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Bureau of Economic Research
Volume Title: Conference on Research in Business Finance
Volume Author/Editor: Universities-National Bureau
Volume Publisher: NBER
Volume ISBN: 0-87014-194-5
Volume URL: http://www.nber.org/books/univ52-1
Publication Date: 1952
Chapter Title: Factors Influencing Managerial Decisions in Determining
Forms of Business Financing: An Exploratory Study
Chapter Author: Neil H. Jacoby, J. Fred Weston Chapter URL: http://www.nber.org/chapters/c4788 Chapter pages in book: (p. 145 - 198)
FACTORS INFLUENCING MANAGERIAL DECISIONS
IN DETERMINING FORMS OF BUSINESS
FINANCING: AN EXPLORATORY STUDY*NEIL H. JACOBY and
J. FRED WESTONUniversity of California, Los Angeles
I BASIC ISSUES AND CONCEPTS
The fundamental question explored by this paper may be stated as follows:
What factors influence the decisions of managements of American business enterprises in determining forms of financing? A subsidiary, though related, question is: What factors should influence managerial decisions regarding forms of financing? For significant differences may exist between actual financing decisions and. the decisions that would be made, if managerial knowledge of the relevant determinants were more precise and complete.
Attention is focussed upon the current status of knowledge of this subject and upon methods of augmenting that knowledge.
The paper represents an effort at synthesis and the formation of concepts. Its main purpose is not to present the results of empirical research.
Nor is it primarily concerned with the factors that determine the inducement to invest, the amount of investment, or the demand for funds by business enterprise. Herein it is assumed that inducements of given strength have led to certain demands for funds; our preoccupation is with the factors that lead managements to adopt one method instead of others in obtaining such funds. Nevertheless, the two types àf decisions clearly are interdependent. The particular forms and variants of financing that are * The authors gratefully acknowledge criticisms and suggestions made by colleagues in the University of California, including Professor W. L. Crum, Professor R. A.
Gordon, Dr. James McNulty, Jr., and Mr. Frank Norton. The study has been facilitated by assistance provided through a University Research Grant from the Committee on Research, University of California.
146 RESEARCH IN BUSINESS FINANCEavailable at any time to business concerns have an influence of considerable importance upon the amount of the current demand for funds. For example, the development by commercial banks of such new credit forms as the term loan has undoubtedly reduced the 'amount of capital rationing undertaken by banks during periods of business recession or high economic uncertainty.
Relation of Public and Business Policy to Knowledge of Financing Forms Manifestly, many issues of public policy and of business policy turn upon adequate knowledge of the matter under examination. An enhanced understanding of the financial decision-making process in business concerns would aid in the realization of a primary aim of public policy — to encourage a sustained, rising level of business investment, and thereby to maintain a high level of employment, production and real income. It would also contribute to the success of business policy, which aims to maximize the present value of the anticipated net income of the firm and to maintain its solvency under the control of its management in a fluctuating environment.
Finally, such knowledge holds much value for investment bankers, commercial bankers, insurance companies and other suppliers of funds by enabling them to adapt more rapidly and more accurately the terms of financing arrangements that they stand ready to offer. It is worthwhile to indicate more specifically what bearing the knowledge of factors influencing decisions on forms of business financing has upon the effectiveness of public policy, business policy, and the policy of suppliers of funds.
Federal fiscal and monetary authorities possess the power to influence the structure of interest rates. Interest-rate policy would be more soundly based if governmental authorities knew to what extent interest-rate structure was determinative of business investment decisions, and how business managements respond to changes in the structure of interest rates with respect to the aggregate amount of investment undertaken and the forms in which it is financed.
Federal tax policy also exercises an important influence upon choices of financing forms. What changes in these decisions would probably occur, if specified changes were made in the federal tax structure? For example, if the federal tax on corporate net income were raised (or lowered) by 50 percent, what would be the probable effect upon aggregate investment by corporate business, and upon the extent to which it would be internally rather than externally financed? Answers to such questions as these would be extremely useful to tax policy makers.
FACTORS INFLUENCING MANAGEMENTS
While financing decisions cannot be based entirely upon quantifiable considerations, the presence of uncertainty calls for a more, not a less, systematic analysis of the relevant factors. Without a systematic approach to the selection of financing forms, important variables may be overlooked or given insufficient consideration. Certain it is that better selection of available forms would increase the survival rate in the business population.
Many enterprises go under during periods of general economic recession — especially those whose sales and profits are highly sensitive to changes in national income — because too large a proportion of their assets was financed by short-term obligations. Ill-conceived financial policy often brings failure to concerns whose managements have well-conceived production and marketing policies with a potential for long-run success. Such failures cause valuable business organizations to be disbanded and productive resources to be reallocated, with social as well as monetary losses to the owners and creditors of the failed ventures.
During recent years American business managements appear to have held expectations of wide fluctuations in business activity, which have made them willing to pay high premiums for reduction in the risk positions of their firms in choosing forms of financing. In many cases such expectations may have caused firms to forego opportunities for profitable investment, where the only available form of was believed to carry too great an exposure to the risk of insolvency in the event of business recession. It is possible that a more accurate evaluation of these risks, present and future, would produce a different pattern of financing forms and a higher aggregate level of business investment.
Finally, more accurate and complete knowledge might enable managements to devise financing programs under which the enterprise would be able to secure funds to finance an expansion of total assets at times when asset prices are relatively favorable. A management that recognized the possibility of the firm's profiting from building assets during cyclical recessions would not finance its current operations from a source of funds under which it is debarred by contract from either making further capital expenditures or obtaining additional funds during the life of the loan contract. Better timing of asset expansion through the business cycle, by more adroit use of financing forms, would not only be profitable to the enterRESEARCH IN BUSINESS FINANCE prise, but it would also make a contribution to general economic stability.
With respect to the policies of suppliers Of funds to business, it appears likely that more knowledge of the influential factors governing the form of the demand for funds would enable them to fashion innovations, and to reduce the extent of the restrictions that they now consider necessary to impose upon the funds they will supply. It might further develop an entrepreneurial attitude on the part of suppliers in assuring that there always exists a financing arrangement which supports and encourages business asset expansion and still provides adequate protection to the supplier.
To the extent that a systematic method of analyzing factors influencing forms of financing may be devised, there would be provided a better basis for predicting the amount of the demand for funds in different forms. Such predictions would be useful to suppliers in setting prices for funds and adjusting their own financial positions to impending changes in market demand.
2 A Classification of Forms Initially, it is necessary to state what is meant by "forms" of business
financing. For purposes of this exploration, the following simple classification is utilized:
Internal financing (}etention of net income in the business, or redirection of assets within a given total) External financing (contracting for funds with suppliers outside the enterprise, including its current stockholders)
a) Equity funds (common and preferred stocks)
b) Credit or borrowed funds
1) short-term (maturing in one year or less)
2) long-term (maturing in more than one year) This classification is not entirely satisfactory, because the distinctions drawn by it may be blurred in practice, or because a single financing transaction may involve several forms of financing simultaneously.
For example, the declaration of a stock dividend by a business corporation entails the allocation of earned surplus, arising from previously retained profits, to the capital account on its balance sheet. This is essentially an incident to internal financing of expansion in total assets, although it also involves the external aspect of issuance of contracts (shares of stock) by the firm to its stockholders. Again, the arrangement of a "revolvFACTORS INFLUENCING MANAGEMENTS ing" line of credit by a business with a bank over a period of several years is essentially a contract for long-term credit, although sums of money actually advanced under the contract may be repaid in their entirety within a year and therefore constitute short-term credit. Or, a term loan made by a bank to a business, repayable over a five-year period in annual installments of equal amount, involves extension of short-term credit to the extent of one-fifth of the total loan and long-term credit to the extent of four-fifths. Despite such difficulties in application, the proposed classification of forms of financin°g possesses the advantage of corresponding to the traditional categories of liabilities carried on business balance sheets. Mixed forms of financing are comparatively infrequent, and borderline cases can usually be classified without great difficulty into one or another category.
For some purposes it is necessary to utilize a more detailed classification of forms of financing, which recognizes that within each category there are several significantly different variants. For example, short-term credit may be evidenced by a single unsecured note of the borrower, or it may consist of a "revolving" fund of credit secured by a changing complex of collateral, such as assigned accounts receivable or warehouse receipts.
Long-term credit may be unsecured or be secured by pledges of real estate, machinery and equipment, on negotiable securities; it may be repayable in a lump sum or in installments of equal or unequal amount.
Equity funds may take the form of common or preferred stocks; and the latter may call for cumulative or non-cumulative dividends, and they may also possess various types of preferences and privileges with respect to claims on earnings or assets, or to control of the corporate board of directors under defined circumstances.
Furthermore, for each form of business financing, and variants thereof, there are usually a number of different types of sources of funds, with each of which, from the standpoint of business management, there are associated certain unique characteristics that differentiate the funds supplied by it from funds supplied by other sources. Thus, consider the case of a business concern that may obtain the funds it requires by borrowing on an unsecured basis for a term of ten years. The source of this credit might be a group of investment bankers who purchased debentures and sold them to the public; it might be a group of insurance companies that privately purchased the debentures for retention in their investment portfolios; or it might be an individual capitalist or investment company with which the business directly negotiated the unsecured loan. We may assume that the legal form of the loan contract was identical in all of these cases. Yet from the point of view of the borrowing business differences in the publicity
150 RESEARCH IN BUSINESS FINANCEassociated with the transaction, in concentration of control of the creditorship rights, and in other factors, may make these three types of transactions clearly distinguishable.
Within the compass of this paper, any summary of present knowledge about factors influencing decisions on forms of financing is bound to be synoptic and impressionistic. A brief review, however, may serve to indicate generally what is known and what remains to be done.
While considerable literature on business finance has appeared, a disprOpOrtiQflate part of it consists of descriptive writing of limited scientific value. The substantial works may be grouped for consideration into six major categories: 1) studies of the formulation of financial plans; 2) studies of financial standards; 3) aggregative studies of financial structure;