WHAT EXPLAINS FIRMS' FINANCING AND INVESTMENT BEHAVIOUR?

Factors influencing financing behaviour

A firm's financing behaviour is related to its capital structure, and before we look at financing options available to the private sector, we need to discuss the capital structure of firms. Capital structure is the specific mixture of debt and equity a firm uses to finance its operations. Capital structure may be explained by a number of theories, including the life cycle theory, the pecking-order theory, the static trade-off theory, the dynamic trade-off theory, and the signalling theory.

The life cycle theory suggests that a firm's access to finance depends on its stage of development. Newer firms tend to rely on owners' capital because, at the initial stages, they may not be in the position to present an attractive investment avenue to attract funding. If they survive the dangers of undercapitalisation, they may then be able to make use of other sources of finance (Chittenden, Hall, & Hutchinson, 1996; Berger & Udell, 1998).

The pecking-order theory (POT) indicates that firms will initially rely on internally generated funds, where there is no existence of information asymmetry, then they will turn to debt if additional funds are needed, and finally they will issue external equity to cover any remaining capital requirements. The notion of asymmetric information suggests a hierarchy of firms' preferences with respect to financing. The order of preferences reflects the relative costs of various financing options. Clearly, firms would prefer internal sources over costly external finance (Myers & Majluf, 1984). Thus, according to the pecking-order theory, firms that are profitable and therefore generate high earnings are expected to use less debt capital than those that do not generate high earnings. In the case of SMEs, they seem to face a more extreme version of the POT, described as a 'constrained' POT by Holmes and Kent (1991) and a 'modified' POT by Ang (1991), because of the difficulty in raising external equity from the capital market. Therefore, they simply rely on retained earnings, additional investment by the owner, and to some extent bank loans and loans from microfinance institutions.

With respect to the static trade-off theory, financial managers often think of the firm's debt-equity decisions as a trade-off between interest tax shields and the costs of financial distress (Myers, 2001). According to Kim and Sorensen (1986), less debt is used when the expected cost of bankruptcy is higher than the tax shields or other benefits of using debt. This theory recognizes the fact that the choice of debt and the choice of equity vary from one firm to another and over time. The general reasoning behind the tradeoff theory is that firms will borrow up to the point where the marginal value of tax shields on additional debt is offset by the present value of possible costs of financial distress (Myers, 2001). This means that firms seek debt levels that balance the tax advantage of additional debt against the cost of possible financial distress. The dynamic trade-off theory holds that firms allow their leverage ratios to fluctuate within an optimal range. Thus, firms adjust current leverage ratios towards a target debt ratio.

Signalling theory also suggests that if a firm raises debt finance, the firm has an investment opportunity that will require more funds beyond the internally generated funds. Therefore, employing more debt in the firm's capital structure often serves as a signal to outsiders about the current situation of the firm as well as the managerial expectations concerning future earnings. Generally, the debt offering is believed to reveal information that the firm has identified positive net present value projects and as such will require more external debt finance to finance such projects (Eckbo, 1986).

The capital structure of firms is determined by a number of conventional factors:

• • Age of the firm - older firms are believed to have a good track record and thus are able to access debt more easily than are newer firms, which have no track record or credit history. Firms that make it beyond the survival stage (in the venture life cycle - from start-up to survival to rapid growth to maturity) would have overcome a number of challenges that make them more attractive to lenders because in essence the risk of the enterprise has reduced. That is, older firms are expected to have a good reputation that they have built over the years, which is understood by the market and which has observed its ability to meet its obligations in a timely manner (Diamond, 1989).
• • Size of the firm - relatively bigger firms are more diversified and are perceived as having lower risk. Thus, they are capable of attracting more debt, especially long-term debt. However, smaller firms have difficulty in attracting long-term debt because of the severe information asymmetry problems between owner-managers of the small firms and potential lenders. Also, long-term debt is likely to be proportionally more expensive for small firms because of the fixed transaction cost. The information asymmetries and transaction costs therefore limit the attractiveness of debt, in particular longterm debt.
• • Asset structure - a firms' asset structure plays a significant role in determining its capital structure. The degree of asset tangibility influences the liquidation value (Titman & Wessels, 1988; Harris & Raviv, 1991). Pledging the firm's assets as collateral reduces the costs associated with adverse selection and moral hazard, and this enhances the firm's access to debt finance at a lower cost.
• • Profitability - profitable firms rely more on internal resources, in line with the 'POT', while less-profitable firms require external debt financing. This is because profitable firms are able to generate enough internal resources and therefore rely less on external sources of finance.
• • Growth - high-growth firms are able to attract debt finance. Firms with high-growth opportunities require more external debt finance to finance the growth.

• • Tax effect - tax has an effect on a firm's capital structure decisions. Corporate taxes allow firms to deduct interest on debt in computing taxable profits. This means that tax advantages derived from debt lead firms to be financed through debt. This benefit is created by the fact that the interest payments associated with debt are tax deductible, while payments associated with equity, such as dividends, are not tax deductible. Thus, this tax effect encourages debt use by the firm, as more debt increases the after-tax proceeds to the owners (Modigliani & Miller, 1963; Miller, 1977).
• • Macroeconomic environment - macroeconomic stability is associated with the use of more equity and less debt (Baum, Caglayan, & Rashid, 2017). Firms in countries which experience macroeconomic instability in the form of high inflation and interest rates tend to use less debt. If they employ debt, this is usually short term.
• • Legal environment - firms in countries that have weak legal regimes tend to employ mainly short-term debt.
• • Institutional investing - countries that have bank-based financial systems tend to have companies with more debt, especially short-term debt. Whereas countries with institutional investors, such as pension funds and life insurance companies, tend to have firms with more equity in their capital structure.

SMEs' capital structures and financing may be influenced by some heterodox factors (see Green, Kimuyu, Manos, & Murinde, 2002; Abor, 2008):

• • Ownership structure - SMEs with a high percentage of managerial shareholders depend less on short-term debt.
• • Industry - access to debt financing varies across industry groups. Firms in the high-technology sector with few tangible assets have been known to rely more on equity than on debt financing.
• • Location of the firm - SMEs located outside a capital city encounter greater difficulty in acquiring debt, especially long-term finance, than do their counterparts located in a capital city.
• • The entrepreneur's educational background - the educational background of the entrepreneur is associated with access to debt finance, implying that better-educated owners do have greater possibilities of borrowing. Better-educated owners find it easier to present a plausible case for a loan to an outside body.
• • The gender of the entrepreneur - men-owned SMEs have easier access to debt finance than do women-owned SMEs. Women-owned businesses are less likely to use debt, for a variety of reasons, including discrimination, greater risk aversion, and ineffective networking (Brush, 1992; Scherr, Sugrue, & Ward, 1993; Aryeetey, Baah-Nuakoh, Duggleby, Hettige, & Steel, 1994).
• • Form of business - limited liability companies have been observed to rely more on long-term debt finance than do sole proprietorships.
• • Export status - exporting firms are better able to obtain debt because of the fact that they are more diversified and tend to exhibit better and stabler cashflows (in line with achieving global diversification and lower systematic risk) compared with nonexporting firms. Further, access to bank finance has been shown to promote exports (see Abor, Agbloyor, & Kuipo, 2014). This increases their ability to fulfil their debt obligations on time, thus increasing their access to more long-term credit.

Factors influencing investment behaviour

Factors influencing investment behaviour are numerous and vary across contexts. Specifically, factors influencing investment behaviour can be grouped as investor-related factors, industry-related factors, social-related factors, and macroeconomic-related factors. For instance, Borges, Bergseng, Eid, and Gobakken (2015) show that social factors influenced investment behaviour in the United States between 2004 and 2012. Specifically, they report local politics and religion as key influences of investment behaviour. Similarly, Salem (2019) posits that risk tolerance, investment confidence, investment literacy levels, and herding behaviour were the critical factors that shaped the investment behaviour of Arab women. Zhao, Chen, and Hao (2018) also posit that investment information diffusion is crucial in shaping investment behaviour. Thus, they show that providing or diffusing investment information helps guide investors to select their investment portfolios. Dominant and key influences of investment behaviour are presented and discussed as follows: ^[1]

• • Productivity of capital (technology) (Alshubiri, Elheddad, & Doytch, 2019; Boonman, Hagspiel, & Kort, 2015) - advancements in technology can help shape investment behaviour. Since technology improves the quality and quantity of goods and lowers the cost of production, frequent changes in technology may require additional investment in order to keep up the change trends in technology.
• • Government policies and regulations - policies and regulations shape investment behaviour (Zhao et al., 2018). For instance, where tax policies (Sineviciene & Railiene, 2015) favour capital gain yields at the expense of dividend yields, investments move towards instruments that provide capital gain return.

• [1] Cost of investment (interest rate) (Drobetz, El Ghoul, Guedhami, &Janzen, 2018) - investment is financed out of savings or by borrowing. This requires compensation for the saver or lender for deferringcurrent consumption. Therefore, investment is strongly influencedby interest rates, which are the cost of investment (debt component).Fligher levels of interest rate discourage investment activities, whilelower interest rates encourage investment activities. • Economic growth (Sunde, 2017) - economic growth shapes the behaviour of investments. That is, if economic growth prospects improve,firms will increase their investments given that expected futuredemand will rise. Similarly, the accelerator theory states that investment depends on the rate of change of economic growth. • Investor confidence (Shahid & Abbas, 2019; Hoffmann & Post,2016) - investment involves some level of riskiness and uncertainty.Hence, the investors invest only when they are confident about costs,demands, and economic conditions. Following the Keynes model, the'animal spirits of businesspeople are a crucial determinant of investments'. This may be fuelled by the political climate and interest rates. • Inflation (Mkaouar, Prigent, & Abid, 2019; Farooq & Ahmed, 2018) - inthe long term, inflation affects the value of investments, which tendsto determine the behaviour of investments. Inflation creates instability and confusion in the costs of investment and erodes the value ofinvestments. Thus, prolonged and instable inflationary periods andenvironments lead to lower levels of investment, due to fear of losingthe value of the investment.