Investigate whether financial conservative policies depend on financial distress - Dissertation Example

The literature review will look at work already done in the area and this along with an analysis of data will be used to arrive at a conclusion. The paper also describes the research methodology that will be used in carrying out the study. Theoretical Framework Central to this investigation is to define trade off and pecking order theories and the terms financial conservatism, financial distress and leverage. A sample of firms that adopts conservative policies as it relates to high levels of cash holdings and low levels of leverage will be identified and data relating to financial conservatism will be analysed.

Trade-off theory predicts that when firms face high expected cost of financial distress and/ or attach a rather low value to interest tax shields, then, they will seek to employ conservative financial policies (Minton and Wruck 2001). Pecking order theory predicts that firms use external financing only when internal funds are insufficient to support discretionary expenditures. When internal funds fall short, managers look first to debt financing and only as a last resort do they turn to using equity financing (Myers 1984).

Definitions Financial conservatism For the purpose of this study financial conservatism is defined as a persistent financial policy of low leverage and high cash holdings. Financial distress Financial distress is the inability to generate revenue when there are too many debts. Literature Review Iona (2004) Berger et al (1997) suggests that managers tend to make more conservative capital structure decisions when are given the power to use their discretion and are therefore free from disciplinary and monitoring mechanisms.

The main motives behind the choice of conservative leverage policies are to reduce the probability of financial distress and bankruptcy and to resist disciplinary actions. Mackie-Mason (1990) used the modified Altman’s (1968) Z-Score to test for the likelihood that a firm will experience financial distress. Similarly, Helwege and Liang 1996; and Graham (2000) have used this variable in their capital structure studies. They have found the Z-Score coefficient to be consistently positive and significant.

This therefore, indicates that financially conservative firms are less likely to face financial distress. Myers (1984) suggests that a firm may seek to maintain slack in the form of reserve borrowing power and target a level of borrowing that lies below its debt capacity. In doing so, the firm can issue safe debt if it needs to avoid any material costs of financial distress. Titman (1984) and Graham (2000) identified industries in which firms are likely to experience significant costs of financial distress.

The suggestion is that sensitivity distress results from high levels of on-going relationships with customers which results from warranties, repairs and upgrades associated with the sale of goods in the computer industry, specialty manufacturing industry, the retail industry and the pharmaceutical/biotechnology firms. Minton and Wruck (2001) indicates that three (3) of the four (4) industry classification mentioned above are associated significantly with the probability of being financially conservative.

Retail firms are less likely to follow policies of low leverage possibly because of the thinking that real estate serves as good collateral for borrowing purposes. Iona (2004) also