Improve Capital Structure Decisions Using Dynamic Capabilities Strategy

What the paper says

Most discussions the finance literature about capital structure decisions center on the notion of optimal capital structure or target capital structure. Researchers have developed a variety of theories to help companies find the optimal long-term capital structure. But one emerging business strategy may be even more useful for finding it: where a company develops its ability to build, integrate, and reconfigure its competencies to handle rapidly changing conditions.1Under a dynamic capabilities strategy, management constantly redirects a firm's assets to pursue maximum profits and value by using the latest developments production, communication, and transportation technologies. The concept of dynamic capabilities is emerging academia as the most authoritative and comprehensive framework for strategy.2In this article, we examine a firm's financing decisions- that is, its capital structure decisions-in the light of dynamic capabilities strategy. We focus on how financing decisions depend on investment decisions, combining the strategic concept of dynamic capabilities with the finance concept of optimal capital structure. Analyzing research on these two concepts together, we uncover some profound insights-as well as some vexing questions that require further research.DYNAMIC CAPABILITIES THEORYFinancing or capital structure decisions depend on investment decisions. But tangible assets are not good investments according to dynamic capabilities theory, which says tangible assets that are commodities are not a source of value creation firms. Creating value rests mostly on scarcity, uniqueness, and capturing value by bargaining with suppliers to get their lowest prices while also charging the highest price that the customer is willing to pay.Instead, intangible assets are emerging as the kind of asset that creates and grows value most effectively. Examples of this include tacit knowledge throughout a firm, the power of a brand, and routines inside a successful research and development (R&D) organization.But how can a company invest them? These assets very rarely are traded like other investments because they are hard to value. It can be difficult to estimate a numerical value, or there may be seemingly endless negotiations between the buyer and the seller because little information about value is available. Thus the best way to grow their value and impact on firm valuation is to carefully nurture them inside the firm and grow their value organically. Firms must organically develop and nurture intangible assets.Dynamic capabilities theory also points that the World Wide Web's reach and richness are affecting what used to be the foundations for business strategy, economies of scale, and scope.3 By connecting a computer to the web, a company can extend both its reach and the richness of information available at near-zero cost. This development enables a firm to increase economies of scale and scope.To see how this happens, envision a firm as nothing but an assemblage of people, resources, and brand. By developing dynamic capabilities, this group can easily morph and change to exploit new opportunities as they arise. The web facilitates this by allowing a firm's diverse and global specialized assets to communicate virtually 24/7 at almost no cost-resulting a huge leverage to economies of scale and scope.This is very different from the old, conventional way of business. Traditionally, by analyzing its economies of scale and scope, a firm tried to increase its size and achieve a dominant market share, acting within its legal boundaries as a corporate entity. Those boundaries between firms have been considered rigid, which enabled a firm to recognize and mitigate its risks by knowing what is in here and out there.Then the firm would use enterprise risk management ment (ERM) strategies to handle risks. In addition, because firms had definitive boundaries, banks could limit their own financial risk of lending to them by using restrictive covenants. …