Financing Mix And Leverages Of Smes In Mauritius Economics Essay CHAPTER 1: INTRODUCTION 1.1Background Small and Medium Enterprise in Mauritius (SME’s) are increasingly playing a strategic role in economic growth and development through their contribution in the creation of wealth, Job creation, and income generation due to a major structural transformation over the last two decades in the Mauritian economy(Velasco and Cruz, 2001; Klapper et al., 2002 and Svejnar, 2002). The SMEs sector has been accounting for over half of total employment in Mauritius during past years, SEHDA Statistics (2009) Registration of Small Enterprises with SEHDA – From 1st July 2005 to 31 December 2009). SMEs also generate more than a third of GDP. Lately, they have been giving signs of having reached a plateau both in terms of employment generation and contribution to GDP. The activity of SMEs is like the equivalent of the internal market in other bigger countries this explains that when external markets are not up to the mark which is the case at present we lean on the internal market, of which SMEs is a big part, to sustain growth. This explains the emphasis being placed in the 2012 budget on this sector of activity. In Mauritius the 12,393 of registered SMEs to the SMEDA (Small and Medium Enterprise Development Authority) were concluded in early 2010 survey and each SME’s have their respective sector of operation and each SME’s adopt their own financing preferences depending on various elements that may affect the business milieu directly or even indirectly as they are operating in a dynamic and fast changing environment. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order According to the latest development in the market, there has been a matter of concern for the SME’s of restructuring their activities, facilities and multi skills to remain competitive, in order to survive and compete with the business environment and not forgetting the diversification which has occurred in the tourism together with the emergence of international services with Offshore and Freeport activities. To react to the international competition in these sectors, Mauritius has made extensive use of modern technology to improve its productivity and efficiency. The real growth rates have been around 5.4% over the past four years, and Mauritius is now classified as a middle-income economy and is one of the healthiest economies in the whole African region (L’express, 16th Nov 2000). There is sufficient evidence that the SME’s sector in Mauritius and on the worldwide perspective had been affected with diverse changes that have occurred. Especially with the emergence of new technology developments and increasingly competitive markets, this had a direct impact on the nature of competition. Therefore, small and medium enterprises represent an important vehicle to address these challenges whether job creation, economic growth and equity. Hence, the Mauritian government believes that the real engine of sustainable and equitable growth remain in the SME’s sectors of our Mauritian economy. Not only is it of great importance for the superior rate of job creation and income generation in our economy, but also it deserves particular attention since the SME sector has been largely neglected in the past. Literature in this area show that, regardless of size, access to finance is one of the key hindrance of SMEs development (Gregory et al., 2005; Van Auken, 2005). In this respect, the financing mix contains various form of financing the SMEs can have resort in order to finance its business activities. In the Financing Mix (Johnsen and Mc Mahon, 2005) has argued that there is five competent theories of SME’s financing namely 1 Static Trade-Off Theory (STOT), 2 Pecking Order Theory (POT), 3 Growth Cycle Theory (GCT), 4 Bootstrapping Financing Theory (BST) and 5 Agency Theory (AGT) thereby these methods of finance help the SMEs to integrate the market easily with less difficulties and keep striving towards excellence and contributing to our Mauritian economy. In contrast to large firms, SMEs face a relative disadvantage to raise finance from formal institutions such as banks in Mauritius and this is supported by (Tucker and Lean, 2003) articulated the existing knowledge on this matter where smallest firms generally have smaller financial reserves geared compared to larger firms due to the difficulty and expense of attracting new equity finance. Thus, such firms do not only experience higher business risk but also higher financial distress risk. Banks tend to respond to risk by adopting a capital-gearing rather than an income-gearing approach to lending. Thus, rather than focusing their consideration on evaluating income streams flowing from an investment project they may focus more on the value of collateral available in the event of financial distress hence , it creates a problem for small firms for not having significant fixed assets to secure on in their early years of establishment. Beyond the provision of financial services, the informal finance is said to offer stronger social capital that SMEs derive enormous social benefits which the formal financial institutions cannot offer (Alabi et al., 2007). More recently, the Government of Mauritius has provided ATS scheme in its budget to provide financial assistance in terms of a partial funding to SMEs for the acquisition of equipment to encourage the SMEs and as well as endow with Export assistance, Bar coding their product and Marketing support scheme Mauritius SMEs (2012) SMEs Schemes from: http://www.gov.mu/portal/sites> [Accessed 18th January 2013]. Nevertheless DBM which is becoming the bank of the SMEs, the government has, with the collaboration of the Bank of Mauritius and commercial banks put in place a total loan facility of Rs 3 billion from banks over the next three years in favour of the SME sector. The interest rate for loans has been negotiated down to 8.5% pa from the existing excessive rate of 14%, Mauritius SMEs (2012) Other Financing Schemes for SMEs from: http://www.gov.mu/portal/sites/smeportal [Accessed 18th January 2013]. Numerous charges usually levied by banks have been negotiated away to keep down those invisible costs. This facilities act as a stimulus for the SME to develop and contribute positively to our economy and being a model in the Indian Ocean. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 1.2 Problem Statement Mauritian SMEs is progressively becoming a pillar of our economy; nevertheless they are unable to access the equivalent kinds of growth funding often made available to huge businesses as argued by (Winborg and Landstrom, 2001). They have been compromised by the persistent and often acute constraints on their access to finance. Finance is the main matter of attraction that precludes the SMEs growth and many governments have attempted to bring a valued resolution by the establishment of specific financing schemes. Information asymmetries often associated with lending to small scale borrowers have restricted the flow of finance to smaller enterprises (Cosh and Hughes, 2000). Undeniably, many SMEs are characterised by a lack of capital hence causing them to fail in their operation that finally lead to closure in the early stages. However, there is very little available data on the type of finances used by SMEs (Cosh and Hughes, 2000). The Government of Mauritius has come forward with various scheme just to promote the setting up of SMEs across the Island and to give them an incentive and at the same time financing part of their strategic operations as argued in the same view by (Brimble et al., 2002 and Hill, 2002), but the results have generally been adverse because of lack of education from the owner and the wariness if they fail in business (Falkena, 2001). Many governments and international financial institutions (IFI) have tried to address the problems of high transaction costs and risks by creating subsidised credit programmes and/or providing loan guarantee. Such projects have often encouraged a culture of non-repayment or failed to reach the target group or achieve financial self-sustainability. Hence, there is a need to look into the different sources of finance (formal, semi-formal and informal) for SMEs healthy development. Though, current empirical literature on financial position of SMEs has not taken these varieties of financing options and the access constraints they face into consideration. Particularly as it is recognized that access to mainstream formal finance by SMEs in most developing countries is miserably limited, it is therefore difficult to pronounce upon whether a particular financing pattern is just an issue of preference or desperation borne out from limited access or constraints to formal finance. Hence SMEs are heavily leveraged by taking huge amounts of loans from financial institutions at a higher rate of interest which may endow them in a financial distress and the asset given as security may be at risk. Institutional credit was known not to be available to SMEs because they are generally considered high credit risks by financial institutions. The perception of small and medium enterprises as high risks is the failure of the SMEs to prepare acceptable or feasible banking business plans to provide to the authorities like Financial Institution (FI) in order to benefit from the facilities offered this can be due to lack of owners education because previous study has shown that owners with low level of education are unable to produce required report to the authorities for processing as they are not a specialist in the field (Tucker and Lean, 2003) This indicate that banking institution asks relevant and pertinent information on overall business matters and performance. In addition it is observed that presence of poor record keeping, accounting operations is not performed as such in the SMEs which can lead to loss of control especially of financial operations which at times make the entrepreneur draw money more than expected from the business either for personal or family use (Shirley Carlon and Darren Massey Chris Evans, 2006). Furthermore the discriminatory cultural practices which at times make it impossible or difficult for women to borrow or own assets or land titles because the risk involved in giving potential women entrepreneur a loan is not considered with a good eye in the past because the lack of motivation, involvement and leadership role towards the success of the Mauritian SMEs (Cosh and Hughes, 2000; Fletcher, 1994). 1.3 Need for study Lately, there has been an amplified importance for a need for study on SMEs in Mauritius. Many studies also have been made to support the argument or controversy about the difficulty of SMEs in getting financing from the financial institutions (Miles and Ward, 1991; Eyiah, 2001; and BNM, 2007). There is substantial amount of literature addressing to the SMEs difficulties encountered in setting up but very few study has been concerned for the continuity and financing needed for the long run operation of the SMEs in Mauritius and how far SMEs are leveraged which lead them in financial distress. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order The role of finance has been viewed as a vital element for development of SMEs (Cook and Nixson, 2000). Based on the study by Jaafar (2004), external financing is the most important capital source for SMEs. Cook and Nixson (2000) concluded that research is required in the form of finance used by the SMEs and the availability by the lending institutions. As for construction industry, only a handful of researches have been carried out on this area. Majority of the studies on SMEs were related to financing on non construction industries (Hamilton and Fox, 1998; Carey and Flynn, 2005 and Watson, 2006). Governments of many countries try to help their SMEs in financing wherever possible (Mizutani, 1999; Brimble et al., 2002 and Hill, 2002), but the results have generally been poor (Falkena, 2001). Even though SMEs face problem in obtaining loans from commercial banks, still , banks represent an important and crucial business partner for development of SMEs in Mauritius (Group of Ten, 2001 and Norton, 2003) including contracting institutions (Yaves et al., 2004). Consequently, there is a need to look among the major sources of finance for SMEs government agencies and commercial banks in order to find out the difficulties in obtaining loans from both (FI). The main objective of the study is to provide some preliminary descriptive evidence of SME financing method uses also known as the financing Mix. To achieve this end, a questionnaire survey was administered to a sample of 100 SMEs in Mauritius examining issues including the capital structure at financing business activities, The five different categories of SMEs was analyzed was Food and Beverages, Leather and Garments, Metal Products, Paper products and Printing and Wood and Furniture. 1.4 Research Questions 1. What kind financing commercial banks and government agencies are made available to small and medium enterprise in Mauritius? 2. What kind of financing SMEs mostly adopt to finance its business activities? 3. What are the reasons for the preference as well as the problems faced in obtaining and repaying loans in terms of leverages? 4. To what extent do leverages affect the SMEs performance and its potential effect on the financial position? CHAPTER 2: LITERATURE REVIEW 2. Definitions of SMEs There is no universally accepted definition of a small and medium business. The definition of what constitutes a SME varies (Taylor and Adair 1994; Reed, 1998); it is generally based on the number of employees and financial turnover. Each organization has derived their own definition of SMEs for convenience in their work. The Bolton report (1971) and the Wilson report (1979) have been the first studies that have investigated small firms in the UK. The Wilson report (1979) finds that SMEs are relatively risky and they expect to face higher interest payments and more stringent conditions than large firms .In Mauritius SME has been redefined, taking into account the volume of investment in equipment which was previously 1 million up to 10 million Mauritian Rupees presently to be classified as a small enterprises and with less than 50 and 200 employees for small and medium scale respectively. A diversity of features differentiates small enterprise from large firms in the context of financial management practices (Ang, 1991). For example, small businesses are not publicly operated and rely mainly on private equity and debt markets to raise capital to finance the business operation. These enterprises are normally owner–managed and the owner-managers generally possess general rather than specific expertise. Transaction costs in small businesses are usually higher than those costs in the large enterprises. According to Hulbert (2001), small firms differ from large firms in a number of ways. Small firms are normally owned by the principal owner and they usually have limited access to capital markets. Also, small firms may suffer more from information problems than their larger counterparts. A recent study by Beck and Demirgüç-Kunt (2011) discovered that the classification of a SME is not very diverse across banks since they find that close to 70 percent of banks define small and medium-sized enterprise as those with sales of less than 2.5 and 10 million dollars, respectively. Furthermore, they come across that the definition make available by banks is amazingly similar to the average annual sales reported by SMEs in recent enterprise surveys conducted (in 183 countries) by The World Bank for the 45 countries in their sample. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2.1Main sources of financing for SMEs. Sources of financing for the SMEs relies mostly on Asymmetric information or more precisely informational murkiness which typically influences the sources of funding of firms. In the midst of the first studies that have attempt to provide a comprehensive survey of the financing of small businesses, Berger and Udell (1998), discovered that SMEs depend on both (internal) equity and debt. Table: 1 SOURCES OF FINANCE SOURCES OF EQUITY SOURCES OF DEBT 1 Principal Owner 1 Financial Institutions (FI) 7 Other Business 2 Angel Finance 2 Commercial Banks 8 Government 3 Venture Capital 3 Finance Companies 9 Individuals 4 Other Equity 4 Other FI 10 Principle Owner 5 – 5 Non financial Business and Governments 11 Credit Cards 6 – 6 Trade Credit 12 Other Individuals Source: Berger and Udell (1998) p168. 2.1.1 Sources of Equity in SMEs financing Among the major source of finance available to SMEs, the market has experienced the emergence of angel capital which consisted of individuals providing risk capital directly to small, private and often newly set up firms (Prowse, 1998). According to Berger and Udell (1998) angels are high net worth individuals who provide and inject sources of capital at the early stage of the new businesses. Prowse (1998) further argues that angels do not figure one of the principal entrepreneur or in his immediate family and close contacts. Angels are often in the second round of financing of a start-up, after the business owner has exhausted financing capacity that is investing all of the money made available to them in the business. Nevertheless, very little is identified about the market’s size, scope and the type of firms that raise angel finance and the types of individuals who provide it, particularly as angel finance is provided in a very informal environment. Prospective entrepreneurs have innovative ideas but always short of scarce resources as well as commercial experience (Keuschnigg and Nielsen, 2003). Start-ups enterprises require considerable funds to invest in capital and to undertake research and development to bring new concept in the market and market their products. In view of the fact that business entrepreneurs are not wealthy enough, they move to individuals who have the money and the required experience and they are termed as venture capitalists. They were regarded as investors who invest in entreprise who needed financing to fund a promising project (Kaplan and Stromberg, 2001). Venture capitalists do not normally benefits from control. Their role is restricted to evaluating, screening, monitoring and providing advice and management expertise. Berger and Udell (1998), regard venture capital as capital provided in a more formal market than angel finance. Berger and Udell (1998) observe that funding provided by financial institutions as being the main category of debt to SMEs. These financial institutions made available comprised primarily of commercial banks, followed by finance companies and other FI. Subsequent to this, the second category of debt is debt provided by non-financial and government sources. This consists primarily of trade credit. The third category of debt is debt provided by individuals. Using US data from the 1993 National Survey of Small Business Finances, Berger and Udell (1998) evaluated the size and age of firms and come across that the largest source of finance for the SMEs were from the principal business owner followed by commercial banks and trade credit. In fact these three sources account for over 70 percent of total funding of the firms used under study. The conclusion of Berger and Udell (1998) seemed to agree with the findings of Pettit and Singer (1985), who uncovered that smaller firms has tended to use more of debt financing and they relied more on internal funds and loans from FI to finance business operations and Business owners do not use much external equity compared to large firms. 2.1.2 Factoring Method for SMEs A significant source of financing for SMEs ignored by Berger and Udell (1998) is factoring. Under factoring, receivables are purchased by the factor rather than used as collateral in a loan. Most specifically, the enterpreuneur is able to sell its overall receivables to a factor. The effect such a method where SMEs can obtain part of financial resources immediately that were in the past tied up in receivables. Factoring is the process that involves the transfer of designation and ownership from the seller to the factor. Factoring agreements envelop a extensive array of issues associated with the relationship between the factor and the client. Bakker, Klapper and Udell (2004) have provided a comprehensive study of the impact of factoring in Eastern Europe. Factoring was illustrated as a form of asset-based finance where the credit extended was based on the value of the payments owed by the borrower’s customers (Bakker, Klapper and Udell, 2004). According to them, factoring is helpful in developing economy particularly with fragile lending laws made available within that territory. Given that factoring is dependent on the quality of the borrower’s accounts, Bakker et al (2004) consider that factoring may be especially attractive to high-risk SMEs where a lot of project and research and development is carried out and huge expenditure is undertaken. Hughes (1997) classified the following sources of financing for SMEs in the UK: banks, venture capital, hire purchase/leasing, factoring, customers/suppliers, partners/working shareholders, other private individuals and finance obtained from other sources. He found that small firms normally had low profitability and were thus heavily dependent on retentions to fund investments. However, the most important source of financing for firms is bank financing. further method of finance has been described as the hire purchase/leasing and funds provided by partners in the industry. Hughes (1997) also found that factoring and trade credit are important sources of financing of SMEs in the United Kingdom. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2.1.3 Sources of Debt in SMEs On the other hand, it is occasionally complicated to scrutinize the sources of funding of firms. As proposed by Berger and Udell (1998) small businesses may be in a period of having a financial growth cycle in which financial needs and options change as the business grows, turn out to be more experienced and more informationally clear. At the start-up stage SMEs are obviously more informationally opaque and thus cannot gain access to external capital when in need. They rely entirely on their own internal finance, trade credit and angel finance. With time as they grow and become less informationally opaque they would then have access to external finance. Therefore, according to Berger and Udell (1998) instead of looking at the sources of funding separately, Business entrepreneur would concentrate on a sequencing of funding over the growth cycle of the firms. Baldwin, Gellaty and Gaudreault (2002), identified 5 financing instruments namely retained earnings, share capital, short-term debt, long-term debt and other. They also identify 4 sources from which finance can be obtained that comprised of internal sources, financial institutions, innovative sources and other, Baldwin et al (2002), distinguish between internal and external sources of finance. Internal sources consist of financing obtained from retained earnings, owner, managers and employees. External financing sources are broken down into 3 categories namely financing obtained from financial institutions, innovative sources and others. Kisgen (2006) also examined to what level credit ratings directly influenced financing decisions. The illustration in Table 2 below shows the various Internal and External sources of Finance available to SMEs Regardless of all the various sources of financing those SMEs can use, most financing of SMEs still come from banks. Beck and Demirgüç-Kunt (2011) investigated this liaison in more detail and use recently gathered data for 91 large banks from 45 countries has been investigated if banks of different ownership types apply different lending technologies and organizational structures when lending to SMEs. They find that foreign banks grant a higher share of collateralized loans, and are at the same time are less likely to rate flexible information as important in evaluating loans, and were also less likely to spread out loan authorization and risk management decisions to the other branch. However, they find few differences in the extent, type, and pricing of SME loans across foreign and domestic private banks. Beck and Demirgüç-Kunt (2011) also found that significant differences across banks in developed and developing countries appear to be driven by differences in the institutional and legal environment. Banks in developing countries has the tendency to provide a lower share of investment loans and impose higher cost to SMEs than those in developed countries where they have a tendency to charge higher interest rates on small business loans. 2.2 World Bank Grant for Mauritian SMEs World Bank till date has granted 20 million USD, an equivalent of about Rs 600 million, to Mauritius for the financing of the Manufacturing and Services Development sector and Competitiveness programmes. (GIS – Feb 23, 2010). Mauritius has obtained a lot of assistance from all its development partners during the last four years to support SMEs. World Bank has mobilized the essential resources to sustain enterprises throughout the global and financial crisis and SMEs who seems to face financial problems. In addition to the present loan agreement, the World Bank is taking into consideration to focus its next Country Partnership Strategy on competitiveness. Among the various support programmes for the SME sector, the European Union is currently supporting the “Improved Competitiveness for Equitable Development program. while the Agence Française de Développement has provided a grant of Euro 1.5 million under the Programme Renforcement de Capacité Commerciale and the Public sector Efficiency programme. The SME sector totalled around 100 000 enterprises and currently employs some 45 percent of the workforce in Mauritius. In the past four years, the sector has generated some 24 000 new jobs which account for 60 percent of the total 40 000 jobs created. since 2006, the total resources mobilized from the World Bank amount to some USD 300 million, equivalent to around Rs 9 billion (MUR), out of which USD 210 million were in the form of budget support to uphold the economic transformation agenda and USD 88 million for infrastructure development, reform of public enterprises and development of the SME sector and the remaining balance were in the form of grants for technical assistance and analytical work for the Mauritian economy. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order GCT It describes the progression of the successful firm through growth phases (Bhaird and Lucey, 2011) along with potential financing problems that may arise at each stage. A biological analogy is sometimes used to describe “. . . the cyclical quality of organisational existence. Organisations are born, grow, and decline. Sometimes they reawaken, sometimes they disappear” (Kimberly and Miles, 1980). Numerous stage models have been developed in the management and organisational studies literature (D’ Amboise and Muldowney, 1988; Poutziouris, 2003), although the number of stages is not standardised (Lester et al., 2008). For example, Steinmetz (1969) proposes a model based on three phases of growth, whilst Lester et al. (2008) propose a five-stage model of organisational growth and development. The financial lifecycle model (as described in Fig. 1: Financial Growth Cycle) incorporates elements of STT, AGT (Jensen and Meckling, 1976), and POH (Myers, 1984; Myers and Majluf, 1984), and describes sources of finance typically advanced by funders at each stage of a firm’s development. 2.9.1 Phases in GCT In this theory, the firm gets better access to venture capital as a source of equity and midterm-loans as a source of debt (Gregory et al., 2005); yet, as the firm gets older and information-wise transparent it tends to have better access to public equity and long-term financing (Gebru, 2009). Gregory et al. (2005) found that only firm size, as measured by total employees, could significantly determine the decision of whether to use insider financing instead of going for public equity or long-term financing. As successful firms survive nascent and start-up phases, and mature through growth stages, personal funding becomes relatively less important as investment finance is increasingly sourced from retained profits (Bhaird and Lucey et al., 2011). Firms faced with the problem of overtrading often seek to alleviate these liquidity problems by increasing their overdraft facility. Thus, it is common for SMEs to have high levels of short-term debt (Ray and Hutchinson, 1983; Michaelas et al., 1999). Sources of finance accessed at mature stage are generally determined by preferences of firm owners, rather than supply side restrictions (Bhaird and Lucey, 2011) due to competition, drastic economic changes, etc. The financial growth lifecycle model developed by Berger and Udell (1998) presents firms on a size/age/information continuum, and describes the increasing array of financing options available to the firm as it survives and grows. Berger and Udell (1998) thus conceptualised the sequencing of funding over the lifecycle of the firm centred on information opacity and following a financial pecking order. However, Berger and Udell (1998) also indicate that ‘‘the growth cycle paradigm is not intended to fit all SMEs and that firm size, age and information availability are far from perfectly correlated’’ 2.2 Static Trade off Theory (STOT) Although, the STOT has been imperative to modern businesses and has prove to be a sensitive research area for academics and practicing managers alike, Gebru (2009) pointed out that its application for SMEs in particular is limited but Business owners could not follow as much (Silveira and Slack, 2001). Particularly for MSEs, This is because the STOT requires a micro-entrepreneur to have financial sophistication and substantial reliable data in application of such techniques as value optimization and others, at the same time increasing the value of the firm and which is impracticable due to the asymmetrical nature of SMEs. However, SMEs usually have weakly organized accounting system adding complexity to data generation problems. STOT predicted that more profitable firms should carry more debt since they have more profits that need to be protected from taxation but Myers (1984), Titman and Wesels (1988) and Fama and French (2002) criticised this prediction. Higher profitability implies lower expected costs of financial distress and also the firms use more debt relative to book assets. The static trade-off theory of capital structure at the same time referred as the tax based theory states that optimal capital structure is obtained where the net tax advantage of debt financing balances leverage related costs such as financial distress and bankruptcy, holding firm’s assets and investment decisions constant (Baxter, 1967 and Altman 1984, 2002). 2.2.1 STOT versus Leverages Furthermore, Static Trade-Off theory maintains that firms select an optimal capital structure by trading off the advantages of debt financing against its cost. The optimum debt level maximizes firm value According to (Shyam-Sunder and Myers, 1999). Hovakimian et al., (2001) confirm that when enterprises adjust their capital structures, they have a tendency to move in a direction where a target ratio which is consistent with theories based on trade-off between the costs and benefits of debt. The static trade-off theory posits that firm value increases (declines) as the financial structure moves closer to (away from) the target. Some authors believe that the target of the business may alter (Hovakimian et al., 2001; Frank and Goyal, 2003). In this model, an experimental change in leverage can be either a target move or an adjustment of the debt level to, or from, the unchanged target within the firm financial structures. Myers (1984), nevertheless, suggested that managers would be reluctant to issue equity if they feel it is undervalued in the market they are operating. The outcome is that investors perceive equity issues to only occur if equity is either fairly priced or overpriced. As a result investors tend to react negatively to an equity issue and business owners are reluctant to issue equity in course of their business operation. Therefore in our Mauritian context we can see that SMEs does not have much resort to the STOT because as argued it demands greater financial sophistication and considerable reliable data to be provided to Commercial banks and any other financial Institution in Mauritius. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2.2.2 STOT-Costs of Financial Distress According to (Warner in 1977 and Barclay, 1995), financial distress consists of both direct and indirect costs. The direct costs of financial distress are acquired in bankruptcy and reorganization such as the direct legal and administrative costs of bankruptcy, the costs that associated with selling the liquidated assets and the costs of shutting down operations. Even though the enterprise would capitalize on value by issuing as much debts as possible, but if the firm used too much debt in its capital structure, there is a higher possibility that the firm cannot meet its interest as well as principal payment and will failure to pay on its debt obligations. More specifically, a firm experience difficulty and trouble meeting its debt obligations is in financial distress. Excluding the direct costs of financial distress, there exist many other indirect costs that associated with financial distress. One of the indirect costs for distressed firms is the cost of losing valued customers for the SMEs. This takes place because bankruptcy may allow firms neglect their future assurance toward customers and as a consequence most of those customers may lose confidence on the SMEs products whose value based on the future service and support of the enterprise. in addition to that, another indirect costs is the distress cost of losing suppliers in which those suppliers are unwilling to provide raw materials to those SMEs who suffer from bankruptcy or having prospect of go into bankruptcy as Suppliers afraid they might not be able to pay for the supplying of raw materials. The most important indirect cost of financial distress is the cost of retaining employees of the SMEs. Normally, most of small firms might be unable to provide job security to its employees during bankruptcy, therefore, the self-confidence of employees weaken and so higher compensation required for the firm to retain its key employees. As a consequence, the assets of a firm and its overall value will be clear off when the firm goes to bankrupt 2.2.3 STOT and Financial Sophistication Moreover in STOT, firms favor external financing scheme to the extent that the marginal benefit due to tax shield advantage of debt is exactly equal to the marginal cost of financial distress (Ross et al, 2000, p. 504). This theory assumes that all factors are assumed to be fixed but the debt-equity ratio. In this theory, value of the business and totality debt are non-linearly related (Ross et al., 2000). Johnsen and McMahon (2005) affirmed that other factors held constant enterprise with more intangible assets need to borrow less, compared with firms with more tangible assets, because of the collateral factor. Importance of static trade-off is expected to be low because the theory requires practicing SMEs owners to have financial sophistication, but normally SMEs owners are rather product specialists. On the other hand, an application of firm value optimization technique under static trade-off theory demands substantial reliable data. However, SMEs usually have weakly organized accounting system adding complexity to data generation problems. In addition to that, recent studies have shown a focus shift from the trade off theory to pecking order theory (Quan, 2002; Mazur, 2007). 2.3 Perking Order Theory (POH) POH is also known as Information asymmetry Theory is the most dominant theories of capital structure of SMEs; POH was first suggested by Donaldson (1961). Since then a large body theoretical and empirical literature has emerged on firms’ Financial Positions during the past decades after the seminal paper of Modigliani and Miller (1958). The relationship between financing decisions and firm value has become highly debatable by Modigliani and Miller (1958). POH acknowledged its first meticulous theoretical foundation by Myers and Majluf (1984). Firm value optimisation with “right” debt-equity mix is often difficult to achieve by SMEs owners and in case of business starts up (Tucker and Lean, 2003) because they usually have inadequate knowledge on financial sophistication. Thus, with globalisation the survival of such businesses can be at stake in the long run. According to Paul et al. (2007), the POH has a relatively dominant explanation for small business finance. Myers and Majluf (1984) argued that if firms issue no new security but only use its retained earnings to support the investment opportunities, the information asymmetric can be resolved. Transaction costs encompass an important role in an enterprise capital structure decision. In addition, the Transaction costs associated with obtaining new external financing are higher than the costs of obtaining internal financing. Internal funds do not bear any transaction costs. Studies are consistent with the pecking order theory (Gaud et al., 2005; Mazur, 2007). Watson and Wilson (2002) analyze the empirical validity of Pecking Order Theory in case of UK small and medium size enterprises (SMEs) split into high information asymmetry firms, low information asymmetry firms and closely-held firms. Besides, they decompose debt into hire purchase liabilities, long term debt, short-term debt and intra-group debt balances respectively to yield a richer explanation of different factors that affect different types of leverage and the empirical validity of (Watson et al., 2002) reflect into our Mauritian SMEs where same method is being adopted. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2.3.1 Windows of opportunity theory in respect to POH According to the windows of opportunity theory (Ritter, 2003) if equity is perceived as cheap, firms may firstly prefer internal funds (as predicted by POT), than equity and only at the end debt. In such case the equity is perceived as really cheap, outside equity may be preferred to internal financing. If debt is cheap when compared to equity, debt is the first choice of the firms, than internal funds and only as last resource the equity. Again, the principle of debt-equity mix applies here also. However, a recent study by Assibey, Bokpin and Twerefou (2011) outlined that Modigliani and Miller theories were developed under the corporate finance and capital structure frameworks of large and medium firms but little interest was paid to SMEs. Therefore, this could lead to information asymmetry problem in terms of communication, credibility and resistance to opt for external financing sources (Hamilton and Fox, 1998). This fact is also supported by financial managerial preferences (Myers, 1984, Michaelas et al., 1999, Hamilton, 1998, Hussain, 2007). The pecking order theory suggests that firms have a particular preference order for capital used to finance their businesses (Myers and Majluf, 1984). Due to the information asymmetries between the firm and potential investors, the firm will prefer retained earnings to debt, short-term debt over long-term debt. The level of debt in a firm’s capital structure is adjusted in response to difference sensitivity to financial needs of the firm over its growth cycle. A notification of increasing capital structure events received by the market termed as good news because financial intermediaries Development Bank of Mauritius can participate and termed as insider participant of the firm to examine the SMEs performance. Managers may have inside information that is not known to the market. Entrepreneurs have more reliable and pertinent information about the true distribution of firm returns than external participant. Business owners tend to limit the use of equity in order to preserve control of the business enterprise (Hutchinson, 1995). 2.3.2 POH versus Education attainments Gebru (2009) pointed out that the less educated SME owners are the higher conformity to the POH. SME owners rather base their financing decisions on matters of intrusion (Hamilton and Fox, 1998). They hardly prefer financing sources, such as equity, for fear of higher interference level (Gebru, 2009). Hence, the relationship between level of education of SMEs owners and their FPs are positively and significantly correlated as stated by Gebru (2009). On the other hand, empirical evidence from previous studies that examined SMEs (Chittenden et al. 1996, Michaelas et al. 1999) was consistent with the pecking-order argument, since leverage was found to be negatively related to profitability. Many recent studies (Gebru, 2009, Abor, 2008, Green et al., 2002) of SMEs in Africa by exploring SMEs’ Financial Position, have attempted to explain in the context of POH. The conclusions, however, have been mixed. 2.3.3 POH versus Leverages Murray and Goyal (2003) demonstrated that POH fails especially for SMEs despite there is information asymmetry problem because some small low-leverage firms prefer to raise finance through share capital. Empirically, Robb (2002) reports that SMEs use relatively more external finance (i.e. debts) than established firms indicating that leverage decreases with the age of the firm while mature ones mainly use retained earnings and equity. As a result, it is important to have a “formal” (long-term) relationship with the FIs in financial markets which may allow easy access of credit funds. It is also relevant in the case when the owner/managers are risk-seekers by nature and are more willing to raise funds through equity shares initially which can bring about positive contribution to the business as well as in society, for example, an investment for construction of new clinics for the welfare of society. Nonetheless, SMEs having more debt than established firms may face from greater difficulties in securing commercial bank debt in Mauritius. Despite these theoretical criticisms, the pecking order remains a predominant theory of financing choice. 2.3.4 POH in Non Listed Firms Consequently, to determine on the Financing Mix of SMEs found in a developing country, it is vital to consider the non-listed firms to derive a true picture of the capital structure stance prevailing in that country. Another important contribution of this study is that it factors in leverage in distinct forms, ranging from liabilities, leases, loans to debt. Such decomposition is considered of paramount significance since the distinct variables may impact differently depending on the type of leverage employed. Finally, this study adds to the scarce literature on capital structure for a developing country based on the fact that most capital structure studies are based on developed countries. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2.3.5 POH Determinants Fama and French (2002) reported that short term variation in earnings and investment is mostly absorbed by debt. In contrast, Frank and Goyal (2003) show that Shyam-Sunder and Myers’ empirical findings supporting the pecking order do not survive when a broader sample of firms or a longer time series is used, while Chirinko and Singha (2000) argued that the empirical test used by Shyam-Sunder and Myers has little power to distinguish among alternative financing schemes for SMEs. Profitable firms are more likely to have more retained earnings. Flourishing SMEs having a sound financial position do not need to rely much on external finance. Empirical evidence from previous studies (Al-Sakran, 2001; Kayo and Kimura, 2010) appears to be consistent with the pecking order theory. Under POH, profitability implies high possibility of adequate amount of cash to reduce the effect and need for financial leverage. Hence, POH predicts a negative relationship between profitability and financial leverage (Vasiliou, 2003). Fama and French (2002) reported that, from their empirical analysis, they identified one inconsistency regarding the trade-off theory that is the negative linkage between leverage and profitability. Romano et al (2001), studied the Financing decisions of small businesses and find that a great number of factors influence SME’s owner-managers financing decisions. One important factor is firms’ attitudes towards the utility of debt as a form of funding. Further research according to Romano et al (2001), cultural, entrepreneurial, personal preferences and attitudes play a major role in financing Mix decisions of SMEs. Other factors such as views regarding control, the age and the size of the firm also play a role. According to Holmes and Kent (1991), SMEs have been illustrated by 2 factors; firstly they cannot issue equity and are much concerned about ownership and control of the SME they owned. Small firms usually do not have the option of issuing additional equity to the public. Even if they were able to issue private equity, managers of SMEs would abstain from doing so, as issuing equity would lead to a dilution in ownership and control. For that reason, managers of SMEs will usually prefer to go for debt financing, mainly comprising of commercial bank financing or chose the DBM which is termed as the SMEs bank in Mauritius. On the other hand, managers of larger firms usually consider a broader range of funding options. Contrasting large firms, SMEs are constrained in their funding options. Therefore, a new hierarchy of sources of finance for SMEs can be defined. In this new hierarchy of sources of finance for SMEs, there are three sources of finance, internal finance, debt finance and new capital contributions. Large firms that have access to capital markets were able to issue equity. However, SMEs do not normally have access to this form of finance. 2.3.6 Pecking Order Theory (POT) Vs Static Trade Off Theory (STOT) The existence of two kinds of equity, Internal and external, where one is found at the top of pecking order and the other one at the bottom, Still, there is not a sound distinct target leverage in POT. Each enterprise under observation institute that the leverage reflects its cumulative requirements for External finance. Shyam-Sunder and Myers (1999), they tested the STOT against POT model using a sample of 157 American enterprises. They put forward that POT is an exceptional first-order descriptor of enterprise financing performance for their sample, but the simple target adjustment model also appeared to perform well. They also tested two models mutually, and the results implied superior confidence in the pecking order than in the target adjustment model. Chirinko and Singha (2000) counter argue the version of (Shyam-Sunder et al., 1999) regression test. They discussed that if contrary to the pecking Order, enterprise would follow a policy of using debt and equity in fixed proportions, and then Shyam-Sunder and Myers regression will identify this ratio. Fama and French (2002) tested the pecking order and trade off model. They find that profitable firms are less levered (after confirming the pecking order), SMEs with huge investment have less market leverage after (confirming the trade off), and short term disparity in the firm’s investment and earnings were mostly absorbed by debt(Confirming the POT).Frank and Goyal (2003) also examined a number of propositions of the pecking Order in the context of Shyam-Sunder and Myers (1999) regression test performed and they also claimed that if the POT is correct, financing deficit ought to wipe out the effects of other variables in the study. Otherwise, the financing deficit is merely one factor among many firms trade off, then is left as a global version of the Trade off Theory. Gaud et al., (2005) find that both the POT and STOT are at work as an illustration of the capital structure of Swiss enterprise. This essay is an example of a student’s work Disclaimer This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers. Essay Writing Service Dissertation Writing Service Who wrote this essay Place an Order 2.3.7 Critical Assessment of Pecking Order Theory Occasionally, the pecking order theory is criticized by others on the areas of its fundamental arguments and suggestions. Adedeji (1998) had opposed the suggestion of POH that internal source of financing is the only determinant that stimulates SMEs to make use of more external debt or equity. This is due to the fact that it may neglect other theories and other factors that might affect the decision of firms in choosing financing tools such as the level of interest rate and government intervention and other Financial Institutions. For instance, government intervention during the financial crisis may make the cost of borrowing cheaper than the cost of internal funds made available in the enterprise and as a result encourage firms to use more debt than retained earnings. Furthermore, the essential dispute of the theory about the transaction and information costs that motivates firms to prioritize on internal source of funds instead of external financing, has been denied by Baskin (1989), Allen (1993) and Adediji (1998). They argued that these costs are not the exclusive issue that might criticize the use of external funds made available by Financial Institution in Mauritius, mainly for equity. Also, they put forward that SMEs are reluctant to issue equity as it may affect the existing balance of control on the behavior of business owners in their investment decision making. Besides that, Fama and French (2005) point out that these SMEs can actually keep away from the information costs or adverse selection problem by issuing equities to employees and existing managers who invest in business. This is because this type of issues does not influence the ownership structure and thus maintain the existing balance of control of the SMEs in the entrepreneur hand rather than in control of financial institutions and any other financial body. As a result, the requirement for issuing debt to finance new potential activities would be reduced. The businesses activities also have minimize the managers-shareholder agency costs by encouraging manager to work harder for the interest of business owner and any investors in the SMEs. 3. Growth Cycle Theory (GCT) It describes the progression of the successful firm through growth phases (Bhaird and Lucey, 2011) along with potential financing problems that may arise at each stage. A biological analogy is sometimes used to describe “. . . the cyclical quality of organisational existence. Organisations are born, grow, and decline. Sometimes they reawaken, sometimes they disappear” (Kimberly and Miles, 1980). Numerous stage models have been developed in the management and organisational studies literature (D’ Amboise and Muldowney, 1988; Poutziouris, 2003), although the number of stages is not standardised (Lester et al., 2008). For example, Steinmetz (1969) proposes a model based on three phases of growth, whilst Lester et al. (2008) propose a five-stage model of organisational growth and development. The financial lifecycle model incorporates elements of STOT, AGT (Jensen and Meckling, 1976), and POH (Myers, 1984; Myers and Majluf, 1984), and describes sources of finance typically advanced by funders at each stage of a firm’s development. 3.1 Time Phases in GCT In this theory, the firm gets better access to venture capital as a source of equity and midterm-loans as a source of debt (Gregory et al., 2005). Yet, as the firm gets older and information-wise transparent it tends to have better access to public equity and long-term financing (Gebru, 2009). (Gregory et al., 2005) found that only firm size, as measured by total employees, could significantly determine the decision of whether to use insider financing instead of going for public equity or long-term financing. As successful firms survive nascent and start-up phases, and matures through growth stages, personal funding becomes relatively less important as investment finance is increasingly sourced from retained profits of the SMEs (Bhaird and Lucey et al., 2011). Firms faced with the problem of overtrading often seek to alleviate these liquidity problems by increasing their overdraft facility. Thus, it is common for SMEs to have high levels of short-term debt (Ray and Hutchinson, 1983; Michaelas et al., 1999). Sources of finance accessed at mature stage are generally determined by preferences of firm owners, rather than supply side restrictions (Bhaird and Lucey, 2011) due to competition, drastic economic changes, etc. The financial growth lifecycle model developed by Berger and Udell (1998) presents firms on a size/age/information continuum, and describes the increasing array of financing options available to the firm as it survives and grows. Berger and Udell (1998) thus conceptualised the sequencing of funding over the lifecycle of the firm centred on information opacity and following a financial pecking order. However, Berger and Udell (1998) also indicate that ‘‘the growth cycle paradigm is not intended to fit all SMEs and that firm size, age and information availability are far from perfectly correlated’’. As observed by K.Padachi (2006), SMEs are often characterized by a low Noncurrent assets base where there is high dependence on short-term funds which is in line with matching or hedging principle (Bhattacharya, 2001). Therefore, the Financing need of owners can be determined easily if owner may yearn for retaining control and independence in the business (Padachi, 2010). Consequently, external providers of funds may have a direct interest in the performance and activities of the business which can benefit the SMEs for borrowings of large debts. 3.2 Financing Vs External Equity It may thus be concluded that these different principles, aspects and approaches discussed above lent support and give a clear understanding to the financing Mix made available to the SMEs. Therefore, all these above mentioned issues are interrelated which can help owners/managers to determine their financing Mix of the SMEs. Most researchers (Berger and Udell, 1998; Binks et al., 1991 and Hughes, 1997; Hamliton and Fox, 1998; Winborg, 2000) argued that a larger number of small firms are unenthusiastic to use outside equity. They prefer to use internal funds in order to avoid intrusion to their business .Owners tried to meet their finance requirements most particularly from pecking order of, first, their own money (personal savings, retained earnings); second, short-term borrowings; third, long-term debt; and, least preferred of all, from the introduction of new equity investors, which represent the maximum intrusion (Cosh and Hughes, 1994).