Literature Review on Determinants of Capital Structure

Now researcher presents a brief discussion on the factors that may have an effect on the firm's debt-equity choice. Various researchers have taken different variables to test capital structure. According to Titman and Wessels (1988), these factors are tangibility of assets, size, growth opportunities, profitability, non-debt tax shields, earnings volatility, uniqueness, and industry classification. But Harris and Raviv (1991), includes advertising expenditure and Research & development (R&D) expenditure in these factors list.

In this paper researcher focuses on four of the above mentioned factors:  tangibility of assets, size, growth, profitability. The researcher excludes other factors such as advertising expenditure, R&D expenditure and industry classification.

The factors, their relation with the capital structure or leverage, their measurement formula and the hypothesized relationship with leverage are discussed below following the discussion after ‘Leverage’.

 Leverage

This is general practice in accounts and finance to take  debt-equity ratio as leverage but before undertaking any investigation of leverage it is appropriate at define  what researcher mean by this term. Rajan and Zingales (1995) referred to Jensen and Mecling (1976), Myres (1977) who have taken debt for different objective and they defined it in different ways.  Rajan and Zingales (1995) emphasized on four definitions of leverage which are given below:

First leverage is the ratio of total liabilities to total assets (TL/TA). This ratio shows what will be left for shareholders after the prior claim by debt holders. Since, total liabilities also includes current liabilities such as account payable and tax payable which arises due to normal business transactions ( and generally do not required to pay financial charges, though qualitative issues are involved here) rather than due to financing. Consequently this represents overstate position of leverage. Second leverage is the ratio of interest bearing debt to total assets (IBD/TA). Here researcher normally excludes trade creditors and accrued expenses from total liabilities. Interest bearing debt includes short and long term debt which was used for financing. Third leverage is the ratio of total debt to net assets (TD/NA), where net assets are fixed assets plus net working capital (Current Assets minus Current Liabilities). Fourth leverage is the ratio of total debt to total equity (TD/TE), where equity includes total liabilities plus capital. It represents the ratio between the capital employed and debt taken.

Booth et al. (2001) define total debt ratio as total liabilities divided by total liabilities and net worth. Mao X Connie (2003) took ratio of long term debt over book value of assets to calculate book leverage ratio.

All these definitions are based on ratios between debt and assets with some variations. Now, the issue is whether these ratios are computed on book values or on the market values. One of the researchers, Fama and French (2002) suggested that these should be on book values. Fama and French (2002) argued in their paper that in the trade off model, agency costs, taxes, and bankruptcy costs push firms to increase debt as earnings increase while in the pecking order model, firms with lots of profits and few investments have little debt.

Another, Thies and Klock (1991) suggested that market values are not easily available because it depends on number of such factors which are out of control of  the firm. So, book values provide relatively ease and accuracy with which it can be calculated. Book values can better reflect management’s target ratios, even management can claim to use book values in order to avoid distortions in their financial planning caused by the volatility of market Drobtez and Fix (2003).  Another reason of this is the cost of borrowing. If a firm falls in financial distress and goes into bankruptcy, then the relevant value of the debt is the book value of debt (Shah & Hijazi, 2004).

Another issue is that whether to take total debt or only long term debt in the measurement of leverage. Although capital structure theories consider long term debt as an alternative for financial leverage (Mao X Connie 2003), we take total debt in the measurement of leverage because in the developing country like Pakistan, firms used to have short term financing. Because  average firm size is small which makes access to capital market difficult in terms of cost and technical difficulties. Booth  et al.(2001) also pointed in their study on determinants of capital structure in developing countries which also includes Pakistan that the use of short term financing is higher than long term financing in developing countries (Shah & Hijazi, 2004).

 Leverage and Tangibility of Assets

Tangibility is an important factor that reduces the agency costs of debt. Capital structure theories argue that the type of assets (tangible and intangible) owned by a firm in some way affects its capital structure decision. Berger and Udell (1995) show that firms with close relationships with creditors need to provide less collateral. They argue this is because the relationship substitutes for physical collateral. If so, researcher find tangibility mattering less in the bank oriented countries. Myers and Majluf (1984) suggest that there may be costs associated with issuing new equity about which the firm's managers have better information than outside shareholders. Issuing debt secured by property with known values avoids these costs. For this reason, firms with tangible assets that can be used as collateral may be expected to issue more debt to take advantage of this opportunity (Titman & Wessels, 1988) and ( Mao X Connie 2003).

Another study by Shah and Hijazi (2004), state that there is a positive relationship between tangibility of assets and leverage. They argue that because a firm with large amount of fixed assets can borrow at a relatively low rate of interest by providing the security of these assets to creditors, is expected to borrow more as compared to a firm whose cost of borrowing is higher because of having less fixed assets. Hence, it implies a positive relation between leverage and tangibility of assets.

Jensen and Meckling (1976) and Myers (1977) argue that without collateralized assets, there is no guarantee exists. This suggests that increased proportion of tangible assets on the balance sheet will also reveal the increased debt capacity. Hence, the trade-off theory predicts a positive relationship between tangibility of assets and leverage. However, if the debt can be collateralized, the borrower is restricted to use the funds for a specified project. Since no such guarantee can be used for projects that cannot be collateralized, creditors may require more favorable terms, which in turn may lead such firms to use equity rather than debt financing (Titman & Wessels, 1988).

However, on the other side, tendency of managers to consume more than the optimal level of perquisites may produce the opposite relation between tangibility of assets and leverage but in contrast the higher leverage also diminishes this tendency because of the increased threat of bankruptcy.

Tangibility of assets is typically measured by the ratio of fixed assets to total assets. This represents the effect of the collateral value of assets of the firm. The studies such as Rajan and Zingales (1995) and Fama and French (2002) also suggest that the ratio of fixed assets to total assets should be an important factor for leverage.

Some studies construct a measure of collateralizable assets as the ratio of inventory plus net property, plant and equipment to total assets. Because tangible assets are easier to collateralize, they suffer a smaller loss of value when firms go into financial distress. Thus, from a trade-off perspective tangibility has an important effect on the costs of financial distress.

The estimated model measures tangibility of assets as a ratio of fixed assets divided by total assets.  It takes gross amount of fixed assets as a numerator instead of the net depreciated value. This is because of two reasons: (i) depreciation method varies firm to firm and, (ii) an asset can be pledge even if it has been fully depreciated. So the first hypothesis to test in the estimated model is:

H 1: A firm having higher percentage of tangible assets will have a higher leverage.

Leverage and Size       

Rajan and Zingales (1995) argued that size may be a proxy for the inverse probability of default. If  it is so, it should not be strongly positively related with leverage in countries where costs of financial distress are low. Rajan and Zingales (1995) further argue that informational asymmetries between insiders in a firm and the capital markets are lower for large firms. So large firms should be more capable of issuing informationally sensitive securities like equity, and should have lower debt. This means that there is a negative relationship between leverage and firm size. Accordingly, the pecking order theory also interprets the same inverse relationship.

The effect of size on leverage is ambiguous. On the one hand, Titman and Wessels (1988) argue that large firms will have more debt because they  are more diversified and have lower default risk. They are also typically more mature firms. They tend to be more diversified and less prone to bankruptcy. These firms have a reputation in debt markets also and consequently face lower cost of debt. Because of this, larger firms employ more debt. Accordingly, the trade-off theory also predicts a positive relationship between firm size and leverage.

The cost of issuing debt and equity is off course related to firm size. In particular, small firms pay much more than large firms to issue new equity and also somewhat more to issue long-term debt. This suggests that small firms may be more leveraged than large firms and may prefer to borrow short term rather than issue long-term debt because of the lower fixed costs associated with this alternative (Titman & Wessels, 1988).

Apart from all above discussion, the estimated model follows what the pecking order model predicts i.e.; negative relationship between leverage and firm size. It uses of sales as an indicator of firm size. So the second hypothesis to test in the estimated model is:

H 2: There is a negative relationship between firm size and leverage. 

Leverage and Growth

Titman and Wessels (1988) and Rajan and Zingales (1995) find a negative relation between growth opportunities and leverage. They argue that the agency costs for growing firms are expected to be higher as these firms have more flexibility with regard to future investments. If a firm is growing that means it has number of projects to undergo which gives it choices of selection. So the bondholders become worried that firms may go for risky projects. Ultimately, bondholders will impose higher costs of lending to the growing firms. Thus, because of higher cost of debt growing firms will use less debt and prefer to issue more equity.

One side, the trade-off theory predicts a negative relation between leverage and growth because the growing firms lose more of their value when they face financial distress. Myers (1977) also suggests the negative relation because of agency costs. See the examples below:

Example I: The underinvestment problem is more severe for growing firms leading these firms to prefer less debt. The underinvestment problem arises because firms with risky debt have an incentive to under invest in projects having positive net present value. Hence, the shareholders bear the entire cost of the project but receive only a fraction of the increase in firm value. However part of it also goes to debt holders.

Example II: The asset substitution problem is also more severe for growing firms because in these firms, it is easier for shareholders to increase project risk and it is harder for debt holders to detect such changes. Thus, debt is more costly for firms with high growth opportunities. So pursue less debt.

Fama and French (2002) explain how the predictions for book leverage carry over to market leverage. The trade-off theory predicts a negative relationship between leverage and investment opportunities. Since the market value grows at least in proportion with investment outlays, the relation between growth opportunities and market leverage is also negative (Drobetz and Fix, 2003).

However, on the other side, the pecking order theory suggests that a firm will use internal financing first which may not be sufficient for a growing firm. The next option for the growing firms is to use debt financing which implies that the growing firms will use a high level of leverage (Shah and Hijazi, 2004).

Indicators of growth include capital expenditures over total assets; the growth of total assets measured by the percentage change in total assets, and research and development over sales also serves as an indicator of the growth. Apart from the different options, the estimated model uses the growth of total assets measured by the percentage change in total assets as a growth indicator because of insufficient data availability with regard to capital expenditure and research and development expenditures. So, the third hypothesis to test in the estimated model is:

H 3: Firms with a higher growth rate will have higher leverage.

Leverage and Profitability

Fama and French (2002) discuss in their paper that in the tradeoff model more profitable firms extensively use debt financing because firms get tax advantage of debt and reduce expected costs of distress and bankruptcy, this is further supported by Strebulaev A. Ilya (2007). In contrast, in the pecking order model, higher earnings result in less book and market leverage. Profitability is negatively correlated with leverage. If in the short run, dividends and investments are fixed, and if debt financing is the dominant mode of external financing, then changes in profitability will be negatively correlated with changes in leverage Rajan and Zingales (1995).

The trade-off theory predicts that profitable firms should have more debt and this is because of three reasons: Expected bankruptcy costs, taxes and agency costs. Firstly, the expected bankruptcy costs are lower for more profitable firms. Secondly, Interest tax shields are more valuable for profitable firms because of the deductibility of interest payments which induces them greatly to finance with debt. Finally, higher leverage helps to control agency problems by forcing managers to pay out more of the firm’s excess cash. This strong commitment to pay out a larger fraction of their earnings to debt payments suggests a positive relationship between leverage and profitability (Jensen & Meckling, 1976).

Different studies find a negative relation between profitability and leverage. This negative relation is interpreted as consistent with the pecking order theory and inconsistent with the trade-off theory. In the pecking order model, there is a certain order given for firms’ financing. Firstly, they finance through retained earnings, secondly from debt, and finally from issuing new equity. This is because of the costs associated with issuance of new equity in the presence of information asymmetries (Myers and Majluf, 1984; Titman and Wessels, 1988).  However, Debt increases when investment need exceeds retained earnings and decreases when it is not sufficient to be covered by retained earnings. So, this is what pecking order model predicts. i.e.; negative relation between leverage and profitability.

Following the Titman and Wessels (1988), the estimated model also predicts the negative relationship between leverage and profitability. Indicator of profitability includes the ratio of net operating income before tax over total assets. So, the fourth hypothesis to test in the estimated model is:

H 4: Firms with higher profitability will have lesser leverage.

The summarized data is available in the table given below that presents the determinants of capital structure, their measurement formula and their hypothesized relationship.