International Journal of Commerce and Finance, Vol. 5, Issue 1, 2019, 1-12 1 CAPITAL EXPENDITURES STRUCTURE, COST OF CAPITAL AND SHAREHOLDERS' WEALTH Hooshang Asheghi-Oskooee University of Qom, Iran Abstract Financing with reasonable cost, correct usage of capital and preventing the creation of unused resources are the financial management’s most important tasks. Appropriate financing and correct investment in assets leads to sustainable growth in shareholders’ wealth. This study was carried out to investigate the relationship between the capital expenditures structure (CES) and the cost of capital with shareholders’ wealth. Using systematic sampling in a five years period, 186 companies, including the listed companies in Tehran Stock Exchange were selected. To analyze data, Partial Least Squares method of Structural Equation Modeling was used. The findings indicated that there is a significant positive relationship between the CES and shareholders’ wealth in total, but some components of the CES are not related to shareholders’ wealth and it is necessary to be studied carefully. Because, understanding the relationship between the CES and shareholders’ wealth is very important to maximize shareholders’ wealth and will be most effective in capital expenditures’ budgeting. Also, there is a significant inverse relationship between the cost of capital and shareholders’ wealth. Keywords: Assets structure, Capital expenditures structure (CES), Cost of capital, Shareholders’ wealth, Unused resources JEL Classification Code No: G31, D24 1. Introduction Providing long-term resources to invest in various economic sectors is one of the major goals of the capital market. The capital markets play a significant role in advancing the countries' economic goals. Typically, the main market capitalization of most countries is the stock exchange. The stock exchange, attracts and directs the savings and liquidity of the community towards productive investments. The main goal of the managers of the companies listed in the stock exchange is to maximize the wealth of their shareholders. The companies' capital structure (resources and expenditures of capital) is one of the factors that can affect this goal. The structure of capital resources (left- hand side of the balance sheet) is one of the important issues for managers (Hassani and Pakmaram, 2017). One of the important responsibilities of managers is to decide on how to obtain resources and allocate these resources to each of the asset considering the goal of maximizing shareholders' wealth. Kind of financing model that can make a financial performance better for the company is the question of many corporate finance managers (Rezagharehbagh and Mohammadi, 2015). On the other hand, the proper use of capital and the prevention of the creation of unused resources while financing at the right cost is one of the most important tasks of financial management. Proper financing and proper investment in assets can lead to sustainable growth of shareholders' wealth. Due to certainty that all assets are related to the company's performance and, consequently, to the shareholders' wealth, many managers and even researchers in the field of financial management and investment have not paid much attention to studying and researching about. While, the preparatory studies undertaken to initiate this study yield a different result. It specifies that all components of assets do not necessarily have the same relation to the performance and wealth of the shareholders. An examination of existing databases shows that, there have been few researches on the structure of capital expenditures (asset structure) in a comprehensive manner. However, there are several studies on working capital (part of the CES). Comprehensive analysis of all items on the right side of the balance sheet is one of the features of the present study. The results of this study can provide a comprehensive view for corporate executives and investors regarding capital structure and affect financing and investment practices. So, because decisions about capital expenditures in assets regardless of how they relate to corporate performance and shareholders' wealth can reduce In te rn a ti o n a l Jo u rn a l o f C o m m e rc e a n d F in a n c e In te rn a ti o n a l Jo u rn a l o f C o m m e rc e a n d F in a n c e In te rn a ti o n a l Jo u rn a l o f C o m m e rc e a n d F in a n c e Hooshang Asheghi-Oskooee 2 the company's return, and consequently reduce wealth and also reduce investors' willingness to invest in companies, this study examines the relationship between CES and cost of capital with shareholders' wealth. The study of the relationship between each component of the company's assets with the cost of capital and shareholders' wealth is a new topic that this paper addresses. In the research process, first, theoretical foundations and research background were reviewed, and then the hypotheses related to research questions were designed and analyzed using Structural Equation Modeling. 2. Literature Review and Research Background 2.1 Literature Review Literature In the last few decades, there have been many changes in the economic situation of countries. This changes, to a widespread, have led the new generation to investing on securities. Business managers are facing a number of challenges. Due to the expansion of online trading and transactions, investors are able to easily transfer their capitals to a company that generates higher returns. There is no trace of the effective rules restricting the displacement of capital. Corporate executives must accept that the capital will go to where it will increase and not remain available to company forever. This situation creates challenges for corporates managers. In short, all these challenges are, management to create value. That is, key systems and processes in business units should be oriented toward value creation and their orientation towards creating value (Izadinia, 2005). The importance and necessity of using financial management also begins at this point. Financial management refers to the managing of capital resources and capital expenditures in such a way that maximize shareholders' wealth (Neveu, 1989). Capital sources are the same as the loans or debts that the company owns or the funds that shareholders have provided to the company in the form of capital and written on the left side of the balance sheet. Capital expenditures are also the acquisition of assets (current assets, fixed assets, investments and other assets) derived from sources of capital and written on the right side of the balance sheet. Given the fact that wealth is derived from the use of assets, the structure of capital expenditures is one of the important factors that financial managers have to pay attention to for maximizing shareholders' wealth. But the proper structure of corporates' capital expenditures is what seems to be neglected in capital market and competition. Minimize the cost of capital is another effective factor in maximizing shareholders' wealth. Because there are different financing methods, the costs of these methods are also varies. Considering the cost of each financing method and its effect on the company's returns and risks, management should choose resources that will minimize financing costs and maximize shareholders' wealth (Molanazari et al., 2009). Given what has been noted, the ability of company to participate in creating wealth for shareholders is one of the key factors in deciding whether to invest or not. This goal (wealth creation) is possible through the proper utilization of resources and lowering the cost of capital. So, this study examines the relationship between capital expenditure structure and cost of capital with shareholders' wealth. 2.1.1 Capital Expenditures Structure One problem with corporate assets is the problem of determining the optimal structure of assets. CES is an important and explicit indicator of investment in assets and financial performance of the company. Due to use of each asset in different parts of the operation, the structure of capital expenditures is influenced by the management's intention to operate more effectively and increase returns. In fact, determining the structure is the decision about the ratio of assets. For example, when more capital is invested in current assets, the company's returns are lower. But, liquidity risk increases if less invested in current assets. Deciding in these cases depends on manager's views about risk and return. In fact, deciding on the CES of a firm is at the discretion of its management, and what actually happens can be different from theory (Chen and Haque, 2015). The CES is the different types of assets shown in the balance sheet (Neveu, 1989). It should be managed more efficiently (Markovic et al., 2009). So, type of industry, organizational strategies, economic requirements, competition, macroeconomic variables such as interest rate and inflation, and financial indicators such as financing methods, business risk, financial risk, credit risk, political risk, etc. are the most important factors that managers have to put under consideration to allocate resources among different types of assets. The decision about the ratio of assets should be in such a way that it leads to the ultimate goal of financial management that is to maximize the Capital Expenditures Structure, Cost Of Capital And Shareholders' Wealth 3 wealth of shareholders. The CES that can maximize wealth, will be realized under the following conditions (Reilly and Brown, 2000; Litterman, 2003): • The CES that yields the highest returns based on a certain amount of risk. • The CES that minimizes the risk of a company for an expected rate of return. 2.1.2 Cost of Capital Issues related to the cost of capital are related to maximizing shareholders' wealth. Each company has its own special risk and return. Each of the investor groups, such as bondholders, preferred stock holders and ordinary share holders, requires a rate of return that is relevant to that risk. Cost of capital can be defined as “the rate that makes the present value of the cash flow equal to the value of the capital of the asset in question” (Goncalves et al., 2018). That is, the cost of capital is the minimum return that the company must acquire to preserve the shareholders' wealth. On the other word, the minimum return that a company must earn to have no change in the company's value. So, if the company earn a higher rate of return than the cost of capital, the market value of the company will be increased and in the opposite, the market value of the company will be reduced (Neveu, 1989). Given that the main purpose of financial management is to maximize shareholders' wealth, it seems that the best way to achieve this goal is to increase the return on investment and minimize the cost of capital. 2.1.3 Maximizing Shareholders' Wealth Many researchers like Bohme et al. (2005), Shen (2006), Anglano et al. (2014), Gonzalez-Alcorta et al. (1994) and Marston et al. (2011), who seems are not financial management specialists have investigated maximization of profit. However, it is possible to consider maximizing profit as one of the objectives of financial management. But it is not the main objective. The goal of financial management is to maximize the current value of the existing stock (Ross et al., 2016), or to maximize shareholders' wealth (Neveu, 1989). Profit maximization is essentially a short-term goal. A company can increase the profit of each share by implementing high risk plans (Neveu, 1989). But increase in the profit does not lead to an increase in share price and shareholders' wealth necessarily; because shareholders give less valence to the risky profits and stocks its profits are more fluctuating. Moreover, the profit can be manipulated (Likierman, 1983; Lambert and Sponem, 2005) and it seems the profit cannot be the only measure to evaluate the value of investment. Regarding the above discussions, it can be concluded that, the company's performance depends on the use of its assets. On the other hand, the provision of assets requires cost. So, it is necessary, while paying attention to the cost of investing in assets, first, buy appropriate assets to the appropriate extent (The CES issues are shapes at this stage) and then, have to be used appropriately to maximize shareholders' wealth. The main question of the research arises at this point. How is the relationship between the CES and the cost of capital with shareholders' wealth? 2.2 Research Background Based on a review of the research background, there is no comprehensive study on the CES. Many previous studies have studied part of the CES - that is, working capital management. Given that the present study has a new and different view compared to previous studies, some researches that are related to the subject are briefly reviewed and then questions and research hypotheses are proposed. Auerbach (1979) stated that investors who seek to maximize their utility, they tend to maximize current value of their investment. Achieving this goal involves investing in projects that its current value considering the expected return rate of investors is positive. In this way, cost of capital is one of the factors affecting the maximization of shareholders' wealth and should be minimized. The capital structure (from an accounting standpoint), that been called the structure of capital resources from a financial management perspective - that is, combination of liabilities and shareholders' equity- affect the cost of Hooshang Asheghi-Oskooee 4 capital. So, to determine the cost of capital, it should be measured the debt and equity costs (Gitman et al., 1982; Francis et al., 2008; Berry-Stölzle and Xu, 2018). Yaghobnezhad et al. (2010) examined various variables of working capital and net operating profit and found an inversely relationship between the variables of working capital management and profitability. They mentioned, an increase in the receivables collection period, the payment period, the Inventory turnover and the cash flow cycle, will reduce profitability. Al-ANI (2013) studied structure of fixed and current assets (it is introduced as the CES by Neveu, 1989). The assets structure doesn’t have a strong impact on ROE, he found. In other words, the change in the structure of assets does not correlate with the change in their returns. In another part of the results, it has been stated that, only the fixed assets affect ROE, while they do not affect ROA. On the other hand, current assets have no effect on ROE and ROA, while assets structure in the petrochemical industry affects ROE. Regarding the results of Al-ANI's research, it seems, the impact of assets structure on the shareholders' wealth can be different in different industries. So, it is important issue to be studied. Tashakori Jahromi et al. (2014) have studied the relationship between working capital variables, such as sales cycle and receivables collection period, with stockholders' wealth (adjusted return). They found, there is a significant positive relationship between working capital components and the optimal level of working capital with stock's adjusted returns. Aktas et al. (2015) found that the existence of an optimal level of working capital policy and converge of that optimal level by increasing or decreasing investment in working capital, improve firms' stock and operating performance. Also, efficient management of working capital can provide a new sources of internally-generated funds, which can be used at the benefit of firms' shareholders. Mun and Jang (2015) suggest that, working capital influences operating profitability. It has a significant inverse relationship with profitability and an increase in working capital has a negative effect on profitability. Also, the cash level is an important factor in efficient management of working capital. Harc (2015) found that tangible assets have a positive impact on the long-term debt. So, it can be concluded that the CES is related to the cost of capital and can ultimately affect the shareholders' wealth. In another study, Ahmad et al. (2017) found a significant and positive impact of asset structure on capital structure. As it was identified before, the asset structure is the CES and the capital structure is liabilities and shareholders' equity, from the financial management perspective. According to the results of this research, it can be argued that the CES can be related to the shareholders' wealth and cost of capital too. 3. Research Questions and Hypotheses There are several researches similar to those reviewed in the previous section. But, as previously mentioned, there is no comprehensive study on the CES and cost of capital which be directly related to the shareholders' wealth. So, given the literature review and study of research background, the following questions were raised. • Is there a significant relationship between the CES and shareholders' wealth? • Is there a significant relationship between cost of capital and shareholders' wealth? • How is the model of relationship between the CES and cost of capital with shareholders' wealth? To answer the first two questions, two main hypotheses and several sub-hypotheses has been raised based on research literature and background. H1: The CES has a significant relationship with shareholders' wealth. H1.1: The Cash to Total Assets ratio (CTA) has a significant relationship with shareholders' wealth. H1.2: The Short-Term Investments to Total Assets ratio (STITA) has a significant relationship with shareholders' wealth. H1.3: The Current Assets to Total Assets ratio (CATA) has a significant relationship with shareholders' wealth. H1.4: The Fixed Assets to Total Assets ratio (FATA) has a significant relationship with shareholders' wealth. H1.5: The Long-Term Investments to Total Assets ratio (LTITA) has a significant relationship with shareholders' wealth. Capital Expenditures Structure, Cost Of Capital And Shareholders' Wealth 5 H1.6: The Other Assets to Total Assets ratio (OATA) has a significant relationship with shareholders' wealth. H2: The cost of capital has a significant relationship with shareholders' wealth. H2.1: The Cost of Debt Capital (CDC) has a significant relationship with shareholders' wealth. H2.2: The Cost of Equity Capital (CEC) has a significant relationship with shareholders' wealth. 4. Methodology The method (strategy) of this study is analysis of secondary data. It is applied research and has used quantitative data to explore and describe the subject. This study examined the business level; that is, companies that have one business, not holding companies having several businesses. For this study, the statistical population encompassed companies listed in the Tehran Stock Exchange. The statistical population was screened, because 1) Holdings, the group companies and companies reporting consolidated financial statements, have more than a business were excluded due to lack of access to detailed data about each business and because this study focused on the business level, 2) Their fiscal year ended in March, 3) need to review past performance of business that require the presence of companies in the stock exchange not less than five years. Finally, some 186 companies were selected as sample based on systematically eliminated sampling. 4.1 Research Variables The independent variables of the research are the CES and the cost of capital and the dependent variable is shareholders' wealth. 4.2 Variables' Measurement Methods To measure variables, standard methods used by most researchers have been hired. 4.2.1 Capital Expenditures Structure The cash to total assets (Deakin, 1972), short-term investments to total assets (Doukas and Lang, 2003), current assets to total assets (Öcal et al., 2007), fixed assets to total assets (Deloof, 2003), long-term investments to total assets (Doukas and Lang, 2003) and other assets to total assets ratios are used to calculate the CES. 4.2.2 Cost of Capital Companies combine equity and debt or loan financing. The firms' cost of capital is usually calculated as the weighted average cost of debt and equity (Ross et al., 2016). It can be calculated by equation 1. Equation 1: Wacc = rdebt(1-tc) D/V + requity E/V There is Wacc = weighted average cost of capital, rdebt = cost of debt capital, tc = tax rate, D/V = debt/total financial resources ratio, requity = cost of equity capital and E/V = equity/total financial resources. Equation 2 (Ross et al., 2016) has been used to calculate the cost of equity capital. Equation 2: RE = D1/P0 + g There is RE = cost of equity capital, D1 = next period’s projected dividend, P0 = current stock price and g = the dividend growth rate. Also, the equation 3 has been used to calculate the cost of debt capital. Equation 3: RD = i(1-t) There is RD = cost of debt capital, i = interest rate debt, t = tax rate. Hooshang Asheghi-Oskooee 6 4.2.3 Shareholders' Wealth For calculating the wealth created for shareholders, the formula provided by Fernández (2002) is used. Equation 4: Created shareholder value=Equity market value×(shareholder return×Ke) Ke is the cost of equity capital that is equal with RE (mentioned in equation 2) and calculated by the same method. 5. Data Analysis and Findings This section consists of categorizing and summarizing and describing and analyzing the data collected. It was done using descriptive and inferential statistics techniques. At first, the research variables were described using descriptive statistics techniques. Then, the structural equation model has been used to construct a model and test the hypotheses. 5.1 Descriptive Statistics Three main variables have been studied. Research data has an interval scale. To describe the variables of the research, the measures of central tendency and index of dispersion are used, which are shown in Table 1. Table 1. Descriptive Statistics Research variables Sample size Mean Median Standard deviation Skewness Kurtosis CTA 186 0.043 0.029 0.049 3.425 18.403 STITA 186 0.020 0.000 0.051 4.473 24.741 CATA 186 0.646 0.681 0.196 -0.601 -0.388 FATA 186 0.246 0.203 0.179 1.127 1.001 LTITA 186 0.078 0.023 0.125 2.333 5.570 OATA 186 0.014 0.004 0.033 5.815 43.695 CEC 186 0.295 0.290 0.202 0.909 3.915 CDC 186 0.150 0.118 0.384 17.270 394.217 shareholders' wealth 186 891221.200 15452.376 8099648.740 4.443 93.511 5.2 Inferential Analysis of Findings In the inferential statistics section, the following tests have been used to investigate the hypotheses: • Confirmatory Factor Analysis • Structural Equation Modeling 5.2.1 Confirmatory Factor Analysis Research variables have been extracted from literature review and previous researches. Confirmatory factor analysis was used to determine the relationship between unobservable and observed variables. Factor loads should be higher than 0.5 and ideally 0.7 or higher (Fornell and Larcker, 1981). Figure 1 shows the path analysis model in the estimating mode of standard coefficients. The summary of the confirmatory factor analysis results is shown in Table 2. It indicates the suitability of the observed variables' factor loads. Capital Expenditures Structure, Cost Of Capital And Shareholders' Wealth 7 Figure 1. path analysis model in the estimating mode of standard coefficients Table 2. Factor Loads of Unobservable Variables Unobservable Variables Items Factor Loads C E S CTA 0.881 STITA 0.872 CATA 0.850 FATA 0.874 LTITA 0.871 OATA 0.503 Cost of Capital CEC 0.928 CDC 0.913 Shareholders' Wealth 1.000 5.2.2 Structural Equation Modeling The structural equation model of the relationship between variables, which was designed using SmartPLS software, was investigated after confirmatory factor analysis and identifying the factor loads. Figure 2 shows the model in the absolute value of t-statistic. This model tests all measurement equations and structural equations using t-statistic. According to this model, if the value of t-statistic is more than 1.96, then the path coefficient in the 95% confidence level is significant. Given that the absolute value of t-statistic for all paths is more than 1.96, the coefficient of paths is significant at 95% confidence level. shareholders' wealth CEC CDC LTITA FATA CATA CTA STITA OATA shareholders' wealth Cost of Capital CES 1.000 -0.164 0.224 0.000 0.000 0.388 0.913 0.928 0.871 0.874 0.850 0.881 0.872 0.503 Hooshang Asheghi-Oskooee 8 Figure 2. Model in the state of absolute significance of t-statistic Validity, reliability and goodness-of-fit indexes of the model are shown in Table 3 and the correlation coefficients and divergent validity index are shown in Table 4. Table 3. Validity, Reliability and Goodness-of-Fit Indexes Unobservable Variables AVE CR R 2 AVE 2R GoF (1) CES 0.673 0.923 0.000 0.860 0.515 0.442 (2) Cost of Capital 0.570 0.814 0.000 (3) Shareholders' Wealth 1.000 1.000 0.265 Table 4. Correlation Coefficients and Divergent Validity Index Unobservable Variables (1) (2) (3) AVE CES 1.000 1.000 Cost of Capital 0.473 1.000 0.820 Shareholders' Wealth -0.434 -0.563 1.000 0.773 Average Variance Extracted (AVE) indicates the convergent validity of the measurement model. If the value is less than 0.5, the validity of the indexes, whether individually or structurally, is doubtful (Fornell and Larcker, 1981). Given that all AVE values are more than 0.5, the measurement model has credibility. Composite Reliability (CR) or convergent validity is present when CR is larger than 0.7 and CR should be larger than AVE too (Hair Jr et al., 2014). As shown in Table 3, both conditions are met. Therefore, the model has the necessary reliability. The results of the main research hypotheses test in Table 5 and the results of sub-hypotheses test are also shown in Table 6. Table 5. Structural Equation Results for Research Hypotheses Test Independent Variable Dependent Variable β t-value Sig R 2 Result Relation Direction CES Shareholders' Wealth 0.388 8.420 0.001 0.224 Confirmed + Cost of Capital -0.164 3.719 0.001 Confirmed - |t|>1.96 Significant at P<0.05, |t|>2.58 Significant at P<0.01 shareholders' wealth CEC CDC LTITA FATA CATA CTA STITA OATA shareholders' wealth Cost of Capital CES 1.000 3.719 8.420 77.401 87.463 59.440 71.558 53.921 77.327 68.109 10.717 Capital Expenditures Structure, Cost Of Capital And Shareholders' Wealth 9 Table 6. Structural Equation Results for Research Sub-Hypotheses Test Independent Variable Dependent Variable β t-value Sig R 2 Result Relation Direction CTA S h a re h o ld e rs ' W e a lt h 0.120 1.579 0.115 0.244 Unconfirmed STITA 0.143 2.237 0.031 Confirmed + CATA -0.085 -1.147 0.252 Unconfirmed FATA 0.288 3.719 0.000 Confirmed + LTITA 0.138 2.852 0.005 Confirmed + OATA -0.008 -0.109 0.913 Unconfirmed CDC -0.174 -1.639 0.009 0.141 Confirmed - CEC -0.233 -3.530 0.000 Confirmed - 6. Discussion and Conclusion According to the research findings, it can be concluded that there is a direct and significant relationship between the CES and shareholders' wealth with 95% confidence. Also, there is a reciprocal and significant relationship between the cost of capital and the shareholders' wealth with 95 percent confidence. Although, in general, the existence of such a relationship is obvious and there is no doubt, but the most important part of the results is related to the details of the relationship. These details were investigated through sub-hypotheses. The results showed that despite the general relationship between independent variables and dependent variable of research, all components of the independent variables do not have the same relation to the dependent variable. This increases the importance of the issue and indicates the need to focus on the CES. The results of the testing of the sub-hypotheses shown in Table 6 show that there is no relation between the CTA, CATA and the OATA with the shareholders' wealth. Cash is one of the components of current assets that Mun and Jang (2015) also have paid attention to the its importance in managing working capital. The absence of a relationship between CTA and CATA with shareholders' wealth, is the same as the results of Al-ANI (2013), Yaghobnezhad et al. (2010) and Tashakori Jahromi et al. (2014). But, differs with the results of Aktas et al. (2015) and Mun and Jang (2015), which focused on working capital and in particular on the cash flow cycle. The differences observed in the results of these studies can be attributed to the time, economic, and political conditions of the countries in which the research is carried out. Also, the type of industry in which the company operates may have a significant impact on the research results. This could be the subject of future researches. In general, it seems, the absence of a significant relationship between the CATA as well as the OATA with shareholders' wealth, appears due to the concept of unused resources. Current assets are items that, if invested in, excessively necessary, reduce stockholders' returns (stockholders' wealth) due to low returns or lack of returns. For example, cash surplus on need, does not produce any returns. Other assets are not used in the company's operations. These assets are acquired and maintained in order to gain more future returns. Obviously, in conditions of market downturn, holding such assets cannot increase the company's returns, and may even reduce the company's return due to the lack of increase in value or even their devaluation. This could reduce shareholders' wealth, especially if it is financed from debt. The results of Harc (2015) and Ahmad et al. (2017) also confirmed, the CES is related to the cost of capital and the capital structure (liabilities and shareholders' equity). Perhaps one of the main reasons for the lack of comprehensive attention to the CES by the researchers is the perception of an obvious relationship between it and the shareholders' wealth, or the firm's performance and returns. But, as stated above, the lack of attention to the proper combination of assets (CES) can create unused resources and thus reduce the returns. Hooshang Asheghi-Oskooee 10 The results of this study showed that the assumption of the existence of the relationship between all the components of the asset with the shareholders' wealth is not correct and it is necessary to decide more carefully on the composition of the assets. Also, researchers need to deviate from focusing only on the left side of the balance sheet and working capital, and to consider the right side of the balance sheet comprehensively. 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