Saturday, February 6, 2010

Thoughts on Linking Corporate Strategy to Capital Structure Diversification Strategy, Type and Source of Financing by Kochhar and Hitt - Earl Malvar

As the authors Kochhar and Hitt have set-out in exploring the relationship of corporate strategy and capital structure, they have conjectured intuitively and proven empirically that there is indeed an interdependent relationship between the two. It is only but rational for borrowers and lenders to close deals only when both sides find it mutually beneficial to do so. Information is powerful in this day and age. In an integrated global market, borrowers and lenders are given so many funding and investment alternatives. Asymmetric information was named a key determinant in investment strategy for both borrowers and lenders. Firms can easily involve themselves in emerging opportunities only when they have the funds/liquidity to do so. As I see it, firms in the practice of involving other people’s money (through debt or equity issuance) are indispensable agents of an active financial system. They serve as facilitators in developing risk and return expectations for the market to evaluate. They allow deserving industries to thrive and the unworthy to fold; short of saying that they keep the spirit of entrepreneurship alive and the gears of innovation constantly turning. As any sound investor would have it, however, involvement is a matter of evaluating the risk in exposing one’s funds. The borrowing company, for its part, can only take what the market is willing to give and it is through this situation that capital structures and corporate strategies become intertwined. I think the article’s conclusion that related diversification is preferably funded by equity financing indicates how an investor/lender can recognize his limits in knowing how a company with proprietary systems, products and other intangible assets operates and would rather invest with the thought that he will only have to look at the bottomline of financial statements and the capital gains and dividend yields he may eventually reap). On the other hand, it was said that debt financing is preferred for unrelated diversification. Following the article’s line of thinking on asymmetric knowledge, an investor may find it more comforting to know that venturing in a new business means both he and the company will have to explore the quirks of the business together with no threat of malicious concealment of facts. As the authors have concluded (albeit finding reason for further studies due to some conflicting test results from Chatterjee and Singh), there is reciprocity between financial strategy and the nature of diversification/expansion that a firm pursues. Further, in interpreting the conclusions of the article, mergers and acquisitions done for related businesses were funded via public funding. This highlights even by simple intuition how available information on the would-be-bought firm reduces the need to justify to the public the company’s decisions and even puts the acquiring company in a better bargaining position simply because it has already been exposed to the same business. As for diversifying to unrelated businesses, direct entry funded by private money may also find good justification in the reasoning that an uninitiated firm entering into a new business venture would find it difficult to value an existing firm in an unrelated business. In fact, it may even be more prudent, though certainly more demanding of work, to build this unrelated business from the ground-up with private money – from investment savvy people who are willing to take the venture and the risk with the company. In summary, it is critical for a firm to know how it will fund its plans so it can minimize effort and costs.

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