Review of The relative influence of competitive intensity and business

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Introduction

The purpose of this report is to critically evaluate a research article written by Johnny Jermias titled "The relative influence of competitive intensity and business strategy on the relationship between financial leverage and performance" which was published in the British Accounting Review in 2008 (See Attached). It was written as part of a response to Modigliani and Miller's (1958) capital structure "irrelevance proposition".

The objective of the article was to investigate the effects of competitive intensity and business strategy on the relationship between financial leverage and the performance of firms. It used data from a case study of selected manufacturing firms in the US to highlight the link between theory and the adoption of firms' competitive strategy. The article concludes that, competitive intensity has a negative effect on the leverage-performance relationship and that, there is the need to consider moderating factors such as strategic choice and the environment in which a firm operates when investigating the effects of leverage on performance.

Structure of the report

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This review begins with my motivation for selecting this particular article. It then summarises the research design, methods of data collection and analysis and the research findings. It also covers a review of the philosophical assumptions that underpin the research design and an evaluation of the ethical perspective with the view to critically understand the issues raised in the research.

Motivation

The concept of analysis and critique of research articles have been and will always be an important and integral aspect of academic settings. The critiquing process allows readers to analyse the data, facts and ideas presented in an article to identify any possible differences in the interpretation and impact assessment, in a rigorous in-depth manner to ascertain or otherwise of any causal claims. The drive behind the selection of this article is based on a number of factors. First, the discussed subject is in my research area hence very relevant to my understanding. Second, the subject area is very useful to industries and management as they've always grappled with the optimal capital structure decision that will help them add value to shareholder's wealth. Besides, it is a key theme that has been very much researched with different dimensions and results hence popular amongst academic journals in the area. Also, the methods of data collection fit into the intended methodology for my research. Last, it suggests a lot of options for further studies which may be relevant for the addition to knowledge.

Research Design

A research design is a logical structure for the research. It deals with logical problems and not logistical problems (De Vaus, 2001). The function of a research design is to ensure that the evidence obtained will enable us answer research questions as unambiguously as possible. When designing research, it is imperative for the researcher to determine the type of evidence that is needed to answer the questions or test a theory in a convincing way. Thus, in social science research, the issues of sampling, methods of data collection (questionnaires, observations, document analysis) etc are all subsidiary to the matter of what evidence the researcher needs to collect (De Vaus, 2001).

There are various research designs some of which are Comparative, Case study, Experiments, Randomised Control Trials, Cross-sectional, Longitudinal, Action research and the like. Although some research designs are often equated with qualitative and quantitative research methods, Yin (1989) argues that, it is erroneous and irrelevant to equate a particular research design with either qualitative or quantitative methods. Robson (1998, p.5) observes that: "Case study is a strategy for doing research which involves an empirical investigation of a particular contemporary phenomenon within its real life context using multiple evidence." The main research design for this article under review in my view is a case study. The reason for this is that the author sampled selected US manufacturing firm and studied the effects of competitive intensity and business strategy on the relationship between financial leverage and the performance of firms.

There is a huge disagreement over the view that the cost of debt is higher for product differentiation firms than cost leadership firms. So by using case studies to examine the effects of competitive intensity and business strategy on the relationship between financial leverage and the performance of firms, it may be possible to uncover the real theorisation whether product differentiation is more costly a strategy than being a low cost producer. The use of case study made it possible for the author to include past and present phenomena drawn from multiple sources of evidence (Leonard-Barton, 1990) and personal observation. The major benefit for using case study as a research design stems from the fact that it allows the achievement of a personal understanding of organisational phenomena (Patton, 1987)

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The problem of internal validity in case studies may be resolved through the use of ideographic, nomothetic and reactive effect etc. In particular, (Jermias, 2008) dealt with internal validity by using nomothetic approach where particular cases (US manufacturing firms) were used to achieve a more generalized understanding of broader theoretical propositions. However, the issue of external validity is not properly dealt with as (Jermias, 2008) statistical selected cases contrary to the recommendation of (Yin, 1989) who argues that, the external validity of case studies is enhanced by the strategic selection of cases rather than by the statistical selection of cases as the strategic selection of cases contributes to literal and theoretical replication.

Hypotheses testing and its relevance to the study

In order to investigate the relative influence of competitive intensity and business strategy on the relationship between financial leverage and performance, the author came up with two hypotheses. On the one hand the null hypothesis stated that the impact of leverage on performance will vary across different strategies, such that the relationship will be more negative for product differentiation firms compared to cost leadership firms. On the other hand, the alternative hypothesis was that, competition will act as a substitute for debt in limiting managers' opportunistic behaviour, such that the relationship between leverage and performance will be more negative as the level of competitive intensity increases. In the end, the null hypothesis was accepted whilst the alternative one was rejected.

Research method

Research methods are the techniques and procedures used to obtain and analyse research data. The researcher adopted the moderated regression model, which indicates his positivist epistemological perspective to express his understanding of the causal link between competitive intensity and business strategy on one hand and financial leverage and performance on the other through a hypothesis testing. Most previous research done in the area of the relationship between financial leverage and performance have produced contradictory results partly because of the use of the universal approach (Ghosh, 1992; Harris and Raviv, 1991; O'Brien, 2003; Robinson and Mcdougall, 2001; Barton and Gordon, 1987). O'Brien (2003) for example notes that these previous studies overlooked the effects of a firm's business strategy and contends that this may account for their contradictory results.

Sample selection and Method of data collection

Data collection is an essential part of every research. For a research to be completed, data must be collected and analysed for warranted claims if any to be established and for conclusions to be drawn. The particular type of data collection method adopted is dependent on the type of research. Related to data collection is the concept of sampling which is the process of selecting a number of cases from a population such that the selected sample may accurately represent the population. To provide useful descriptions of a population, the sample must contain essentially the same variations as the population. There are basically two major types of samples namely non-probability sampling and probability or random sampling. Non-probability sampling could be convenience samples, quota samples, purposive or judgmental samples, theoretical samples and snowball or network samples. Probability sampling could be a simple random sample, systematic sample, stratified sample and multi-stage cluster sampling.

The researcher effectively used secondary data of manufacturing firms from the US (SIC 2000-3999) listed in the Compustat S&P 500 database, the US economic census (US Department of Commerce, 2000) together with financial information of firms from the COMPUSTAT S&P500 in his analysis. There are several sources of secondary data including achieves, government publications, and corporate documents. The use of such an existing data could provide valuable information in a less expensive manner especially if it is of good and quality source. It also helps the researcher to save time and money. However, secondary data can also pose greater challenges for the researcher. The major challenge could be the identification a reliable quality source of information to avoid biases and the avoidance of the use of outdated information into the research.

The analysis of the sampling technique showed that the study adopted purposive sampling technique to select participants for this study. The reason is that the author was interested in specific firms with certain attributes such as "a firm had to report total assets, total sales revenues, total liabilities, total equities, cost of goods sold, net income, market value and research and development expenses" (Jermias, 2008, p. 5). The concentration ratios (HI) for the firm's SIC code had to be available in the US 1997 economic census as well". The outcome of this was the elimination of those firms that did not meet the selection criteria even though these firms may be progressive in terms of strategic direction and focus. This has the potential of affecting the result of the study. For example, the reduction in sample size may affect the representativeness of the sample thereby affecting generalisability of the study findings across the industry.

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In my view, the unequal categorisation of the 582 sampled firms into 325 cost leaders and 257 differentiators may have had an effect on the outcome, although the process of eliminating firms from the database was rigorous, fair and objective. In addition, the concentration of firms in the manufacturing sector on the basis that firms in the manufacturing industry employ different types of strategies to compete is flaw. In today's competitive and dynamic business world, all firms in all industries employ different strategies to compete. Similarly the concentration of USA manufacturing firms may not sit well with effective generalisation as different countries and continent may pose different political, economic, social, technological and environmental challenges.

Findings and warrant claims

It is important as researchers to ensure that the claims that are made are always supported by relevant evidence because a coherent argument based on a clear reasoning and conclusions allow readers to judge if such claims are adequately supported by evidence. It is also necessary to ensure that both the claim and the evidence are logically related. Gorard (2002) argues that, if a research is intended to change the reader's view, then the warrants must be explicit in the research report

The purpose of the article was to investigate the effects of competitive intensity and business strategy on the relationship between financial leverage and performance. In line with the hypothesis, the results indicate that competitive intensity and business strategy do affect the leverage-performance relationship such that it is less negative for cost leaders than for product differentiators. The results are consistent with the view that debt financing offer cost leaders the benefit of tax advantages and accord them increased efficiency due to the constraints imposed by debt holders (Jensen, 1986; O'Brien, 2003; Simerly & Li, 2000). However, the cost of debt will be higher for product differentiation firms since lenders' constraints might limit managers' ability to be creative and innovative, which is crucial for these firms to thrive and succeed.

Moreover, the results suggest that competition acts as a substitute for debt in reducing the cash flow available to managers. Therefore, the benefits of debt diminish as the level of competitive intensity increases.

The effect of the strategy/leverage and competitive intensity/leverage interactions on performance is inconsistent with the irrelevance proposition made by Modigliani and Miller (1958).

In my view, the researcher is able to make these claims because there is a clear, explicit warrant between the observation data and the conclusion. A claim which is in line with what Fisher (2001) states that an "arguments… always contain a set of claims which are presented as reasons for accepting some further claim" which is confirmed by Thouless (1930) that, "every argument can be reduced to the form of an assertion that if P is true, then Q is true"

Areas of concern

There are some areas that need further attention associated with the research, some of which are highlighted below:

In the first place, the research only considered limited range variables that may affect the relationship between financial leverage and performance. However, the results could be different if other confounders in the form of other organisational variables such as managerial characteristics, types of control and types of management accounting systems might affect this relationship.

Secondly, although industry concentration ratios are considered by many to be the most relevant variable by which to measure competitive intensity (e.g., Ramaswamy, 2001; Grosse & Yanes, 1998), the competitive intensity itself might be influenced by other variables such as technology, barriers to entry, government regulations and availability of substitutes etc. Thus the researchers reliant on the measure of competitive intensity based on industry concentration ratios might not completely capture the competitive environment hence may be flawed.

Moreover, a recent study by Parthiban et al., (2007) revealed that even the type of debt whether relational or transactional debt in a firm's capital structure may influence the relationship between competitive strategy and performance. Here, the researchers found that R&D intensive firms that rely heavily on relational or bank debt perform better than those that rely more on transactional or bond debt. This research has proven that further future research need to be carried out to determine whether the results might vary across different type of debt.

Lastly, the sample data from US manufacturing firms was too simplistic hence there is the need to increase the sample size across industries and possible other regions and continents to ensure effective generalisation. Future research needs to examine whether the results of this study can be extended to other industries and/or other countries. (O'Brien, 2003; Harris & Raviv, 1991) argue that the most interesting application of business strategy to the topic of financial leverage is to explain intra-industry variation in the use of debt versus equity financing.

Philosophical perspectives

Fundamental to every enquiry are questions that need answers. The provision of answers to these questions to a large extends depends on the researchers view on issues such as what constitute acceptable knowledge, the nature of reality that informs the relationship between the researcher and the object of knowledge and the process to be followed to create knowledge. The answers to these questions express a disposition that gives an indication of the researcher's view on these issues. Johnson & Clark (2006) states that as researchers, we need to be aware of the philosophical commitment we make through our choice of research strategy since it has significant impact on what we do and to understand what we investigate. They further argue that, the important issue is not so much whether our research should be philosophically informed, but it is how well we are able to reflect upon our philosophical choices and defend them in relation to the alternatives we could have adopted.

A scan through the evolution of academic research dispositions (paradigms) reveals paradigms are differentiated by the answers adherents provide to questions centred on ontological and epistemological positions (Guba, 1990). Similarly, Saunders et al, (1997) argue that the two major ways of thinking about research philosophies are ontology and epistemology.

Many ontological positions have been adduced to in literature, but the three prominent amongst them are the positivist/functionalist, interpretive/constructivist and critical paradigms (Guba, 1990; Blaikie, 2000; Grix, 2002). The positivistic ontology holds that reality exists independently of social actors and science is based on observations and its measurements (Denzin & Lincoln, 1994). The interpretivists believe that reality is socially constructed and one cannot access the external world irrespective of its existence or otherwise (Blaikie, 2000) whilst the critical realism ontological position accepts the existence of social reality and human construction but holds that groups and organisations generate actual events (Sayer, 1992). It must be realised that, the positivist objectivity assumption and the subjectivity assumption from interpretive paradigm present limitations and distortions.

Blaike (2000) assets that, epistemology deals with the possible ways of gaining knowledge and considers what constitutes acceptable knowledge in a field of study. Many epistemological positions have been adduced to in literature. Prominent amongst them are positivism, realism and interpretivism.

The philosophy of the positivism is akin to the position of the natural or physical scientist who are obsessed with facts. The positivist only sees acceptable knowledge (reality) as represented by objects that are considered to be real with separate existence to that of the researcher. They believe that, data collected must be less open to bias and therefore more objective. Positivist epistemologists prefer observable social reality that could lead to law-like generalisation similar to those produced by the physical and natural scientist (Remenyi et al, 1989, p. 32). They mostly use existing theory to develop hypothesis that can be tested to confirm, refute or develop new theories using statistical analysis. Positivist epistemologists generally undertake research in a value-free environment such that they are independent of and neither affects nor is affected by the subject of the research (Remenyi et al, 1989, p.33). They use highly structured methodology in order to facilitate replication (Gill & Johnson, 2002).

This philosophical position of realism is similar to the positivist in that it assumes scientific approach to the development of knowledge and believes that there is reality quite independent of the mind. Bhaskar (1989), a critical realist argues that as researchers we will only be able to understand what is going on in the social world if we understand the social structures that have given rise to the phenomena. He stress that, what we see is only part of the bigger picture Bashkir (1989). The epistemological position of the interpretivism is that, it is possible for researchers to understand differences between humans and understand the world better by conducting research among people rather than objects in their roles as social actors and to adopt an emphatic stance.

The underlying philosophical perspective of this article is Positivist, which usually makes use of quantitative methods. It tries to figure out the social situation by categorizing individual components of a phenomenon and elucidating this phenomenon in terms of construct and relationship between constructs (Cavaye, 1996). In terms of this article the author tries to establish and statistically measure the effects of competitive intensity and business strategy on the relationship between financial leverage and the performance of firms. Here there is a cause and effect situation where there is an independent variable (in this case financial leverage) and dependent variable (performance of firms).

This is an epistemological position that advocates that reality can be captured using methods that are more akin to the natural sciences. From this perspective there is an objective reality "out there" that can be known and measured and the role of the researcher is that of an independent observer who can observe or "capture" that reality as it occurs without influencing the capturing process. In contrast, in a qualitative approach, the researcher tries to be acquainted with a phenomenon from the perspective of the actors directly involved with the phenomenon under consideration (Cavaye, 1996).

Axiology

This is an aspect of philosophy that studies judgement about value including aesthetics and ethics. Axiology argues that the role of our values may determine the credibility of the outcome of an enquiry. Heron (1996) argues that our values are the guiding reasons of all human actions and that, the demonstration of our axiological skills determine the selection of our research process. Heron (1996) further argues that the choice of our philosophical approach is a reflection of our values and data collection techniques.

The position of a researcher on the issue of whether scientific knowledge is 'values-free' or 'value full' influences epistemological position taken and the methodology employed for any scientific enquiry. Two positions on the value judgment debate are held by those who strongly believe in the tenets of positivism and the interpretive paradigm. The underlying issue behind these two positions is whether reality exits independently of human actors. If this assumption is granted, then it can be argued that the objects of science are value-free. However, the human connection to the practice of science cannot be overlooked, hence involves value judgment.

Ethics

It is always advisable as researchers to comply with good ethical practice and exhibit good research 'citizenship' and personal responsibility. Research ethics relates to questions about the formulation of the research topic, the research design, gaining access, data collection process, data analysis, data storage and finally the write up and distribution. Ethics ensure that researches are both methodologically sound and morally defensible to all those who are involved.

Research ethics has been defined as "the moral principles guiding research, from its inception through to completion and publication of results and beyond - for example, the collection of data and physical samples after the research has been published" (ESRC Research Ethics Framework 2005, p. 7). Similarly, research ethics is the appropriateness of the researcher's behaviour in relation to the rights of those who may become the subject or are affected by your work. Cooper and Schindler (2008, p.34) see research ethics as norms or standard of behaviour that guide moral choices about our behaviour and our relationship with others. A social norm indicates the type of behaviour that needs to be adopted in a particular situation (Robson 2002 and Zikmund 2000). It is recommended that ethical issues are carefully considered throughout the course of the research and be guided by a code of ethics set by the regulatory body. Such codes must be written in abstract terms and designed to prevent misconduct (Bell and Bryman 2007)

As per the nature of journal article writing, ethical issues considered are not overtly stated. It is therefore my expectation that all ethical protocols were followed as suggested in the ESRC Research Ethics Framework (2005, p.7).

Conclusion

The main objective of this assignment was to critically review an article written by Jermias (2008) titled "The relative influence of competitive intensity and business strategy on the relationship between financial leverage and performance by summarising its research design, methods of data collection and analysis, findings and an evaluation of the philosophical principles that underpin these features. The article possesses the qualities of a well researched work. The author conducted a thorough review of the literature; the analysis was carefully done to bring out the key issues of the study. The conclusion drawn was the acceptance of the null hypothesis that, competitive intensity has a negative effect on the leverage-performance relationship and that, there is the need to consider moderating factors such as strategic choice and the environment in which a firm operates when investigating the effects of leverage on performance. In my opinion, the article achieved its objective by confirming the null hypothesis and rejecting the alternative one. The article also made a major academic contribution on the issue of leverage and capital structure, an issue that has for a long time been grappled with by management of organisations in determining an optimal capital structure.