What happens when a company needs extra funding in order to expand? Do economic theories reflect what happens in reality? Dubai-based online MSc in Corporate Finance graduate Rania El Sheimy set out to explore this issue in her master’s dissertation. She was surprised by what she found.
“It is like you are moving chairs, you are sitting at the other side of the table and looking at it from the company’s perspective.” That’s how Rania, a corporate banker by profession, describes the experience of conducting her online MSc in Corporate Finance dissertation research into how listed companies in the United Arab Emirates (UAE) make funding decisions.
Rania looked at the behaviour of non-financial firms listed on the Dubai Financial Market, considered by many to be the most advanced financial market in the Gulf Cooperation Council (GCC) area. While it could be expected to perform in a similar way to other major markets, Rania’s research showed that there are significant differences between Dubai and developed markets in other regions, at least in terms of how capital structure decisions are made.
Rania studied online for her master’s while continuing in her full time job. She graduated in December 2016 and received a Student of the Year award. Watch this video of her journey to graduation.
“We as banks know how to provide finance, but I wanted to get a better understanding of why a Chief Financial Officer might decide to go for loans and why he might decide to go for equity. What factors influence that decision? What are the parameters?” she explains.
“Some of the results were very shocking,” she says. “Equity was always the last resort, which completely revokes the notion that the more developed the financial market, the more the equity issuance and hence the more reliance on equity.”
There are two principal theories to describe how companies make capital structure decisions. According to static trade-off theory developed by Modigliani and Miller (1958), companies aim for an optimal mix of debt and equity that balances the costs and advantages of each. In contrast, the pecking order theory promoted by Stewart Myers (1984) suggests that companies do not aim for a target capital structure, but rather have a hierarchy of preferred sources of funding, looking first to internal funds and then to debt, with equity-raising as the least preferred option.
Rania combined qualitative and quantitative methods in her study, concluding that the financing behaviour of the firms in her sample aligns most closely with the pecking order theory.
She also found that financial leverage – or whether or not companies use debt financing – is not significantly influenced by the industry average and the UAE’s unique institutional setup. In addition, her research showed that size is positively related to leverage, while profitability, age, business risk and liquidity are negatively related to leverage.
Across all sectors, Rania found that having a strong and established relationship with a corporate relationship manager was extremely important to CFOs. “In such a banks-oriented financing market, relationship banking is the most important determinant of leverage in the UAE,” she explains. Corporate bankers take note.
References Modigliani, F., & Miller, M. H. (1958) The cost of capital, corporation finance and the theory of investment.
The American Economic Review, 48 (3), 261-297
Myers, S. C. (1984) The capital structure puzzle. The Journal of Finance, 39 (3), 574-592
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