1. INTRODUCTION:
One of the
most important decisions in the field of corporate finance pertains to
financial policy. Using debt financing can have both positive and negative
effects on the value of the firm. On the other hand, debt financing is
value-enhancing for the firm because it provides a tax shield. Furthermore,
debt allows reducing the conflicts of interest between managers and
shareholders. On the other hand, the use of debt may increase bankruptcy costs
and may lead the managers of firms with growth opportunities to accept
sub-optimal investment opportunities. In addition, debt often does not
constitute an appropriate solution to finance highly innovative start-up
companies.
Capital structure
refers to the different options used by a firm in financing its assets.
Generally, a firm can go for different levels/mixes of debts, equity or other
financial arrangements.
It can
combine bonds, lease financing, bank loans or many other options with equity in
an overall attempt to boost the market value of the firm.
In their
attempt to maximise the overall value, firms differ
with respect to capital structures. This has given birth to different capital
structure theories that attempt to explain the variation in capital structures
of firms over time or across regions. The capital structure of firms can be
explained by the following theories:
1.1 Miller and Modigliani Theory of Irrelevance:
Modigliani
and Miller (1958) explained that the value of the firm is independent of the
capital structure it takes on (MM irrelevance). They argue that there would be
arbitrage opportunities in the perfect capital market if the value of the firm
depends on its capital structure. Furthermore, investor can neutralise
any capital structure decision of the firms if both investor and firms can
borrow at the same rate of interest.
1.2 The Trade-off Theory:
The
Trade-off theory posits that there exists a trade off
between the costs and benefits of debt financing that leads to an optimal
capital structure. In order to maximise the value of
the firm, managers should determine the optimal level and then aim at reaching
that level. The various costs in this theory are bankruptcy costs, agency costs
and loss of non-debt tax shields. These costs become especially relevant in a
situation of financial distress and have often been subsumed under 'costs of
financial distresses'. In contrast with these costs, the major benefit of debt
financing is the tax shield of interest expense.
1.3 Signaling Theory:
The
signaling theory is based on asymmetric information problems. In the firms
where individuals who supply capital do not run the firms themselves, there
exist two types of asymmetric information problems. The first problem arises
when there is adverse selection. The controlling managers may possess some
information that is unknown to outside investors. In such case the financing
method can serve as a signal to outside investors. Facing information asymmetry
between inside and outside investors, firms end up having a financial
hierarchy. First they try to use their retained earnings, and then more to debt
when their internal funds run out. Equity is issued only when firms have no
more debt capacity. This process is termed as 'Pecking order theory'.
The agency theory is based on second problem due to information asymmetry that
we explain at the next theory section, and here it is only mentioned that the
conflict arises when there is moral hazard inside the firm, which is called the
agency costs of equity.
1.4 The Agency Theory:
Jensen and Meckling (1976) identify the possible conflict between
shareholders and managers interests because of the manager's share of less than
100 percent in the firm. Furthermore, acting as agents to shareholders,
managers try to appropriate wealth away from
bondholders to shareholders by taking more debt and investing in risky
projects. The managers given role has many implications for the capital
structure of a firm.
2. Prior
Research And Hypotheses Development:
Size:
Rajan and Zingales (1995) argue that
"Larger firms tend to be more diversified and fail less often, so size …
may be an inverse proxy for the probability of bankruptcy". Alternatively,
Smith and Warner (1979) and Michaelas et al. (1999)
argue that the agency conflict between shareholders and lenders may be
particularly severe for small companies. Lenders can manage the risk of lending
to small companies by restricting the lenth of
maturity offered. Small companies can therefore be expected to have less long
term debt – but possibly more short term debt – than larger companies (Barnea et al. (1980), Whited
(1982), and Stohs and Mauer
(1996)).
Cruthley and Hanson (1989) and Rajan and Zingales (1995) find
significant positive correlation between company size and leverage, while Stohs and Mauer (1996) and Michaelas et al (1999) find debt maturity to be positively
correlated with company size. So the first hypothesis is as follows:
H1:
There is a significant positive relationship between size and leverage of the
firm.
Tangibility:
A
firm with large amount of fixed asset can borrow at relatively lower rate of
interest by providing the security of these assets to creditors. Having the
incentive of getting debt at lower interest rate, a firm with higher percentage
of fixed asset is expected to borrow more as compared to a firm whose cost of
borrowing is higher because of having less fixed assets (Attaullah
Shah & Tahir Hijazi
(2004)).
While
Bradley et al., Titman and Wessels, and Rajan and Zingales find a
significant positive relationship between tangibility and leverage, Chittenden
et al. find the relationship between tangibility and leverage and long term
forms of debt, a negative correlation is observed for short term debt elements.
Similarly, Stohs and Mauer
(1996) find debt maturity to be highly correlated with asset maturity, providing
strong support for the maturity matching principle (Brealey
and Myers (1996)). We hypothesise:
H2:
There is a significant positive relationship between tangibility and leverage
of the firm.
Profitability:
According
to Pecking order theory, firms prefer using internal sources of financing
first, then debt and finally external equity obtained by stock issues. All
things being equal, the more profitable the firms are, the more internal
financing they will have, and therefore we should expect a negative relationship
between leverage and profitability (Harris and Raviv
(1991), Rajan and Zingales
(1995), Booth et al. (2001)).
In a
trade-off theory framework, an opposite conclusion is expected. When firms are
profitable, they should prefer debt to benefit from the tax shield. We hypothesise:
H3:
There is a significant negative relationship between profitability and leverage
of the firm.
Growth
opportunities:
For
companies with growth opportunities, the use of debt is limited as in the case
of bankruptcy, the value of growth opportunities will be close to zero. Jung et
al. (1996) show that firms should use equity to finance their growth because
such financing reduces agency costs between shareholders and managers, whereas
firms with less growth prospects should use debt because it has a disciplinary
role (Jensen (1986), Stulz (1990)).
Rajan and Zingales (1995) find a negative
relationship between growth opportunities and leverage. They suggest that this
may be due to firms issuing equity when stock prices are high. We hypothesise:
H4:
There is a significant positive relationship between Growth opportunities and
leverage of the firm.
3. Methodology:
Data Collection and Variables Definition:
The sample used in this study includes 268
non-financial firms listed in Tehran Stock Exchange (TSE). This sample
constitutes 78 percent of the total listed firms in TSE. The choice of firms
was based on the availability of data. Our study analyses cover a period of
five years from 2004 to
Table 1 summarises
the discussion on the determinants of capital structure and their measures and
the expected relationship with leverage as par our hypotheses.
Table 1: Potential
Determinants of Capital Structure, Their Measures, and Expected Relationship with Leverage
|
Determinant |
Measure
(Proxy) |
Expected
Effect on Leverage (Hypothesis) |
|
Size |
Log of Sales |
Positive |
|
Tangibility |
Total Fixed Assets/Total assets |
Positive |
|
Profitability |
Net Income/Net Sales |
Negative |
|
Growth opportunities |
Market Value of Equity + Total
Assets-Net Worth/Total Assets |
Positive |
Statistical Methods:
We used panel data regression analysis. The
panel data analysis facilitates analysis of cross-sectional and time series
data. We use the pooled regression type of panel data analysis. The cross
section company data and time series data pooled together in a single column
assuming that there is no significant cross section or temporal effects.
The general form of our model is:
= 
Where,
=
Leverage of a firm i at the time of t
= The intercept of the equation
= The change co-efficient for 
variables
= The different independent variables for
leverage of a firm i at the time of t
i = The number of
firms (in this study 268 firms)
t = The time period (in this study 5
years)
specifically, when we convert the above equation into
our specified variables, the equation will be:
= 
Where,
LV = Leverage
SZ = Size
TG = Tangibility
PF = Profitability
GO = Growth opportunities
e = The error
term
4. RESULTS:
Table 2 present the mean, maximum, minimum and standard
deviation for our variables that discussed above.
Table 2: Five-years
Summary of Descriptive Statistics
|
|
Leverage |
Size |
Tangibility |
Profit
ability |
Growth
opp. |
|
Mean |
.2206 |
5.3443 |
.3595 |
-.0717 |
1.3862 |
|
Maximum |
.8478 |
7.6917 |
.8948 |
1.7466 |
6.2535 |
|
Minimum |
.0000 |
3.1262 |
.0211 |
-34.1098 |
-3.1768 |
|
Stan. Deviation |
.1612 |
.6177 |
.1932 |
2.2147 |
.7525 |
To check for the possible multicollinearity among the independent variables, we
calculate the Pearson's co-efficient of correlations for the independent
variables. Table 3 presents the results.
Table
3 : Estimated
Correlations Between Independent Variables
|
|
Size |
Tangibility |
profitability |
Growth opp. |
|
Size |
1.0 |
|
|
|
|
Tangibility |
0.071 |
1.0 |
|
|
|
Profitability |
0.310 |
0.032 |
1.0 |
|
|
Growth opp. |
0.126 |
0.099 |
0.141 |
1.0 |
As we can see from the table 3, the multicollinearity problem is not too severe among the
selected independent variables. However, the table sheds light on some
interesting correlations. First, size is positively correlated with the other
three variables. The second observation is the positive correlation between
profitability and size suggesting that large firms are more profitable. Third,
tangibility is positively correlated with the other variables. It is observe
that large firms have more-fixed assets as a percentage of total assets.
Fourth, the positive correlation between size and growth shows that large firms has grow more.
The table 4 shows the summary output for
the regression analysis. The R-square shows that only 24 percent of the
variations in the dependent variable (Leverage) are explained by the variations
in the given four independent variables. The adjusted R-square is slightly
below the R-square. The F-statistics shows the validity of the model as its
96.50130 value is well above its Prob(F-statistic) value of 0.00000.
Table
4: Summary Output of the Regression
Analysis
|
Independent Variables |
Coefficient |
Std. Error |
t-Statistic |
P-value |
|
Size |
0.308 |
0.016 |
0.786 |
0.628 |
|
Tangibility |
0.261 |
0.048 |
5.437 |
0.000 |
|
Profitability |
-0.014 |
0.004 |
-3.278 |
0.001 |
|
Growth opp. |
-0.020 |
0.012 |
-1.578 |
0.116 |
|
R-square |
0.24460 |
MS of Regression |
3.33706 |
|
|
Adjusted R-square |
0.24300 |
Sum square Regression |
11.43033 |
|
|
Standard Error F-statistic |
0.22409 |
Sum squared residuals |
53.34661 |
|
|
Prob(F-statistic) |
96.50130 0.00000 |
Total sum of square |
72.77803 |
|
Analyzing the results for the effects of
independent variables on dependent variable, we find that size is positively
correlated with leverage. This suggests that large firms in Iran borrow more
and small firms are fearful of more debt. However, we do not find much evidence
that this relationship is statistically significant. Though the positive sign
confirms our hypothesis about size, the statistical insignificance does not
support our hypothesis. Thus we reject our first hypothesis.
Asset tangibility is significant positively
correlated with leverage at 1 percent level. Thus we accept our second
hypothesis. The results thus confirm the trade-off theory that debt level
should increase with more fixed tangible assets on balance sheet.
Profitability is significant negatively
correlated with leverage at 1 percent level. Profitability is negatively
correlated with income. This suggests that profitable firms in Iran use more of
equity and less debt. This supports the pecking order theory and also approves
our hypothesis about profitability.
A growth opportunity is negatively related
to leverage. This suggests that growing firms in Iran use more of equity and
less debt to finance the new investment opportunities. This supports the simple
version of pecking order theory that suggest growing firms will resorts first
to the internally generated funds for fulfilling their financing needs.
However, this does not support the extended version of pecking order theory
that suggests that internally generated funds may not be sufficient for a
growing firms and next option for such firm would be to use debt financing.
As we find that a growth opportunity is
negatively related to leverage, thus we reject our last hypothesis.
5. CONCLUSIONS:
In this paper, we use pooled regression model of
panel data analysis to measure the determinants of capital structure in listed
Iranian non-financial firms for five-year period. We use the book value (i.e., dividing book value of long-term debt by sum
of net worth and book value of long-term debt) as a proxy for leverage. We use four independent variables to measure
their effect on leverage.
The results show that size measure by taking log of
sales is positively correlated with leverage; however, this relationship is not
statistically significant. This suggests that large firms will employ more
debt. The implication is that large firms consider themselves to have less
chances of falling into financial distress and have more capacity to absorb
shocks. One may also infer that fixed direct bankruptcy costs are smaller for
large firms as a percent of their total value; that is why they do not fear
bankruptcy that much as the smaller firms do. Facing lower bankruptcy costs,
large firms take more debt.
The results also show that asset tangibility is
significant positively correlated with leverage. We may conclude that asset
structure is matter in determination of capital structure of Iranian firms.
Strong relationship was found between profitability
and leverage. Profitability as measured by dividing net income
by net sales is negatively correlated with leverage that supports the pecking
order theory.
Growth measured by the market-to-book ratio is negatively correlated with leverage that supports
the simple version of pecking order theory that growing firms finance their
investment opportunities first by their internally generated funds. However
this does not support the extended version of picking order theory.
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Received on 29.03.2011 Accepted on 20.04.2011
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Asian J. Management 2(2): April-June, 2011 page 63-66