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The determinants of capital structure: evidence
from selected ASEAN countries
Ng Chin Huat
Bachelor of Accountancy (Hons)The Northern University of Malaysia
Sintok, KedahMalaysia
1995
Submitted to the Graduate School of Business
Faculty of Business and Accountancy
University of Malaya in partial fulfillment
of the requirements for the Degree of
Master of Business Administration
December 2008
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The determinants of capital structure: evidence from selectedASEAN countries
By Ng Chin Huat
Abstract
Corporate structure is an important research area in corporate finance and it remains
the core of literature studies for academicians. However studies had focused on firms
in developed countries and little attention on how firms in developing and emerging
market decide on their capital structure strategy. Therefore this study attempts to fill
the gap by analyzing the capital structure for listed firms in the ASEAN region.
The sample comprises 155 listed companies from four selected ASEAN main stock
exchange index-links components for the period from 2003 to 2007.
The study found profitability and growth opportunities for all selected ASEAN
countries exhibit statistical significant of inverse relationship with leverage whereas
non-debt tax shield has significant negative impact on leverage as for Malaysia index
link companies only. Firm size gave a positive significant relationship for Indonesia
and Philippine index link companies. As for the four country-effect factors; stock
market capitalization and GDP growth rate show significant relationship with
leverage while bank size and inflation indicate insignificant impacts on leverage.
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Acknowledgements
To my beloved family and friends, who have constantly been supportive and
understanding throughout my MBA study, I owe great thanks. Specifically, I owe the
greatest debt to my parents who have been an important motivation for this thesis and
who continually provide role models. This work is devoted to them.
It has also been an enormous challenge to maintain motivation, quality and innovation
within a balanced research dissertation. I would like to record my sincere thanks and
appreciation to my supervisor, Mr. Gurcharan Singh A/L Pritam Singh, for his prompt,
constructive guidance, and continued support given to me during my dissertation
work. Special thank to Dr. Rubi binti Ahmad, my second examiner for her positive
comments.
Finally, I also wish to extend my gratitude and special thanks to the lecturers and staff
of Graduate Business School, University of Malaya for their valuable coaching and
insights throughout my MBA course.
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Table of Contents
Abstract ..........................................................................................................................ii
Acknowledgements.......................................................................................................iii
List of Tables ...............................................................................................................vii
List of Symbols and Abbreviations ............................................................................viii
CHAPTER 1: INTRODUCTION..................................................................................1
1.1 Background....................................................................................................1
1.1.1 Overview of ASEAN.................................................................................3
1.2 Problem Statement .........................................................................................4
1.3 Research Questions/Objectives of the Study .................................................6
1.4 Purpose and Significance of the Study ..........................................................8
1.5 Scope of the Study .........................................................................................9
1.6 Limitations of the Study ..............................................................................11
1.7 Organization of the Study ............................................................................12
CHAPTER 2 : LITERATURE REVIEW ..................................................................13
2.0 Chapter Overview ........................................................................................13
2.1 Introduction..................................................................................................13
2.2 Capital structure in a perfect market............................................................15
2.2.1 The Modigliani and Miller Propositions..................................................15
2.3 Capital structure in the real world................................................................16
2.3.1 Trade-off theory .......................................................................................16
2.3.2 Asymmetric information..........................................................................18
2.4.3 Agency Costs ...........................................................................................22
2.4 New development in capital structure .........................................................24
2.4.1 Shocks to the capital structure and adjusting behavior ............................24
2.4.2 Dynamic adjustment to target leverage and adjustment speed ................25
2.4.3 Major real investments.............................................................................26
2.4.4 Macroeconomic shocks............................................................................27
2.4.5 Rating.......................................................................................................27
2.4.6 Behavioral corporate finance ...................................................................28
2.5 Related literature on the international capital structure ...............................30
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2.5.1 Capital structure around the world: The roles of firm- and country-
specific determinants by De Jong et al. (2008)....................................................30
2.5.2 The determinants of capital structure: evidence from the Asia Pacific
region by Deesomsak et al. (2004). .....................................................................31
2.5.3 Determinants of Capital Structure: Evidence from the G-7 Countries byAggarwal and Jamdee (2003). .............................................................................32
2.5.4 Capital structure in developing countries by Booth et al. (2001). ...........34
2.6 Determinants of capital structure .................................................................35
2.6.1 Country-specific determinants .................................................................36
2.6.2 Firm-specific determinants ......................................................................40
2.7 Chapter Summary ........................................................................................45
CHAPTER 3 : RESEARCH METHODOLOGY ......................................................46
3.0 Chapter Overview ........................................................................................46
3.1 Development of Hypotheses ........................................................................46
3.1.1 Profitability ..............................................................................................46
3.1.2 Growth opportunities ...............................................................................47
3.1.3 Non-debt Tax Shield ................................................................................48
3.1.4 Firm size ..................................................................................................48
3.1.5 The size of the banking industry and stock market development. ...........48
3.1.6 GDP growth rate. .....................................................................................49
3.1.7 Inflation....................................................................................................49
3.2 Selection Measures ......................................................................................50
3.2.1 Leverage...................................................................................................50
3.2.2 Size of the banking industry and stock market ........................................51
3.2.3 GDP growth rate ......................................................................................52
3.2.4 Inflation....................................................................................................52
3.2.5 Profitability ..............................................................................................52
3.2.6 Firm growth .............................................................................................52
3.2.7 Non-debt Tax Shield ................................................................................53
3.2.8 Firm size ..................................................................................................53
3.3 Sampling Design..........................................................................................53
3.4 Data Collection Procedure ...........................................................................56
3.5 Data Analysis Techniques ...........................................................................57
3.6 Chapter Summary ........................................................................................58
CHAPTER 4 : RESEARCH RESULTS....................................................................59
4.0 Chapter Overview ........................................................................................59
4.1 Summary Statistics ......................................................................................59
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4.1.1 Dependent variable (Leverage)................................................................59
4.1.2 Firm-specific independent variables ........................................................60
4.1.3 Fixed country effects analysis of the determinants of leverage in the
selected ASEAN ..................................................................................................62
4.2 Analyses of Measures ..................................................................................634.2.1 Test of non-stationary ..............................................................................63
4.2.2 Test of multicollinearity...........................................................................65
4.2.3 Test of autocorrelation .............................................................................66
4.2.4 Test of heteroskedasticity ........................................................................67
4.3 Testing of Hypotheses .................................................................................68
4.3.1 Cross-sectional results for individual countries and firm-specific effects
over the whole sample period ..............................................................................68
4.4 Chapter Summary ........................................................................................74
CHAPTER 5 : CONCLUSION..................................................................................75
5.0 Chapter overview .........................................................................................75
5.1 Discussion and Conclusion ..........................................................................75
5.1.1 Summary of findings ...............................................................................75
5.2 Suggestions for Future Research .................................................................79
5.3 Policy implication ........................................................................................80
5.4 Chapter Summary ........................................................................................81
References....................................................................................................................82
Appendix 1: List of Companies Selected ....................................................................91
Appendix 2: Description of Variables and Data Sources ............................................94
Appendix 3: Unit Root Test.........................................................................................95
Appendix 4: Autocorrelaton Test ..............................................................................102
Appendix 5: Decision Rules of Durbin-Watson d Test .............................................105
Appendix 6: Multicollinearity Test............................................................................106
Appendix 7: White’s Heteroskedasticity Test (With Cross Terms) ..........................108
Appendix 8: Final Multiple Regression Results........................................................109
Appendix 9: Summary of Predictions........................................................................112
Appendix 10: Summary of Hypotheses Testing Results ...........................................113
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List of Tables
Table 1.1 Selected Basic ASEAN Indicators 3
Table 3.1 List of Stock Exchanges in Selected ASEAN Countries 53
Table 4.1 Statistics of Leverage Ratio 59
Table 4.2 Statistics of Firm-specific Independent Variables 60
Table 4.3 Statistic of Country-specific Determinants 62
Table 4.4 Summary Result of Unit Root Test Using ADF 64
Table 4.5 Pairwise Correlation Matrix Between Explanatory Variables 65
Table 4.6 Summary of Durbin-Watson Test 66
Table 4.7 Summary of White’s Test (Cross Terms) 67
Table 4.8 Firm Specific Analysis of Determinants of Leverage 69
Table 4.9 Country Effects Analysis of Determinants of Leverage 72
Table 5.1 Summary of Firm-specific Determinants 75
Table 5.2 Summary of Country-specific Determinants 77
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List of Symbols and Abbreviations
ADF Augmented Dickey-Fuller
ASEAN Association of South-East Asian Nations
BANK Private credit by deposit bank over GDP
BLUE Best linear unbiased estimator
CEO Chief executive officer
CFO Chief financial officer
EBIT Earnings before income tax
EBITDA Earnings before income tax, depreciation and amortization
G-7 Group of Seven (Canada, France, Germany, Italy, Japan,
United Kingdom and United States of America)
GDP Gross Domestic Product
GDPRATE Gross Domestic Product growth rate
GROWTH Firm’s growth opportunities
LEVRATIO Leverage ratio
MM Modigliani and Miller
NDTS Non-debt tax shield
INF Annual inflation rate
OECD Organization of Economic Co-operation and Development
OLS Ordinary least square
NPV Net present value
PROFIT ProfitabilityR&D Research and development
ROA Return on assets
SIZE Firm size
STKMKT Stock market capitalization over GDP
U.S. United States of America
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CHAPTER 1: INTRODUCTION
1.1
Background
For the past fifty years after the influential irrelevance theory of Modigliani and
Miller (1958) on capital structure, academicians have debated rigorously on this
capital structure theory through many empirical studies (example in Harris and Raviv,
1991 in their article “The theory of capital structure”). In order to approve or dispel
the irrelevance theory, others have studied the determinants of firms’ capital structure
choices with frictions such as agency signaling costs (Heinkel, 1982; Poitevin, 1989),
bankruptcy (Ross, 1977), taxes (Leland and Toft, 1996), institutional and historical
characteristics of national financial systems (La Porta et al., 1997, 2006; Rajan and
Zingales, 2003), but the understanding of the determinants of national and
international capital structure is still limited and vague (Aggarwal and Jamdee, 2003).
In the early years, firms in United States were the primary source of these research
studies and the coverage was extended to Europe and Japan in mid of 1980s (Kester,
1986; Rajan and Zingales, 1995; Cornelli et al., 1996). In the aftermath of the Asian
financial crisis in 1997, efforts were focused on emerging countries to shed some light
on the factors that caused the turmoil in the region. Despite of this attempt, however,
there have been only a few studies thus far because of the constraints on corporate
financial data in the region (Fan and Wong, 2002; Deesomsak et al., 2004; Driffield et
al., 2007). Moreover, still very little is understood about the determinants of the
firm’s financial structure outside the United States and major developed countries,
with only a few researches analyzing international data (Rajan and Zingales, 1995;
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Booth et al., 2001; Antoniou et al., 2002; De Jong et al., 2008). Undoubtedly, there
is not enough evidence on how theories formulated for firms operating in the major
developed markets can be applied to firms outside these markets coupled with
differential in institutional and legal frameworks. Consequently, incomprehensive
conclusions and puzzling questions are left either partially or completely unanswered
in the area of international capital structure. With the pressing globalization trend,
managers of today need to be readily equipped with in-depth knowledge of
international capital structure in strategizing crucial capital structure decisions and
this remains one of the key success factors of their firms’ survival.
The knowledge of capital structures has mostly been derived from data from
developed economies that have many institutional similarities. The purpose of this
paper is to analyze the capital structure choices made by companies from developing
countries that have different institutional structures. The prevailing view, for example
Mayer (1990) seems to be that financial decisions in developing countries are
somehow different. For example, Mayer (1990) is the most recent researcher to use
aggregate flow of funds data to differentiate between financial systems based on the
"Anglo-Saxon" capital markets model and those based on a "Continental-German-
Japanese" banking model. However, because Mayer’s data comes from aggregate
flow of funds data and not from individual firms there is a problem with this
approach. The differences between private, public, and foreign ownership structures
have a profound influence on such data, but tell nothing about how profit-oriented
groups make their individual financial decisions.
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1.1.1 Overview of ASEAN
The Association of South-East Asian Nations (commonly known as ASEAN) is a
geopolitical and economic organization of ten countries located in South-East Asia,
which was formed on 8 August 1967 by five founding members, namely Indonesia,
Malaysia, Philippines, Singapore and Thailand. Subsequently other member states
joined ASEAN - Brunei (1984), Vietnam (1995), Laos and Myanmar (1997) and
Cambodia (1999). Its main objectives are to accelerate economic growth, social
progress and cultural development in the region; and promote regional peace and
stability. As of 2007, the ASEAN has a population of about 575 million, a total area
of 4.5 million square kilometers, a combined gross domestic product of almost
US$1,282 billion, and a total trade of about US$1,405 billion as shown in Table 1.1.
Table 1.1Selected Basic ASEAN Indicators
Growthrate ofGDP GDP Merchandise trade
Total landarea
Totalpopulation
Atconstant
pricesat current
prices Exports Imports Total trade
km2 Thousand Percent US$ million US$ million US$ million US$ million
Country 2007 2007 2007 2007 2006 2006 2006
Brunei 5,765 396 0.6 12,317.00 7,619.40 1,488.90 9,108.30
Cambodia 181,035 14,475 10.1 8,662.30 3,514.40 2,923.00 6,437.40
Indonesia 1,890,754 224,905 6.3 431,717.70 100,798.60 61,065.50 161,864.10
Lao PDR 236,800 5,608 6 4,128.10 402.7 587.5 990.2
Malaysia 330,252 27,174 6.3 186,960.70 157,226.90 128,316.10 285,543.00Myanmar 676,577 58,605 5.6 12,632.70 3,514.80 2,115.50 5,630.30
Philippines 300,000 88,875 7.4 146,894.80 47,410.10 51,773.70 99,183.80
Singapore 704 4,589 9.3 161,546.60 271,607.90 238,482.00 510,089.90
Thailand 513,120 65,694 4.8 245,701.90 121,579.50 127,108.80 248,688.30
Viet Nam 329,315 85,205 8.5 71,292.10 37,033.70 40,236.80 77,270.50
ASEAN 4,464,322 575,525 6.5 1,281,853.90 750,708.00 654,097.80 1,404,805.80
(Sources: ASEAN Finance and Macro-economic Surveillance Unit Database and ASEAN Statistical Yearbook 2006, ASEANTrade Database as of 18 July 2007, IMF World Economic Outlook Database as of October 2007)
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1.2 Problem Statement
Capital structure decision remains one of the important strategies to corporate
manager because it affects firm’s value. For instance, Damodaran (2001) states that if
the objective in corporate finance is to maximize firm value, then firm value must be
linked to the three decisions: investment, financing and dividend.
Ross (1977)’s model suggests that the values of firms will rise with leverage, since
increasing leverage increases the market’s perception of value. Suppose there is no
agency problem, i.e. management acts in the interest of all shareholders, the manager
will maximize company value by choosing the optimal capital structure: highest
possible debt ratio. High-quality firms need to signal their quality to the market, while
the low-quality firms’ managers will try to imitate. According to this argument, the
debt level should be positively related to the value of the firm.
McConnell and Servaes (1995) find that high-growth firms’ corporate value is
negatively correlated with leverage, whereas for low–growth firms’ corporate value is
positively correlated with leverage.
Stulz (1990) argues that debt can have both a positive and negative effect on the value
of the firm. He develops a model in which debt financing can both alleviate the over-
investment problem and the under-investment problem and assumes that managers
have no equity ownership in the firm and receive utility by managing a larger firm.
The power of manage may motivate the self-interest managers to undertake negative
present value projects. To solve this problem, shareholders force firms to issue debt.
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But if firms are forced to pay out funds, they may have to forgo positive present value
projects. Therefore, the optimal debt structure is determined by balancing the optimal
agency cost of debt and the agency cost of managerial discretion.
From the above discussion, it is proven that capital structure is one of the main drivers
for firm’s value. However many empirical studies are done in the developed
countries such as United States, Europe and Japan (Rajan and Zingales, 1995;
Cornelli et al., 1996) and only a few research are in the Asia region (Fan and Wong,
2002; Deesomsak et al., 2004; Driffield et al., 2007). Hence the question whether the
capital structure determinants in the developed countries could also be replicated to
developing countries remains ambiguous due to differences in institutional and
historical environments (Jack and Ajit, 2003). No study has been done using
specifically the ASEAN’s firms to analyze the capital structure and its determinants.
Even though there are studies focused on national level [Wiwattanakantang (1999) for
Thailand; Suto (2003) for Malaysia; Prasad et al. (2003) for Thailand and Malaysia],
there is no study on cross-country comparison between ASEAN countries.
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1.3 Research Questions/Objectives of the Study
In this research, in line with the problem statement as above, a few objectives are
outlined as the guiding principle to this study. The focus of this paper is to on
answering the three questions:
1. Do corporate leverage decisions differ significantly between developing and
developed countries?
Previous studies have mainly focused on the developed countries in analyzing the
capital structure decision but researches in the developing countries are limited. Thus
one of the objectives of this study is to analyze corporate leverage decisions in
ASEAN region as they are in the emerging and developing market. Thereafter the
comparison between developed and developing countries will be done to examine any
significant different in their corporate leverage decisions.
2. Are the factors that affect individual countries’ capital structures similar between
developed and developing countries?
In this objective, the factors that influence the capital structure in the developed
countries are extended to the developing countries in order to observe any significant
differences among them (Rajan and Zingales, 1995; Booth et al., 2001). In this
context, comprehension of the linkages between both categories will benefit managers
in deciding capital structure strategy in era of globalization.
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3. Are the predictions of conventional capital structure models improved by knowing
the nationality of the company?
In this objective, this study tries to determine whether the predictions of capital
structure decisions can be improved by linking the nationality of the company with
the conventional capital structure models. With this knowledge, managers will have a
competitive advantage in formulating their capital structure strategy by knowing the
nationality of the company, particularly in ASEAN members.
In order to answer the above questions, the objectives are geared toward the
following:
(a) To examine the country-specific determinants such as size of banking
industry, stock market, and GDP growth and inflation in relation to the capital
structure.
(b) To examine the firm-specific determinants such as profitability, growth
opportunities, non-debt tax shield and size in relation to the capital structure.
(c) To determine which of the capital structure theories are pertinent to ASEAN
listed companies in order to adopt a more efficient financing mix.
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1.4 Purpose and Significance of the Study
The purpose of this study is to examine the determinants of capital structure at both
country and firm levels to further the understanding of the different characteristics of
capital structure in the selected ASEAN countries (Malaysia, Indonesia, Philippines
and Thailand). As each country has its own uniqueness, the results of this study will
be useful in understanding which theories of capital structure are robust to such
differences.
The main contribution of this study is to provide valuable knowledge of cross border
comparison of the capital structure determinants in the context of developing and
emerging markets, in general; and specifically ASEAN to academicians and
practitioners. This is to complement the abundant literatures of capital structure done
in developed countries such as United States and Europe (Auerbach, 1985; Titman
and Wessels, 1988; Rajan and Zingales, 1995; Cornelli et al., 1996; Wald, 1999; Hall
et al., 2004).
In addition, with the most recent data available in this study, the development of
capital structure after the Asian financial crisis could also be evaluated in view of the
changing in financial markets and economic conditions.
Previous studies using Asia Pacific companies are limited and almost none
concentrating in ASEAN countries (published studies include Wiwattanakantang,
1999 for Thailand; Fan and Wong, 2002 and Driffield et al., 2007 for East Asia; Suto,
2003 for Malaysia; Prasad et al., 2003 for Thailand and Malaysia; Cassar and Holmes,
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2003 and Zoppa and McMahon, 2002 for Australia; Deesomsak et al., 2004 for Asia
Pacific region; Fattouh et al., 2005 for South Korea). Hence this study intends to fill
this gap by analyzing capital structure determinants based on ASEAN countries.
Lastly, the findings of this study may provide valuable insights in term of the
complexity and robustness of capital structure decisions to the corporate managers in
the global market.
1.5 Scope of the Study
In the area of any study, it’s expected to encounter numerous issues such as the
concentration of field study, data collection and others which are constraint by
available resources like timeframe, monetary and availability of information. This
study is of no exceptions where the scope is limited to the study of capital structure in
the corporate finance field, the sample size and lastly the time period of study. The
detailed of the scope of this study are as follows:
(a) The sample companies will be selected from the main stock indexes from four
Stock Exchanges in the ASEAN region. The entire population of listed companies in
the four Stock Exchange is 2,131 with total market capitalization of US$837,119
million as at 31 December 2007 (World Federation of Exchanges 2007). However the
sampling is from 275 companies, merely a 13 percent of population but representing
over 70 percent of total capitalization except for Philippine being only 54 percent.
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(b) Four countries representing ASEAN are selected, namely Malaysia, Indonesia,
Philippines and Thailand out of ten countries. The choice of countries is motivated by
several factors. Firstly, they are all being the emerging market where the literature on
determinants of capital structure is limited. Secondly, they are hit severely in the
Asian financial crisis in 1997. Thirdly, they share the common attributes in
accounting practices, corporate governance and corporate control.
(c) As for companies selected, only non-financial firms were used. This is due to
the reasons that financial firms such as banks and insurance companies’ leverage are
strongly influenced by investor insurance schemes. Furthermore, their debt-like
liabilities are not strictly comparable to the debt issued by non-financial firms.
Finally, regulations such as minimum capital requirements may directly affect capital
structure.
(d) The sample companies are not categorized into industry classification due to
the small sample size. However as the listed companies are index-linked stocks,
there is requirement for sector representation; hence no further work is performed on
the industry classification effect.
(e) The study period for the study is five years from year 2003 to 2007. They
represent the most current data available and are obtained from the Bloomberg,
Financial Times and Reuters database. The financial information for last five years
will be extracted for the 155 index link companies from selected ASEAN countries.
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1.6 Limitations of the Study
As for the limitation, the following are expected:
(a) The study is restricted to the sampling from stock indexes of the Stock
Exchanges in the four ASEAN countries; the result may be biased towards big and
well established firms and may not be a good representative for the population of the
firms in ASEAN countries taking into account of the fact that there are many small
and medium-sized companies. However this reflects a better representation as having
high percentage in asset capitalization of the firms listed.
(b) This study has not taken into account the difference in accounting policy
adopted by various countries, in particular the depreciation charges (proxy for non-
debt tax shield variable). However as the companies are public listed companies,
they generally follow the internationally accepted accounting standard in their
accounting policy as required by their reporting country authorities.
(c) This study has not employed country dummy variables when analyzing the
country-specific factors as to reduce the complexity of the multiple regression
equation as there are four countries involved and to mitigate this problem, pooling of
all listed companies in four countries is used.
(d) The study period may be too short, i.e. from the year 2003 to 2007.
Nevertheless, this study is to see the immediate effect of the capital structure
decisions after the Asian financial crisis.
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1.7 Organization of the Study
The remainder of the paper proceeds as follows: Chapter Two will review the main
theoretical framework such as country-specific factors (macroeconomics); and firm-
specific determinants affecting capital structure. Chapter Three provides the research
methodology along with the description of the database, data structure, hypotheses
and analysis techniques. In Chapter Four, the results and analysis of this study are
presented. Chapter Five concludes this dissertation as well as suggestions for future
study and policy implementation.
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CHAPTER 2 : LITERATURE REVIEW
2.0 Chapter Overview
This chapter will introduce the literature on capital structure. Various theories
associated with capital structure in the perfect market and real world such as
Modigliani and Miller Propositions, Trade-off, Asymmetric Information and Agency
Costs theories will be presented. New developments in the capital structure are also
discussed. Furthermore, two types of determinants of capital structure: country-
specific and firm-specific variables are later discussed.
2.1
Introduction
In corporate finance, capital structure refers to the way a firm finances its investments
through some combination of equity, debt, or hybrid securities (Ross et al., 2007,
page 426). A firm's capital structure is then the composition or the structure of its
liabilities. For example, a firm that sells RM20 million in equity and RM80 million in
debts is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of
debt to total financing is 80% and is referred to as the firm's leverage. In reality,
capital structure may be highly complex and comprises of many sources (Frecka,
2005). A firm's capital structure has an important influence on the financial
performance and firm efficiency (Ghosh, 2008; Margaritis and Psillaki, 2007).
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Well, then how should a firm choose its debt to equity ratio? And, what is the optimal
capital structure for a firm? Whether or not an optimal capital structure do exists is an
issue in corporate finance (Myers, 1984; Hatfield et al., 1994).
A firm can choose any capital structure as it wishes. It is the result of deliberate
choice on the corporate management, investors’ attitudes and market conditions for
long-term funds. A firm could increase or decrease its debt/equity ratio by either
issuing more debt to buy back stock or issuing stock to pay debt. The objective of
managing capital structure is to mix the financial sources used by the firm in a way
that will maximize the shareholders' wealth and minimize the firm's cost of capital.
This proper mix of funds sources is called optimal capital structure (Ross, et al.,
2005).
Haugen and Senbet (1988) argue that capital structure is strongly related to the choice
between internal and external financial instruments. Thus, optimal capital structure
will be impacted by the expected costs of financial distress either direct cost, such as
the costs in the case of bankruptcy, or indirect costs, such as lost of sales. Therefore,
financial distress is an important criterion for capital structure decisions
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2.2 Capital structure in a perfect market
2.2.1 The Modigliani and Miller Propositions
The Modigliani-Miller (“MM”) theorem (1958) formed the basis for modern thinking
on capital structure. Assuming in a perfect capital market (no transaction or
bankruptcy costs; perfect information); firms and individuals can borrow at the same
interest rate; no taxes; and investment decisions aren't affected by financing decisions.
It does not matter if the firm's capital is raised by issuing stock or selling debt and
what the firm's dividend policy is. Therefore, the MM theorem is also often called the
capital structure irrelevance principle.
Modigliani and Miller made two findings under these conditions. Their first
proposition was that the value of a company is independent of its capital structure.
Their second proposition stated that the cost of equity for a leveraged firm is equal to
the cost of equity for an unleveraged firm, plus an added premium for financial risk.
This implies that the firm's debt to equity ratio does not influence its cost of capital. A
firm’s value is only determined by its real assets, and it cannot be changed by pure
capital structure management. Consequently, it means that there is no optimal capital
structure exists (Ross et al. 2007, pp. 433-440)
However, there is a fundamental difference between debt financing and equity
financing in the real world with corporate taxes as dividends paid to shareholders
derive from the after-tax profits and interest paid to bondholders is out of the before-
tax profits – commonly recognized as interest tax shield (Graham, 2000; MacKie-
Mason, 1990). Moreover, firms (or their managers) themselves do not believe in the
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irrelevance of capital structure. For instance, in Graham and Harvey (2001) and
Brounen et al. (2006)’s survey on chief financial officers of U.S. and Europe firms
illustrate that the majority of firm managers consider capital structure decisions
important for firm value and that firms have some target debt-equity ratio.
2.3 Capital structure in the real world
The theories below try to address some of the imperfections by relaxing assumptions
made in the MM model such as no taxes, no transactions or distress costs, common
objectives among decision-makers (value maximization) and perfect information.
2.3.1 Trade-off theory
The trade-off theory of capital structure refers to the idea that a company chooses how
much debt finance and how much equity finance to use by balancing the costs and
benefits. It states that there is an advantage to financing with debt, the tax benefit of
debt and there is a cost of financing with debt, the costs of financial distress including
bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers
demanding disadvantageous payment terms, bondholder/stockholder infighting, etc).
The marginal benefit of further increases in debt declines as debt increases, while the
marginal cost increases, so that a firm that is optimizing its overall value will focus on
this trade-off when choosing how much debt and equity to use for financing (Ross et
al., 2007; Barnea et al., 1981).
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The empirical relevance of the trade-off theory has often been questioned (Frank and
Goyal, 2003). Miller (1977) and Graham (2000) argue that the tax savings seem large
and certain while the deadweight bankruptcy costs seem minor. This implies that
many firms should be more highly levered than they really are. Myers (1984) was a
particularly fierce critic to trade-off theory because it seemed to rule out conservative
debt ratio by taxpaying firms. Welch (2002) has argued that firms do not undo the
impact of stock price shocks as they should under the basic trade-off theory and so the
mechanical change in asset prices that makes up for most of the variation in capital
structure.
Empirical evidences in the tradeoff theory are extensive. For instance, Bradley et al.
(1984) find that firms’ optimal leverage is inversely related to the expected costs of
financial distress and to the amount of non-debt tax shields. They also find the highly
significant inverse relation between firm leverage and earnings volatility. According
to Myers (1993), the evidence against the tradeoff theory is the inverse correlation
between profitability and financial leverage and the same finding is substantiated by
Rajan and Zingales (1995) for G7 countries. Titman and Wessels (1988) find a
significant negative relationship between profitability and debt ratios. However, the
tradeoff theory predicts the opposite relationship unless profitable firms incur more
agency costs than less profitable firms as the debt ratio increases. Titman and Wessels
(1988) find no relationship between debt ratios and a firm’s expected growth, non-
debt tax shields, volatility, or the collateral value of its assets.
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2.3.2 Asymmetric information
Firm managers or insiders are assumed to possess private information about the
characteristics of the firm's return stream or investment opportunities. In one set of
approaches, capital structure is designed to mitigate inefficiencies in the firm's
investment decisions that are caused by the information asymmetry. This branch of
the literature starts with Myers and Majluf (1984) and Myers (1984). In another,
choice of the firm's capital structure signals to outside investors the information of
insiders. This stream of research began with the work of Ross (1977) and Leland and
Pyle (1977). Various approaches to the asymmetric information are discussed in the
following subsections.
2.3.2.1 Pecking order theory
Myers and Majluf (1984) showed that, if investors were less well-informed than
current firm insiders about the value of the firm's assets, then equity may be mispriced
by the market. This underinvestment could be avoided if the firm could finance the
new project using a security that was not so severely undervalued by the market. For
example, internal funds and/or riskless debt involve no undervaluation, and, therefore,
would be preferred to equity by firms in this situation. In addition, Myers (1984)
stated that companies prioritized their sources of financing according to the law of
least effort or resistance. This pecking order theory maintained that businesses adhere
to a hierarchy of financing sources and prefer internal financing when available, and
debt was preferred over equity if external financing was required (Myers, 1984).
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Pecking order theory tries to capture the costs of asymmetric information. Hence
internal debt is used first, and when that is depleted debt is issued, and when it is not
sensible to issue any more debt, equity is issued. Thus, the form of debt a firm
chooses can act as a signal of its need for external finance. The pecking order theory
was popularized by Myers (1984) when he argued that equity is a less preferred
means to raise capital because when managers (who are assumed to know better about
true condition of the firm than investors) issue new equity, investors believe that
managers think that the firm is overvalued and managers are taking advantage of this
over-valuation. As a result, investors will place a lower value to the equity issuance
as evidenced by equity issue announcements are met with a negative market reaction
(Asquith and Mullins, 1986) and the markets reaction to security issue announcements
are more negative for issues of riskier securities (Hadlock and James, 2002).
The evidences of pecking order theory are as follow. Kester (1986), in his study of
debt policy in U.S. and Japanese manufacturing corporations, finds that the return on
assets is the most significant explanatory variable for actual debt ratios. MacKie-
Mason’s (1990) result suggests that the importance of asymmetric information gives a
reason for firms to care about who provides the funds (e.g., between public and
private debt) because different fund providers have different access to information
about the firm and different ability to monitor firm behavior. This is consistent with
the pecking order theory implied by Myers and Majluf (1984) since private debt will
require better information about the firm than public debt. Shyam-Sunder and Myers
(1999) show that firms follow the pecking order in their financing decisions where
firms with a positive financial deficit (a function of dividend payments, net capital
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expenditure, net changes of working capital and operating cash flows after interest
and taxes) are more likely to issue debt.
The pecking order is found to be much more binding force for small firms and non-
dividend paying firms, supporting the hypothesis that small firms are more likely to
follow the pecking order because of the difficulty in accessing external financing
sources (Byoun and Rhim 2003).
Tests of the pecking order theory have not been able to show that it is of first-order
importance in determining a firm's capital structure. However, several authors have
found that there are instances where it is a good approximation of reality. Fama and
French (2002) found that some features of the data were better explained by the
Pecking Order than by the Trade-Off Theory. Frank and Goyal (2000) showed, among
other things, that Pecking Order theory fails where it should hold, namely for small
firms where information asymmetry is presumably an important problem.
2.4.2.2
Signaling model
The seminal contribution in this area is that of Ross (1977). In Ross' model, managers
know the true distribution of firm returns, but investors do not. The main empirical
result was that firm value (or profitability) and the debt-equity ratios are positively
related. Managers benefit if the firm's securities are more highly valued by the market
but are penalized if the firm goes bankrupt. Investors take larger debt levels as a
signal of higher quality. Since lower quality firms have higher marginal expected
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bankruptcy costs for any debt level, managers of low quality firms do not imitate
higher quality firms by issuing more debt.
Heinkel (1982) considered a model on return distribution is assumed to be such that
"higher" quality firms have higher overall value but lower quality bonds (lower
market value for given face value), hence higher equity value and therefore high value
firms issue more debt. Since higher quality firms have higher total value, the result
that they issue more debt is consistent with Ross (1977) result. Another model that
uses debt as a signal is that of Poitevin (1989) which involves potential competition
between an incumbent firm and an entrant. The benefit of debt is that the financial
market places a higher value on the debt financed firm since it believes such a firm to
be low cost. The main result is that issuance of debt is good news to the financial
market.
Several studies exploit managerial risk aversion to obtain a signaling equilibrium in
which capital structure is determined. The basic idea is that increases in firm leverage
allow managers to retain a larger fraction of the (risky) equity. The larger equity share
reduces managerial welfare due to risk aversion, but the decrease is smaller for
managers of higher quality projects. Thus managers of higher quality firms can signal
this fact by having more debt in equilibrium (Leland and Pyle, 1977; Blazenko, 1987).
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2.4.3 Agency Costs
Corporate managers are the agents of shareholders, a relationship form with
conflicting interests. The separation of management and ownership in a firm causes
the agency problems. Because management and shareholders each attempt to act in
their own self- interests, managers may make decisions that are not in line with the
goal of maximization of shareholders' wealth.
Agency theory, the analysis of such conflicts, is now a major part of the finance
literature. The payout of cash to shareholders creates major conflicts that have
received little attention. Payouts to shareholders reduce the resources under
managers’ control, thereby reducing managers’ power, and making it more likely they
will incur the monitoring of the capital markets which occurs when the firm must
obtain new capital (Easterbrook, 1984; Rozeff, 1982). Financing projects internally
avoids this monitoring and the possibility the funds will be unavailable or available
only at high explicit prices.
Managers have incentives to cause their firms to grow beyond the optimal size.
Growth increases managers’ power by increasing the resources under their control. It
is also associated with increases in managers’ compensation, because changes in
compensation are positively related to the growth in sales (Murphy, 1985).
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There are three types of agency costs which can help explain the relevance of capital
structure as discussed by Smith and Warner (1979):
2.3.3.1
Asset substitution effect
As Debt to Equity increases, management has an increased incentive to undertake
risky (even negative Net Present Value, NPV) projects. This is because if the project
is successful, share holders will receive all the upside, whereas if it is unsuccessful,
then debt holders will receive all the downside. If the projects are undertaken, there is
a chance of firm value decreasing and a wealth transfer from debt holders to share
holders (Zhang, 2006; Gavish and Kalay, 1983).
2.3.3.2 Underinvestment problem
If debt is risky (e.g. in a growth company), the gain from the project will accrue to
debt holders rather than shareholders. Thus, management has an incentive to reject
positive NPV projects, even though they have the potential to increase firm value
(Hirth and Uhrig-Homburg, 2007).
2.3.3.3
Free cash flow
Unless free cash flow is given back to investors, management has an incentive to
destroy firm value through empire building and perks (Jensen, 1986).
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Jensen and Meckling (1976) argue that these relationships between the agency costs
of debt and the amount of the debt may result in an optima1 capital structure. This
optimal capital structure can be achieved in two distinct ways. First, agency costs of
debt may offset the tax advantage of debt financing. There is a trade-off between the
tax benefits and agency costs since both the tax benefits and agency costs of debt are
positively related to the amount of the debt employed. Secondly, an optimum
proportion of outside debt and equity may be chosen in order to minimize total agency
costs. This is the trade-off between agency costs of debt and agency costs of equity,
even in a world without taxes.
2.4
New development in capital structure
After reviewing the above major theoretical ideas of capital structure from MM
Propositions to the three famous alternative theories, Trade-Off, Pecking Order and
Agency Costs, a brief discussion on the new development in capital structure is
outlined in subsection below.
2.4.1 Shocks to the capital structure and adjusting behavior
Since the existence of firm adjustment behavior to capital structure shocks appears as
the main feature that allows for testing the trade-off versus other theories (Myers,
1984), one important way to learn about capital structure issues is to examine firm
behavior after exogenous shocks. The inherent difficulty is to decide on the
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exogeneity of economic events. One particularly interesting attempt in the literature to
test for adjustment behavior by Welch (2004) relies on market-value-based leverage
shocks due to stock price changes. The market-value based capital structure changes
with the market price of equity, and therefore at almost any given point in time, given
the volatility of today’s equity markets. Welch (2004) examines, whether firms adjust
their capital structures after these shocks to maintain some target debt ratio by issuing
and repurchasing debt and equity. The analysis is based on data of publicly traded U.S.
corporations from the period 1962 to 2000. The Welch (2004) study exemplifies the
basic idea of using exogenous shocks to capital structures to test for firm adjustment
behavior.
2.4.2
Dynamic adjustment to target leverage and adjustment speed
In the dynamic version of the classic trade-off theory, target leverage can be time-
varying. If there are deviations from the optimal capital structure, the theory states
that there will be adjustment toward the “optimal” target. Depending on the costs of
adjustment, target leverage will be adjusted at a different pace (Frank and Goyal,
2008; Titman and Tsyplakov, 2007). The major objective of capital structure research
using dynamic partial adjustment models is then to estimate the speed of adjustment.
Flannery and Rangan (2006) analyze whether U.S. firms indeed have long-run target
capital structures and if so, how fast they adjust to this target. In comparison to prior
studies, they put special emphasis on the econometric methods and the model
specification, emphasizing the need to take the panel nature of the data into account.
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2.4.3 Major real investments
Another strand of the literature analyzes a fundamentally different shock to capital
structures of firms, but in a dynamic context as well. The studies by Mayer and
Sussman (2005) and Elsas et al. (2007) examine dynamic financing patterns of U.S.
firms when undertake major real investments. Mayer and Sussman (2005) consider
equity and debt issues following spikes in firms’ investment expenditures, while Elsas
et al. (2007) examine jumps (rather than spikes) in capital expenditures. Both studies
pursue the idea that the exercise of very large real investment options allows to
observe major financing decisions by firms. Moreover, if the major real investment is
more driven by the availability of the investment opportunities rather than the
availability of investment funding, it will constitute an exogenous shock to the sample
firms’ capital structure.
Another novelty of the above studies is that they rely on an event driven framework
that is particularly suited to analyze adjustment behavior. Also, as pointed out by
Leary and Roberts (2005) and Hovakimian et al. (2004), if adjusting capital structures
entails some fixed cost, firms should be closest to their desired capital structure after
major recapitalizations. Mayer and Sussman (2005) show that external funds are used
before internal funds are exhausted, contradicting a strict pecking order of financing,
though the observed debt preference is consistent. Elsas et al. (2007) show in addition,
that even in the event year, the financing of the major investment moves the firm
strongly towards its target capital structure, in the frequent case, where financing is
predominantly based on debt financing Elsas et al. (2007) also show that stock-price
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run-ups preceding the major investment strongly increase the likelihood of equity
issues, consistent with market timing behavior.
2.4.4
Macroeconomic shocks
One stream of literature is concerned the impact of macroeconomic conditions on
corporate leverage. Macroeconomic shocks are highly exogenous to the single firm in
the economy. Within their analysis, Hackbarth et al. (2006) provide an overview of
recent theoretical works in this area. In an empirical study, Campello (2003) analyzes
the influence of exogenous shocks in the product market environment on capital
structure, using aggregate demand shocks as a proxy. Campello (2003) finds that debt
financing and relative-to-industry sales growth have a negative relationship in
industries with low industry leverage during recessions, but not during booms. This
effect cannot be observed in industries with high industry leverage. In a further
empirical analysis, Korajczyk and Levy (2003) also examine the impact of
macroeconomic conditions on leverage, controlling for firm-specific variables. They
find financially unconstrained firms issue equity pro-cyclically and debt counter-
cyclically, although the underlying economic rationale remains somewhat unclear.
2.4.5 Rating
The study by Kisgen (2006) emphasizes a determinant of capital structure decisions
that has received only little attention before – the rating of companies by external
rating agencies like Moody’s or S&P. Kisgen (2006) tries to analyze how the
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financing behavior of firms is affected if firms are near credit rating upgrades or
downgrades. The basic idea is that under both the trade-off and the pecking order
theory the capital structure depends on the (marginal) costs of debt and equity. Since
rating changes might affect the costs of capital, potential rating changes through
financing decisions can alter the target debt level or the marginal benefit of debt over
equity, rendering the corporate rating a potentially important determinant. Arguably,
this effect will increase when a firm is closer to a rating change. Correspondingly,
Kisgen (2006) analyzes firm financing decisions, when firms are close to rating
changes and finds that these firms issue significantly less debt than other comparable
firms. This finding is robust even if one controls for several differing approaches to
take “standard” capital structure determinants into account
.
2.4.6
Behavioral corporate finance
In behavioral corporate finance, the assumption of fully rational investors (fully
rational behavior means that all agents in the market have rational expectations and
are expected utility maximizers) and managers is abandoned. Beliefs and preferences
may be non-standard and thus allow for irrational behavior, and theories taking this
into account might lead to new determinants that help improving the understanding of
capital structure determinants (Barberis and Thaler, 2003; Baker et al., 2007). In the
behavioral corporate finance literature, two salient approaches have emerged (Neus
and Walter, 2008). In the irrational investors approach, rational managers are facing
irrational investors. The associated literature basically deals with inefficient markets
and rational managers exploiting mispricing, such as the market timing story of Baker
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and Wurgler (2002). In the irrational managers’ approach, it is assumed that not fully
rational managers are operating in efficient markets, i.e. facing rational investors.
Most of the literature in the irrational managers’ approach focuses on deviations from
rational expectations. There is some evidence from social psychology that individuals
and especially managers have biased beliefs. Some possible distortions in managerial
beliefs emphasized in the behavioral corporate finance literature are optimism and
overconfidence (Barberis and Thaler, 2003).
Ben-David et al. (2007) analyze whether CFOs are overconfident and whether this
has an impact on corporate policies, including capital structure issues. The authors
measure managerial overconfidence based upon stock market predictions made by
CFOs. They use a survey of S&P 500 return forecasts of CFOs between 2001 and
2007. They derive several hypotheses on corporate policies that the financing-related
hypotheses state that overconfident managers perceive their firms’ equity to be
undervalued by the market, that leverage increases with managerial overconfidence,
and that overconfident managers repurchase shares more often. They find that CFOs
are overconfident, i.e. they underestimate the variance of market returns, because
realized market returns are within the estimated 80 percent confidence intervals only
38 percent of the time.
Malmendier et al. (2007) test capital structure-related hypotheses using two
alternative measures of managerial irrationality. The first hypothesis by Malmendier
et al. (2007) is that overconfident managers prefer debt to equity conditional upon
using external financing, because managers perceive the price of newly issued equity
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as too low in their model. Their second hypothesis is that managers prefer internal to
external financing unconditionally, which might result in using debt too
conservatively, thus not exploiting the tax benefits optimally. Testing the first
hypothesis, the evidence implies that overconfident CEOs are less likely to issue
equity in comparison to their peers, which supports pecking order financing due to
overconfidence. Malmendier et al. (2007) also find support for their second
hypothesis that overconfident CEOs rely more heavily on internal financing.
Furthermore, they find that the longer a firm is managed by overconfident managers,
the higher is the firm's leverage in the long term.
2.5
Related literature on the international capital structure
This section will discuss in summary on the most recent literatures on capital structure
from the international perspective.
2.5.1
Capital structure around the world: The roles of firm- and country-
specific determinants by De Jong et al. (2008).
The study analyzes the importance of firm-specific and country-specific factors in the
leverage choice of firms from forty two countries around the world for the period
from 1997 to 2001. Their analysis yields two new results. First, they find that firm-
specific determinants of leverage differ across countries, while prior studies implicitly
assume equal impact of these determinants. Second, although they concur with the
conventional direct impact of country-specific factors on the capital structure of firms,
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they show that there is an indirect impact because country-specific factors also
influence the roles of firm-specific determinants of leverage.
The standard firm-specific determinants of leverage like firm size (natural logarithm
of total sales), asset tangibility (net fixed assets over book value of total assets),
profitability (operating income over book value of total assets), firm risk (standard
deviation of operating income over book value of total assets) and growth
opportunities (market value of total assets over book value of total assets) are chosen.
Besides that, large number of country-specific variables in their analysis, including
legal enforcement, shareholder/creditor right protection, market/bank-based financial
system, stock/bond market development and growth rate in a country’s gross domestic
product (GDP). One leverage ratio is used as proxy to capital structure: book value of
long-term debt over market value of total assets calculated as book value of total
assets minus book value of equity plus market value of equity. Two ordinary least
squares (OLS) regression analysis techniques are used in this study, i.e. simple pooled
OLS and weighted least squares regression.
2.5.2 The determinants of capital structure: evidence from the Asia Pacific
region by Deesomsak et al. (2004).
The paper contributes to the capital structure literature by investigating the
determinants of capital structure of firms operating in the Asia Pacific region, in four
countries with different legal, financial and institutional environments, namely
Thailand, Malaysia, Singapore and Australia. The results suggest that the capital
structure decision of firms is influenced by the environment in which they operate, as
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well as firm-specific factors identified in the extant literature. The financial crisis of
1997 is also found to have had a significant but diverse impact on firm’s capital
structure decision across the region.
The leverage ratio used in this study is debt to capital ratio as calculated by total debts
over total capital (total debts plus market value of equity plus book value of
preference shares). The determinants are tangibility (total fixed assets over total
assets), profitability (EBITDA over total assets), firm size (natural log of assets),
growth opportunities (book value of total assets less the book value of equity plus the
market value of equity divided by the book value of total assets), non-debt tax shield
(depreciation over total assets), liquidity (ratio of current assets to current liabilities),
earnings volatility (absolute difference between the annual percentage change in
earnings before interest and taxes), and share price performance (the first difference
of the logs of annual share prices, matched to the month of firms’ fiscal year-end).
Seven country-specific variables, namely the degree of stock market’s activity, the
level of interest rates, the legal protection of creditor’s rights, ownership
concentration, and three country dummies are used. The fixed effect panel and
pooled OLS procedures were used to analyze the relationships with leverage.
2.5.3 Determinants of Capital Structure: Evidence from the G-7 Countries by
Aggarwal and Jamdee (2003).
This study builds on the seminal work of Rajan and Zingales (1995) on the
determinants of capital structure in an international setting. Using the same database
with more recent data, an expanded set of leverage determinants, and improved
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methodology (panel analysis allowing for time-series and cross-sectional analysis),
this study re-examines both country- and firm-level determinants of capital structure
choices across the G7 countries (US, Japan, UK, Germany, France, Italy, Canada).
First, the overall average leverage in 2001 is lower than in 1991. Second, the
determinants of capital structure traditionally found useful in the U.S. lose some of
their explanatory power overseas. Third, book debt ratios seem on average to depend
positively on tangibility of assets, company size, R&D expenses, and protection of
control rights and negatively on the market to book ratio, profitability, bankruptcy
probability, and market access. These findings should be of much interest to
managers, investors, and policy makers.
Two measures of leverage based on the adjusted debt to capitalization ratio are used
as the dependent variables, i.e., book and market leverages, which are the ratios of
adjusted debt to adjusted debt plus book or market value. For book leverage equity is
measured at book value and for market leverage it is measured at market value.
This paper examines the time series-cross-sectional regression of debt to book and
debt to market equity against fixed assets (Tangibility), investment opportunities
(Market-to-book ratio), firm size (Log of Sales), Profitability (ROA), the probability
of bankruptcy (Z-Score), uniqueness of product (R&D), equity and/or bond market
accessibility (Market Accessibility), measures of investor protection (Legal origin,
Anti-director), and measures of controlling shareholder rights (Cash-flow rights,
Control rights).
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2.5.4 Capital structure in developing countries by Booth et al. (2001).
The study analyzes capital structure choices in ten developing countries: India,
Pakistan, Thailand, Malaysia, Turkey, Zimbabwe, Mexico, Brazil, Jordan, and Korea;
for the largest companies in each country from 1980 to 1990. As for the debt ratio,
three ratios are used:
i. Total debt ratio = Total liabilities / (Total liabilities + Net worth)
ii. Long-term book-debt ratio = (Total liabilities – Current liabilities) / (Totalliabilities - Current liabilities + Net worth)
iii. Long-term market-debt ratio = (Total liabilities – Current liabilities) / (Totalliabilities – Current liabilities + Equity marketvalue)
The macroeconomic variables used are: stock market value/GDP, liquid
liabilities/GDP, real GDP growth rate, inflation rate and Miller tax term. As for the
firm-specific variables are as follow: tax rate (average tax rate), business risk
(standard deviation of ROA), asset tangibility (total assets less current asset divided
by total assets), size (natural logarithm of sales), return on assets (earnings before tax
divided by total assets) and market-to-book ratio (market value of equity divided by
book value of equity). For data analysis, they use the regression analysis with simple
pooling and fixed-effects model.
They find that the variables that are relevant for explaining capital structures in the
United States and European countries are also relevant in developing countries,
despite the profound differences in institutional factors across these developing
countries. By knowing these factors helps predict the financial structure of a firm
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better than knowing only its nationality. Their finding is consistent with the Pecking-
Order Hypothesis and also supports the existence of significant information
asymmetries.
2.6 Determinants of capital structure
A lot of discussion whether or not an optimal capital structure even exists is raised
among academicians. An important concern for researchers is to investigate the
factors that influence the capital structure position of a firm. If analysts have the
ability to find the major determinants of capital structure, managers can make a sound
decision about the capital structure of the firm with the information of those
determinants (Prasad et al. 1997).
In most previous studies, a firm’s capital structure was usually represented by
financial leverage. According to Rajan and Zingales (1995), there is no clear-cut
definition of leverage in the academic literature and the specific choice depends on
the objective of the analysis. For instance, the agency problems associated with debt
(Jensen and Meckling 1976; Myers 1977) largely relate to how the firm has been
financed in the past, and thus on the relative claims on firm value held by equity and
debt - the relevant measure is probably the stock of debt relative to firm value. Aghion
and Bolton (1992) have focused on leverage as a means of transferring control when
the firm is economically distressed, from shareholders to bondholders. Here, the
important question is whether the firm can meet its fixed payments, and consequently,
a flow measure like the interest coverage ratio is more relevant.
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As for the definition of leverage, the ratio of total liabilities to total assets is the
broadest one and is used in many empirical studies (Ross et al. 2007). However,
Rajan and Zingales (1995) point out that this definition is inappropriate for financial
leverage since total liabilities include items used for transaction purposes (e.g.,
accounts payable) rather than for financing.
In this study, two major types of variables are looked into: country-specific and firm-
specific determinants, in analyzing the impacts on firms’ leverage choice.
2.6.1 Country-specific determinants
The following literatures specifically examine only the direct impact of country
characteristics on leverage. In an analysis of ten developing countries, Booth et al.
(2001) find that there are differences in the way leverage is affected by country-
specific factors such as GDP growth and capital market development. They conclude
that more research needs to be done to understand the impact of institutional factors
on firms’ capital structure choices. The importance of country-specific factors in
determining cross-country capital structure choice of firms is also acknowledged by
Fan et al. (2006) who analyze a larger sample of thirty nine countries. They find a
significant impact of a few additional country-specific factors such as the degree of
development in the banking sector, and equity and bond markets.
In another study of thirty OECD countries, Song and Philippatos (2004) report that
most cross-sectional variation in international capital structure is caused by the
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heterogeneity of firm-specific, industry-specific, and country-specific determinants.
However, they do not find evidence to support the importance of cross-country legal
institutional differences in affecting corporate leverage. Giannetti (2003) argues that
the failure to find a significant impact of country-specific variables may be due to the
bias induced in many studies by including only large listed companies. She analyzes
a large sample of unlisted firms from eight European countries and finds a significant
influence on the leverage of individual firms of a few institutional variables such as
creditor protection, stock market development and legal enforcement. Similarly, Hall
et al. (2004) analyze a large sample of unlisted firms from eight European countries.
They observe cross-country variation in the determinants of capital structure and
suggest that this variation could be due to different country-specific variables.
2.6.1.1 Size of the Banking Industry and Stock Market
The difference in the development of banks versus financial markets has long been
perceived as a possible determinant of capital structure (Mayer, 1990; and Rajan and
Zingales, 1995). This indicator of banking or market development may cause
differences in the accessibility to external financing by firms in that the monitoring
activities and controls of firms by financial institutions are more available in bank-
oriented countries where the weight of the banking sector is heavier than that in the
market-oriented countries. This implies that as equity markets become more
developed, they become a viable option for corporate financing and firms make less
use of debt financing. Similarly, countries with a relatively large banking sector are
more likely to be associated with higher private sector debt ratios.
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The two indicators are credible measures of the overall ability of the private sector to
access capital. Previous studies appear to agree on the negative relation between the
size of stock market and leverage level (Demirguc-Kunt and Maksimovic, 1998 and
1999; Booth, et al. (2001); and Giannetti, 2003). In the article by Demirguc-Kunt,
and Maksimovic (1999), they reported a positive sign for the relation between the
banking sector/GDP and debt to asset ratios (long term debt and short term debt)
when leverages were regressed on the banking sector/GDP variable alone. However,
negative signs are generated once other institutional variables are added in their
models.
2.6.1.2
Gross Domestic Product Growth Rate
The growth rate of GDP is an important macroeconomic variable. If investment
opportunities in an economy are correlated, there should be a relationship between the
growth rate of individual firms and the growth rate of the economy. Thus, the
aggregate growth rate may serve as a control variable in cross-country comparisons of
firm financing choices. As in the case of the variable of the size of the banking sector,
the relation between GDP growth rate and leverage ratios does not seem clear.
Interestingly, contrary to Demirguc-Kunt and Maksimovic (1998), La Porta et al.,
(1997) argue that although GDP growth rate are positively related to indebtedness of a
country, the statistical significances of these results do not carry over once the legal
system is accounted for.
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Since economy-wide growth opportunities (GDP growth rate) are closely correlated
with firms’ growth opportunities, firms with large growth opportunities tend to use
less debt in optimality as argue by Myers’ hypothesis (1977). An alternative
explanation is that mature firms with large economy-wide opportunities may not
require large amounts of external funds, and thus turn out to have lower leverage
levels. This is consistent with the pecking order theory propagated by Myers (1984).
In the contrast, Booth et al. (2001) find that in developing countries, higher economic
growth tends to cause the increase of total book value of debt and long-term book
value of debt ratios whereas higher inflation causes them to decrease.
2.6.1.3 Inflation
Another important factor to be considered is the effect of inflation on the capital
structure because debt contracts are generally nominal contracts and high inflation is
likely to discourage lenders from providing long-term debt (Fan et al., 2006).
DeAngelo and Masulis (1980) argue that inflation leads to more debt since inflation
lowers the real cost of debt, the demand for corporate bonds increases during
inflationary periods. On the other hand, if corporate bonds’ return becomes higher
relative to stocks’ return as inflation decreases, the aggregate demand of corporate
bonds increases.
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2.6.2 Firm-specific determinants
A large number of studies on capital structure have concentrated on figuring out the
determinants affecting the optimality of capital structure and providing theoretical
explanations of the relationships between firm characteristics and capital structure
(Titman and Wessel, 1988; Harris and Rajiv, 1991; Welch, 2002; Frank and Goyal,
2008). Theories developed to explain the optimality of capital structure have been
mainly driven on the basis of bankruptcy costs, agency costs, asymmetric information
as well as debt tax shield effects (Ross, 1977; Myers and Majluf, 1984; Graham,
2000). If the empirical implications of firm-specific determinants of capital structures
differ across countries, they should result in different features of international capital
structure (Fan et al., 2006). Three possibilities are explained as the reasons for the
variations of international capital structure.
First, the theories underlying capital structure could be applicable only to some
countries. For example, agency theory predicts that leverage increases with a decrease
in profitability (negative relationship) (e.g., Kester, 1986; Friend and Hasbrouck,
1988; Titman and Wessels, 1988), whereas asymmetric information theory posits the
reverse relationship (e.g., Heinkel, 1982; Blazenko, 1987; Poitevin, 1989). Therefore,
the effects of firm-specific determinants of capital structure could be different across
countries, and therefore cause variations in international capital structures.
Second, the variations in international capital structure could be caused by differences
in the levels of the determinants of capital structure. Even though the effects of the
determinants on capital structure work more or less in similar ways across countries,
the observed capital structures would differ across countries if the magnitudes of the
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determinants differ from country to country. For instance, if the average size of firms
in a country is small relative to another country, the mean leverage of firms may differ
across countries (De Jong et al., 2008).
Third, even if the heterogeneities at the level of firm-specific determinants are
controlled for, the cross-country variations in international capital structure could
survive only if the sensitivities of leverage to the changes in the determinants differ
across countries. In fact, this possibility appears to be closely related to institutional
determinants, especially in legal systems (La Porta et al., 1997). For example, if
agency problem, as mentioned above, is not serious in civil-law countries, where
ownership by large shareholders is more common, this legal environment may affect
the sensitivities of leverage to changes in several firm-specific determinants, and
thereby cause variation in international capital structure. In other words, it should be
noted that firm characteristics could be influenced by legal environments; therefore,
the extent to which firm characteristics affect capital structure choice could vary with
legal systems (Gonzales, 2002).
2.6.2.1 Profitability
Corporate performance has also been identified as a potential determinant of capital
structure. The tax trade-off models predict that profitable companies will employ
more debt since they are more likely to have a high tax burden and low bankruptcy
risk. On the other hand, the pecking order theory of finance proposed by Myers (1984)
prescribes a negative relationship between debt and profitability on the basis that
successful companies do not need to depend so much on external funding. They can,
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instead, rely on their internal reserves accumulated from past profits. The validity of
the two opposing hypotheses is, thus, another issue that needs to be resolved
empirically.
Profitability is measured by normalizing the firm's earnings before interest and taxes
(EBIT) with total assets. Since retained earnings of companies are expected to be
highly correlated with their past profits, the preceding year's EBIT to measure
profitability is chosen. In this way, the proxy also enables the testing of pecking order
hypothesis.
2.6.2.2
Growth opportunities
Higher growth opportunities provide incentives to invest sub-optimally, or to accept
risky projects th