Literature Review Agency Cost And Maturity Matching Theory
2.1 Agency Cost Theory
Myers (1977) discussed that risky debt financing caused low investment benefits when a firm's investment had chances to look for growth option. Financial Analysts worked to represent equity holders failed to accomplish profitable investment options because risky debt control a part of equity holders’ incentive in the form of a decrease in the probability of default. Myers represented that low investment benefits could be assured by providing short-term debt to mature before the growth options utilized. The hypothesis was that the firm’s assets had a greater ratio of growth options were used shorter-term debt.
Titman (1992) presented that if growing firms both the greater chances of bankruptcy and positive future-outlook then got incentive from borrowing short-term debt and going for a constant-rate contract. Briefly, there was an acceptance in the literature that growth (market-to-book ratio of assets) should be inversely correlated to debt maturity in the agency/contracting costs perspective.
Williamson (1988) firms with more tangible assets should find asset substitution (risk shifting) more difficult, which lowers debt agency costs and thus raises optimal leverage.
Hart and Moore (1995) defined the role of long-term debt in controlling management’s capability in increasing funds for future projects. It was analyzed that long-term debt may restrict self-interested managers from financing non-profitable investments entails a direct variation of long-term debt with market-to-book ratio. Therefore, the relationship between growth options and debt maturity structure had an experimental issue.
Diamond (1991) focused on the relationship between debt maturity and the credit value of a firm. Diamond defined liquidity risk as the risk that debtors were lost control rents because creditors do not want to refinance, and therefore choose to liquidate the firm. Because short-term debt was seen by Diamond as being debt that matures before the profits of an investment were received, it was necessary to refinance short-term debt. For firms with high credit worthiness, the liquidity risk was not relevant. A decreased in credit worthiness did not lead to a ‘crunch’ of credit to the firm. For this reason, firms with a high credit rating were expected to borrow on the short term. For firms with a medium credit rating, the liquidity risk could be important. Firms with a low credit rating also interested to borrow on the long term. Firms with a low credit rating were therefore forced to borrow on the short term.
Firms with comparatively greater ratio of future investment opportunities tend to be littler. Barnea, Haugen, and Senbet (1980) found that organization conflicts, similar to Myers's (1977) underinvestment problem, could be restrained by reducing the maturity of debt. Therefore, smaller firms which faced additional harsh agency conflicts than larger well-maintained firms may use shorter-term debt to mitigate these conflicts.
In most cases, the issuing costs of a public debt issue were fixed, and these costs were therefore self-determining of the size of the debt. Because public debt had a longer maturity than private debt, a positive relation between the size of a firm and the maturity of debt was proposed. However, those reasoning did not apply to small unlisted firms, because these firms make very little use of public debt. The present study also included leverage and industry affiliation as determinants of debt maturity. Arguably, larger firms lower asymmetric information and agency problems, higher tangible assets relative to future investment opportunities, and thus, easier access to long-term debt markets.
The reasons why small firms were forced to use short-term debt include higher failure rates and the lack of economies of scale in raising long-term public debt. It was further argued that larger firms tend to use more long-term debt due to firms remaining financial needs (Jalilvand and Harris, 1984). Agency problems (risk shifting, claim dilution) between shareholders and lenders may be particularly severe for small firms. Then, bondholders attempt to control the risk of lending to small firms by restricting the length of debt maturity. Large (small) firms, thus expected to had more long (short)-term debt in capital structure. Consequently, these arguments imply a positive impact of firm size on debt maturity.
It was widely accepted by the current literature that larger firms with lower agency costs of the debt (Ozkan, 2000, Yi, 2005 and Whited, 1992), because these larger firms were believed to an easier access to capital markets, and a stronger negotiation power. Hence both these arguments favored larger firms for issuing more long-term debt compared to smaller firms. In addition to it Smith and Warner (1979) argued that smaller firms were more likely to face higher agency costs in terms of a conflict of the interest between shareholders and debt holders.
Hoven and Mauer (1996) found out only little evidence for the agency cost aspect that debt maturity used to restrict the conflicts of interest between share holders and debt holders. Although smaller firms in the sample lead to used short term debt, findings also suggested that firms with big amounts of growth options small leverage, and hence small to moderate incentive of debt maturity structure to reduce the conflicts of interest above the utilization of those options.
Barclay and Smith (1995 ) test of the determinants of corporate debt maturity accepted the hypothesis that firms with greater growth choices in investment opportunity sets issued large amount of short-term debt. Study also found that firms issue large amount of long-term debt. The findings were robust to surrogate measures of the investment opportunity set. Technique as well propose to growth options in the firm’s investment opportunities be key in discussing both the time-series and cross-sectional fluctuation in the firm's maturity structure. Study also supported strong relationship among firm size and debt maturity: superior firms issue a considerably bigger proportion of long-term debt. This was uniformed with the observance that small firms dependent more heavily on bank debt that traditionally had shorter maturity than public debt.
Smaller firms had large growth options, which were indicating to employ shorter-term debt to reduce the agency conflicts; these indications assume debt as uncertain. Though, the capital structure theory suggested that these firms employ moderate amounts of leverage to mitigate the risk of financial loss. As such, firms with low leverage and low chances of financial loss would likely be unbiased to employ debt maturity structure to restrict agency conflicts, all other matters remain constant. Agency cost theory also proposed that smaller to medium size firms relatively higher agency costs because the possible divergence of risk shifting and reducing the concentration between equity holders and managers (Smith and Warner, 1979). To overcome the issue and to control the agency cost short-term debts were recommended Barnea, Haugen, and Senbet (1980, 1985). The large constant flotation cost of constant securities comparative to the small size of the firm had an additional barrier that stops all small firms’ access to the capital market.
Smith (1986) argued that managers of regulated firms had less discretion over investment decisions, which reduces debt agency costs and increases optimal leverage. Shah and khan (2005) evidenced the blended support for the agency cost, Study findings showed that smaller firms employ more shorter term debt then longer term debt; even there was no evidence that growing firms employ more of short-term debt as assumed by (Myers, 1977) that debt maturity varies inversely to proxies for firm’s growth options in investment opportunities, The implication of firm size variable also verify the information asymmetry hypothesis, established it costly to access capital market for long term liabilities.
2.2 Maturity Matching Theory
A frequent recommendation in the literature discussed that a firm should go with the maturity structure of its assets to that of its debt. Maturity matching could concentrate on these threats and thus a structure of corporate hedging that decreased projected expenses of financial suffering. In a related element, Myers (1977) explained that maturity matching could control agency conflicts between equity holders and debt holders by ensuring that debt repayments had planned to match up with the decrease in the worth of assets in place. At the closing stages of an asset's life, the firm encountered a reinvestment judgment. Concerning to debt that matures at that time assists to restore the suitable investment benefits as soon as new investments were needed. Though, this analysis specifies that the maturity of a firm’s assets did not the only determinant of its debt maturity. Its growth options play a vital role as well. Chang (1989) revealed that maturity matching could reduce organization expenses of debt financing.
Stohs and Maurer (1996) and Morris (1976) argued that a firm could face risk of not covered sufficient cash in case the maturity of the debt had shorter than the maturity of the assets or even vice versa in case the maturity of the debt was greater than asset maturity (the cash flow from assets necessary for the debt repayment terminates). Following these arguments, the maturity matching principle belongs to the determinants of the corporate debt maturity structure.
Emery (2001) argued that firms avoid the term premium by matching the maturity of firm’s liabilities and assets. Hart and Moore (1994) confirmed matching principle by showing that slower asset depreciation means longer debt maturity. Therefore, this study expected a positive relationship between debt maturity and asset maturity. Gapenski (1999) differentiated two strategies of maturity matching namely the accounting and financing approach. The accounting approach considers the assets as current and fixed ones and calls for the financing of the current assets by short-term liabilities and of the fixed assets by long-term liabilities and equity. The financing approach considers the assets as permanent and temporary. In these terms the fixed assets were definitely permanent ones and some stable part of the fluctuating current assets was also taken as permanent. This approach then suggests financing the permanent assets by long-term funds (long-term liabilities and equity) and temporary assets by short-term liabilities. Consequently, the financing approach generally employs ceteris paribus more long-term liabilities than the accounting approach does. Firms also consider asset maturity as an essential determinant of the debt structure. In contrast, companies that a greater reliance on external finance face a comparatively weaker agency problem. The related agency costs were lower because the higher income variability of these firms erodes their capacity to cover their interest and credit payments.
Hoven and Mauer (1996) come across with well-built support for the regular textbook recommendations that firms should compare the maturity period of firm’s liabilities to that of firm’s assets. Study results were indicating asset maturity a key aspect in discussing instability in debt maturity structure.
Shah and khan (2005) found unambiguous support for maturity matching hypothesis. Study findings reveal that the fixed assets vary directly with debt maturity structure.
Myers (1977) argued that maturity matching of firm assets and liabilities could also partially serve as a tool for mitigation of the underinvestment problem, which was discussed in the agency costs theory section. Here the maturity matching principle ensures that the debt repayments should be due according to the decrease of the asset worth. Comparing maturities as an effort to list debt repayments to match up with the decrease in expected worth of assets now in place.
Gapenski (1999) differentiates two strategies of maturity matching namely the accounting and financing approach. The accounting approach considers the assets as current and fixed ones and calls for the financing of the current assets by short-term liabilities and of the fixed assets by long-term liabilities and equity. The financing approach considers the assets as permanent and temporary. In these terms the fixed assets were definitely permanent ones and some stable part of the fluctuating current assets is also taken as permanent. This approach then suggests financing the permanent assets by long-term funds (long-term liabilities and equity) and temporary assets by short-term liabilities. Consequently, the financing approach generally employs ceteris paribus more long-term liabilities than the accounting approach does.
The financing approach brought more stable interest costs than the accounting approach; but as the yield curve was usually upward sloped, the financing approach was also more costly. The financing approach versus accounting approach decision making was thus a classical risk return trade-off relationship. In praxis, the corporate commonly favor the accounting approach before the finance approach, the same holds for our consideration of maturity matching for the empirical evidence of the debt maturity structure. Based on these maturity matching arguments, balance sheet liquidity implied an impact on the corporate debt maturity structure.
The financing approach compared with accounting approach decision making had a classical risk return trade-off relationship. In praxis, the corporate commonly favor the accounting approach before the finance approach, the same holds for our consideration of maturity matching for the empirical evidence of the debt maturity structure. Based on these Maturity matching arguments, this study considered the impact of balance sheet liquidity immunization on the corporate debt maturity structure.
Guedes and Opler (1996) stated that the mean of estimation of asset maturity did not appear to be vary much between firms, those issue debt (term of one to nine years) and firms that issued debt up to twenty nine years term. But firms that issue debt for greater than thirty years term had assets with significantly long lives. Assumptions expect that firms compared the maturity of assets and liabilities show that partially correct.
Morris (1976) argued that such a strategy allows firms to decrease uncertainty both over interest costs over the asset's life as well as over the net income those were derived from the assets. (Emery (2001) the higher the term premium, the stronger should be the firm's incentive for maturity matching.
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