CHAPTER 02
The literature included two types of theories about the debt maturity structure: agency cost theory and maturity matching theory.
2.1 Agency Cost Theory
Myers (1977) discussed that risky debt financing caused low investment benefits when a firm's investment had chances to look for growth option and low investment benefits could be assured by providing short-term debt to mature before the growth options were utilized. The hypothesis was that the firm's assets had a greater ratio of growth options in shorter-term debt.
Titman (1992) presented that if growing firms had the greater chances of bankruptcy and positive future-outlook then those firms could acquire incentives from borrowing short-term debt. There was an acceptance in the literature that growth (market-to-book ratio of assets) should be inversely correlated to debt maturity in the agency/contracting costs perspective.
Hart & Moore (1995) defined the role of long-term debt in controlling management's capability in increasing funds for future projects. It was analyzed that long-term debt may restrict self-interested managers from financing non-profitable investments entailed a direct variation of long-term debt with market-to-book ratio. Therefore, the relationship between growth options and debt maturity structure had an experimental issue.
Diamond (1991) defined liquidity risk as the risk that debtors were lost control rents because creditors do not want to refinance, therefore they decided to liquidate the firm. Because short-term debt had seen by Diamond as debt that mature before the profits of an investment were received, it was necessary to refinance short-term debt. For firms with high credit worthiness, the liquidity risk was not relevant. A decreased in credit worthiness did not lead to a 'crunch' of credit to the firm. For this reason, firms with a high credit rating were expected to borrow on the short term. Firms with a medium credit rating, the liquidity risk could be important, but they also interested to borrow on the long term. Firms with a low credit rating were therefore forced to borrow on the short term.
Barnea et al. (1980) found that organization conflicts, similar to Myers's (1977) underinvestment problem, could be restrained by reducing the maturity of debt. Therefore, smaller firms which faced additional harsh agency conflicts then larger well-maintained firms might use shorter-term debt to mitigate these conflicts.
In most cases, the costs of a public debt issue were fixed, and these costs were therefore self-determining of the size of the debt. Because public debt had a longer maturity than private debt, a positive relation between the size of a firm and the maturity of debt was proposed. However, those reasons did not apply to small unlisted firms, because these firms make very little use of public debt. The present study also included leverage and industry affiliation as determinants of debt maturity. Arguably, larger firms had lower asymmetric information and agency problems, higher tangible assets relative to future investment opportunities, and easier access to long-term debt markets.
The reasons why small firms were forced to use short-term debt include higher failure rates and the lack of economies of scale in raising long-term public debt. It was further argued that larger firms were tend to use more long-term debt due to firms remaining financial needs (Jalilvand & Harris, 1984). Agency problems (risk shifting, claim dilution) between shareholders and lenders may be particularly severed for small firms. Bondholders attempt to control the risk of lending to small firms by restricting the length of debt maturity. Large (small) firms, thus expected to had more long (short)-term debt in capital structure. Consequently, these arguments implied a positive impact of firm size on debt maturity.
It was widely accepted by the current literature that larger firms had lower agency costs of debt Ozkan (2000), and Whited (1992), because these larger firms were believed to an easier access to capital markets and a stronger negotiation power. Hence both these arguments favored larger firms for issuing more long-term debt compared to smaller firms. In addition to it Smith & Warner (1979) argued that smaller firms were more likely to face higher agency costs in terms of a conflict of the interest between shareholders and debt holders.
Hoven & Mauer (1996) found out only little evidence for the agency cost aspect that debt maturity used to restrict the conflicts of interest between share holders and debt holders. Although smaller firms in the sample used short term debt, findings also suggested that firms with big amounts of growth options had small leverage and hence small to moderate incentive of debt maturity structure to reduced the conflicts of interest above the utilization of those options.
Barclay & Smith (1995) tested the determinants of corporate debt maturity hypothesis that firms with greater growth choices in investment opportunity sets issued large amount of short-term debt, study also found that firms issue large amount of long-term debt. The findings were robust to surrogate measures of the investment opportunity set, techniques as well which proposed to growth options in the firm's investment opportunities be key in discussing both the time-series and cross-sectional fluctuation in the firm's maturity structure. Study also supported strong relationship among firm size and debt maturity: superior firms issue a considerably bigger proportion of long-term debt. This was uniformed with the observance that small firms were dependent more heavily on bank debt that traditionally had shorter maturity than public debt. Smaller firms had large growth options, which indicated to employ shorter-term debt to lessen the agency conflicts; these indications assumed debt as uncertain. Though, the capital structure theory suggested that these firms employed moderate amounts of leverage to mitigate the risk of financial loss. As such, firms with low leverage and low chances of financial loss would likely be unbiased to employ debt maturity structure to restrict agency conflicts, all other matters remained constant. Agency cost theory also proposed that smaller to medium size firms relatively faced higher agency costs problems because the possible divergence of risk shifting and reduction in the concentration between equity holders and managers (Smith & Warner, 1979). To overcome this issue and to control the agency cost short-term debts were recommended (Barnea et al. 1980). The large constant flotation cost of constant securities was comparative to the small size of the firm which had an additional barrier that stops all small firms' accessed to the capital market.
Smith (1986) argued that managers of regulated firms had less discretion over investment decisions, which reduced debt's agency costs and increased optimal leverage. Shah & Khan (2005) evidenced the blended support for the agency cost, study results showed that smaller firms employed more shorter term debt then longer term debt; even there was no evidence that growing firms employed more of short-term debt as assumed by Myers (1977), that debt maturity varied inversely to proxies for firm's growth options in investment opportunities, The implication of firm size variable also verified the information asymmetry hypothesis, which established it costly to accessed capital market for long term liabilities.
2.2 Maturity Matching Theory
A frequent recommendation in the literature discussed that a firm should compare maturity structure of its assets to that of its debt. Maturity matching could concentrate on these threats and structure of corporate hedging that decreased projected expenses of financial suffering. In a related element, Myers (1977) explained that maturity matching could control agency conflicts between equity holders and debt holders by ensuring that debt repayments had planned to match up with the reduction in the worth of assets in place. At the final stage of an asset's life, the firms encountered a reinvestment judgment, concerning to debt that matures at that time assists to restore the suitable investment benefits as soon as new investments were needed. Though, this analysis specified that the maturity of a firm's assets was not the only determinant of debt maturity, growth options also played a vital role as well. Chang (1989) revealed that maturity matching could reduce organization expenses of debt financing.
Stohs & Maurer (1996), and Morris (1976) argued that a firm could face risk that did not cover sufficient cash in case the maturity of the debt had shorter maturity than the maturity of the assets or even vice versa in case the maturity of the debt was greater than asset maturity (the cash flow from assets necessary for the debt repayment terminated). Following these arguments, the maturity matching principle belongs to the determinants of the corporate debt maturity structure.
Emery (2001) argued that firms avoid the term premium by matching the maturity of firm's liabilities and assets. Hart & Moore (1994) confirmed matching principle by showing that slower asset depreciation signified that longer debt maturity. Therefore, this study expected a positive relationship between debt maturity and asset maturity.
Hoven & Mauer (1996) found well-built support for the regular textbook recommendations that firms should compare the maturity period of firm's liabilities to that of firm's assets, study results were indicating that asset maturity a key aspect in discussing instability in debt maturity structure.
Shah & Khan (2005) found unambiguous support for maturity matching hypothesis, study findings revealed that the fixed assets varied directly with debt maturity structure.
Myers (1977) argued that maturity matching of firm assets and liabilities could also partially serve as a tool for mitigation of the underinvestment problem, which was discussed in the agency costs theory section. Here the maturity matching principle ensured that the debt repayments should be due according to the decrease of the asset worth. Comparing the maturities as an effort to list debt repayments to match up with the decrease in expected worth of assets now in place.
Gapenski (1999) differentiated two strategies of maturity matching namely the accounting and financing approach. The accounting approach considered the assets as current and fixed ones, and called for the financing of the current assets by short-term liabilities and fixed assets by long-term liabilities and equity. The financing approach considered the assets as permanent and temporary. In these terms the fixed assets were definitely permanent ones, and some stable parts of the fluctuating current assets were also taken as permanent. This approach then suggested financing the permanent assets by long-term funds (long-term liabilities and equity), and temporary assets by short-term liabilities. Consequently, the financing approach generally employed ceteris paribus more long-term liabilities than the accounting approach did.
The financing approach brought more stable interest costs than the accounting approach; but as the yield curve was usually upward sloped, the financing approach was also more costly. The financing approach versus accounting approach decision making was thus a classical risk return trade-off relationship. In praxis, the corporate commonly favored the accounting approach before the finance approach. Based on these maturity matching arguments, balance sheet liquidity implied an impact on the corporate debt maturity structure.
Guedes & Opler (1996) stated that the estimation of asset maturity did not appear to be very much between firms, those issued debt (term of one to nine years), and firms that issued debt up to twenty nine years term. But firms that issued debt for greater than thirty years term had assets with significantly long lives. Assumptions expected that firms should compare the maturity of assets and liabilities showed that partially correct.
Morris (1976) argued that such a strategy allowed firms to decrease uncertainty both over interest costs over the asset's life as well as over the net income those were derived from the assets. Emery (2001) the higher the term premium, the stronger should be the firm's incentive for maturity matching.
