ERASMUS UNIVERSITY ROTTERDAM ERASMUS SCHOOL OF ECONOMICS Department of Business EconomicsBachelor Thesis Entrepreneurship

DETERMINANTS OF CAPITAL STRUCTURE OF SMEs

Author: K.M.A. Romijn

Student number: 328622kr

Thesis supervisor: A. van Stel

Finish date: July 2016

ABSTRACT

This paper analyzes how country- and aggregated firm-specific variables affect the capital structure of

European small and medium sized enterprises. 11,720 firms across 11 European countries are studied

using data from the year 2009 to 2014. Data from a survey done by the European Central Bank and

European Commission are used. Country specific variables are examined to find out to what extent they

affect capital structure of SMEs. The determinants of capital structure namely GDP per capita, GDP

growth, inflation and interest rate are tested. The aggregated firm specific variables are Turnover,

General Economic View and Profitability. Two theories are used to examine how these variables affect

the capital structure. The two theories used are the pecking order theory and the trade-off theory. The

results show that macroeconomic and aggregated firm specific variables are an important aspect in

explaining SME’s capital structure and cannot be neglected.

Keywords: Capital Structure, Trade-off Theory, Pecking Order Theory, SME, Cross Country Data

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TABLE OF CONTENTS

ABSTRACT .............................................................................................................................................. ii

TABLE OF CONTENTS............................................................................................................................. iii

CHAPTER 1. Introduction ....................................................................................................................... 1

CHAPTER 2. Literature Review................................................................................................................3

2.1 Pecking Order theory....................................................................................................................... 3

2.2 Tradeoff theory ............................................................................................................................... 4

2.3 Determinants.................................................................................................................................... 5

CHAPTER 3. Research Question & Hypotheses...................................................................................... 8

CHAPTER 4. Data & Methodology........................................................................................................ 12

CHAPTER 5. Results...............................................................................................................................17

CHAPTER. 6 Conclusion…………………………………………………………………………………………………………………….21

CHAPTER 7. Bibliography...................................................................................................................... 23

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1 Introduction

Small and Medium Sized enterprises, hereinafter SMEs, are central to economic prosperity of almost

every developed country. They boost competition and entrepreneurship. They provide efficiency,

innovation and aggregate productivity growth (Grossman & Helpman, 1993), (Bhaskaran,2006).

According to the Organisation for Economic Co-operation and Development, SMEs in OECD countries

stand for more than 60% in the economy. This illustrates the importance of SMEs. Different cross

country studies have shown that there are multiple factors which are capable of explaining SMEs capital

structure. Decisions relating to financing the assets of a firm are very crucial in every business. By

determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest as

well as maximizing its market value. There are some variables which have an influence on how firms

determine their capital structure. Identifying to what extend country- and aggregated firm specific

variables affect it was one of the major reasons for writing this research paper.

There are large numbers of research papers with the focus on determinants which affects a firm’s capital

structure. However, most of the research done on capital structure has been carried out on large listed

companies in the US. The most prominent theories that came out of all this research were the trade-off

theory and pecking order theory. There has been a large number of empirical work done in order to test

both theories, and some have favored one theory over the other. Yet, there still is no clear answer on

which theory explains capital structure best. Rather, it seems like both theories are only partly capable

of explaining capital structure of companies. This research paper will focus on the capital structure of

SME’s in Europe and try to provide new insight on how these two theories explain capital structure.

The first authors who developed a capital structure theory were Modigliani and Miller in 1958. The

proposal of this theorem, under certain assumptions, is that the market value of the firm is independent

of its capital structure composition (Modigliani & Miller, 1958). Since then, numerous economists

presented their financial leverage theories to try and explain the different compositions of debt ratios

maintained by firms. Some theories suggest that debt is relevant due to the existence of information

asymmetry (Myers & Majluf, 1984). Other theories mention that the existence of bankruptcy and taxes

are what make debt relevant (DeAngelo & Masulis, 1980). However, the empirical evidence regarding

the alternative theories lead to different results and conclusions.

This paper contributes to the literature by examining which country specific variables as well as

aggregated firm specific variable influence the capital structure of SMEs in Western Europe. In

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particular, we address the following question: ‘To what extent do macroeconomic variables and

aggregated firm-specific variables help in explaining the capital structure in small and medium sized

businesses in Western Europe’

The remainder of this paper is organized as follows. In chapter 2 a literature review will be conducted,

starting with the paper of Myers and Majluf. In this chapter earlier studies on capital structure will be

explained. In chapter 3 the research question and hypotheses will be explained. Chapter 4 will present

the data gathered for this research, as well as the theories and methods which were used to conduct

this study. Chapter 5 is where the results of the research will be presented. In the last chapter a short

summary will be provided along with a conclusion.

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2 Literature Review

2.1 Pecking Order theory

The Pecking Order Model developed by Myers and Majluf (1984), suggests that firms prefer internal

funding over external funding. Capital structure is driven by a firm’s desire to finance new investments,

first internally, then with debt, and if all else fails equity is generated as a last resort. So the firms don’t

have an optimum debt to equity ratio. This theory is applicable for large firms as well as small firms.

When it comes to pecking order theory it has been supported by many academics. Merton Miller and his

colleague Franco Modigliani published their paper on capital structure in 1958. In this paper they

presented what is nowadays often referred to as M&M’s proposition I, also known as ‘The Irrelevance

Proposition’, which is considered to be the first real theory on capital structure. M&M stated that the

value of a leveraged firm is equal to the value of an unleveraged firm (Modigliani & Miller, 1958,).

The logic behind the proposition was that the value of a pizza does not depend on how it is sliced

(Myers, 2001). The composition of assets on the left hand side of a balance sheet will generate expected

cash flow for a company. Depending on the operating risk of the company the cash flows are discounted

to find the value of the company. According to the proposition, the amount of debt relative to equity

only serves to determine the split of cash flows between equity holders and debt holders, and does not

affect the value of the company. This statement however, only holds in the fabricated world of M&M,

where capital structures are perfect.

While this theory is based on a perfect world, it triggered something very valuable, namely emphasizing

the importance of the capital structure theory. “The Irrelevance Proposition” brought a stream of

research trying to disprove M&M’s proposition, in other words that financing actually matters. Several

research has shown that the Modigliani-Miller theorem fails under a variety of circumstances (Frank &

Goyal, 2005). The most commonly used factors include bankruptcy costs, consideration of taxes,

transaction costs, and agency costs.

Referring to the pizza again, Myers argues that the value of a pizza actually depends on how it is sliced,

since consumers rather pay more for more slices, than for a whole pizza (Myers, 2001). One of the

aspects of the pecking order theory is that when it comes to profitable firms, they would always prefer

internal financing if available. Retained earnings have no adverse selection as compared to equity and

debt. This argument is supported by Fama and French (2000) who found that profitable firms were less

leveraged as compared to non- profitable firms.

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2.1.1 SME’s & Pecking Order theory

The structure of SMEs and their availability to capital is very different to that of large firms. It is

therefore essential to verify if the pecking order theory is also valid for SMEs. When testing the pecking

order theory for SMEs, it is important to identify the reason why SMEs behave according to this theory,

since the reason can be very different compared to large firms. There are some clear explanations why

the pecking order theory should be able to explain the behavior of SMEs regarding their capital

structure.

One of these reasons is that SMEs are often owned by one shareholder, who at the same time, are the

founder of the firm. Issuing equity can lead to a loss of control over the company and is therefore not

the first choice of the owner. The avoid issuing equity, the owner may turn to debt for financing his

business (Lopez- Garcia & Mestre-Barbera, 2011). This is in line with the pecking order theory where

financing with debt is preferred over financing with equity.

2.2 Trade-off Theory

Probably due to the many critics that the irrelevance proposition was based on a perfect world, M&M

decided to add taxes, in a later paper (Modigliani & Miller, 1963). By taking into account that interests

are tax deductible, which leads to tax benefits, their model introduced an interest tax shield. Internal

financing is generally thought to be less expensive than external financing, because there are no

transaction costs and there is no need to pay taxes associated with paying dividends. Yet, when debt is

assumed to be risk-free and there is no drawback in increasing one’s leverage then an optimum capital

structure consists only of debt. This induced an increase in the popularity of the tradeoff theory.

The tradeoff theory suggests that the optimal capital structure of a company is based on a tradeoff

between the value of the interest tax shield and the leverage cost. The optimal capital structure is where

the marginal increase in the additional leverage costs negates the marginal benefits of the increase in

the interest tax shield from additional leverage. Leverage costs are direct costs of bankruptcy, lawyers’

fees, administration expenses etc. Bankruptcy cost is a cost directly incurred when the perceived

probability that the firm will default on financing is greater than zero. One of the bankruptcy cost is

liquidation cost, which represents the loss of value as a result of liquidating the net assets of the firm.

Another bankruptcy cost is distress cost, which is the cost a firm incurs if stakeholders believe that the

firm will discontinue. A study however, showed that bankruptcy cost is negligible, and therefor do not

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rationalize the borrowing among most firms (Warner & Gruber, 1977). According to the tradeoff theory,

firms are expected to look for a target debt ratio (Jalilvand & Harris, 1984).

2.2.2 SME’s & Trade-off Theory

Normally, research on capital structure including the trade-off theory has been performed on large

listed US companies, due to the better availability of data. However, in this paper we will focus on SME’s

and therefore it is felt necessary to elaborate whether one can expect SME’s to behave in a similar way

as large companies in terms of the trade-off theory. Several papers have been published with arguments

that support financial decisions by managers of SME’s, indicating that they can be explained by the same

theories used for large firms i.e. pecking order theory and trade-off theory (Sogorb-Mira, 2005).

However, SME’s might face certain problems that large firms do not face to the same degree.

One possible example in which SME’s might not follow the trade-off theory as compared to large firms is

the lack of knowledge among managers. These managers should be aware that having a higher leverage

may be advantageous. Many small firms led by entrepreneurs will have skills that are not in the field of

finance, and therefore might not have the knowledge to take advantage of this (Jensen & Uhl, 2008).

Managers who do not possess this knowledge tend to operate at a lower debt level than is optimal.

Another important issue is the potential financial constraint SMEs have compared to large firms. This

implies that SMEs might not be able to acquire debt as easily as large firms, due to information

asymmetry. This doesn’t have to be a big issue, but it becomes a serious problem if the lack of debt

financing results in SME’s having to pass up on profitable investment opportunities which may restrict

growth.

2.3 Determinants

There have been a lot of theories to explain the capital structure choices which firms make. Most of

these theories were mainly developed and tested in advanced countries like the US. Some studies have

been conducted for the G7 countries which show that the capital structure choices in these countries

are similar to one and other (Rajan & Zingalas, 1995). The authors did a firm level research with size,

asset tangibility, growth rate and profitability as independent variables. They found that 19% of the

variation in the firms’ leverage in the G7 countries is explained by these factors. The findings in these

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paper was also supported by the author Wald (1999), who continued Rajan and Zingales’ paper to study

the capital structure determinants including Germany, Japan, France, US and the United Kingdom. Other

authors like Fama and French (2002) reached a similar conclusion about companies financing behavior,

where the pecking order theory couldn’t be rejected.

As previously mentioned, most research on capital structure has been performed on datasets consisting

of large listed companies mainly located in the US. Even though attention on SMEs has been increasing

lately, research on capital structure has primarily been based on US firms (Sulla, Sarria- Allende &

Klapper, 2002). Earlier studies that highlight the importance of country specific variables are e.g. (Booth

et al, 2001), (Jõeveer, 2005) and several others. The importance of country level variables is emphasized

in these studies. Jõeveer makes an important statement in her paper in connection with the country

level variables. She argues that country level variables have a larger impact on the capital structure of

SMEs. Small firms are more likely to operate under borrowing constraints, so they will face non- firm-

specific determinants of capital structure. Her paper points out the importance of country level variables

in the context of this study since it only deals with SMEs. This might suggest that when a company

reaches a certain size, the importance of country level variables is reduced because the company might

obtain access to other capital markets.

Studies on the capital structure of firms, have attempted to identify country specific determinants of

capital structure choices as function of the factors that build the theories such as the pecking order

theory. There have been some country specific determinants of capital structure identified, based on

the most accepted theoretical models of capital structure. The country specific determinants many

previous studies have used to determine their impact on the capital structure decisions include the

Gross Domestic Product (GDP), growth rate, inflation, interest and taxes. A paper written by Bas,

Muradoglu and Phylaktis (2009) show that most of the macroeconomic variables are significant. The

coefficient estimates of GDP per capita and growth were positively correlated, while inflation and taxes

had a negative effect on leverage. These results are not shared by all. Authors Jensen and Uhl (2008)

have contradicting results in their paper. The different views suggest that the study on determinants of

capital structure is not yet complete and gives room for further studying.

This paper will take both theories into account while examining the factors which may influence a firms’

capital structure. Many studies have been published about these two theories, but most of them have

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been focused on only one. Therefore, it is hard to conclude if one is better than the other. A paper by De

Jong, Verbeek and Verwijmeren (2011), studies how these two theories do against each other. The

authors wanted to study if the pecking order theory was better than the tradeoff theory. The important

difference in the prediction is that the tradeoff theory argues that a firm increases its leverage until it

reaches its target debt ratio, while the pecking order theory yields debt issuance until the debt capacity

is reached. For example, the research did on 6000 US firms between 1985 to 2005 shows that pecking

order theory captures the issue decisions of firms better than the tradeoff theory. On the other hand, a

company’s capital structure decisions are better explained by the tradeoff theory if focused on the

repurchase decisions. Therefore, it was concluded that neither was better than the other. By testing the

firm- and country specific variables on capital structure, an expected outcome can be made by using

either the tradeoff theory or the pecking order theory.

The following section will explain the research question and hypotheses that will be used to conduct this study.

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3 Research question and hypotheses

In the literature review, the most important capital structure theories were reviewed together with

some empirical evidence. It was also shown how the focus on macro- and firm specific variables in

explaining capital structure choices has increased in the past few years. In this study it is expected that

the capital structure of firms is influenced by the macroeconomic variables as well as aggregated firm

specific variables. This expectation can be summarized by the following research question:

‘To what extent do macroeconomic variables and aggregated firm-specific variables help in explaining

the capital structure in small and medium sized businesses in Western Europe’

The results that will be obtained by this study may produce valuable information to policy makers on

which factors affect the capital structure of SMEs. Traditional capital structure theories do not take

macroeconomic variables into account that influence SMEs access to debt and therefore only illustrate

an incomplete picture. This paper controls for the following macroeconomic variables: GDP per capita,

growth rate of GDP, inflation rate and the interest rate. These will be further explained and the expected

outcomes are shown in table 1.

Gross Domestic Product per capita

Gross Domestic Product (GDP) is the expenditure on final goods and services minus imports: final

consumption expenditures, gross capital formation and exports less imports. Intuition behind this is that

the higher the GDP per capita is the richer a country is. A wealthy country may indicate that firms have

more retained earnings compared to poorer countries and are more capable of financing themselves

with internal finance. According to the pecking order theory this means that GDP and leverage are

negatively associated with each other. On the other hand, a well-developed capital market makes it

easier for SMEs to borrow money. If debt is considered to be risk-free there is no drawback in increasing

one’s leverage, then firms will most likely borrow more. Therefore, the first hypothesis is as follows:

‘The GDP per capita is positively correlated with the capital structure of SMEs’.

Gross Domestic Product Growth

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GDP growth (GDPGROWTH) is used as a macroeconomic variable to proxy for the overall state of the

economy in a country. A growing GDP signals that firms have better investment opportunities and are

expected to create more profits. The pecking order theory suggests that these improved economic

conditions lead to a higher free cash- flow. This means that firms have more internal funds, which

decreases their need for external funding. Earlier studies show that pecking order theory is applicable

for SMEs, which means that SMEs will prefer internal funding over external funding if there is a GDP

growth. According to the pecking order theory, GDP growth is positively related with capital structure in

the short term, but negatively related in the long run. However, as the firm grows, their requirement of

finance increases. Growth is likely to push SMEs into borrowing if their internal finance is not enough to

finance the increasing demand. Therefore, the trade-off theory suggests a positive association between

GDP growth and capital structure in the long run. The second hypothesis is ‘the growth rate of GDP is

positively correlated with the capital structure of SMEs’.

Inflation

This variable is represented in the regression as (INFLATION). Inflation provides evidence on the stability

of the local currency and is measured based on the GDP deflator. If this increases, the cost of equity as

well as the cost of debt should increase. However, this might not be the case in real terms, due to the

deterioration of the real value. Furthermore, when part of the interest paid on a loan is actually

compensation for deterioration of the principal, then also the value of the tax shield is increased,

because part of the principal repayment is then tax-deductible (Jensen & Uhl, 2008). Therefore, a

positive relation between inflation and leverage can be expected. Countries with high inflation are

associated with high uncertainty (Demirgyc- Kunt & Maksimovic, 1996). The rate of inflation may

influence the riskiness of debt financing so that lenders are more likely to avoid providing debt. The

trade-off theory puts the emphasis on using more debt, but an increase of inflation will most likely lead

do less lending. Therefore, we expect inflation to be negatively correlated with capital structures of

SMEs. According to the pecking order theory, inflation would have no effect on capital structure

(Houwen, 2011). The third hypothesis is ‘Inflation is negatively correlated with the capital structure of

SMEs’.

Interest

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If interest rate increases firms will be less willing to finance new investment with debt. According to the

pecking order theory, additional debt will be less attractive due to the increase cost of borrowing

(Bartholdy & Mateus, 2008). This indicates a negative relation between the interest rate and leverage.

The trade-off theory states that interest are tax deductible, which leads to tax benefits. This is the

reason why a positive relationship is expected with capital structure. The fourth hypothesis is as

follows: ‘The change in interest rate is negatively correlated with the capital structure of SMEs’.

VARIABLE DEFINITION Trade-off theory Pecking Order Theory

GDP Gross Domestic Product + -GDPGROWTH Growth rate of the Gross

Domestic Product+ +

INFLATION Inflation rate +/-INTEREST Interest rate + -

Table. 1 Macro-Economic Variables.

The availability of reliable data is scarce due to the fact that most studies which focus on capital

structure of SMEs are researched with firm level variables. However, with the Doing Business initiative

of the World Bank, the available data has increased. Most of the country specific variables will be

obtained through this database. Using this source of data and researching several countries to create

variation in the country specific variables, it is expected to see a relationship between these variables

and the capital structure of SMEs. This may provide additional insight into capital structure theories and

the importance of country specific variables. Knowing which specific variables influence capital

structure, it is possible for policy makers to use this information to change certain government policies

in order to provide SMEs with additional support. This does not mean that unexpected findings will not

be elaborated on. If possible, further interesting findings will be analyzed and concluded on, or

otherwise suggested for further research.

The second part of this study will investigate the relationship between aggregated firm specific variables

and capital structure. There has been previous study done on this topic, but none which uses the Survey

on Access to Finance of Enterprises as a database. The three aggregated firm specific variables obtained

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from this data source are the Turnover rate, the General Economic Outlook, and the Profitability. These

variables will be further explained and their expected effect on capital structure will be shown in table 2.

Turnover

The variable turnover will be used as a proxy for the size of a company and will be denoted as

TURNOVER. Small firms are often managed by very few people whose main objective is to keep the

majority of the firm. That is why internal financing is preferred over external financing, in order to lower

the risk of losing control. Therefore, following the pecking order theory a positively relation is expected.

Moreover, small firms have a higher risk of default compared to larger firms. Reason for this is that

larger firms tend to be more diversified and should lead to a lower debt to assets ratio for smaller firms.

The trade-off theory suggests that more debt financing is weighted against the potential cost of

bankruptcy which is affected by de probability of default (Rajan & Zingales, 1995). According to this

theory, size is positively related to the capital structure (Jõeveer, 2006). The fifth hypothesis is that

‘Turnover is positively correlated with the capital structure of SMEs’.

General Economic Outlook

This variable is represented in the regression as (GVIEW). This variable will be used as a proxy for future

growth opportunities. High future growth opportunities will lead firms to finance themselves more with

equity than with debt, because less leveraged firms are more likely to maximize profitable investment

opportunities (Myers, 1977). This is also in accordance with the trade-off theory. It is however expected

that retained earnings are not enough to finance all projects, meaning that debt financing has to be

sought. This indicates a positive relation between debt and growth opportunities, and is in line with the

trade-off theory. The sixth hypothesis can be denoted as ‘General Economic View is negatively

correlated with the capital structure of SMEs’.

Profitability

Profitably of SMEs is used as an aggregated firm specific variable to test the amount of debt in a firm

and is denoted as PROFIT in the regression. According to the trade-off theory profitable firms have a

lower probability of financial distress and find interest tax shields more valuable (Houwen, 2011).

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Therefore, firms should seek more debt instead of equity. Yet, according to the pecking order theory

firms prefer using internal financing over external financing, so profitable firms will use more equity. It is

expected that profitability and capital structure is negatively correlated. Therefore, the seventh

hypothesis is that ‘Profitability is negatively correlated with the capital structure of SMEs’.

VARIABLE DEFINITION Trade-off theory Pecking Order Theory

TURNOVER Turnover + -GVIEW General Economic Outlook - +PROFIT Profitability + -

Table. 2 Aggregated Firm Specific Variables.

In the following section named Data I will describe how this particular data was obtained and from

which sources they were gathered. Any change done with the obtained data will also be explained.

Further, the methodology will also be described in the next part.

4 Data & Methodology

To conduct this research various kinds of data is needed. These are collected from a couple of different

sources. Some of these sources are well known databases, for example the World Bank database. Below

follows a description of the different types of data and some attributes of these data.

Our main dataset is a country-level survey data for 11,720 firms from Survey on Access to Finance of

Enterprises (SAFE) conducted in the euro area. This is an investigation performed by the European

Central Bank (ECB) and European Commission (EC) to study the general characteristics of the euro area.

The results in the SAFE database is an aggregated data source of SMEs across 12 European countries.

This signifies that these variables refer to the average results obtained within a country and year of the

enterprises that participated on the survey. The countries included in this survey are the four largest

euro area countries namely Germany, France, Italy, Spain and 8 other countries (Belgium, Ireland,

Greece, the Netherlands, Austria, Portugal, Finland and Slovakia). The smallest countries in the euro

area (Estonia, Cyprus, Latvia, Lithuania, Luxembourg, Malta and Slovenia) are excluded, since they

represent less than 3% of the total number of employees in the euro area and excluding them only has a

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very marginal impact on the results for the euro area as a whole. In this paper we will focus on the data

gathered for eleven European countries. Slovakia is excluded, because not enough data was available.

SME Turnover Total Assets Number of Employees

Medium companies < 50 million EUR ≤ 43 million EUR ≤ 250

Small Companies < 10 million EUR ≤ 10 million EUR ≤ 50

Micro companies < 2 million EUR ≤ 2 million EUR ≤ 10

Table 3. Source:http://ec.europa.eu/enterprise/enterprise_policy/sme_definition/index_en.htm

Firms can be divided in different size classes. They are defined as small and medium if they meet the

criteria stated in table 3. The data provided by SAFE was collected to construct a comparable precision

for micro, small and medium-sized firms, taking into account total employment in these size classes. In

this study we will target the small and medium size companies and not the micro companies. The reason

for this is that not much data is available for micro firms due to the fact that this group is not required to

make annual reports public.

This research is based on firms from 11 European countries. Here the capital structure of SMEs for all

countries is gathered with the exception of Slovakia. This country is excluded from the paper because

there is not enough data to study. Our sample period covers the years 2009 to 2014. A reason for this

particular period is that the data is gathered after the financial crisis of 2007-2008. Looking at the data

there seems to be no irregularities.

Using the Safe database, the dependent variable is obtained, namely the debt-to-assets ratio. A country

level variable is obtained from this database as well, namely the change in interest rate. After gathering

the data from the SAFE survey, three other macroeconomic variables are then gathered. These are

obtained from the World Bank database. The three country specific variables gathered here are the

Gross Domestic Product per capita, Gross Domestic Product growth rate and the inflation rate. However,

because the data obtained from the World Bank are annual percentage, the data obtained from the

SAFE survey also need to be generated into annual percentage data. Following mathematics ruling semi-

annual data was converted to annual data. The chosen independent variables were chosen, because it’s

well accepted that these are macroeconomic variables which may influence a firm’s capital structure.

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This is also consistent with earlier research on country level basis for capital structure (Bas, Muradoglu

and Phylaktis, 2009).

After gathering macroeconomic variables, aggregated firm specific variables were then gathered. The

aggregated firm specific variables gathered were Turnover, General Economic View and Profitability. All

these variables were gathered from the SAFE survey. The data gathered here are changes in percentage

on a semi- annual basis, which were converted to annual data.

After the data is gathered and structured; the regression model is built and tested. One of the most

commonly used ways of assessing the relationship between debt and its determinants is the OLS

regression. Considering the previously defined determinants of debt used in this study, the evaluation of

an OLS regression can be presented in the following way:

The relationship between a continuous response variable (Y) and a continuous explanatory variable (X) is

presented. Here α indicates the value of Y when all values of the explanatory variables are zero. The β

parameter indicates the average change in Y that is correlated with a unit change in X, while taking the

other explanatory variables into account. OLS regression is particularly powerful as it relatively easy to

also check the model assumption such as constant variance, linearity and the effect of outliers using

simple graphical methods (Hutcheson and Sofroniou, 1999).

The variable that we intend to explain is SMEs capital structure. Capital structure is defined as the way a

corporation finances its assets through some combination of equity, debt, or a combination of both. The

composition, the ‘structure’ of how a firm is being financed is then called capital structure (Jensen & Uhl,

2008). Here, capital structure is defined as the total debt ratio. This is obtained by dividing total debt

with total assets;

There are a lot of papers where total debt is separated in long-term debt and short- term debt.

However, other studies show that using the total debt ratio show similar results to the long-term (Wald,

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1999). Therefore, using the total debt ratio is sufficient and reliable and is in accordance with similar

papers (Rajan & Zingales, 1995; Deesomsak et al, 2004).

The relationship of the independent variables with the dependent variable will be studied with the

following regression:

TDR= β0+ β1*GDPCAPITA+ β2*GDPGROWTH+ β3*INFLATION+ β4*INTEREST+ β5*TURNOVER+

β6*GVIEW+ β7*PROFITABILITY

The countries included in this paper will be tested with these regression models. The independent

variables will be accepted if they have a significant effect on the dependent variable or rejected if this is

not the case. For this research a 5% significance level and 10% significance level will be maintained.

When using a 5% significance level, it is accepted that there is a 5% probability that the null hypothesis is

wrongly rejected (and 10% when using a 10% significance level); this is called the type 1 error. The type

2 error is the probability that the null hypothesis is not rejected when it should have been. Choosing a

higher significance level gives a greater chance of accepting the null hypothesis, however this also

increases the chance of a type 1 error. A higher level of significance lowers the security of the test

result. Rejecting the null hypothesis can only be done with a certain amount of certainty, a relationship

between two variables can never be completely ruled out.

4.2 Descriptive Statistics

In this part the descriptive statistics of this study will be briefly mentioned and are represented in table

4. This table shows the descriptive statistics of 11 European countries during the period 2009 until 2014.

These observations are measured in percentage change (∆%). An important descriptive statistic is the

standard deviation, which is in some cases higher than the mean of the sample. This signifies that there

are high deviations within the 11 countries tested. There seems to be no irregularities.

Table 4. Descriptive Statistics

∆% N Minimum Maximum Mean Std. Deviation

TDR 66 -63 45 -13.24 19.987GDP 66 -8.885 4.870 -.904 2.952GDPGROWTH 66 -9.132 5.199 -.632 2.976INFLATION 66 -67.200 107.000 42.758 27.281

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INTEREST 66 -68 222 49.92 78.583GVIEW 66 -92.646 108.107 -44.211 40.538TURNOVER 66 -87.777 107.012 .804 50.464PROFIT 66 -94.676 52.265 -33.431 38.572Valid N (listwise) 66

Table 5 provides the Pearson correlation for the variables in the regression and is used to examine the

possible degree of collinearity among these variables. As can be seen from the data in table 5, the

correlation coefficients are not large enough to cause collinearity problems in the regression and are

statistically significant. Most of the independent variables co-vary at a significance level of 1% with the

exception of GVIEW & INTEREST, which co-vary on a significance of 5%. Another interesting observation

can be found by looking at the first column. It can be noticed that most independent variables seem to

be negatively correlated with TDR, with the exception of INTEREST.

Table 5. Correlations

TDR GDP GDPGROWTH

INFLATION

INTEREST GEO TURNOVER PROFIT

TDR 1

GDP -.425** 1

GDPGROWTH -.414** .985** 1

INFLATION -.069 .064 .063 1

INTEREST .424** -.158 -.174 .027 1

GVIEW -.436** .596** .572** -.013 -.306* 1

TURNOVER-.691** .742** .746** .105 -.477** .711** 1

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PROFIT -.763** .644** .656** .055 -.511** .728** .955** 1

*P<0.05, **p<0.01

In the next section named Results, the results obtained from these test will be described. It will be

examined if these were the findings which were expected. Implication of different coefficients will also

be deliberated on.

5 Results

5.1 Country Specific VariablesThe empirical results from the regression analysis on the country specific determinants are denoted in

table (4). These findings are for the period 2009 to 2014. Yearly dummies have also been included in the

regression to control for any differences across time, with 2009 as the basis. The relation between

capital structure and the Gross Domestic Product per capita (GDP) was expected to be positive, but

shows a negative relationship at a 5% significance level. Earlier studies done on the relationship

between GDP per capita and capital structure show a positive significant relation (Jensen & Uhl, 2008).

Due to the negative coefficient results from GDP, the first hypothesis is rejected. GDP and capital

structure are not positively associated with each other. Therefore, this variable does not follow the

trade-off theory and the assumption that SME’s would borrow more in a country with increasing GDP

finds no support. A wealthy country may indicate that these firms have more retained earnings and thus

need less debt to finance themselves. Most of the countries used in this data belong to the top 30

wealthiest countries in the world (cia.gov, 2015). This may be an explanation why the GDP is consistent

with the pecking order theory rather than the trade-off theory.

The relation between the growth rate of GDP (GDPGROWTH) and capital structure is found to be

significant at a 5% significance level. This finding is consistent with earlier studies done on the

relationship of the GDP’s growth rate and capital structure (De Jong, Kabir & Nguyen, 2008). The second

hypothesis is not rejected. The results show a positive association between the growth rate of GPD and

capital structure. This variable follows the pecking order theory as well as the trade-off theory. SMEs will

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use more internal funds as the GDP grows. However, as the firms grows they will start to use more debt

if their internal finance is not enough to finance the increasing costs of investment (Bas, Muradoglu &

Phylaktis, 2009).

The change in inflation was measured with the change in the GDP deflator and shown in the table as

INFLATION. The results show an insignificant effect on capital structure of SME’s while maintaining a 5%

significance level. This is consistent with earlier studies where inflation also had an insignificant effect on

capital structure (Noguera, 2001). Inflation was expected to be negatively associated with capital

structures of SMEs, but the results show that they are positively associated with each other. This finding

is consistent with earlier studies where it was shown that firms use more debt in inflationary periods

(Modigliani, 1983). The deterioration of the real value may explain the positive association between

these variables. Deterioration of the real value leads to repayments being tax-deductible, which makes

borrowing more attractive (Jensen & Uhl, 2008). Therefore, we can reject the third hypothesis. The

variable inflation has a positive association with capital structure and is consistent with the trade-off

theory.

The relationship between capital structure and the change in interest rate is shown to be significant at a

5% significance level. The results show that the interest rate and capital structure are positively

associated with each other. Therefore, this variable does not follow the pecking order theory but follows

the trade-off theory, which suggest that as the interest rate increases they will use more external funds.

Firms should aim towards more debt financing due to the tax deductions associated with the interest

payments on debt (Modigliani & Miller, 1963). This encourages the use of more external finance as more

debt increases the after- tax earnings when the interest rate goes up. The fourth hypothesis is therefore

rejected and is consistent with the trade-off theory and not the pecking order theory, which was

originally believed.

5.2 Aggregated Firm Specific Variables

The empirical results from the regression analysis on the aggregated firm specific determinants are also

denoted in table (6). These findings are for the period 2009 to 2014, measured on an annual basis. The

relation between capital structure and turnover (TURNOVER) reveals a positive coefficient, indicating

that the two variables are positively associated with each other. This result is consistent with other

empirical research done on the relationship between size and capital structure (Jõeveer, 2006; Rajan &

Zingales, 1995). The trade-off theory suggests that more debt financing is weighted against the potential

cost of bankruptcy which is affected by de probability of default (Rajan & Zingales, 1995). According to

18

this theory, size is positively related to the capital structure (Jõeveer, 2006). Myers and Majluf (1984)

state that the bigger the firm, the lower the information asymmetry. Because information is an obstacle

for firms to borrow money, larger firms can get loans easier than smaller firms. The fifth hypothesis finds

support and cannot be rejected.

The relation between profitability (PROFIT) and capital structure is found to be negative as expected

with a significant probability. Previous studies which analysis the relationship between profitability and

capital structure also report a significant effect (Rajan & Zingales, 1995; Cassar & Holmes, 2003).

However, they only use a limited set of variables to test their hypothesis. In comparison to these earlier

studies, this paper includes additional aggregated firm specific variables to overcome a possible omitted

variable problem. The negative and significant result is consistent with the pecking order theory,

demonstrating that firms prefer to use internal sources of financing over external when profits are high.

Profitable firms generate enough internal funds to finance new projects, and therefore do not depend

as much on raising funds via an issue of debt. The sixth hypothesis is not rejected.

The general economic outlook variable (GVIEW) is also shown in table (6). According to the trade-off

theory, a negative relationship is to be expected. The results are significant, but show a positive

coefficient. The result is consistent with an earlier study carried out in Europe by Jensen and Uhl (2008),

but in contrast with other empirical findings (Devesa & Esteban, 2008). The sixth hypothesis is rejected

and it can be concluded that future growth opportunities cannot be explained by the trade-off theory.

Following the pecking order theory, firms who see growth opportunities will use retained earnings first

to finance new projects. However, it can be expected that these internal funds are not enough to

entirely finance these new projects. Therefore, SMEs will have to borrow additional capital.

The adjusted R-squared compares the explanatory power of regression models that contain different

number of predictors. It can be observed in table 7 that the adjusted R-squared for this regression is

above 50% (76%). This indicates that the model captures a good part of the variations in this regression.

Country- and aggregated firm specific variables should therefore not be neglected in capital structure

studies since they have a large explanatory power.

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N=66 Coefficient t-Statistic p-valueGDP -7.243 -2.17 0.034GDPGROWTH 7.315 2.3 0.025INFLATION 0.00003942 0.1 0.921INTEREST 0.078 2.11 0.04TURNOVER 0.391 3.19 0.002PROFIT -0.913 -6.92 0GVIEW 0.142 2.58 0.013DUMMY2010 -16.212 -2.6 0.012DUMMY2011 -21.583 -2.9 0.005DUMMY2012 -15.919 -2.97 0.004DUMMY2013 -24.681 -3.94 0DUMMY2014 -4.991 -1.04 0.303

Table.6 Regression Results

Adjusted R-Squared

0.761Table.7

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6 Conclusion

The aim of this paper was to find how certain variables may influence the capital structure of SME’s in

Europe. Through the course of the years much research has been conducted on this subject, yet most

studies were focused on firms in the United States. This study focuses only on the Small and Medium

firms mentioned in table 3. The aggregated data for the 11,720 firms in Europe is used for the period

2009 until 2014. The research on European countries is very limited. This paper is an attempt to add to

the existing pool of literature by analyzing how macro- and aggregated firm specific variables explain

capital structure changes using different theories. To answer the research question, 7 hypotheses were

formulated. To test these hypotheses data was gathered from the World Databank and from the Survey

on Access to Finance of Enterprises.

With the results obtained from testing the hypotheses the research question ‘To what extent do

macroeconomic variables and aggregated firm specific variables help in explaining the capital structure

in small and medium sized businesses in Western Europe’ can be answered.

The 7 variables which were studied in order to answer the research question were the 4 country specific

variables GDP per capita, GDP growth rate, inflation rate, interest rate and the 3 aggregated firm specific

variables Turnover, General Economic View and Profitability. The hypotheses constructed were based

on theories which were most commonly used to explain the variable in question.

The trade-off theory makes it possible to explain part of the capital structure of SMEs. Turnover is

significant positively related to the total debt ratio, as expected from theory. Interest rate is found to be

significant negatively related to the total debt ratio, which was not expected. SMEs use more debt

financing, because they receive tax deductions when the interest goes up. This makes it very attractive

to pursue more external financing. The last variable which can be explained by the trade-off theory is

the inflation rate. A negative relation was expected between inflation rate and capital structure, but the

results showed a positive relation instead. This variable can be explained by the trade-off theory, even

though it was not significant. Deterioration of the real value leads to repayments being tax deductible,

which makes debt more attractive than internal financing.

The pecking order theory also explains the debt policy in SMEs quite well. According to this theory SMEs

would prefer internal funds over external funds. Consistent with this theory, GDP growth leads to more

21

borrowing by SMEs. In the short run firms will use internal funds to finance new projects, but will switch

to external financing in the long run. This is explained by the fact that SMEs don’t have enough internal

funds to keep financing new project long term and therefore have to switch to external financing.

Another variable which is consistent with the pecking order theory is the variable Profitability. This

variable is significant negatively related to capital structure. Profitable firms generate enough internal

funds to finance new projects, and therefore do not depend as much on raising funds via an issue of

debt. The variables GDP and General Economic View were expected to be consistent with the trade-off

theory, but are explained by the pecking order theory instead. Most countries used in this study belong

to the richest countries in the world and may therefore indicate that firms inside these countries have

more retained earnings to finance themselves. More retained earnings will lead to SMEs having less

need for debt finance. The significant positive relation between General Economic View and capital

structure can be explained by the fact that most SMEs don’t have enough internal resources to fund

themselves. Therefore, they must seek additional capital to be able to invest in new projects.

Most of the variables did not show the relationship which was expected, based on the chosen theories.

Nevertheless, all but one was strongly significant. Most of the earlier studies only take one theory into

account while examining a firms’ capital structure, but this study has shown that both the pecking order

theory as well as the trade-off theory needs to be to be taken into account while studying a firms’ capital

structure. Furthermore, the results obtained in this study have shown that macroeconomic and

aggregated firm specific variables are an important aspect in explaining SME’s capital structure and

cannot be neglected.

The main downfall of this study is the narrow timeframe which was used. Further research could benefit

from choosing a longer period of time in order to study these determinants, and their effect on capital

structure, better. This study was also not sufficient enough to make a statement on which of the two

used theories are better in explaining the capital structure of SME’s. It is an attempt to identify

relationships between certain determinants and leverage. Future studies may want to use both theories

to examine the variables which affect the capital structure of SMEs.

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