Whitley (1992) observes that developing economy firms follow corporate structures that are similar to those of conglomerates. This suggests that the issue of the relationship between a firm’s strategy and its capital structure has special relevance to any study examining the financial behaviour of firms in a developing economy. The empirical literature on these issues can be divided into two groups. The first examines the direct impact of diversification strategies on capital structure while the second explores the influence of firm-specific assets on capital structure.24
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The latter can be indirectly examined via the impact of tangibility on the demand for debt. This issue, along with other hypotheses that are simultaneously tested within previous research, will be reviewed later in this paper. What follows considers only the former strand of work.
Formal econometric testing of the impact of corporate strategy on the firm’s capital structure was started by Barton and Gordon, (BG, 1988). Strategy is a proxy for management values, goals and motivations for firm diversification. It must therefore also include managers’ preference for debt and equity. A central issue here is the impact of diversification on risk, which in turn influences the firm’s gearing. Thus, firm strategies which involve diversification into unrelated activities have the lowest risk associated with them since there is no order to the process of diversification, ceteris paribus; the reverse is true for firm strategies which involve diversification into related activities. Accordingly, management strategy impacts on the firm’s financial structure. A sample of 279 Fortune-500 US industrial firms covering the period 1970 - 1974 was divided into four groups: single strategy, dominant strategy, related strategy and unrelated strategy. Several results emerged from this research. First, overall, there was sufficient statistical evidence for not rejecting the hypothesis that corporate strategy does influence the capital structure decisions of the firm. In relation to single strategy firms, it was found that the average debt level was significantly lower than all other categories. However, there was no significant difference between the average debt level of firms following dominant strategies and the overall average debt level of the sample as a whole. The average debt level of firms that adopted a related corporate strategy was lower than that for firms in the unrelated category. Finally, firms with an unrelated strategy had the highest debt ratios of all. Moreover, such debt levels were significantly higher than those for single and related category firms.
Lowe et al. (1994) extend BG's work by investigating whether the corporate strategy of the firm influences its capital structure in a sample of Australian public companies for the period 1984 to 1988. The sample was divided into the same four groups used by BG. This procedure initially gave results that were mostly insignificant. However, by pooling the data and using dummy variables to differentiate the effects of each type of strategy in the whole sample, more efficient estimates were obtained. Lowe et al. report that the gearing of firms which adopt either a single-firm, a dominant- firm or a related-firm strategy is not affected by that strategy, but the gearing of firms which adopt an unrelated strategy is affected by the strategy. These are clearly not the same as BG's results. Riahi- Belkaoui and Bannister (1994) also consider the impact of corporate strategy on the financial structure of the firm. They conduct a longitudinal study to capture the effects of the implementation of a decentralised M-form (multi-divisional) organisation structure on the firm’s capital structure. Data for a period of 5 years before and 5 years after the point of restructuring was collected from COMPUSTAT and MOODY’s Industrials Manual for 62 firms. Covariates of firm size, growth in total assets and growth in GNP are used as control factors for the early/late adaptation of M-form structures. This is motivated by the belief that late adapters learn from the experience of early movers and thereby restructure faster and more efficiently. An analysis of covariance is used to test the overall relationship between the organisation structure and capital structure. The results indicate that those firms that adopt a change in structure to form a multidivisional organisation are associated with a shift in capital structure and a significant increase in long-term debt in comparison with those with an hierarchical structure.
All the work reviewed so far has concentrated on large firms. Jordan et al. (1998) extended the analysis by examining the role of strategy in smaller UK firms. The influence of strategy should be different from that in large firms, since the ownership and risk characteristics of small firms are distinct from those of large firms. The role of competition is thought to be more eminent than that for corporate strategy in determining the demand for funds by smaller firms. Jordan et al. effectively test for the impact of both competitive and corporate strategies. Using a sample of 275 small UK firms for the period 1983 - 1993, which (as with BG and Lowe et al.) was split according to whether the firm adopted either a corporate or a competitive strategy. In relation to the former, it was found that corporate strategy per se did not influence smaller firm’s capital structure. However, when the same analysis was applied to firms that used competitive strategies, it was found that competitive strategy did influence capital structure.
Table 3 summaries the main findings of these studies. It seems clear that strategy does influence the firm’s capital structure, but further research is required to identify the precise channels through which this influence is felt, as the results of the main studies do not offer a clear consensus on this point. ___________________________________________________________________________
Table 3 about here