In this essay, I will give brief review notes for “Access to Capital Structure, and the Funding of the Firm” (Omer Brav 2009) which will be focused on the goal of this easy, how and why the theoretical hypotheses are tested and what are the findings. Some discussions about data, methodology used and theory defects will also be included in this essay for critical comment.
Since earlier capital structure theories are usually subject to public companies, it is very interesting to see whether there is a big difference between public and private companies. The author concentrated on the capital structure difference between UK public and private companies. Based on the data sourced from FAME, it can be found that private firms have general higher gearing than public firms in the UK, 33.7% for Private vs 22.5% for Public; and short-term takes a higher proportion of total debt for the private company than for public company.
To clarify this difference, Barv(2009) raised up two effects: ”the level effect” and “sensitivity effect”. The first effect refers to relative cost of equity to debt (likelihood of choosing the debt over equity), and later one refers to absolute cost of accessing capital or stock market (likelihood of accessing external capital markets). Some other researchers’ evidence, such as Faulkender & Petersen (2006), supported “the level effect” theory. While some further examinations by Barv (2009) himself show gearing ratio for private companies are more sensitive to operating performance than to trade-off theory determinants. Furthermore, the adjusting frequency of gearing ratio for private companies is very low.
Barv (2009) tried to explain the difference from deviations of the assumptions in M&M(Modigliani and Miller) theorem: One reason that is supported by Amihud, Lev, and Travlos (1990) is losing control risk, the owner tries to cut equity financing to avoid diluting controls, the other one is about information asymmetry. Furthermore, Brav found there is a lag between profitability increasing and incremental investment for the private company rather than for public company.
To sum up, Barv(2009) states the purposes of his paper are: 1)document systematic differences between financial policies of private and public companies, 2) Information asymmetry and losing control risk are two main reasons for this difference, 3)the relationship between levels of accessing public equity market and companies’ financial policies.
The main purpose of this empirical research is to test whether these two effects are significant or not. Since it is very difficult to test these two effects directly, Barv developed several testable impacts to test them.
For level effect, as the relative cost of debt is higher than equity, based on rational choice, the first hypothesis (L1) is that gearing ratios of private companies are higher than public companies. And based on pecking order theory,...