Final Draft - Capital Structure in ASEAN

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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


3.1 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


4.1 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

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Final Draft - Capital Structure in ASEAN