Tutorial 2 (Week 3) Solutions

Ch01
 Exercises
#: 1, 2, 6, 12, 13
 Case Study: SMEs prefer debt over equity

1. How could you go about measuring the size of a business enterprise? What approach would you
recommend? Why?

Size can be measured by adopting a quantifiable measure, such as number of employees (equivalent full-
time); turnover; value of total assets. The most commonly adopted measure is number of employees.
Qualitative measures could also be used, such as the key business decisions are made by 1 or 2 people
who own and manage the business. These measures are much more difficult to apply, hence the default
by most researchers and government bodies to a quantitative factor. Whatever measure is adopted it will
not capture all small firms, as there will be outliers. For example, some owner-controlled businesses are
very large corporations, such as the Packer family controlled group of companies. Also there are firms that
would meet the criteria with respect to size (number of employees), but the decisions are not made by
the owners, a good example is that of franchise outlets. Most franchise agreements require that owners
conform to particular branding, advertising, presentation etc. and meet certain financial performance
targets. Whatever measure is adopted, to support comparisons between firms the measure should be
consistently adopted. One reason for this is that research shows that the alternative quantitative
measures are not interchangeable.

2. Explain the agency theory view in defining firms by size.

Agency theory seeks to explain the relationships between business owners (normally shareholders) and
managers. Basically, where there is a separation of ownership and control then terms and conditions need
to be established (normally in some contractual form) to align the interests of the parties and encourage
behaviour consistent with those objectives. The same applies for the relationship between borrowers and
lenders, in that debt holders need to be encouraged (or required) to behave in a way that minimizes the
risk of default on debt repayment. For small business there are relatively less agency relationships,
because in most cases there is no (or minimal) separation of ownership and control. This has led to the
view that small firms are firms with low agency relationships or costs and as firms grow, then so do agency
costs. For example, as a firm grows more employment contracts are written; external funding may be
required to support growth; parts of the business activity may be under the control of an employee as
opposed to the owner. It is also argued that small firm owners will often actively avoid agency
relationships. One example of this is the fact that most small firms stay small.
6. What characteristics of small enterprises are likely to give rise to differences in capital structures
between small enterprises?

Capital structure refers to the mix of debt, equity and retained earnings used to fund operations. The
desire for control on the part of owners will be the primary factor influencing capital structure. The greater
the desire for control the greater the use of retained earnings and additional contributions by existing
owners. There will be a trade-off between control and business growth. There are other factors which
influence capital structure, such as the relative risk of the business; industry in which the business
operates; relative size; overall performance of the business; track record of owner/managers; ability to
offer assets as security for debt. This is a very complex question as all of these variables interact to
influence the capital structure of a small firm. There is also the “pecking order” literature which suggests
that there is an order of preference for funds – owners’ equity, retained profits and additional owner
contributions; debt – short- then medium/long-term; new equity holders. For small firms the pecking
order is often constrained as small firms do not have ready access to equity markets or venture capital.

12. Why should financial management be so important to the wellbeing of a small enterprise? Can you
explain why financial management and financing issues appear to lack the required priority of owner-
managers?

Simply, without appropriate management of financial matters a business will not be viable. Liquidity stress
is listed as one of the top five reasons for business bankruptcy. Financial management covers all aspects
of operations from payment of expenses to collection of revenues, to the availability of funds to replace
redundant physical assets. Small firm owners do not tend to have a financial background of any formal
training in financial management. Many owners are drawn to a particular activity because it suits their
personal preferences or they have some knowledge of training appropriate to the products or services
provided by the business. The focus therefore tends to be on the operating activities of the entity not the
financial aspects. As most owners do not understand financial information it is not an information set they
routinely seek. Students might like to suggest how financial management could be explained to small
business owners so that they appreciate the need to establish appropriate systems and to utilize the
information to assist and support business decisions.

13. Who should be responsible for the financial management and financial decisions of a small
enterprise? What role, if any, should external advisers play?

The owners should be responsible. They are normally responsible for all key business decisions and
business performance. They should access appropriate internal support, such as the business bookkeeper
and, if large enough, the business accountant. They should include such staff in decision-making
processes. Almost all small firms have an external professional accountant. However, this person is
normally only consulted to assist in completion of statutory reporting requirements (normally annually).
However, the research literature indicates that a significant proportion of owners will contact their
accountant for advice with respect to significant capital expenditure decisions. The students should
consider this problem – small firm owners should access a greater and more detailed level of financial
feedback on a regular basis, which will come at a cost. However, what incentive do they have to adopt
this approach when they do not understand how to interpret and utilize the information?
Case Study: SMEs prefer debt over equity, pp. 27-28
1. The article suggests that small business owners are ‘familiar’ with the banking system, ‘making it
relatively easy to get access to debt finance’. This contrasts with the number of businesses citing
liquidity problems in operating the business. Is the access to debt funds as simple as the article
suggests? What factors restrict access to debt by small business owners?

Access to debt funds is far from “simple”. We know very little about businesses that do not start or close
because they cannot secure funding. Access is constrained to those businesses that have assets they can
supply as acceptable security. Factors restricting access to debt include: Lack of assets to secure debt;
banks do not lend on risk but against a set of criteria which applicants need to meet; the costs of meeting
the criteria are sometimes prohibitive, representing up to 20% of funds sort; lack of understanding on the
part of owners as to funding options.

2. According to the article, only 16 per cent of small firms changed their finance service provider over a
two-year period. Why would firms be reluctant to change finance service providers?

There are normally transaction costs which act as a deterrent to changing institutions. Also, most owners
are not aware of the range of options or costs, so are not aware of alternatives. You might ask the students
to explain transaction costs in terms that assist a small business owner understand the concept.

3. How would a small firm raise external equity in the economy? The article suggests that small firms
do not seek external equity as there are few avenues of external equity readily available. Perhaps
there are few avenues as demand is limited. Discuss this in the context of the objectives of small firm
ownership. Particular reference should be made to the last paragraph of the article.

Remember, most small firms cap growth to the point where they have achieved personal or financial
objectives, without losing control. This means that to some extent there is limited demand for equity
funds or debt that changes the status quo. In terms of raising external equity, there is a public float (this
is expensive and the firm must be at a reasonable size to justify the expense); private placement (where
investors are approached to invest in the firm, normally supported by a business case, financials and
business plan), this group includes business angels; issue of equity to a venture fund (who will normally
be seeking to exit within 3-5 years and make a significant capital gain in the process). Ask the class what
they would do if they needed to raise funds and debt wasn’t an option.
Ch08
 Exercises
#: 1, 3, 7, 15
1. What are the main ways of entering a small enterprise and what are their advantages and
disadvantages?

The main ways of entering a small enterprise are by starting a new enterprise, purchasing an existing
enterprise, entering a family enterprise, or by franchising. The advantage of starting a new enterprise is
that it is often cheaper to do this than to buy a business since it is not necessary to buy the "goodwill"
involved in an existing business. However, on the other side starting a new business involves more
uncertainty than buying an existing business. Entering a family business may be an option for some people
and it has the advantages of usually being at low or no cost and of entering a business that is already
established. The problems with a family business can be that it involves working with other family
members that in turn can lead to conflict. Franchising is a popular form of entering a small business and,
as with buying an existing business, the main advantage is that of having a ready-made product or service
for which there is known to be demand. Against this has to be set the restrictions that franchisors impose
on franchisees.

3. Discuss the financial implications of the various legal structures available to small enterprise.

Sole proprietorship – because of the lack of distinction between the owner and the business, the
owner’s personal assets are at risk in the event of the failure of the business. Sources of finance available
to the sole proprietor are usually limited to family members, trade creditors and (short-term borrowings
from) banks.
Partnership – the financial implications associated with partnerships are similar to those of sole
proprietorships, where all partners have unlimited liability should the business fail. Finance is also limited
to family members, creditors and banks. However, due to the fact that there are more people involved
(than in a sole proprietorship) personal resources are likely to be greater in total.
Incorporation – private companies have fewer sources of finance available to them than listed
public companies, since they cannot access the stock market for equity or issue their own debt. Their
ability to raise finance is, therefore, likely to depend on size, assets available as collateral, the quality of
management, the nature of the industry and their track record.
Public companies have greater access to funds than do the other legal structures of small
enterprise because of access to the stock market. However, they face costs of increasing disclosure
requirements and stock market flotation.

7. Why might a potential small enterprise owner-manager consider franchising as an option for entering
small enterprise?

A potential small enterprise owner-manager might consider franchising as an option for entering small
entering small enterprise for the following reasons:
(i) It provides a ready-made business with tried operating methods and well-developed training and
support facilities.
(ii) It also provides a trademark and a national image that facilitate national advertising.
(iii) Since most franchisees are chosen after a screening process, failure rates for franchises are often
lower than for other small enterprises.
(iv) An association with a well-known franchise may help in raising finance.

15. Discuss the relative importance of agency theory and financial considerations in determining
ownership structure.

Financial and agency theory considerations are interrelated with agency theory being increasingly invoked
in recent years to explain ownership structures. Agency theory helps to explain differences in ownership
structure in terms of “residual claims” on profit. In a small enterprise residual claims belong to the owner
who is likely to also be the manager. This reduces “pure” agency costs and maximises incentive but at the
cost of inefficiencies in the form of under-investment and lack of diversification. Under-investment is due
to the moral hazard involved in lending to or investing in closely held companies. Shareholders in large
corporations are less likely to be managers but are more able to diversify their portfolios. Larger
corporations are less prone to under-invest because of their access to the stock market that requires that
they take steps to reduce moral hazard such as disclose more information and spread their shares more
widely. Consequently, both forms have advantages and disadvantages and co-exist in the market.