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«Volume Title: Conference on Research in Business Finance Volume Author/Editor: Universities-National Bureau Volume Publisher: NBER Volume ISBN: ...»

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So long as the firm is producing a satisfactory return, stockholders are likely to remain passive and acquiescent. They accept the judgment of management on issues of policy, because they recognize the limitations upon their own knowledge of relevant facts. If the firm becomes unprofitable, loses ground to competitors, or appears to be missing evident opportunities, stockholder interest in business policy quickly becomes articulate, and managers are called upon to defend their decisions. The management group typically does not have divergent interests from those of the ownership group. Rather, management's appreciation of the complex of factors that bear upon decisions is wider and its horizon of planning may be more distant. Hence one is justified in concentrating attention upon managerial attitudes in studying factors that influence forms of financing.32 Indirect Influences on Managerial Decisions So far, the problem of constructing an analytical framework to deal with problems of choice in forms of financing has been approached through a consideration of the financial decision-making process within the business firm. This approach has indicated that numerous factors bear directly upon such choices from the point of view of management. Such factors obviously include the relative costs of obtaining funds under different types of financing contracts. They also embrace the relative amount of risk imposed by different contracts upon the firm, and the evaluation of risks by the management group. The relative effects of different financing contracts upon the status of management and its powers of control also appear to be influential.

The authors have benefited from valuable suggestions by W. Yost Fulton, arising out of his experience as an investment banker, on the relation between management personnel and financial decisions; see his discussion, which follows, of our paper in its earlier version. Mr. Fulton is not, of course, responsible for the views expressed in this section.


It is now necessary to recognize that the financing decisions of the firm are determined, not alone by factors influencing its management directly, but also by factors influencing the decisions of suppliers of funds.

That is to say, the decisions of suppliers limit the range of alternative financing forms open to a particular business at a given time. Hence, a complete analysis of the problem of choice requires a consideration of the factors operative on the supply side of the financing markets which influence management indirectly.

This analysis may be restated for clarity. The range of choice open to the management of a business with respect to the form of its financing is limited and circumscribed by the decisions of suppliers of funds. These decisions, in turn, appear to be based upon the characteristics of the business as they are seen by suppliers, and upon the generally accepted financial standards that are applied to the business by suppliers of funds. Within this range, the management 'of an enterprise exercises its discretion in choosing from among those forms of financing that are available to it in the market.

The economic characteristics and performance of the firm, including its size, age, profitability, position in the industry, stage of growth, assets, collateral security, seasonal 'and cyclical fluctuation, future prospects and the reputation and record of its management are all obviously taken into account in "rating" its worthiness to receive funds on an equity or credit basis. Apart from such general economic characteristics, suppliers apply to each firm the generally accepted financial "standards," which take the form of financial ratios and magnitudes considered to be appropriate for the industry or line of trade in which the firm is engaged. Financial standards must be applied with discrimination and interpreted with care; but they are widely utilized and undoubtedly exercise an important influence upon the supply of funds available to an enterprise.

Clearly, the two sets of variables — those directly affecting business managers and those indirectly affecting managements through their influence upon suppliers of funds — are interacting. Managements may be presumed to be aware of the financial standards commonly applied by suppliers of funds, and of the characteristics of their enterprise which are considered to be significant. To the extent that managements possess and use such knowledge, they modify the forms of their demand for funds to meet the conditions of supply. Similarly, suppliers of funds may be preof the factors that directly influence sumed to possess some managerial preferences for financing forms, and through time the financial standards and business characteristics that determine their supply functions will be modified in the light of them. Hence, observation of the


alternative forms of financing under consideration by the management of a business may reveal as much about the decisions of suppliers on the forms of financing they will make available as it reveals about the preferences of management.

A Tentative Classification of Influential Factors A comprehensive classification of factors determining the decisions of business 'managements in choosing forms of financing may now be set forth. It represents 'a collation and synthesis of factors referre4 to in published literature, augmented by interviews and correspondence with financial executives of several samples of business firms. The classification is tentative and undoubtedly incomplete, for the present state of knowledge does not permit of a definitive framework. Much further empirical investigation is required to refine and expand the classification, as well as to discover the weights that should be attached to each factor or category of factors.

The proposed classification is intended to be interpreted in dynamic terms, in that all of the factors possess a time dimension. Present decisions as to forms of financing turn partly upon management's anticipations of relative shifts in the terms carried by various financing forms. To illustrate, a firm may elect to borrow on short term because its management anticipates a reduction in long-term money rates relative to short-term rates in the future. Such relative shifts may affect each of the factors listed in the classification, so that it would be unnecessarily duplicative to include anticipations explicitly.

Tentative and incomplete though it is, the classification is believed to provide a more comprehensive, systematic, and valid conceptual framework for dealing with decisions regarding financing forms than any that has previously been formulated. It demonstrates the wide range of factors involved in such decisions. At the minimum, its use should lessen the prçbability that erroneous conclusions will be drawn on the basis of oversimplified analyses.

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case of common stock the annual dividend requirement per share/net proceeds per share ratio in the case of preferred stock issues)

2) Cost of obtaining funds (Sums paid to investment bankers, lawyers, accountants, engineers and other experts; value of time of executives and other employees; registration, ffling, recording, and other fees required by law; other cost incurred prior to receipt of funds by the business)

3) Cost of utilizing the funds (Cost of assembling, pledging, transporting and releasing collateral security; fees of stock transfer and registrar agents; cost of listing securities on exchanges and ffling reports with exchanges; other costs incurred while funds are in use by the business)

4) Effects upon tax liability (Extent to which federal, state, and local tax liabilities are presently or potentially affected)

5) Flexibility in amount of funds utilized (and charged for) (Degree to which funds in use and charged for are related to temporal changes in the requirements for funds by the enterprise; extent to which contract does not impose obligation to pay for "idle" balances)

B) Qualitative Factors in Funds Supplied

1) Speed of availability (Rapidity with which funds are placed at the disposal of the enterprise after negotiation of the contract)

2) Breadth of publicity (Range of disclosure of business affairs required; extent of publicity required or probable and its effect upon business operations)

3) Amount of advice and counsel provided by supplier of funds (Value, in the judgment of the management, of financial counsel and advice provided by supplier as part of the transaction without additional charge. Value, in the judgment of the management, of organizational, personnel and business policy services provided by supplier as part of the transaction without additional charge)

C) Inherent Risk Factors

1) Relative rigidity of contractual terms (Relative vulnerability of the firm to fluctuations in sales and net income, in the light of the fixity of payments for the use of funds)

2) Flexibility of repayment schedule (Degree of flexibility in loan contract regarding repayment of debt, including provisions for gearing repayments to sales, profits, cash "throw-off" ability; provisions for renewal at option of borrower, etc.)

3) Pledge of assets required (Range and extent to which assets are required to be pledged as collateral security; extent to which assets are rendered unavailable as a basis for future financing) It is recognized that the expected dividend rate is viewed by some as a more appropriate measure of cost to the firm. An approach which avoids a direct calculation of the cost of equity funds evaluates the cost of alternative financing forms by measuring their effects upon capitalized earnings per common stock share. This may be regarded as an alternative formulation of the relationship cited above.


4) Liabilities imposed on management (Degree to which officers and directors are exposed to suits by stockholders, or to legal actions by governmental regulatory agencies)

5) Foreclosure of other sources of funds (Extent to which resort to other sources of funds is inhibited by formal agreement or informal understanding; failure to develop alternative contacts for lines of credit)

6) Policies of supplier in event of default (Probability that supplier of funds will modify terms of contract in event of difficulty; reputation of supplier for pursuing strict or lenient policies in enforcing obligations)

7) Likelihood of renewal (Probability that the initial financing experience will open up opportunities for utilizing the source of funds to meet future requirements of the business)

8) Impact of business fluctuatidns upon the firm (Income elasticity of demand for the firm's products; need and ability to achieve liquidity as general anticipations change; impact of secular changes in demand and technologies)

D) Factors Influencing Management's Evaluation of Risks

1) Management's attitude toward uncertainty (Relative aggressiveness of management; willingness to take chances)

2) Term of management's service in office (Duration of present management's tenure in office; expectations of duration of tenure in the future)

3) Extent of management's experience (Length of service in other firms as well as the present firm; nature and duration of experience in the performance of executive duties; indicated ability to conduct effectively an enlarged scale of operations)

4) Maturity of the organization as an operating unit (Length of time that members of the present organization have been functioning together; frequency and recency of changes in scope of operations requiring formal organization structure changes; extent to which high morale and effective organization communication has been achieved)

5) Extent of management's ownership interest (Magnitude of personal stake in the enterprise; influence of stewardship responsibilities)

6) Extent of managerial influence on the board of directors (Extent of management representation on the board; extent of indirect influence on the board; degree of confidence of the board in management and variations in the range of decision-making power delegated to the management by the board)

7) Security of management's control position (Degree of exposure of present management to replacement by virtue of shifts in ownership of voting securities, presently or contingently)

8) Expectations regarding economic change (Appraisal by management of the nature of likely short- or long-run business fluctuations; the Weltanschauung of management toward economic change)


E) Factors Affecting Management's Power of Action

1) Approval of owners and other.gr,oups (Measure of "social approval" accorded the form of financing by stockholders, employees, customers, governmental agencies and other groups, according to prevailing attitudes)

2) Shifts in the locus of legal control rights (Extent of dispersion and shifts of voting securities and the probable impact of any changes upon the range of powers delegated to management)

3) Effects upon range of managerial decision-making powers (Extent to which management is required to secure approval from source of funds regarding capital expenditures, changes in officers' salaries, payment of dividends, and other matters as a condition of obtaining funds)

4) Restrictions upon use of funds (Degree to which uses of funds are restricted by the supplier; degree of freedom with which management may employ funds in acquiring assets of different kinds)



A) Characteristics of the Firm

1) Size of firm (Size, measured in total assets, is positively correlated with fund availability because larger firms usually have greater market and earnings stability)

2) Age of firm (Age is positively correlated with fund availability because it implies a record of successful operation and solvency)

3) Profitability of the firm (Historical record and future prospects of the profit rate, measured by rate of earnings on invested capital or on net sales)

4) Position in the industry (Occupancy of market of the industry, role as innovator in the industry)

5) Stage of life-cycle of the industry (Whether fundamental demand-supply forces indicate a growing, mature, or declining role of the industry in the economy)

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