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«The Determinants of Capital Structure: Comparison between Before and After Financial Crisis Barry Harrison and Theodorus Wisnu Widjaja1 ABSTRACT The ...»

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Economic Issues, Vol. 19, Part 2, 2014

The Determinants of Capital Structure:

Comparison between Before and After Financial


Barry Harrison and Theodorus Wisnu Widjaja1


The financial crisis of 2008 provides an interesting opportunity to investigate the

effect of the crisis on the capital structure decisions of firms. Over the years, capital structure choice has attracted considerable attention in the literature and is important to firms, investors and policy makers. We find that during the 2008 financial crisis, the coefficients of tangibility and market to book (MTB) ratio exert a stronger influence on capital structure choices than prior to 2008. We also find that the coefficient of profitability exerts less influence on capital structure choice than before the crisis. In addition, the sign of the coefficient of firm size is negative, which is exactly the opposite of the situation that existed before the crisis. Further analysis indicates that during the 2008 financial crisis, pecking order theory has more explanatory power than trade-off and market timing theory.

1. INTRODUCTION In pursuit of maximising firm value, financial managers are charged with two main responsibilities: investment decisions and capital structure choices (Watson and Head 2010). The capital structure of a company is particularly important, because it impacts on the ability of the firm to take up investment opportunities. For example, debt gives firms more financial agility in taking up investment opportunities because, in general, debt can be raised more quickly than either equity finance or the accumulation of earnings. Debt might also enable firms to increase their after-tax earnings by exploiting available tax shields.

Myers (2001) has argued that there is no universal theory of the debt/equity choice and no reason to expect one. Despite this, scholars formulate the determinants of capital structure in the framework of trade-off theory, pecking order theory, or market timing theory. However, earlier tests of these theories produced ambiguous results. For example, the trade-off theory

- 55 B Harrison and T Widjaja argues that the correlation between profitability and leverage ratio is positive and the higher the profit, the higher the leverage ratio. On the other hand, Rajan and Zingales (1995) find a negative correlation between profitability and leverage ratio implying that the higher the profitability, the lower the leverage ratio. Akdal (2010) finds that the market to book ratio is negatively correlated with leverage ratio, while Lemmon and Zender (2010) find a positive correlation between market to book ratio and leverage ratio. These opposing results suggest that capital structure theories might not be consistent as financial and/or economic conditions change.

Bharath et al (2009) investigate the core of pecking order theory: asymmetric information. The proxies for information asymmetry are market liquidity and transactions costs. Transaction costs (for example the bid-ask spread) have three main components: order processing, inventory, and adverse selection. Bharath et al (2009) argue that adverse selection is positively correlated with the level of information asymmetry. Furthermore, they find that if the basic assumption of pecking order theory, severe adverse selection (and information asymmetry), is dominant in the data, then the theory performs better in predicting capital structure choices.

The recent financial crisis provides an opportunity to investigate the effect of a financial shock on capital structure and to assess the performance of the various theories of capital structure. Bhamra et al (2010) find that firms are more conservative in their financial policy knowing that there is a possibility of rare and random economic crises. Ariff et al (2008) find that the speed of capital structure adjustment is significantly slower for financially distressed firms. A survey of the real effects of financial constraints during financial crises reveals that constrained firms tend to use internal funding and put more effort into obtaining credit from banks, anticipating restricted access to credit in the future (Campello et al 2010).

The purpose of this paper is to investigate whether the recent financial crisis has had any impact on the financial structure of firms. Table 1 presents some introductory data which, at the very least, suggests that the financial crisis might have led to a change in firms’ preferences for raising capital through leverage.

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Capital structure theory stems from Modigliani and Miller (1958), who argue that firm value is uninfluenced by capital structure choices and that capital structure is irrelevant to both firm value and the cost of capital, as long as firms focus on value maximisation. Given certain assumptions,2 Modigliani and Miller (1958) argue that any attempt to reduce the proportion of equity in the firm's overall capital structure by substituting debt for equity would equivalently reduce the price of debt and raise the price of equity, thus keeping the overall cost of capital constant (the reverse holds as well). However, it is now generally recognised that the assumptions made by Modigliani and Miller (1958) are too restrictive and as a result other theories have emerged in the capital structure debate.

Pecking order theory, trade-off theory and market timing theory have thrown up several variables as possible determinants of capital structure, including tangibility, profitability, size, market to book ratio, and liquidity. In brief, pecking order theory implies that firms prefer to employ internal finance and, when external finance is necessary, debt is preferred to equity. The rationale for this is based on information asymmetry: managers are better informed than outsiders about the firm’s prospects and are thus less likely to issue equity when they feel the firm is undervalued. Market timing theory takes a different view and implies that managers are indifferent between sources of finance from one period to the next: they simply use the least cost method available at the time the firm is seeking finance. Trade off theory implies that firms exploit tax shields up to the point at which additional debt would increase the likelihood of financial distress.

Investigations into capital structure have produced ambiguous results.

Marsh (1982) for example, finds that tangible assets and leverage are positively correlated. Shah and Khan (2007) find that a company which has a relatively large proportion of fixed assets usually pays lower rates of interest on its borrowing costs. Myers and Majluf (1984) and Titman and Wessels (1988) find that profitable companies tend to finance investments from internal sources and therefore such companies tend to be associated with lower levels of leverage.

Using international samples of the G7 countries, Rajan and Zingales (1995) focus on four determinants of capital structure: tangible assets, market to book ratio, size, and profitability. They find that in most countries, size and tangible assets are positively correlated with the level of debt, providing support for the trade-off theory of capital structure. However, they also find that market to book ratio and profitability are negatively correlated with the level of debt, which provides support for the pecking order theory. This ambiguity is explained by Myers (2001) who suggests that any capital structure theory might work better in some circumstances than others, since the theories could not be applied generally to various sets of capital structure determinants used in the studies.

- 57 B Harrison and T Widjaja Focussing on US companies in the period 1973-1994, Graham (2000) finds that the benefit of capitalised interest tax shields is about 10 per cent of firm value, but that the level of debt could be increased up to the point where, although incremental benefit decreases, the overall benefit of the tax shield rises to up to 15 per cent of firm value. The existence of unused tax shields, and therefore by implication conservatism towards increasing debt levels, reflects only weak support for trade-off theory, since this theory suggests firms should exploit the tax shield benefit effectively.

Using survey data from 16 European countries (Austria, Belgium, Greece, Denmark, Finland, Ireland, Italy, France, Germany, Netherlands, Norway, Portugal, Spain, Switzerland, Sweden, and United Kingdom), Bancel and Mittoo (2004) examine the relationship between theory and practice in capital structure decisions across countries with different legal systems. Their results show that financial flexibility is a significant factor in financial decisions. Financial flexibility is gained by having the ability to properly time debt or equity issuance according to the level of interest rates and the market value of equity. Furthermore, their findings show that firms do not rank agency costs or asymmetric information as important considerations in capital structure decisions. Overall they conclude that support for trade-off theory in capital structure choice is more apparent than support for pecking order theory.

Akdal (2010) examines different types of firm characteristics in the UK which may be related to the capital structure of firms, and finds that profitability, non-debt tax shields, volatility, and liquidity are significantly negatively correlated with the level of debt, giving some support to pecking order theory. However, tangibility and size are significantly positively correlated with the level of debt, providing support for the static trade-off theory. Lemmon and Zender (2010) control for debt capacity when investigating the capital structure of public companies in the United States between 1971 and 2001. Having allowed for debt capacity, they find that pecking order theory explains the observed financing behaviour of a broad cross section of firms because, on average, firms use internal funding to finance their investments.

In a different study, Antoniou et al (2008) argue that despite extensive investigation of capital structure, two fields remain unexplored by researchers. One is the impact of dissimilarities in the legal and governance environment. In the UK and USA we have common law and a market based governance structure, whilst in France and Germany the law is codified and bank based governance structures are the norm. Japan is a hybrid of both.

The second factor is the impact of macroeconomic conditions which might influence the capital structure choice of firms. These authors find similarities between the determinants of capital structure among the five countries investigated, but the importance of these factors varies between the countries. This suggests that firm-specific factors cannot altogether explain capital structure and that country specific factors are also important. They also find evidence that the macroeconomic environment is important in explaining capital strucEconomic Issues, Vol. 19, Part 2, 2014 ture choice, but again the importance of this varies between the countries needs to be investigated.

Similarly, De Jong et al (2008) investigate the influence of firm-specific and country-specific factors in the capital structure choice of firms in a sample of 42 countries between 1997 and 2001. They find that firm specific factors (asset tangibility, firm size, and profitability and growth opportunities) have a significant impact on the capital structure choice in most countries.

However, they also find that, for each country investigated, at least one of these factors is not significant and in a few countries, capital structure is inconsistent with the predictions of any theory of capital structure. They further find that creditor right protection, bond market development and GDP growth have a significant impact on corporate capital structure. The implication is that firms in countries with stronger legal protection and healthier economic conditions are more likely to take on debt. In other words, country specific factors matter in capital structure decisions.

Most studies show a positive correlation between leverage and tangibility (and size), which implies a role for trade-off theory in capital structure decisions. However, this role for trade-off theory is contradicted, since the correlation between leverage and profitability is negative. This contradictory finding can be found in several studies, such as Titman and Wessels (1988); Rajan and Zingales (1995); Antoniou et al (2008); De Jong et al (2008); and Akdal (2010). Fama and French (2002) argue that each capital structure theory possesses one defect in predicting the financing choices of firms. Thus pecking order theory fails to explain why small, low-leverage, growth firms have large equity issues whilst trade-off theory is unable to explain the negative correlation of leverage and profitability.

Shyam-Sunder and Myers (1999) investigate a sample of 157 US firms and find that these firms largely finance their deficits with debt. They conclude that the pecking order theory provides a good first-order approximation of the financing behaviour of the firms investigated. Consistent with this view, Fama and French (2002) report that short term variation in earnings and investment is mostly absorbed by debt. In contrast, Frank and Goyal (2003) show that Shyam-Sunder and Myers’ empirical findings supporting pecking order theory do not survive when a broader sample of firms, or a longer time series, is used. Chirinko and Singha (2000) argue that the empirical test used by Shyam-Sunder and Myers has little power to distinguish the order of the financing schemes. They argue that the model used by Shyam-Sunder and Myers neglected the possibility of hidden costs of debt or hidden benefits of equity, which might change the preference of the financing order.

A recent study Bartiloro and Iasio (2012) provides an insight into how recent events in the financial system have impacted on firms' capital structure. Economic theory suggests that developed financial systems stimulate economic growth by improving efficiency in the allocation of resources to productive units. This process of channelling funds from savers to productive

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