Question

how a firm’s capital structure can be impacted or influenced by major changes in economic cycles (recession/Covid19)?

Answer 1

Capital structure decisions are of core importance to a firm's growth. Economic cycles impact these decisions largely. There are two important theoretical frameworks regarding capital structure : Static trade-off theory and Pecking order theory. Bothe the theories explains how leverage is dependent on various factors and how the leverage ratios are expected to behave under different circumstances. At times, these thoeries provide contrasting conclusions as to the behaviour of leverage in the capital structure during various phases of a business cycle.

According to the Static trade-off theory, the optimal capital structure is determined by trading off the benefits and costs of debts. It also points out that the leverage ratios must go down in times of recession as the taxable income and the need for debt are lower in these periods.

On the other hand, pecking order theory states that the leverage ratios remain unaffected during the recession time as these ratios don not get adjusted to certain 'optimal level' due to changing circumstances . These ratios get affected only when there is an opportunity of investments with positive Net Present Values come by, In such a situation, the need for finance is met by the retained earnings followed by debt and finally equity. During recession, the quantum of retained earnings with firms might be usually low and the issue of equity shares is not feasible due to the fall in share prices. This makes the firm to take decisions on issue of debt instruments to meet the requirements, which leads to a rise in the leverage ratios. Thus, contrasting conclusions are putforth by these two theories regarding the capital structure debt-equity mix.

The income of firms fall during recession which leads to an increase in their indebtedness. This raises concerns on the creditworthiness of the firm which has a negative impact on bankruptcy risks and costs. The combined effect of increased bankruptcy costs with tightened lending terms of debt suppliers increases the cost of debt. The beneficial effects of leverage such as tax shields , disciplinary effect etc decreases. As the debt trade-off becomes more unfavorable in times of recessions, the optimal leverage ratio decreases, forcing firms to deleverage.