1

Analysis of the most important factors for financing structure

- Case study: before vs. after crisis for U.S.A. -

Author: Onea Andreea

COORDINATOR:Prof. Univ. Dr. Anamaria Ciobanu

INTRODUCTION

This paper is developed in order to analyze and highlight, in the context of existing

theories and models until now, how the global economic crisis started in 2008 influenced the

financing decision and capital structure of U.S. pharmaceutical companies listed at New York

Stock Exchange, where the research and development expenses must be significant and

should not be reduced disregarding the economic context.

Part one of the paper describes the general aspects of financing a company. A number

of theories and models of capital structure have been developed over time by the most

important economists. These theories try to explain the percentage of debt and equity in

balance. The starting point for explaining the capital structure is considered to be Modigliani

and Millers theory, even if five years later this theory has been disputed, being considered a

model without a solid empirical foundation. But the capital structure theories developed later,

such as tradeoff theory, pecking order theory or agent theory have shown that an enterprise

can change the market value and the growth rate by changing the ratio between equity and

debt. These modern theories of capital structure take into consideration for establishing the

optimal structure of capital, taxes, costs due to lack of liquidity, information asymmetry, agent

costs, the effects of market imperfections and institutional constraints.

Titman and Wesselss paper (1988), The Determinants of Capital Structure

Choiceanalyzes the explanatory power of some recent theories of optimal capital structure.

Theories suggest that firms select the capital structure depending on the attributes that

2

determine different costs and benefits associated with debt and equity financing. The study

extends empirical evidence on capital structure in three ways presented in the extended thesis.

The results of this study show that companies with unique and specialized products have

relatively low debt indicators. In this context, uniqueness is given by research and

development expenses, sales expenses or the rate at which employees leave work voluntary.

Also, authors have noticed that small firms tend to use significantly more short-term debt than

larger firms.

The literature has been highlight a number of determinant of capital structure, which

are divided into two groups: on the one hand are external factors, including country-specific

economic framework where a particular company operates, and on the other hand specific

factors of comapnies that are linked to their performance. Most important external factors that

influence directly economic capital structure in different countries, are the macroeconomic

indicators. More specifically, it is inflation, interest rate and economic growth which lead to

cost and financing structure changes. Among internal factors, those that are specific to each

entity separately, we can mention the degree of profitability, firm size, assets tangibility,

bankruptcy costs and development opportunities.

Modigliani-Miller model, developed in 1958, is the first rigorous theoretical work with

the object of study to determine the financial structure of enterprises. The authors postulated

the existence of perfect capital markets, arguing that firms value does not depend on the

financing structure, in a given risk class. According to two authors, financing structure is

expressed by the debt ratio, which is equal to the ratio of debt financing (eg loans from banks,

government securities, etc..) and total business assets.

After the analysis made by the two authors, they found two sentences, as follows: the

first one indicates that a company's market value is independent of capital structure, in other

words the market value is constant regardless of the weight of debt and equity . The second

sentence supports the point that the average cost of capital of an enterprise does not vary with

the ratio between debt and equity, so it is not influenced by the indebtedness of the company.

Also, Modigliani and Miller found that the value of a company depends only on

income from its assets and not on the way in which the income is distributed between

dividends and accumulated profits.

3

In a new article, published in 1963, 5 years after developing the first model, the two

teachers cancel one of the initial hypotheses, the absence of taxation. Introducing taxation in

the analysis they have made it, and calculating the amounts of income directed to state from

the capital of investors, the two authors have developed two sentences: the amount of

indebted companies is the same with one of a company without debt (in the same class of risk

conditions), plus the gain resulting from financial leverage. The second sentence reffers to the

cost of equity of a indebted company which is equal to the cost of capital of a company

without debt, plus a risk premium that can be deduct from a number of factors such as: degree

of financial leverage, income tax rate, or the difference between cost of equity and borrowed

capital cost (the case of a company without debt).

Agent theory starts with Jensen and Meckling (1976) Theory of the Firm: Managerial

Behavior, Agency Costs and Ownership Structure. This paper focuses on aspects of agent

theory, property rights theory and the theory of finance, in order to develop a theory of the

firms ownership structure. The agent theory shows that leverage is directly proportional to

the importance of reputation management, enterprise value, treasury, and its liquidation value.

However, there is inverse relationship between leverage and interest rate, growth

opportunities and growth prospects of determining the cost of the company.

Information assymetry reserach began with Ross, Leland and Pyle (1977). Ross's

theory indicates that managers are those who hold the information in unaltered state on

business results and their distribution, and not investors. This aspect leads to a problem with

the weakness caused by lack of information of investors, resulting in an asymmetry of

information between individuals within the company, especially managers, and outside

persons, namely investors.

The economists Kraus and Litzenberger (1973) have developed a version of the

classical trade-off theory, which argues that optimal leverage shows a balance between tax

benefits of debt and bankruptcy costs. The two authors have introduced taxes and bankruptcy

costs in an econometric model of capital market conditions, resulting the idea that the market

value of an indebted company is the same as a company without debt plus the present value of

the reduction applied tax interest, less the present value of bankruptcy costs.

Pecking order theory was developed following two papers written in 1984 by Stewar

Myers and Nicholas Majluf, in order to try to highlight the costs of information asymmetry,

since investors dont know the true value of assets and business development opportunities, so

4

they can not properly evaluate the shares of the company, in order to finance other new

investements.

Part two presents the typology of existent models and analyses for developed

countries and for Romania. Also I tried to explian the necesity of perform the study before

and after economic crisis.

One of the most significant analyzes was the study realized by swedish researcher

Han-Suck Song, in 2004. He studied data from 6,000 Swedish companies, in a panel data

analysis, between 1992 and 2000, choosing three methods for measuring the level of debt,

according to their relevance and importance.The first was based on the ratio of total debt and

total assets, because this report represents the general definition of a companys. The second

method of measuring started from the long-term debt in total assets, in this case excluding

accounts payable, in particular for suppliers. The third method of measuring debt analyzed by

Han-Suck Song, refers to the ratio between debt and equity, which is considered the most

relevant method of calculation because it takes into account the impact of financing decisions

taken in the past .The conclusion reached by Han-Suck Song was that debt, disregardless of

the method of calculation, has determinants like the weight of fixed assets in total assets,

profitability and income variability. For the firms studied in that period, other factors,

including research and development expenditure ratio in turnover, have very low relevance

for debt.

The study of Murray Frank and Vidhan Goyal analyzed companies operating in the

U.S. and listed on the stock exchange, using data from the period 1950-2000, in order to

determine factors influencing the leverage. The two researchers studied 29 factors, but after

applying the model, the results demonstrate that are only 7 relevant factors, which provides

the model a strong basis. From the fact that the two researchers have found seven factors that

influence directly the leverage, it results that it is possible to find in the near future a unified

theory of the leverage.

Another baseline study on capital structure for firms in developed countries was

developed in 1988 by researchers Sheridan Titman and Roberto Wessels. They analyzed a

total of 469 firms using data for the years 1974 to 1982, and their model was based on the

study of eight explanatory variables for capital structure, as follows: the structure of assets,

taxation, growth, product uniqueness, industry classification, size, volatility and profitability.

Atfer applying the regression analysis, the two researchers have concluded that the most

5

relevant factors for the capital structure of studied enterprises were, in this order: the structure

of assets, uniqueness (measured as the ratio of research and development expenditures to

sales), industry classification, size, volatility and profitability.

The study developed by Nikolaos Daskalakis and Maria Psillaki in 2009 was based on

an analysis of panel data from a sample of companies from Greece, France, Italy and

Portugal, between the years 1998-2002. The two authors have made a comparison between

the four countries and between factors influencing capital structure for firms in each country.

Factors outlined and studied by the authors were the structure of the assets, firm size, growth

rate, profitability and risk.

Empirical studies in this area have been developed for the case of Romania too, by

Romanian researchers.

First of all, the study of Mihaela Dragot in 2005 (PhD thesis) - "Analysis of the determinants factors of financing policy of companies listed on capital markets' it main

objective was to identify policy issues with applicability on the case of firms acting on the

Romanian economic area. Period analyzed in this study was between the years 1997 - 2003,

on a sample of about 50 companies listed on Bucharest Stock Exchange, whose assets were

approximately 10% -11% of GDP. The author of the paper has used a number of five

indicators and divided the periodbetween two sub-periods, noting that the first sub-period the

indebtedness degree had higher values, taking into account the fact that the indicators were

expressed in market values and thus the undervaluation of listed secutrities reduced the value

of market capitalization.

The study of Dan Nicolae Ivanescu (PhD thesis) - "Analysis of the determinants of

financial structure of the company" started also from a sample of Romanian companies listed

on Bucharest Stock Exchange. A first result was a very low proportion of long-term debt due

to high costs of Romanian companies resources. The main source of financing is the equity,

followed by liabilities of operations and financial liabilities. As stated in previous subsections,

financing and capital structure are strongly influenced by the macroeconomic environment,

through inflation, interest rate, exchange rate etc.

The last part of chapter two was dedicated to analyze the opportunity of developing

the model for Romanian economy. In the case of Romania, the drastic decrease in

consumption since 2010, political instability and the tendency of banking to grant loans in

6

much difficult conditions until the crisis in our country, have led to environmental

degradation and economic fluctuations in the finance business and external factors were more

important than internal ones in the capital structure of Romanian companies.We considered it

appropriate to conduct a survey on the U.S. economy, specifically the pharmaceutical

companies listed on stock exchanges, because it can be accurately highlight the factors that

influenc capital structure, especially their evolution after the outbreak of the crisis, compared

with the period immediately preceding the crisis.

Part three starts withthe study based on a sample of 70 companies listed on the New

York Stock Exchange, analyzed on the period 2006-2011. Because I thought it is important to

observe the effects of economic crisis, this period was divided into two sub-periods, namely

2006 - 2008, respectively from 2009 to 2011. Financial and accounting information necessary

for the study were obtained from several sources, but the main site that provides this type of

information is http://pages.stern.nyu.edu/~adamodar/ created by Aswath Damodaran,

Professor of Finance at the University of New York.

Choosing a variable indicating a fairly indebtedness of a firm is not a standard

procedure and there are several indicators that can illustrate the indebtedness. Over time, in

the literature, were found several methods of calculating indebtedness, and of all we find that

the most suitable for this analysis is indicatorTotal Debt / Total Assets, which will be the

dependent variable in the presented model. After justify the selection made for the calculation

of indebtedness, we still must find the relevant factors which influence it. Thus, for

determining the economic indicators that are important in the capital structure, we performed

a wider selection of indicators that can become explanatory variables in a regression equation

for determining the degree of indebtedness, and after a descriptive analysis we selected only

those indicators relevant to the study.

Atfer performing the descriptive statistic tabel, we observed that the average of

leverage was 34,2%. Also we find an average of 13,6% of tangible assets and the market-to-

book-value (MBR) shows growth possibilities of the enterprise, its average is higher than one

suggesting possibility of increasing investments in these companies, at least for the period

studied. The average value of 11.83 which indicates the weight of R & D expenditures in total

turnover shows that U.S. pharmaceutical companies directs large sums of money to this

department. In the second period, 2009 2011, indebtedness increased by 11.6 percentage

7

points to 45.8% value, which is somewhat surprising, since the crisis, risk and fear of debt in

a turbulent period of global economy supposed to lead to lower leverage.

To quantify the relationship and correlation of chosen indicators it is essential to

effectuate the correlogram, with which we can determine whether or not exist a strong a

correlation between two or more indicators. Because indicators like CPR/AT (equity / total

assets) and LNCA (logharitm of size) are strongly correlated with some of the other

indicators, the risk of distorting the regression equation coefficients by decreasing its

significance is very high. As these two parameters directly influence other indicators, they

will not take account in the econometric model in order to determine factors and their

influence on capital structure.Regarding GROWTH indicator, it was removed from the

analysis because in the regression analysis for 2006-2008, it showed statistically

insignificant,because its associated coefficient had a probability of 39%,and the relevance

level at which we work is 5%.

The regression equation for 2008 has the following form:

From this determination function of indebtedness, we observe that the greatest

influence has assets tangibility (TANG), while the value of the ratio of R & D expenses

(RDCA) has almost no influence on leverage. The only variable that has a negative influence

is profitability, explained by the reduction trend of debt when profitability increases. Assets

tangibility increases leverage because lenders require tangible assets as collateral for loans, so

the more assets tangibility is higher, the greater is the indebtedness.

For the comparative analysis before versus after economic crisis, the results are

similar. For the analysis before the crisis we have the following results:

The coefficient of determination R-square, with a high value of 0.88 indicates that

leverage changes are well explained by variations in the other variables. Thus, we can state

that leverage is influenced to a large extent by the values of the factors that compile the

independent variables.Durbin-Watson test (DW) can range between 0 and 4, and a value less

than 2 signifies a positive autocorrelation, and when is greater than 2 there is a negative

autocorrelation at a significance level . Obviously, a value of DW around 2 indicate lack of

8

autocorrelation. In our test, Durbin - Watson has a value of 2.25, being the threshold of

acceptability of the hypothesis that there is no residual autocorrelation variable.

For the analysis after the economic crisis, the coefficient of determination R-square

has a similar value, of 0,89, but the Durbin-Watson test indicates a value of 2,59 so the errors

are negative autocorrelated. One of the most important conclusions is based on comparing the

results obtained in the two periods analyzed, as follows:

a) Profitability decreased leverage influence after the crisis, so the coefficient of this

indicator reduced to a value close to zero which means that its influence decreased

significantly after establishment of the crisis. This indicates that profitable companies were

not financed from loans during economic prosperity, while during the crisis, profitability has

not influenced the financing decision of the companies so much. Market instability and falling

investor confidence have led to this situation.

b) Assets tangibility maintained constant influence on leverage. This is by far the

indicator which largely determine the degree of leverage, so that, in times of economic crisis

and in the preparatory too, companies with high assets tangibility have shown a trend towards

debt. The reason is that credit grantors take measures to protect themselves, demanding

tangible assets as collateral. When assets tangibility is higher, the rise will increase lenders to

lend, thus increasing indebtedness.

c) The influence on leverage of the ratio of market value and book value has increased

slightly but it remained very low, but not negligible. Explanation of the positive influence of

this report is given by the fact that a change upward in the market value of an enterprise

involves new investments for production, development and innovation, investments that

companies prefer to do by increasing debt, despite economic crisis .

d) The ratio of research and development expenses to sales has no significant impact

on leverage in any of the periods studied. There is one change in sign of the coefficient of this

indicator caused by the establishment of crisis, from plus to minus. This can show future trend

to an inverse relationship between leverage and the ratio of R & D expenses amid economic

recession. This is explained by the fact that pharmaceutical companies tend not to debt during

the crisis to support research and development department, despite the potential high costs for

this activity.

9

The way in which the influence of the factors listed above has determined the capital

structure in the two periods studied, show us that the impact of economic crisis on the

financial statements of U.S. pharmaceutical companies was not so severe, and they continue

to be attractive for investors, to realize investments, to fall into debt, even more than the

period preceding the full installation of the economic crisis.

One of the main conclusions of this paper is that the assets tangibility is the most

important variabile that has a great influence on the debt of a company, and, more than this,

its influence wasnt affected by the crisis at all. In the opposite way, the explanatory variabile

that had almost no influence on the financing structure was the ratio of research and

development costs over the income of a company. From another point of view, I can say that

the theory that best suits the studied companies is the pecking order theory.

Another important conclusion of this study is that the debt of companies that sell

indispensable products (that have an inelastic demand) doesnt shrink during recession

periods, because the pharmaceutical enterprises studied had increased their debt after 2008,

using tangible assets as loan securities.

As a future research direction, I can say that it would be very interesting to investigate

how does the financing structure and debt of these companies evolves after the end of the

financial crisis, thus completing an entire economic cycle. This can be later transformed into a

general model that could provide help for those who make decisions regarding optimal

financing structure, so that the financing of a company will imply a lower risk and also

provide a greater company value.

BIBLIOGRAPHY

Amdur, David, (2009) Capital Structure over the Business Cycle, Georgetown University

Department of Economics, Working Paper No. 580

Booth, Laurence, Varouj, Aivazian, Demirgue-Kunt, Asli i Maksimovic, Vojislav (2001) Capital Structures in Developing Countries, The Journal of Finance, Vol. 56, No. 1, pag.

87-130

Baker, Malcolm, Stein, Jeremy, i Wurgler, Jeffrey (2002) When Does the Market Matter? Stock Prices and the Investment of Equity-Dependent Firms, NBER Working Papers, pag. 9

10

Baker, Malcolm i Wurgler, Jeffrey (2002) Market timing and capital structure, Journal of Finance, vol. 57, pag. 1-32

Ciobanu, Anamaria (2006) Analiza performanei ntreprinderii, Editura ASE, Bucureti Daskalakis, Nikolaos i Psillaki, Maria (2009) Are the determinants of capital structure country or firm specific?, Small Business Economics, Springer, vol. 33(3), pag. 319-333

Dragot, Mihaela (2005) Analiza factorilor determinani ai politicii de finanare a societilor comerciale listate pe piaa de capital, Editura ASE, Bucureti Dragot, Mihaela (2006) Decizia de investire pe piaa de capital, Editura ASE, Bucureti Dragot, Mihaela, Dragot, Victor, Obreja Braoveanu, Laura i Semenescu, Andreea (2008) Capital structure determinants: a sectorial analysis for the Romanian listed companies,

Economic Computation and Economic Cybernetics Studies and Research, vol. 1-2

Dumitrescu, Dalina, Ciobanu, Anamaria (2002) Evaluarea ntreprinderilor, Editura

Economica, Bucureti Frank, Murray i Goyal, Vidhan (2007) Capital Structure Decisions: Which Factors are Reliably Important?

Harris, Milton i Raviv, Artur, (1991). The theory of Capital Structure, Journal of Finance, vol.46

Hayne, Leland i Pyle, David (1977) Informational Asymmetries, financial structure, and financial intermediation, The Journal of Finance, Vol. 32, No. 2

Hirshleifer, David i Thakor, Anjan (1992) Managerial conservatism, project choice, and debt, The Review of Financial Studies, Vol. 5, No. 3, pag. 437-470

Jensen, Michael i Meckling, William (1976) Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure

Korajczyk, Robert i Amnon, Levy (2002) Capital structure choice: macroeconomic conditions and financial constraints, Journal of Financial Economics, No. 68, pag. 75-109

MacKay. Peter i Phillips, Gordon (2002) Is there an optimal industry financial structure?, National Bureau of Economic Research, Working Paper No. 9032

Mayer, Colin i Sussman, Oren, (2004) A New Test of Capital Structure, University of Oxford

Modigliani, Franco i Miller, Merton (1958) The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review, Vol. 43, No. 3, pag. 261-297

Myers, Stewart (2001) Capital Structure, The Journal of Economic, Vol. 15, No. 2, pag. 81-

102

11

Rajan, Raghuram i Zingales, Luigi (1995) What do we know about capital structure? Some evidence from International Data Journal of Finance, vol. 50, pag. 1421-1460

Ralf, Elsas, Mark, Flannery i Jon, Garfinkel, (2006) Major Investments, Firm Financing Decisions, and Long-run Performance

Ross, Stephen (1977) The Determination of Financial Structure: The Incentive-Signalling

Approach, The Bell Journal of Economics, Vol. 8, No. 1., pag. 23-40

Song, Han-Suck (2004) Capital structure determinants. An Empirical Study of Swedish

companies, Stockholm

Stiglitz, Joseph, (1969). A re-examination of the Modigliani-Miller theorem. The American

Economic Review, vol. 59, pag. 784-793.

Stiglitz, Joseph, (1988) Why Financial Structure Matters, The Journal of Economic

Perspectives, vol.2, pag 121.

Titman, Sheridan (2001) The Modigliani and Miller theorem and market efficiency,

National Bureau of Economic Research, Working Paper No. 8641

Titman, Sheridan i Wessels, Roberto (1988), The Determinants of Capital Structure Choice, The Journal of Finance, Vol. 43, No. 1, pag. 1-19

Tudose, Mihaela (2006) Gestiunea capitalurilor ntreprinderii. Optimizarea structurii

finaciare, Ed. Economic, Bucureti, pag 103 Ursu, Gabriel (2010) Optiuni de finanare ale firmelor n economiile emergente, Tez de doctorat, Univ. Alexandru Ioan Cuza, Iai http://pages.stern.nyu.edu/~adamodar/ - informaii financiare pentru popularea bazei de date http://nasdaq.com/ - informaii financiare pentru popularea bazei de date http://investing.businessweek.com - informaii financiare pentru popularea bazei de date