Capital structure, growth and corporate performance

So far we have discussed the effects of growth and capital structure separately. The theories we presented on growth largely predicted a positive relationship between growth and performance, with the exception of Gibrat’s law and inertia theory. Capital structure theory largely predicted a negative link between debt levels and firm outcomes, excepting trade-off theory and the Modigliani-Miller theorem. In this subchapter we present theories where growth and capital structure in conjunction determine performance outcomes. We first discuss capital opportunity cost theory, before reviewing a holistic model for firm growth and capital flows.

29 2.1.3.1 Capital opportunity cost theory

The capital opportunity cost theory state that there should be a positive relationship between leverage and the current growth opportunities a firm faces (Barton & Gordon, 1988; Toy et al., 1974). The theory states that high-growth firms have above-average investment opportunities, i.e. projects generating positive net present value (NPV) for the firm. These firms therefore have a high opportunity cost of hoarding capital rather than investing the money. For particularly fast-growing firms, it is reasonable to expect that cash requirements for further investments at some point exceed the capacity for generating funds internally (Barton & Gordon, 1988). The best solution, according to pecking-order theory, then becomes borrowing external capital to continue growth. Gupta (1969) further argues that high growth firms might frequently turn to external capital, as this allows flexibility in investments decisions. Managers with a sufficient desire for high growth might also accept restrictive debt covenants to achieve leverage (Barton & Gordon, 1988). This might mitigate some of the potential underinvestment problems associated with debt-overhang and pecking-order theory.

If high-growth firms actually do face above-average investment opportunities, we should expect a positive relationship between leveraged growth and performance outcomes.

Assuming managers make accurate project NPV predictions, firms with above-average investment opportunities should also be more profitable. Naturally, they should also have larger growth potential relative to other firms. In sum, capital opportunity cost theory state that there should be a positive relationship between high leverage and high growth opportunities, and performance outcomes.

2.1.3.2 Capital allocation, growth prospects and the selection environment

So far we have presented a number of different theories and ideas. In an attempt to pull the different strands together, we present a holistic model for capital structure and growth, developed by Knudsen & Lien (2014). The model combines product market insights from our growth theories with factor market insights from theory on capital structure.

In the model, productivity is the determining factor of competitive outcomes in both factor and product markets. More productive firms “win” in product markets, where selection pressures cause these firms to increase market shares. A similar pattern will emerge in factor markets, where capital is allocated to more productive firms at the expense of less efficient companies. A key difference in factor market allocation, however, is the existence of a time

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horizon aspect. Firms with low levels of profitability or productivity today might still be attractive if growth prospects are sufficiently high. In normal times, investors are therefore indifferent regarding the exact period in which productivity occurs. An example used by Knudsen and Lien is the recent valuation of Snapchat to 19 billion dollars – a company almost completely devoid of current revenue generation. This characteristic of capital markets is important for ensuring efficient resource allocation. Without it, financing R&D-intensive projects and innovation might for example be problematic. In addition to attracting equity and credit in factor markets, a third and last source of finance is through retained earnings. The discussion so far can be summed up in the model below.

Figure 1: Selection environments and capital flows

The left hand side of the figure shows the three potential capital sources of firms – retained profits, equity and credit. The inflow from these increase capital reserves of companies, which is depleted by capital outflows – deficits, investments in growth and dividend payouts. The inflows can also be seen as a form of feedback from the environment. If investors and creditors view the company as a viable investment object, they will allocate capital to the

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firm. If customers value and purchase the firm’s products and services, feedback is provided through high earnings.

A central implication from the model is that the nature of these capital flows will depend on the type of company. Companies that are highly profitable today receive substantial capital inflows through retained earnings. However, they might have fewer investment opportunities, therefore preferring to let the cash flow out through dividends. Firms with high growth potential, on the other hand, might have negative current profits, while the majority of capital outflows are funneled into growth investments. This is supported by Chakravarthy & Lorange (2009), who find that only a small percentage of firms are able to simultaneously achieve high growth and high profitability. The growth projects of high-potential firms are then mainly financed through equity or credit, since they have limited ability to use retained earnings. The point is that two companies can have the same net capital inflow, but through very different channels. Furthermore, two companies can have the exact same valuation, with drastically different earnings and dividend flows.

What does all of this mean? First, there is a key implication for the interplay between growth and capital structure. So far the discussion points towards equity and credit as the most viable source of finance for high growth firms. However, in light of pecking-order theory, funding growth by issuing new equity should be the last resort for firms. This leaves high-growers with debt as their main source of capital. This model therefore also predicts a positive relationship between growth opportunities and debt levels, similar to the capital opportunity cost theory. Furthermore, provided the temporal indifference of investors hold, a firm’s access to external capital should not depend on current performance and growth prospects. In other words, factor market allocation should not discriminate against firms whose high-productivity phase lies in the future, rather than today.

So far we have discussed a variety of theoretical mechanisms that explain how growth and capital structure affect corporate performance. The structure and theoretical relationships can be illustrated in the model below. We started with discussing effect 1, the impact of growth on corporate performance. We then moved on to theoretical implications for capital structure on performance outcomes, before arguing that there could be an interaction effect between our two main variables. We now turn to how recessions can impact the mechanisms discussed above.

32 Figure 2: Relationship between growth, capital structure and corporate performance