The relationship between sustainable value creation and dynamic capital structure management

Abstract

In this paper the case for the relationship between dynamic capital structure management and sustainable value creation has been argued. The dissertation addresses the need for dynamic rather than static capital structure management. Research has been done on capital structure dynamics with the intention of developing a model for improved and dynamic capital structure management for sustained value creation. The author has provided a theoretical overview of the two Modigliarii and Miller (M&M) propositions, capital structure models and the most important factors determining an appropriate capital structure for a company. Empirical research has been done on JSE listed companies in the industrial sector for the period 1997-2006. The relationship between capital structure determinants and sustainable value creation, as reflected in company share prices, has been investigated as part of the empirical study. The results from the statistical analyses have been used to develop a model for dynamic capital structure management. It has been expected that the value of a firm and certain capital structures would be strongly correlated, but research has shown that capital structure variables and change in share price are weakly correlated for companies listed in the industrial sector. Therefore, a change in the share price model does not make sense and has not been developed. On the contrary, empirical research has found a statistically significant relationship between capital structure variables and companies' debt to equity ratios. Based on this knowledge/research, four multi factor models have been developed for debt to equity at a 5% level of significance. The idea behind the multi factor models is to determine which variables have been the best predictors (individually and combined) of the expected direction of movement of companies' debt to equity ratios. The results from testing the model confirmed that the four debt to equity variables (return on equity, return on assets, debt to asset ratio and net profit margin) are significant indicators of the direction of movement of a company's debt to equity ratio. The models become stronger predictors of the expected direction of movement of debt to equity ratios as the number of variables included in the model increases. Three of the most significant explanatory variables in the four factor model of debt to equity are profitability ratios, which mean that industrial companies are managed, using financial ratios instead of value based management variables. Therefore, it can be argued that industrial companies listed on the JSE are far from practising value based management. Capital structure decisions are important not only because of the need to maximise returns to various organisational constituencies, but also because of the impact such decisions have on an organisation's ability to deal with its competitive environment. Therefore, the four factor model suggests a practical and dynamic way for companies in the industrial sector to manage an optimal capital structure to ensure sustainable value creation.