Debt maturity structure and cost stickiness
| Author | Mabel D. Costa,Ahsan Habib |
| DOI | http://doi.org/10.1002/jcaf.22479 |
| Published date | 01 January 2021 |
| Date | 01 January 2021 |
structure of the market. Firms with little available infor-
mation may experience higher costs of capital. The
impact of information in influencing the costs of capital
are indicated by several studies (Botosan, 1997;
Christensen, de la Rosa, & Feltham, 2010; Easley &
O'hara, 2004; Feltham, Robb, & Zhang, 2007; Huang
& Kang, 2018; Hughes, Liu, & Liu, 2007; Lambert,
Leuz, & Verrecchia, 2012; Perera & Nimal, 2017). For
instance, the rational expectations model explains the
relationship between private information and the costs of
capital. Besides, Ahn, Horenstein, and Wang (2018)
explain the effects of asymmetric information on the
asset equilibrium price.
Some researchers have shown the role of private
information in dictating the prices of assets. Bai, Bali,
and Wen (2019) for instance build on the classic analysis
of rational expectation to elucidate the role of asymmetric
information on asset value. They find that the presence
of agents in transactions affects the risk–return tradeoffs
thus affecting the portfolios held by the informed and
uninformed investors. Besides, Dow and Gorton (1995)
explains that informed investors may profit from their
information while the uninformed investors' loss due to
lack of information. The main set back of this setback is
that it does not consider the costs of capital in its
assumption.
Another set of literature considers the role of incom-
plete information and symmetric information. Particu-
larly, Amihud (2018) investigates the effects of capital
market equilibriums in situations where the agents lack
some information about certain assets in the market. In
this model, agents who have information on the existence
of certain assets may decide on the distribution of
returns. However, the information is incomplete because
not all agents have knowledge of such information. The
analysis by Amihud shows that the value of an organiza-
tion's assets may be lower due to the existence of incom-
plete information. However, in normal circumstances,
some investors may have more knowledge about returns
than others. Besides, all the investors know about the
existence of every asset in the market through the infor-
mation that may be asymmetric.
Lastly, information disclosure by a firm may affect
the costs of capital because disclosure of private informa-
tion turns it into public information (Deno, Loy, &
Homburg, 2019). The presence of public information
means that each investor has access to information
regarding investments. Since the process of producing
information is costly, individuals ought to spend consid-
erable resources to collect information. Public informa-
tion increases the value of assets and capital since the
information lowers the risks of uninformed investors to
hold assets (Gârleanu & Pedersen, 2018). Diamond and
Verrecchia (1991) state that disclosure of information can
either improve or worsen liquidity depending on the
decisions by holders of information. The accessibility of
public information affects the riskiness or profitability of
an investment. Other researchers such as Kandelousi,
Alifiah, and Karimiyan (2016) incorporate other impor-
tant elements of information sharing such as insiders and
strategic disclosure issues.
2.2 |Cost of capital
The cost of capital is the amount expected by investors
after they have offered the capital required by a business.
Mostly, the sources of capital in a firm comprises of
investors who purchase stocks and the bondholders who
offer loans to an organization (Hertig, 2019). Conse-
quently, companies are expected to make returns that
ensure that both investors and the debt holders get
expected returns on investments. The cost of capital may
entail the mechanical calculations by financial people,
which is then used by management to come up with a
hurdle or discount rate. Businesses have to exceed the
hurdle rate in justifying investments (Anderson, Byers, &
Groth, 2000).
Mostly, the costs of capital may be slightly under the
required rate of return (McNulty, Yeh, Schulze, &
Lubatkin, 2002). The costs of capital in a firm are used to
determine the soundness of an investment. Besides,
investors use the costs of capital to assess the riskiness of
an investment. Companies only choose to commit their
finances in projects whose return exceeds the costs of
capital. As such, managers should always look for invest-
ments that exceed the costs of capital in an individual
organization (Easley, O'Hara, & Yang, 2016). Conversely,
investors look at the beta or volatility of investments to
determine whether an investment is worthwhile. The
costs of capital determine the corporate strategies and the
ability of an organization to compete in the future. Busi-
nesses may use the costs of capital to make capital
budgeting decisions to offer a strategic advantage to a
firm in the short run.
Though investment opportunities' in organizations
differ, the techniques of evaluating the financial returns
are similar. However, the value of investments made an
organization depend on the profitability of the invest-
ment portfolio undertaken by a firm. The expectations
about an investment determine whether a company will
make positive or negative returns. The costs of capital
influence the hurdle rate and the capital structure in a
firm. Also, the costs of capital may determine the opera-
tions of a firm that in turn determine the profitability
(Scott & Pascoe, 1984). According to Kandelousi
TÜREGÜN 3
structure of the market. Firms with little available infor-
mation may experience higher costs of capital. The
impact of information in influencing the costs of capital
are indicated by several studies (Botosan, 1997;
Christensen, de la Rosa, & Feltham, 2010; Easley &
O'hara, 2004; Feltham, Robb, & Zhang, 2007; Huang
& Kang, 2018; Hughes, Liu, & Liu, 2007; Lambert,
Leuz, & Verrecchia, 2012; Perera & Nimal, 2017). For
instance, the rational expectations model explains the
relationship between private information and the costs of
capital. Besides, Ahn, Horenstein, and Wang (2018)
explain the effects of asymmetric information on the
asset equilibrium price.
Some researchers have shown the role of private
information in dictating the prices of assets. Bai, Bali,
and Wen (2019) for instance build on the classic analysis
of rational expectation to elucidate the role of asymmetric
information on asset value. They find that the presence
of agents in transactions affects the risk–return tradeoffs
thus affecting the portfolios held by the informed and
uninformed investors. Besides, Dow and Gorton (1995)
explains that informed investors may profit from their
information while the uninformed investors' loss due to
lack of information. The main set back of this setback is
that it does not consider the costs of capital in its
assumption.
Another set of literature considers the role of incom-
plete information and symmetric information. Particu-
larly, Amihud (2018) investigates the effects of capital
market equilibriums in situations where the agents lack
some information about certain assets in the market. In
this model, agents who have information on the existence
of certain assets may decide on the distribution of
returns. However, the information is incomplete because
not all agents have knowledge of such information. The
analysis by Amihud shows that the value of an organiza-
tion's assets may be lower due to the existence of incom-
plete information. However, in normal circumstances,
some investors may have more knowledge about returns
than others. Besides, all the investors know about the
existence of every asset in the market through the infor-
mation that may be asymmetric.
Lastly, information disclosure by a firm may affect
the costs of capital because disclosure of private informa-
tion turns it into public information (Deno, Loy, &
Homburg, 2019). The presence of public information
means that each investor has access to information
regarding investments. Since the process of producing
information is costly, individuals ought to spend consid-
erable resources to collect information. Public informa-
tion increases the value of assets and capital since the
information lowers the risks of uninformed investors to
hold assets (Gârleanu & Pedersen, 2018). Diamond and
Verrecchia (1991) state that disclosure of information can
either improve or worsen liquidity depending on the
decisions by holders of information. The accessibility of
public information affects the riskiness or profitability of
an investment. Other researchers such as Kandelousi,
Alifiah, and Karimiyan (2016) incorporate other impor-
tant elements of information sharing such as insiders and
strategic disclosure issues.
2.2 |Cost of capital
The cost of capital is the amount expected by investors
after they have offered the capital required by a business.
Mostly, the sources of capital in a firm comprises of
investors who purchase stocks and the bondholders who
offer loans to an organization (Hertig, 2019). Conse-
quently, companies are expected to make returns that
ensure that both investors and the debt holders get
expected returns on investments. The cost of capital may
entail the mechanical calculations by financial people,
which is then used by management to come up with a
hurdle or discount rate. Businesses have to exceed the
hurdle rate in justifying investments (Anderson, Byers, &
Groth, 2000).
Mostly, the costs of capital may be slightly under the
required rate of return (McNulty, Yeh, Schulze, &
Lubatkin, 2002). The costs of capital in a firm are used to
determine the soundness of an investment. Besides,
investors use the costs of capital to assess the riskiness of
an investment. Companies only choose to commit their
finances in projects whose return exceeds the costs of
capital. As such, managers should always look for invest-
ments that exceed the costs of capital in an individual
organization (Easley, O'Hara, & Yang, 2016). Conversely,
investors look at the beta or volatility of investments to
determine whether an investment is worthwhile. The
costs of capital determine the corporate strategies and the
ability of an organization to compete in the future. Busi-
nesses may use the costs of capital to make capital
budgeting decisions to offer a strategic advantage to a
firm in the short run.
Though investment opportunities' in organizations
differ, the techniques of evaluating the financial returns
are similar. However, the value of investments made an
organization depend on the profitability of the invest-
ment portfolio undertaken by a firm. The expectations
about an investment determine whether a company will
make positive or negative returns. The costs of capital
influence the hurdle rate and the capital structure in a
firm. Also, the costs of capital may determine the opera-
tions of a firm that in turn determine the profitability
(Scott & Pascoe, 1984). According to Kandelousi
TÜREGÜN 3
© 2020 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jcaf J Corp Acct Fin. 2021;32:78–89.
78
BLIND PEER REVIEW
Debt maturity structure and cost stickiness
Ahsan Habib | Mabel D. Costa
School of Accountancy, Massey
University, Auckland, New Zealand
Correspondence
Ahsan Habib, School of Accountancy,
Massey University, Private Bag, Auckland
102904, New Zealand.
Email: a.habib@massey.ac.nz
Abstract
This paper investigates the association between debt maturity structure and
cost stickiness. One view in the cost stickiness literature suggests that man-
agers deliberately continue to expand resources for their own private benefit,
despite a decrease in the activity level. We examine whether short-maturity
debt constrains such opportunistic cost stickiness. We find evidence supporting
this hypothesis. We further document that availability of free cash flows, earn-
ings management incentive, and the structure of executive compensation all
exacerbate the agency problem-induced cost stickiness, but that short-maturity
debt constrains those sources of cost stickiness. We contribute to the scant
body of empirical research that explores the potential factors that could attenu-
ate cost stickiness.
KEYWORDS
agency problems, cost stickiness, debt maturity, free cash flows
1|INTRODUCTION
We investigate the association between debt maturity
structure and costs stickiness. Our research is motivated
by the desire to better understand the role of debt struc-
ture in inducing or constraining cost stickiness. Costs are
a fundamental component of accounting and, hence,
understanding cost behavior is of paramount importance
for decision making. The traditional view of cost behavior
assumes a mechanistic relation between costs and cur-
rent activity, modeled as “fixed”and “variable”costs
(Noreen, 1991). However, subsequent research has dem-
onstrated that such a mechanistic relationship fails to
capture the asymmetric behavior of costs arising from
resource commitment and resource adjustment decisions.
The theoretical perspective on cost stickiness relies on
the notion that many costs arise from managers' deliber-
ate resource commitment decisions. Once committed, it
is not easy to cut back resources without incurring some
kind of adjustment costs, defined as “economic sacrifices,
social, contracting or psychological costs, which emerge
during the resource-adjustment process”(Venieris,
Naoum, & Vlismas, 2015, p. 55). Therefore, to the extent
that managers understand the trade-offs between
maintaining unutilized capacities versus scaling back,
they will reduce expenses to a lesser extent when activity
decreases than they will expand resources when activity
increases, thus generating cost stickiness (Anderson,
Banker, & Janakiraman, 2003; Banker, Byzalov, &
Chen, 2013).
1
This perspective suggests an “efficiency
view”of cost adjustments whereby, by retaining
unutilized capacities, managers are taking a long-term
view for minimizing adjustment costs.
However, an alternative perspective proposed in the
literature as a potential determinant of cost stickiness is
“managerial opportunism”(Chen, Lu, & Sougiannis,
2012). The “managerial opportunism theory”predicts
that the misalignment of interests between shareholders
and managers could lead to agency problems, whereby
managers engage in activities for maximizing their per-
sonal benefit instead benefitting the firm's shareholders
(Jensen & Meckling, 1976). One such manifestation of
the agency problem is “empire building”: managers' ten-
dencies to grow the firm beyond its optimal size by
maintaining unutilized resources (Hope & Thomas, 2008;
Jensen, 1986; Masulis, Wang, & Xie, 2007; Stulz, 1990).
Received: 5 September 2020 Revised: 9 November 2020 Accepted: 11 November 2020
DOI: 10.1002/jcaf.22479
J Corp Acct Fin. 2020;1–12. wileyonlinelibrary.com/journal/jcaf © 2020 Wiley Periodicals LLC 1
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