Financial rules and regulations within the environment that the business operates, determines its access to capital, its capital structure, and its funding, be it a public or private firm. There are several theories concerning capital structure of a firm such as the pecking order hypothesis, Modigliani & Miller Theory, (M &M), and trade off theory. Furthermore, there is a striking difference between private and public firms, which is their leverage ratios, level of information asymmetry between the outsider and insiders of the company, and ownership structures. Private firms have higher financial costs, which tend to affect their financial policies. This eventually affects the funding of the firm, and its projects due to the limited outlay of investment capital.
The cost of capital and financial policies is what drives private firms to go public to obtain cheaper and better access to external equity capital. This can result to level effect where the firm’s private equity costs more than the public equity. In addition, the relative cost of equity is higher in private than in public firms. Therefore, private firms end up having higher debt ratios than public firms, and are less likely to use the equity choice. This is the implication of the level effect. It may also result into a sensitivity effect, whereby private equity costs more than public equity, thus a higher cost for accessing external capital markets for private firms than for public firms (Baker & Martin, 2011).
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Data is very crucial in determining the debt equity capital that a firm should use. For example, in the United Kingdom, all companies with limited liability form after incorporation by the Companies House. They get data from several sources to support their calculations, e.g. Cash flow statements, income statements, ownership information, and balance sheet. They can also do sampling from the FAME database to determine the best equity ratios to use. Models of the Capital structure theory generate predictions on market debt ratios, thus determining the issuance, leverage and repurchase definitions. Data errors usually occur since most UK based companies do not file their information with the Companies House electronically. Truncation occurs to arrive at an approximate figure.
The access to public capital markets affects the financial policy of the firm. This is because it helps determine the debt ratios of the firm and weigh the possibilities of going with a public or a private equity. This enables firms to rebalance their capital structures. This is because of the sensitivity to characteristics of the firm such as growth, and profitability. These two help in realizing the target debt ratios and the actual debt ratios respectively. After carrying out a complete hypothesis, the firm then makes the all-important decision on whether to raise capital or to retire it. This helps it select the debt equity choice where it borrows money from the public. Consequently, the firm’s robustness.
The fundamental difference between public and private firms is their ownership structure. Private firm have less shareholder, owners of the company, as compared to their public counterparts who have very many shareholders. This leads to frictions in the information asymmetries of the private firm, which may lead to decision to issue equity and become a public company. This reduces the concentration of power in the said companies, and allows it to seek debt capital from the public. It also enables the firm to determine the leverage options it seeks to pursue so that it can maximize its earnings per share, and consequently, its return on investment. This helps them achieve their main objective of profit and wealth maximization (Choi, 2003).
Access to capital and the funding of the firm is most reliable in the publicly limited companies than their brothers in private wing. This is because public firms are more open to scrutiny by the public, investors, and interested stakeholders, than private firms are. This enables them get all the information they require about the firm. Therefore, they are able to make an informed decision when they invest in a public firm, and can even calculate their expected returns on investments. This is why shares of a public company, or an IPO from them, would sell at a much faster rate compared to an offering from the private firms. This is because of the restrictions within private firms.
In conclusion, a universal database of all companies incorporated in the United Kingdom enables learners determines the financial policies of public and private firms. It helps determine both the level and sensitivity effect of the firm. Furthermore, it helps them identify the market frictions, which make equity from the private firms more costly than equity from public firms. The ownership of the firm comes in when determining the information asymmetry between insiders and outsiders of the firm. Finally, the information explains how the access to public capital markets by firms; either public or private has a major effect on other aspects of the firm’s investments and funding. Public firms increase their investments in response to an increase in profitability.