. The construct of the capital structure.
The first and the most outstanding allusions to the term capital structure are found in the works of Modigliani and Miller (1958, 1963).
Later contributions have improved corporate financial techniques, whose main purpose is the generation of value. In those terms, the principal components of such structure can be explained in WACC terms and by the different criteria for its calculation, like:
- An asset analysis according to market value.
- A beta estimation for companies that are not listed on the stock exchange.
- Consideration of fixed assets so that cost of resources is reflected in the WACC.
However, it seems that this concept is constituted over methodological biases that are conceived according to the valuation of capital stock and, apparently, over a subjective valuation of the leverage ratio and the repercussions that this provokes in the generation of value for the shareholders. Considering this, it can be assumed that the valuation of the capital structure alludes to irrational components that are conceived in terms of the financial risk valuation and this, in turn, is associated with behavioral mechanisms based on the perception of the environment.
This assumption represents the major motivation of the aforementioned research, where it is proposed that the “capital structure” concept is formed by combined perceptions of the behavioral, structural and the process variables formulated during the valuation of an optimal financial structure.
According to Pérez J.A. et al. (2019), the above aims towards explaining the multidimensional, complex construct related to the capital structure of the CFOs’ cognitive representation built from their traditional financial analysis. In that construct, the risk valuation is in line with the environment conditions. The importance of such a construct lies in its ability to reflect the values, attitudes and beliefs of the respondents also opening an important opportunity to study capital structure from a behavioral-type approach supplementary to the traditional method. The instrument of this study is the aforementioned 44-item survey that was thoroughly designed and applied on-line.
However, the study analyzed the components of capital structure in specific dimensions or latent variables that comprise its construct.
3. Analysis of the results.
In order to establishment and delimitation of the dimensions that comprise the established construct, traditional financial theory and the indicators that describe the components of the capital structure, the following seven dimensions were built as follows:
- Dimension 1: Capital cost
- Dimension 2: Transaction cost
- Dimension 3: Cash flow adjustment
- Dimension 4: Leverage ratio
- Dimension 5: International leverage
- Dimension 6: Leverage ratio control
- Dimension 7: Other factors (environment)
In this regard, the applied questionnaire yielded the following results:
For Dimension 1, “Capital Cost,” the results displayed that the capital cost is mainly defined in terms of the valuation of financial assets and its calibration with risk factors.
Dimension 2, “Transaction Cost” enabled the researcher to observe that the criteria IRR, NPV and Profitability Index are most popular. Regarding the applicability of one or other criterion, it is worthy to mention that the IRR criterion is very important for those companies that are in financial difficulties, mainly because this approach allows the firm to analyze thoroughly the cash flows in case of a certain investment.
Dimension 3, “Cash Flow Adjustment,” considered that the prime factors that interfere in the cash flows adjustment are: inflation, interest rate, and leverage ratio. While the company’s assts value criterion has less impact on this type of decisions. This is consistent with the theory, because the main concern of large and mature companies with high leverage ratios are factors that precisely affect the indebtedness level.
Dimension 4 “Leverage Ratio,” is fundamentally defined by the debt-ratio analysis and by the time in which shareholders retrieve the future profits of their investment with external capital. In turn, leverage is not measured in line with the political or with the intention of minimizing the financial risk, yet, it will be subsequently demonstrated that there is a strong interrelationship between the political, social and economic environments that determines an intense interference on the company’s leverage ratio.
Afterwards, in the case of Dimension 5, “International Leverage,” it appears that the debt issuance in other countries is linked to the term basis profits, interest rate, and, above all, to the feasibility of finding fewer banking restrictions that enable firms to acquire greater profits. This is due to a favorable tax treatment for companies with a high exposure abroad.
Dimension 6, “Leverage Ratio Control,” was added to determine additional factors that affect in the debt decision-making of the CFOs. The results showed that in defining the debt-equity ratio, additional factors related to the company’s projection are considered before clients and suppliers, but, above all, they strive to limit the leverage ratio so that the shareholders capture the future profits in an efficient fashion.
Finally, Dimension 7 “Other Factors (Environment),” aims to provide information about additional parameters that intervene in irrational decision-making by the CFOs. This dimension made it possible to observe emotional components, outside of financial corporate analysis, that have some degree of interference in the final decision of senior executives. As reported by the results, the social, political and economic environments intervene profoundly in the financial decision-making of the respondents.
The work intends to provide a first approximation towards the comprehension of the cognitive biases that are involved in corporate financial decision-making in determining capital structure. Thus, it must be considered that the verification of the latent variables underlying the observed variables are not limiting and, therefore, should be verified by subsequent studies.
In particular, the necessity of using larger samples for the confirmation of the construct represents a substantial opportunity for future investigations to determine, in a more accurate manner, the dimensions that compose the established theory.
- Bunge M. (1973). La ciencia, su método y la filosofía. Buenos Aires: Siglo XX.
- Fama, E. F. (1970). Efficient capital markets: a review of theory and empirical work. The Journal of Finance, 25, 383–417.
- Jose Anselmo Perez Reyes, Montserrat Reyna Miranda and Jorge Vera-Martínez (2019). Capital structure construct: a new approach to behavioral finance. Investment Management and Financial Innovations, 16(4), 86-97. doi:10.21511/imfi.16(4).2019.08
- Modigliani F., & Miller M. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Association, 48, 261–297.
- Modigliani F., & Miller M. (1963). Corporate income, taxes and the cost of capital: a correction. American Economic Review.