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Similar to Modigliani and Miller’s (1958) irrelevance proposition for capital structure,

Stiglitz (1974) argues that in perfect capital markets, the debt maturity structure of a firm is irrelevant for its value. Following this, numerous theoretical and empirical studies have

67 challenged this maturity structure irrelevance proposition due to the market imperfections that play a role in determining the maturity structure of a firm. These theoretical extensions, originating as a result of the irrelevance proposition proposed for debt maturity structure, can be broadly grouped into four categories: (1) Agency/contracting Cost Hypothesis (2) Assets Maturity Hypothesis, (3) Implication of Taxation for the Debt Maturity Structure and (4) Information Asymmetry and Signalling Theories of debt maturity structure. Each of these will be discussed in the following sections.

4.1.1. Agency/Contracting Cost Perspective

Many theoretical studies view debt maturity structure as a means to reducing potential conflicts between shareholders and bondholders. As discussed in Section 3.1.5, risky debt financing may increase potential conflicts of interests between bond and shareholders. These conflicts may arise when firms have included risky debt in their capital structure and plan to undertake some positive NPV projects, the benefits of which have to be shared between the bondholders and shareholders. However, when the firm already has risky debt outstanding, the bondholders may capture more benefits from the project, such that existing shareholders do not earn the required return from that investment project. This may in turn give rise to potential agency conflicts over materialising those opportunities, leading to debt overhang or underinvestment problems.

Among other ways to resolve these conflicts, such as the inclusion of restrictive covenants in debt contracts and reducing the amount of leverage in the capital structure, Myers (1977) and Bodie and Taggart (1978) argue that reducing the maturity of the debt in the capital structure is also likely to lessen any underinvestment problems. The reduction in the maturity of debt ensures that the short-term debt matures before the growth opportunities are exercised as the firm gets an opportunity to re-contract and re-price its debt such that all the gains from the new investment opportunity do not accrue to bondholders.

It is also argued that short-term debt holds a higher effective priority, as it is paid first. Ho and Singer (1982) argue that short-term debt is similar to secured debt, even if the priority in bankruptcy is equal for both short and long-term debt. Short-term debt also helps lenders to monitor borrowing firms, which may also effectively reduce the disincentive to invest. For example, Barclay and Smith (1995) argue that most bank loans are short-term as the reduced term of the debt gives banks superior bargaining positions, and maximises the

68 effectiveness of the monitoring activities. Easterbrook (1984) further argues that the agency cost of monitoring is also lower when firms issue short-term debt on regular basis, as the market evaluates the prospects and reviews the firm on a regular basis. Hart and Moore (1990) and Stulz (1990), arguing along the same lines, suggest that long-term debt discourages any managerial discretion in making poor investments. They would mean that firms should use more long-term debt when they have fewer growth options. The contraction cost hypothesis therefore suggests that firms with a higher growth opportunities set tend to prefer to have shorter debt maturity in their capital structure.

Given that smaller firms normally have higher growth opportunities than large firms (Denis, 1994), smaller firms are likely to have more short-term debt in their capital structure. Smith and Warner (1979) argue that small firms are also more likely to face potential conflicts of interest between bondholders and shareholders. This is because lenders know that small firms’ owner/managers will gain greater advantage from any wealth transfer in favour of their shareholders due to them having a higher stake in the firm. Therefore, they are more likely to substitute one asset for another, thus altering the

overall risk of the firm (Scherr and Hulburt, 2001; Pettit and Singer, 1985). Barnea et al.

(1980) argue that such conflicts can be curtailed by lowering the maturity in the capital structure. Moreover, long-term debt, specifically the long-term public debt, has fixed flotation costs which small firms are less capable of paying (Barclay and Smith, 1995). These costs include legal fees, investment banker fees, filing and other transaction costs and they can play a significant role in explaining the choice between public and private

debt (Krishnaswami et al., 1999). Although such costs offer economies of scale, small

firms are unable to take advantage of these opportunities due to their limited resources. Consequently, they are forced to take private debt, which has an overall low cost, particularly a low fixed component of the cost, with shorter maturity. Hence, the contracting cost argument implies a shorter maturity of debt for small firms compared to larger firms.

4.1.2. Assets Maturity Hypothesis

One of the risks associated with debt financing is an inability to service the fixed cash outflows with the cash inflows generated by the operations of the business (Morris, 1976; Myers, 1977). This risk can be minimised by matching the stream of the incoming and outgoing cash flows with each other. This may serve as a hedging policy for the firms

69 whereby the maturities of assets are matched with the maturity of debt. In this case, firms may have enough funds generated from the assets so that they can service debt or retire debt at the maturity of the debt. When debt matures before the end of the asset’s life, this event may elevate the risk of a firm, as there is a possibility that not enough funds are generated to pay back the debt by the time of the retirement. Similarly, if debt is due to mature after the end of the assets’ life, the funding source and volume is uncertain at the maturity of debt and it is likely that the firm has already used up the cash flows generated from the assets. Both situations push firms into unfavourable conditions and may elevate their risk of liquidation. It is also argued that underinvestment problems can be minimised when the schedule of repayments corresponds with the declining value of assets (Myers, 1977). It follows that firms will finance long-term assets with debt of longer maturity and short-lived assets with short-term debt.

4.1.3. The Role of Taxation for the Debt Maturity Structure

Another possible explanation for the choice of debt maturity structure can be found in the

tax related theories by Kane et al. (1985) and Brick and Ravid (1985, 1991). Kane et al.

(1985) argue that optimal maturity structure can be reached by trading off the benefits of tax against bankruptcy costs and the cost of raising the debt. They show that a firm’s optimal debt maturity structure is likely to have a negative relationship with its tax advantages and a positive relationship with the flotation costs of the debt. The reason for this is that the flotation costs decrease the advantages associated with the debt. When there is a decrease in the tax advantages of debt, firms are likely to choose higher maturity in the debt structure to ensure that the flotation costs are amortised over a longer period of time, such that the tax advantages of debt are never less than the amortised flotation costs.

Conversely, Brick and Ravid (1985) postulate a positive relationship between taxation and debt maturity structure. If the term structure of the interest rate has an increasing slope, then the optimal strategy for the firms would be to increase their proportion of long-term debt. This is because if the yield curve is upward sloping, it will increase the present value of the tax shields in the initial years, thus reducing the tax burden of a firm. This will have a direct effect on a firm’s value. In addition to the accelerated tax advantages proposed by Brick and Ravid (1985), Brick and Ravid (1991) argue that the long-term debt is also optimal, when the term structure of interest rates is either flat or even downward sloping. It is argued that in the case of uncertain interest rates, firms with long-term debt are less

70 concerned about adverse shifts in interest rates, unlike firms who have more short-term debt. This increased debt capacity particularly increases the value of tax benefits of debt. Therefore, the higher the effective tax rate, the higher will be the proportion of long-term debt. On the other hand, Lewis (1990) argues that taxation does not have any effect on the debt maturity structure once capital structure and debt maturity structure are simultaneously determined. Therefore, firms can achieve an optimal capital structure by various combinations of short-term and long-term debt. These tax related theories collectively suggest a mixed relationship between taxation and the debt maturity structure.

4.1.4. Information Asymmetry and Signalling Theories

The choice of debt maturity structure may also depend on private information which management holds about the quality of their firm. Flannery (1986) and Kale and Noe (1990) are among the initial studies which model the role of signalling for the maturity structure of a firm’s debt. In the presence of information asymmetry, Flannery (1986) argues that insiders choose a particular maturity structure of their debt to signal to outsiders the true quality of the firms. Flannery argues that high quality firms will elect to have shorter debt maturity in their capital structure compared to low quality firms, given that there is a positive transaction cost. If the markets cannot distinguish between good quality and poor quality firms, good quality firms are more likely to issue short-term debt when insiders know that their firm is undervalued.

Flannery’s model assumes that issuing short-term debt frequently over a given period incurs more fixed transaction costs than issuing long-term debt and this cost has to be sufficiently high so that good firms will choose a maturity structure to identify themselves as better firms. If there had been no costs associated with the issuance of short-term debt, all firms, whether of good or poor quality, would have the incentive to issue short-term debt. This would create a pooling equilibrium such that the market could learn nothing about the firm’s quality and their beliefs would remain the same after the issuance of the debt. However, if the flotation costs are sufficiently high for the short-term debt, low quality borrowers cannot mimic high quality borrowers and they have no choice but to issue long-term debt. This results in a separating equilibrium such that high quality borrowers issue short-term debt and low quality borrowers issue long-term debt.

71 Flannery’s model assumes that all firms, whether of high or low quality, will have a preference for short-term debt but the transaction costs associated with short-term debt will not permit low quality borrowers to issue more short-term debt. However, Kale and Noe (1986) argue that such separating equilibrium can exist without the transaction costs. Due to information asymmetry, uninformed investors might misprice the securities. Although both types of long and short-term securities are subject to mispricing, long-term debt is more specifically sensitive to such mispricing. Good quality firms would therefore like to reduce the losses due to mispricing of long-term debt and issue more undervalued short- term debt. On the other hand, the low quality borrowers will issue more overvalued long- term debt. The theoretical models from both studies thus predict a negative relationship between a firm’s quality and its maturity structure.

To summarise, this section has provided a review of the different theoretical frameworks that emerged as a direct or indirect critique of debt maturity irrelevance. It has highlighted several different factors that affect the maturity structure of the firms, such as agency costs faced by firms, their maturity of assets, information asymmetry and firms’ willingness to signal quality, and minimisation of their tax burdens. The next section provides a review of the empirical evidence on the debt maturity structure of the firms based on the theories above. It highlights the prominent factors, which are argued to be of prime importance for the determination of the debt maturity structure of firms.