ESTIMATING THE COST OF CAPITAL AND ITS DETERMINANTS IN SMALL AND MEDIUM ENTERPRISES1 Introduction

1.1 Background

Small and medium enterprises are becoming increasingly important in the economy. They play an important role in promoting economic development, creating jobs and increasing economic diversity. Due to their rate of flexibility and versatility, SMEs are able to adjust to changes in economic environment better than bigger organisations. According to Padoan,Arzeni and Organisation for Economic Co-operation and Development (2010), there were approximately 4.6 million SMEs in 2010 and forms 99.9% of all businesses by number. This comprised of more than half of employment in the private sector and half of the entire turnover in the private sector. The contribution and significance of SMEs towards the economy has evolved over time as the operating environment change (Carboni 2010). In most cases, it is the SMEs that enter a new industry first before the larger firms identify the importance of large scale operation in the new industry (Padoan, Arzeni& Organisation for Economic Co-operation and Development 2010).

According to Ang (1991), SMEs are small and medium enterprise, managed by the owner, rather than a professional manager on behave of the business shareholders. Most SME have less than 100 workers, they are legally independent and own a very small share of the market.In the UK, SMEs contribute largely to economic growth and transformation. Over time, they have created positive value to the economy and contributed towards balanced and sustainable economic growth, social stability and employment. Although the SMEs in UK play an important role in the economic growth, the access to finance has always been limited even in the global operation (Carboni 2010). In most cases, the access to finance for SMEs varies depending on a number of factors such as availability of finance channels, management experience, marketing capabilities, the development of a given jurisdiction and personal connection between the owners and financiers. During the start-up stages, promoters of the SMEs often rely on their own capital such as personal credit cards, savings, loans or equity from family, friends, banks and other financial institutions (Chui et al 2002: Claudio et al.2001). In addition to venture capitalists, credit access can be also be availed by suppliers. According to Bloomfield (2008), the challenge faced by SMEs in accessing finance has been amplified by the increased effects of global financial crisis, which led to the current reforms in finance. These changes include the introduction of strict capital requirements for financial institutions related to Basel III.Strengthening the financial institutions and the banking sector has had the effect of decreasing the effect of intermediation as banks become more risk averse when extending credit especially to the SMEs (Roche & Great Britain 1998). Thus, it has been made important to examine all the possible alternatives of accessing credit for the SMEs. Raising capital through organised, transparent and reliable market can provide reliable sources of finance at a relatively lower cost.

It is important to note that although the criteria used by the banks in lending have been tightened, various economic recessions have increased the underlying credit risk for SMEs (Berger, Klapperand Udell 2001). This is mainly due to sales decline and greater uncertainties. According to Fraser (2009), ration of the number of business with low probability to declined dropped by 48% between 2004 and 2008. However, 71% of the businesses did not make unauthorised excess on the overdraft facilities. This explains some of the increased difficulties the SMEs experience in their efforts to raise capital. The current Euro zone turmoil has caused uncertainties in the entire global economy. Although there is evidence that both banks and businesses are becoming more prepared to handle the economic shock, a default of large Euro zone country cause result to major financial crisis due to UK banks exposure to the market.

Therefore, identifying the most suitable estimating the cost of capital and capital structure of SMEs is very important. A suitable capital structure can help an organisation to maintain a competitive advantage in the market and provide positive effect on the countrys economy (Bloomfield 2008). The main objective of any firm is wealth maximisation and obtaining the right cost of capital should provide directions on how a firm plans to fund its projects and meet the objectives. In this regards, the ability of an SME to access finances helps in facilitating start-up of new businesses, funding business investment and ensuring the business achieve its growth potential. 1.2 Rationale for the Study

Most businesses have been able to obtain financial access as they need but there are various structural and market failures affecting the supply of equity and debt financing to the SMEs. This has resulted to a discriminative denial of access to capital to potentially successful business ideas. These market failures are related to asymmetrical information. These failures exacerbates during uncertain economic situations when banks and other lenders become more risk averse due to increased uncertainties.

Understanding the market uncertainties can help the researcher in understanding the existing undersupply of equity finance to young but highly potential businesses. This is due to the fact that investing in innovative business during the start-up stage can lead to a number of positive spill-over effects. This can increase the rate of knowledge transfer and innovativeness to other parts of the economy which financial sector fails to consider when investing in venture capitals.

The problem discussion shall review all relevant literature in regards to the structure of capital. According to Beltrame, Cappelletto and Toniolo (2014), most studies focus on the capital structure among the top companies or those listed in the stock market, thus overlooking the capital structure of SMEs. Different empirical studies on the capital structure have gathered data from businesses categorised as large businesses. As illustrated by Hunter and Tan (2007), the existing research on the capital structure of SMEs indicates that there is a big difference between their capital structure and that of the larger businesses.

1.3 Research Problem

Despite the role played by SMEs in the UK economy, the financial constraints faced during operation have a negative effect on development of the business and potential growth to the national economy (Ang 1991). This is a worrying trend for a first world country with the requisite infrastructure and technology to access more funds at a low cost. Most SMEs in the country do not have the capacity in terms of exposure and technological knowhow to manage their activities in most of the highly competitive industries (DeGeeter, 2010). Consequently, the businesses are unable to record the same quantity of output as compared to the bigger firms and with no audited financial statements (an essential requirement); they are not able to access credit from financial institutions (Coleman 2000). Therefore, the details of SMEs financial conditions may be inaccurate or incomplete making lenders deny them credit or offering the credit at very high cost due to the risks involved.

The other issue that makes credit inaccessible for SMEs in UK is inadequate capital base. An organisation is required to meet a certain capital threshold in order to be considered for credit lending (Hunter & Tan 2007). In this situation, most SMEs are unable to provide the collaterals often ending up with little access to funds that are adequate to for the development of their projects.

Euro zone crisis and economic depression have also affected the financial policies. The financial crisis of 2008-09 happened because banks were able to make too much money. The banks were able to increase the housing prices through speculation in the financial markets. Lending too much money made existing loans unpayable and financial market almost became bankrupt (DeGeeter, 2010). After the crisis, banks refused to lend unless to investments they were sure they will be paid, thus limiting their overall lending. This decision on players in the financial market affected even the innocent SMEs who only required relatively small amount of capital for their business.

1.4 Research Hypotheses

The study will be based on the following hypothesis;

H0: There is no relationship between the cost of capital and the success of SMEs in the UK.

H0: The SMEs are not able to adjust their cost of capital during and after thefinancial crisis

1.5 Aims and objectives of the study

This research aims to identify the estimated cost of capital and its determinant in small and medium enterprises in the United Kingdom. The research will seek to understand how the SMEs managed to adjust their financial and capital requirements during different phases of the financial crisis. The study is modelled in a manner which the impact of capital estimation determines the success of small and micro businesses. The model involves controlling business specific variables such as management styles, the size of the SMEs and the period of operation. The study will contribute to the existing literature on access to finance for SMEs and the success of respective businesses. The findings will contribute in forming a link between SMEs access to capital and their performance in an economically turbulent environment. For this reason, this study will attempt to fill the gap by extending the knowledge of credit access for SMEs in UK despite various global financial crises that have shaped financial policies in the Euro zone. It will be important to analyse how the economic environment have affected development of policies in the financial institution which in turn has had some impacts on capital access to the SMEs. The aim of this research is to assess how the cost of capital has affected the performance of SMEs in economic development, innovation and job creation. The study will also seek to establish how the SMEs have adapted to the changes in operating environment especially on the lending policies and changes in cost of capital.

1.6 Research Questions

The study will seek to answer the following research questions on the factors affecting SMEs cost of capital:

1. What are the factors affecting the cost of capital for SMEs in the UK?

2. How did SMEs adjust their cost of capital during and after thefinancial crisis?

The objectives of this study will seek to;

1. To establish the factors that affects the cost of capital for SMEs in the UK.

2. To evaluate how the SMEs adjust their cost of capital during and after thefinancial crisis 2 Literature Review

2.1 Introduction

The discussion on the cost of capital dates back to Modigliani and Miller (M&M, from now on) theorem proposed four decades ago. Researchers propose some theories such as leverage relevance theories as alternatives to the MM theorem. Existing studies categorise capital structure theory into three main groups: agency cost theories; tax-based theories; asymmetric information and signalling theories. This section provides a brief overview of how SMEs compute their cost of capital based on the capital structure theories. The value of the firm value is the discounted stream of its expected cash flows. Investors hold claims on the firm's cash flows. In particular, debt holders claim regular repayment of principal and interest while equity holders lay claim on firms residual stream of cash flows. In essence, equity claims are riskier because there is no guaranteed payment on equity.

SMEs utilise a combination of both debt and equity funds in their capital structures. By taking into consideration of the various constraints within each firm, firms tend to differ in their proportion of firm, each firm attempts to have the right combination of debt and equity to maximise value. Capital structures define how firms finance investment projects. In essence, capital structure determines the manner in which firms divide profit between owners of the firm and creditors. Ross et al. (2008) notes that deciding on the right combination of debt and equity is a critical issue for firms. Issuing equity is an expensive undertaking as compared to debt, but debt generates higher riskparticular in periods of rising cost of borrowing. As a result, the main concern is to find the best proportion of debt and equity in a firms capital structure (Modigliani & Miller, 1958).To maximise firm value, the general approach is to minimise the cost of capital by using more of the cheaper between debt and equity. Modigliani and Miller (1963) notes that increasing leverage tend to increase the interest tax shield, which in turn enhances a companys value. On the other hand, increasing the level of debt tends to increase a firms financial distress cost, thereby decreasing a companys value. In another study Bradley et al. (1984) defines the optimal capital structure as the level of leverage that provides the best combination of the tax benefit and financial distress cost.

2.2 Capital Structure Theories Firms capital structure of firms is a puzzle because it is difficult to find the ideal financing structure for projects. As mentioned in the previous section, the literature on the cost of capital is based on the seminal work of Modigliani and Millers (1958). It is imperative to note that these studies majorly focus on large corporations leaving out SMEs.

There are various studies that have looked at SMEs capital structure approaches for SMEs. The papers use empirical methodologies that are empirically testing the models developed for large entities. Later studies attempt to take into consideration the special features of SMEs. Entrepreneurs' personal wealth mainly influences SMEs capital decisions, and there tends to be no clear separation between personal and business risk. Another issue highlighted in literature for SMEs is information asymmetry faced by financers (Heyman et al., 2007). In essence, the lack of proper information on SMEs tends to create funding barriers. Hence, the financing decisions are constrained by big information asymmetries (Berger et al., 2001). Psillaki and Deskalakis (2009) note that SMEs cost of capital is country specific and affected by asset structure (rtqvist et al., 2006).

When firms are mature and become informationally transparent, can they be able to gain access to public debt and equity funding (Gregory et al., 2005). As a result, Holmes and Kent (1991) uses a restricted form of the pecking order theory and posit that equity funding is expensive for SMEs. In another study, Ang (1992) posits that SMEs owners fund then using a mix of personal and firms wealth. Raising capital using equity implies a dilution of shares, something that family-owned SMEs may not be willing to take. Family owners are very concerned about losing control over their firm because they want to pass to the next generation.

2.3 Components of Capital Structure

2.3.1 Equity Financing

A firm that does not use debt financing is often referred to as the levered firm (Bradley & Roberts 2004). This phenomenon brings about business risk. Business risk refers to the potential and imminent risk that a firm is exposed to if it does not use debt financing. The return on investment in firms that do not use debt financing is measured by return on equity which is represented as the shown below:

Return on Equity (ROE) = Net income to common stock holders/Common equity

This ratio shows that the business potential risk of a firm that does not use debt financing is the measure of standard deviation of its ROE as Brigham and Houston (2007) posited.

2.3.2 Debt Financing

A firm that resorts to debt financing to service its operation is referred to as the levered firm. Brigham and Houston (2007) asserted that firms resort debt financing due to the financial risk they face. The financial risk arises from the additional risk that common stock holder face upon resorting to use debt financing. In other words, the financial risk is the likelihood that the firms earnings will not be improved due to the method of financing opted. Brigham and Houston (2007) further observed that the financial risk arises from the fact that debt has a mandatory call of the firms cash-in terms of interests-which must be paid periodically before the shareholders can share the earnings.

2.3.3 Cost of Capital

Since the choice of capital structure affects the cost of capital, firms influence their cost of capital through various ways. Brigham (2004) asserted that equity capital-providing investors are often in more risky position as opposed to debt providers. This is because owners are the ultimate claimants of the net cash flows of a firm. In particular, equity holders receive returns through dividends while debt holders receive interest on debt before the equity holders can claim their dividends. As such, cost of capital refers to the cost attached to different sources of financing (Shyam-Sunder & Myers, 1999). According to him, the shareholders are often not in a position to make explicit the return on their capital contribution in the case of equity financing. However, capital raised through debt financing has a predefined rate of interest on the principal amount attached to it which forms the overall cost of capital for an organization. Therefore, it is imperative to understand that levered firms depend on debt financing for financial capitalization which increases the risk of debt payment and the return to shareholders. Importantly though, Brigham and Houston (2007) in his study of capital financing noted that both equity and debt financing require higher returns to bear the risk. According to Shyam-Sunder & Myers, 1999), among the two popular forms of financing, debt financing is preferred to other capital financing options because it looks cheaper. Other scholars who have advance the argument for the utilization of debt financing to other financing options cited the advantages such as the effect of tax shields on corporate financing (Modigliani & Miller 1958). On the other hand, Myers (2001) warned of the possible danger and imminent risk associated with debt financing citing financial distress and indirect or direct bankruptcy costs which arise whenever shareholders exercised their rights to default. As such, the choice of capital financing has a bearing on the overall performance of a firm.

2.4 Determinants of Capital Structure

Since the 1960s, the subject of capital structure has become one of the most productive yet misunderstood areas of research in the field of corporate finance, giving rise to a multitude of theoretical and empirical studies. Early researchers in the field of capital structures proposed that choices of finance are irrelevant in typical markets (Modigliani and Miller, 1958). Subsequent theoretical contributions cited that firms can maximize their respective market value by using the associated tax benefits to debt financing before increasing their respective cost of bankruptcy. Jensen & Meckling (2006) embarked on the capital structure decision puzzle by citing that although employees are employees are hired to further owners objectives, they end up becoming biased towards preserving their own private interests. Consequently, the agency cost was included in the capital structure equation as an important variable that could eliminate agency problems that arise from information asymmetries between the investors and the managers (Jensen & Meckling 2006). In the subsequent research, the pecking order theory was design. According to Myers and Majluf (1984), pecking order theory states that that information asymmetries causes firms to opt to finance their activities through internal financing or perhaps debt issuance but on rare occasion resorts to issue of new equity. Most recently, the Equity Market timing theory has been widely applied in the field of capital financing that proposes that firms should resort to issue new equities whenever there is a difference between its market value and accounting value.

Notwithstanding, the existing body of literature on capital structure suggest that very few authors have embarked on investigating the financing decisions of small and medium enterprises. This limitation often arises because SME data are often scarce and in most cases unreliable. This is because SME are typically owned private entities which, under statutory laws or otherwise, are not required to disclose detailed information or audit their reports. At the same time, it is often presumed that privately owned small or medium enterprises would eventually transform to become publicly traded companies; besides, very few SME issue publicly traded securities or list their shares on stock exchange market.

2.5 Determinants of Financial Performance in SMEs

Cash flow, liquidity, cost of capital and leverage measures cover the capital structure of a firm and the ability of the organization to service its liabilities in a timely way. Each of the three categories relate significantly to firms performance. Leverage is a measure of a firms financial structure and includes such measures as debt to total assets, debt to equity and time interest earned. Liquidity measures provide elaborate description of the ability of a firm to convert assets to cash and include such measures as current ratio and quick ratio. Cash flow measures provide descriptions of the amount of cash a firm can generate based on the source of the cash relative to the cash demand in the firm. In this sub-section, particular attention is focused on leverage and the cost of capital.

2.5.1 Leverage and Firms Performance

Leverage measures describe a firms financial structure. In other words, financial leverage refers to the extent to which operating assets are finance with debt versus equity (Pennman 2001). This measure brings forth the concept of cost of capital-in terms of interests-whose impact on the performance of small and medium size enterprises is being investigated in the current paper. Debt obligations generally encompass the payment of interest and the principal amount on a periodic basis but within a particular period of time using a firms cash generating in its operations. On the other hand, common equity does not necessitate the periodic returns to capital providers or for the retirement of capital investment of equity holders in a firm. As such, equity holders receive returns after all other creditor obligations are satisfied while debt holders receive fixed payment. Penman (2001) argued that if the amount of a firms profit exceeds the cost of borrowed capital, the excess becomes additional profit for the shareholders. Conversely, if a firm earns profit in shortage of the cost of borrowed capital, the shareholders shoulders the shortage while the debt holders continue to receive their return in terms of interests. Therefore, whenever the ratio of capital obtained through borrowing to the capital provided by equity, the higher the cost of capital which creates potential losses for the equity holders. As such, the higher the cost of capital, the performance of the small and medium size firm deteriorates. Brush, Bromiley and Hendrickx (2009) noted that the managers in SMEs have limited strategic choices to choose from in highly leveraged firms due to their inability to raise additional debt capital or the excess pressure requiring them to used costly equity financing. Overall, the cost of capital affects the overall performance of small and medium size firms.

2.5.2 Cost of Capital and Firms Performance

Erasmus (2008) noted that, the cost of capital for a firm is usually determined by computing its weighted cost of capital. The weighted average cost of capital incorporates the cost of equity after tax and the cost of other different forms of debt after tax. According to Modigliani and Miller (1963) study on capital structures and financial performance, it become apparent that when a company uses debt financing in its capital structure, the average cost of capital reduces while profitability is enhanced. With profitability as an important measure of financial and overall performance of a firm, Pandey (2005) noted that cost of capital has a significant effect on financial performance which can either be negative or positive.

2.6 Impact of Financial Crisis on SMEs Cost of Capital

During the recent global financial crisis, the level of credit issuance to non-financial firms was considerably reduced. The impact was severe in advanced markets countries, notably the US and UK. Nonetheless, there is no definitive evidence that firms excessive leveraging led to the financial crisis. In a study by Kayo and Kimura (2011), the authors analysed 40 countries, using firm-level factors and market timing efforts as factors affecting firms capital structure decisions. Also, they show that non-financial firms in advanced markets were unable to take full advantage of lucrative financing schemes. Potentially, there are many significant changes in the financial system that triggered the recent global financial crisis. It is imperative for researchers to examine the effect of these changes further before making definitive conclusions.

The severity of the recent financial crises left firms in a financially constrained position. As a result, a majority of the financially constrained firms had their funding sources limited in capital markets while the cost of borrowing rose significantly. Also, firms faced difficulties in issuing or renewing credit lines. Additionally, the financially constrained firms were had to forego lucrative investment opportunities given the constrained funding sources. In this regard, some of the financially constrained firms were forced to offload their assets to fund their activities (Campelloet al.,2010).Given that asset declines can significantly affect firms ability to raise debt, it is likely that firms may be forced to adjust their capital structure tomanage the severe circumstances during a financial crisis. Overall, researchers assume that capital market conditions before the financial crisis tend to be positive than during and after the financial crisis.

According to Doukaset al.(2011), the aspect of adverse selection related to equity issuance has significant effects on capital structure choices. If equity is more expensive than debt, then firms will take more leverage to finance their activities. The use of debt increases when debt markets are more favourable as compared to equity markets, irrespective of the costs associated with an adverse selection that a firm may be facing. Furthermore, the authors demonstrate that the impact of adverse financial conditions on debt-financing can endure for more than five years after the year of issuing. They do not find evidence of the trade-off theory of capital structure in the capital structure decisions of the sampled firms. The underlying argument is that even before a financial crisis, in times of favourable capital markets, trade-off theory cannot fully explain firms capital structure decisions. Choeet al.(1993) notes that financial managers are expected to minimise the cost of issuing equity. The authors find that in periods of economic growth, firms face lower costs of adverse selection, resulting in more equity issuance as compared to debt. Dittmar and Dittmar (2008) corroborates this finding, noting that during a period of economic expansion, the cost of equity significantly reduces as compared to the cost of debt. For this reason, equity financing activities increase in times of economic expansion, significantly affecting firms activities.

2.7 Factors That Inhibit Ease Of Accessing Finance for SMEs in the UKAs of May 2013, UK financial institutions total outstanding amount of lending to SMEs was approximately 170 billion (Hussain, et al., 2006). Approximately 17 billion of the amount was obtained in form of over drafts. SMEs lending by financial institution in the UK represent approximately 35% of total amount lending to non-financial organizations. However, despite the high percentage of lending, SMEs in the UK experience obstacles when looking for finance. UK lenders such as banks rely on the security guaranteed by existing assets of the business and track records to get assurance on the ability of the business to pay the loan. These factors enable lenders simply and reduce the cost of conduction a detailed financial assessment of every SME in the UK. Unfortunately most SMEs are new and small businesses, they may not have the required track record, history or existing asset base to give potential lending firms their assurance. Approximately 38% of all loan applications by SMEs that are not more than 5 years old are rejected by UK banks (Darvas, 2013). In comparison, only 19% of all loan applications by SMEs more than five years old are rejected (Berry, Grant & Jarvis, 2004). BIS commissioned research reported that 27% loan application for firms with an annual turnover of less that 1 million are rejected compared to 16% for businesses with a turnover of over 1 million. The research also highlights on the rejection rates of term loans and overdraft to have been significantly high between 2008 and 2009 which reflect constraints by banks on the supply of credit (Hussain, Millman and Matlay, 2006). Lack of tract record and existing capital base are some of the factors that inhibit SMEs in the UK from accessing finance easily. Since most SMEs are small and newly opened, the year factor plays an important role in determining the ease with which they access finance by banks and other lending institutions.

2.8 Summary of Literature

The literature review synthesised various papers on capital structure theories and related empirical results. Overall, the conventional opinion is that capital structure significantly affects firms financing decisions. Thus, it is envisaged that reasonable use of leverage can help to increase firm value through the reduction of the cost of capital. Literature shows that, when leverage increases beyond an optimal level, the cost of capital increases more than the increase in firm value. There is no universal identification on the optimal capital structure. Evidently, there is no consensus on the most appropriate capital structure theory and what depicts an optimal capital structure in the application. Nonetheless, there a sample evidence of correlations between firm-level factors and capital structure decisions. Additionally, some previous studies utilise balanced panel data, which limits the inclusion of all obtainable data in a panel regressions. Thus, the use of unbalanced panel regression procedure can allow researchers to overcome this limitation. For the paper to analyse the impact of the financial crisis on firms capital structure, the present study will incorporate the effects of the 2007-2010 financial crisis on SMEs cost of capital. It is imperative to control for the period of the recent global financial crisis (2007-2010) and use firm-specific variables to model capital structure determinants in the context of UK listed non-financial SMEs.BibliographyAkdal, S. (2010). How do firm characteristics affect capital structure? Some UK evidence, MPRA, Working Paper no. 29657.

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