Week 4: Stakeholder Theory of Capital Structure Flashcards
What is the stakeholder theory of capital structure?
Way in which a firm & its nonfinancial stakeholders interact is important determinant of firm’s optimal capital structure as it affects firm’s financial decision-making.
Who are nonfinancial stakeholders?
Associates of firm e.g. customers, employees, suppliers, competitors & community in which firm operates, who DO NOT HAVE DEBT OR EQUITY STAKES IN FIRM, but have stake in firm’s financial health.
How does a firm’s financial condition affect customers & suppliers?
Firm’s decisions relating to quality of its product depends on its financial condition –> e.g. rate of return for producing product of particular quality must > firm’s cost of capital –> otherwise if condition not met firms may have to produce lower quality products –> financial condition can affect how firm perceived in terms of being a reliable business or supplier.
How does a firm’s financial condition affect employees?
Affects firm’s ability to attract & retain human capital –> e.g. corporate distress can lead current employees to search for more stable positions & new recruits to focus their searches elsewhere –> concerns about short-run solvency strain firm’s reputation for treating employees fairly as corporate distress often leads firms to pay lower wages & to downsize their workforce.
Why are employees often reluctant to do business w a highly levered firm?
Financial distress can affect firm’s incentive to honour its implicit contracts w them e.g. to avoid immediate bankruptcy, a highly levered firm could have strong incentives to increase cash flows by cutting costs related to employee benefits –> rational employees would demand higher wages for their labour –> reduces firm value.
Which types of firms should have relatively less debt in their capital structures?
Firms which experience higher financial distress costs:
1) FIRMS W PRODUCTS W UNOBSERVABLE QUALITY OR FUTURE SERVICING REQUIREMENTS:
e.g. if firms w high-tech equipment or complex machinery face financial distress & are unable to meet debt obligations, it may struggle to maintain quality or service levels expected by customers –> potential revenue losses & repetitional damage –> if firm’s products require ongoing maintenance or servicing, financial distress can impede its ability to provide these services, further deteriorating customer satisfaction –> hence lower debt levels may reduce impact of financial distress, providing firms with greater financial flexibility to continue operations in econ. downturns or unexpected challenges w/out compromising product quality or service standards.
2) Employees & suppliers requiring specialised capital/training –> e.g. if firms requiring specific capital investments or training faces financial distress & is unable to meet debt obligations, they may struggle to retain skilled employees or secure critical inputs from specialised suppliers, creating supply chain disruptions –> can hinder firm’s ability to maintain operations, fulfill orders, or deliver products/services on time –> potential revenue losses & reputational damage –> hence lower debt levels may reduce likelihood of firm’s financial distress by safeguarding operational continuity & competitiveness.
Which types of firms should have relatively more debt in their capital structures?
Firms which experience lower financial distress costs:
1) FIRMS SELLING NONDURABLE GOODS OR LESS SPECIALISED SERVICES: nondurable goods are consumed quickly, reducing risk of quality deterioration or service disruptions if firm faces financial distress –> firms providing less specialised services may have more flexibility in adapting to changing mkt conditions or sourcing alternative suppliers, mitigating impact of financial distress on their operations –> hence higher debt levels may provide tax advantages e.g. as interest is tax deductible –> can potentially achieve higher returns on equity for their shareholders, provided financial distress risk managed.
2) FIRMS WHOSE QUALITY CAN EASILY BE ASSESSED –> decreases firm’s reliance on brand image/reputation to drive sales even under financial distress as customers make purchasing decisions based on tangible attributes so may have high level of trust in firm –> reduces vulnerability of firm to financial distress damage.
How may high leverage & financial distress benefit firms?
IMPROVES BARGAINING POSITION W UNIONISED EMPLOYEES –> e.g. if firms face pressure to raise wages but would adversely affect profits, firm can respond by issuing debt & repurchasing shares w proceeds –> reduces no. of outstanding shares –> increases earnings per share (EPS) –> increases company’s stock price –> increases leverage –> increases interest payments –> profits decrease even before wage renegotiations –> firm less able to meet debt obligations so can justify a smaller wage increase.
Why should firms react to an increase in employment protection laws by reducing financial leverage?
Employment protection laws protect employees’ rights by making it more difficult for firms to lay off workers or adjust labour force –> firms may be more reluctant to hire new employees due to difficulties in adjusting future workforce –> increased labour mkt rigidity –> employer-employee relationship resembles debtor-creditor relationship where wages are like coupon payments on debt –> crowds out financial leverage as firms less inclined to take on additional debt due to large existing labour cost obligations –> raises firms restructuring costs as more expensive & difficult to restructure labour force –> cost of financial distress for given level of debt increases as firms may struggle to meet both labor & debt obligations –> firms incentivised to reduce their financial leverage & instead may rely more on equity or other forms of financing that do not carry same level of fixed obligations as debt.
How does debt in a firm’s capital structure affect its competitiveness & market share?
MAKES FIRMS LESS AGGRESSIVE COMPETITORS –> leveraged firms prioritise meeting debt obligations & having enough cash flows within business rather than engaging in potentially risky competitive activities e.g. predatory pricing strategies, innovation, marketing campaigns, or expansion into new mkts which may reduce retained earnings & pose sunk costs –> hence leveraged firms face higher risk of predatory actions by their competitors which may attract customers away from them or undermine their reputation, potentially diluting its mkt share –> risk of mkt share dilution worsened by leveraged firm’s inability to invest in new projects & expand business operations which may worsen its reputation.
