Exploring a capital structure decision-making framework for financially distressed companies

Abstract

Depending on the stage of its life cycle, a company will require a different composition of its capital structure. The life cycle stage does not automatically determine the probability of financial distress for a company. However, the inverse is true; financial distress can determine the life cycle phase of a company. The question that academics and practitioners continue to grapple with is, what should the financially distressed company’s capital structure consist of to maximise its chances of success? This study explores severity of distress, reasonable prospect to rescue a financially distressed company, various capital structure theories, and the determinants of capital structures to investigate what may inform capital structure decision-making for distressed companies. The aim of this study is to explore a capital structure decision-making framework for financially distressed companies. This is achieved by investigating the following research questions: 1. How does severity of distress impact the capital structure decision of financially distressed companies? 2. How does the reasonable prospect of rescuing a company affect the capital structure decisions of financially distressed companies? 3. What are the determinants of the capital structure of financially distressed companies? 4. What decision-making framework should funders and practitioners use when considering the capital structure decisions of financially distressed companies? The main contributions of this study were to expand on the existing frameworks to evaluate severity of distress on a framework that is more aligned to capital structure decision-making. Furthermore, it was also to further investigate the boundaries of the zone of insolvency and its consequences for capital structure decision-making. However, the study explored how severity of distress and the zone of insolvency impact the reasonable prospect of rescuing a company. This study then aims to contribute further to the limited academic literature that is available on the concept of reasonable prospect and explores how existing reasonable prospect calculations can be adapted to make them less subjective and align them to make sense of the capital structure that financially distressed companies require. The unique circumstances that a company in financial distress finds itself in result in determinants affecting its capital structure that is different from the norm. This study explored possible determinants that have a practical implication as well for companies in financial distress. The study then aims to propose a capital structure decision-making framework that can be used for future research and by practitioners to hopefully move the capital structure debate and practical value thereof forward for practitioners. Literature review The literature review explored the literature on severity of financial distress, the zone of insolvency, and the reasonable prospect of rescuing a company. Furthermore, the study reviewed the three main capital structure theories, namely, the irrelevance capital structure theory, the trade-off theory, and lastly, the pecking order theory and considered the impact of financial distress. The study also focuses on the shutdown rule and key case law to assist in the exploration of determinants of capital structure when a company is financially distressed. Theoretical framework To address this gap in theory, the researcher explores what may inform capital structure decision-making for distressed companies from an ontologically subjective constructivist-interpretive paradigm, believing that knowledge comes from facts associated with real-life cases and their context. The reality for a financially distressed company is not the norms that govern the company as a going concern in finance, accounting, investment, and economic disciplines. The researcher’s epistemological position acknowledges that as a constructive interpretivist, the researcher is inclined to a more qualitative research methodology to explore and understand the phenomenon of financially distressed companies’ capital structure. Methodology A mixed-method approach was used to first explore the constructs and themes around severity of distress, zone of insolvency, reasonable prospect to rescue a company, and capital structure of companies in financial distress through a review of relevant literature. This was followed by pilot qualitative semi-structured open-ended interviews with various industry experts that span management, practitioners, and funders. As a practitioner in the field, the researcher’s own observations were also used for further triangulation. The themes and constructs established were then further explored through a Qualtrics questionnaire extracted from the initial concourse statements. The final Q-set of 66 statements was then sorted by expert industry participants and analysed using the PQMethod software for quantitative correlation and factor extraction. Finally, a holistic interpretation of all statements to explore the phenomenon was made to find synergies between the data and the theories explored. Interpretation The interpretation revealed a surprisingly high correlation between the three-factor arrays (viewpoints) identified through the Q method process and the three main capital structure theories, namely, pecking order theory, trade-off theory, and irrelevance theory, that were selected as the focus during the literature review. Another surprising outcome was the realisation after exploration of a holistic range of statements that the factor arrays did not favour a particular capital structure theory but rather differentiated the use of a capital structure theory based on severity of distress and the reasonable prospect of rescuing the company. The determinants that have an impact on the determination of severity of financial distress and the calculation of the reasonable prospect were also explored. This study proposes a less subjective framework that can practically be aligned to the distressed company capital structure. Discussion This study concluded by making observations on the propositions made from the original literature review. Furthermore, a capital structure decision-making framework for financially distressed companies is proposed that will hopefully evoke further academic debate and be useful for practitioners. Conclusion This study explored literature relevant to the phenomenon of capital structure decision-making for financially distressed companies. Furthermore, the gaps identified in the literature and lacking in practice were addressed with the mixed-method exploratory research using the Q methodology for the first time in this context. The results were surprising findings linking severity of distress, reasonable prospect, the determinants of capital structure for financially distressed companies, and the capital structure theories in a new way. This allowed for the proposal of a capital structure decision-making framework for financially distressed companies that will hopefully evoke further academic research and practical application.