Testing the pecking order theory and static tradeoff theory:
The role of corporate governance and creditor protection
Name: Anna Szućko Student number: s3408280
Study Program: MSc International Financial Management Thesis supervisor: Dr. Raymond Zaal
Second supervisor: Dr. Wolfgang Bessler
Abstract
Capital structure choices pose various challenges to companies which include strategic decision making concerned with determining an optimal mix of debt and equity. These decisions are of paramount importance for a company’s growth, hence its long term existence and fulfilment of corporate objectives. Based on the sample of international companies and their financial data from 2011 to 2016, the paper investigates the capital structure choices of these companies, particularly examining the impact of corporate governance and degree of creditor protection on capital structure-related decisions. The evidence presented implies that firms tend to follow the pecking order behavior. The results also suggest that given the presence of a moderating effect of corporate governance, the pecking order argument involving profitability and leverage becomes stronger. On the other hand, while including control variables in the model, the relevance of asset tangibility associated with the static tradeoff theory turns insignificant. In terms of the degree of creditor protection, its moderating effect weakens the relationship between asset tangibility and leverage, and strengthens the one between profitability and leverage. Both results are consistent with prior literature.
Key words: Capital structure, pecking order theory, static tradeoff theory, corporate governance, creditor protection
1. Introduction
Capital structure is a concept which has always been of crucial importance to the researchers and financial experts. Capital structure is defined as options that a firm use to finance its assets (Bhaduri, 2002). Altogether with the cost of capital, it is commonly regarded as a significant contributor creating a gap between economic and accounting profit. The cost of funds that are borrowed is delineated in debt and equity, one being more costly than the other. Accounting and economic profit calculations involve a fair market value of a firm’s securities hence they are not determined by historical values of equity. For this reason the weighted average cost of capital needs to be calculated. It includes the proportion of debt and equity and its cost within the capital structure.
Capital structure is of paramount importance for a company's growth, hence its long term existence and overall fulfilment of corporate objectives. Certainly, based on a company's perspective, it is beneficial to operate at an optimal capital structure as it has an influence on, not only cost, but also availability of capital which bears an influence of a firm's performance. The decision concerning the efficient capital structure is not only valuable in terms of meeting the expectations of numerous corporate constituencies, but most importantly, it is associated with maintaining the competitive advantage within the organizational environment (Simerly and Li, 2000; Mitani, 2014).
Over many decades, the topic of a firm's capital structure has been the subject of extant studies attempting to examine key corporate leverage decisions of firm's executives. Among the research, a couple of theories worth attention have emerged. These include the irrelevance theory of capital structure (Miller and Modigliani, 1958), the static tradeoff theory (Kraus and Litzenberger, 1973), and the pecking order theory (Myers and Majluf, 1984). Since managerial decision making is strongly related to capital structure, the purpose of this study is to answer the underlying research question: To what extent do the determinants of the static tradeoff theory and pecking order theory prevail in the capital structure patterns of the companies? To develop the answer, hypothesizing about the capital structure and its determinants would mainly be based
on the two theories and relationship between the determinants which these theories suggest, additionally incorporating the moderating role of a firm level variable of corporate governance, and country level variable being the degree of creditor protection.
The empirical investigation is based on the dataset consisting of international companies and refers to prior literature. The static tradeoff theory holds that the actual debt ratio moves towards an optimum or target level which is primarily determined by a firm's probability of running into financial distress and available tax shield benefits. Thus, the theory predicts a positive relationship between leverage and profitability of a company since a company running a risk of facing financial distress would borrow less (Chen, 2004; Tong ang Green, 2005; López-Garcia, and Sogorb-Mira, 2008). On the other hand, the pecking order theory argues that, due to adverse selection, the preference is given to the internal, rather than external finance. It also implies a negative relationship between leverage and profitability of a company. This hypothesis is empirically supported by, inter alia, Booth et al. (2001), De Jong et al. (2008), and Rajan and Zingales (1995).
Both theories have been commonly tested in prior literature, with significantly greater attention paid to the companies incorporated in the United States. Regarding other developed countries, the tests have delivered mixed results with a critical bias for firms incorporated in Europe (Devic and Krstic, 2001; Gaud et al., 2007; Delcoure, 2007) . For instance, Gaud et al. (2007) suggest that the corporate capital structure of European companies cannot be explained by the static tradeoff theory nor the pecking order. On the other hand, according to Tucker and Stoja (2011), both theories might explain the capital structure choices of the UK companies, although in general neither of the theories supply sufficient explanation. In addition, several authors indicate that the differences of European legal and banking system, corporate governance, creditor protection and stock markets as compared to the rest of the World bear influence on the possible explanations of the capital structure decisions in Europe (Burlacu, 2000; Delcoure, 2007).
A limited number of research papers have been devoted to investigate the prevalence of either of the theories taking into consideration the moderating effect of corporate governance on a firm level. It is a topic of a discussion since firms represent the interests of their stakeholders and therefore the corporate governance of a company has implications with regard to this fact. Corporate governance is seen as a mean to managerial incentive schemes, ownership allocation and capital structure. Prior studies have provided evidence that the quality of corporate governance on a firm level influences the capital structure of companies (Jensen and Meckling, 1976; Titman et al. 2006). Corporate governance is of critical importance to ensure transparency, accountability and balanced wealth distribution. In response to the developments in the financial markets and the urge to increase minority shareholders protection companies restructure their corporate governance mechanisms which simultaneously affects the liquidity and equity-debt mix within financial markets (Jensen and Meckling, 1976). This, in turn, has an impact on the capital structure and tradeoffs that firms need to make.
In terms of a country level variable and in line with, among many, Giannetti (2003), Deesomsak et al. (2004) and De Jong et al. (2008), present paper employs the degree of creditor protection as a factor which might bear an impact on the corporate leverage levels. Creditor protection is seen as the extent to which bankruptcy laws and collateral tangibles provide protection for debt holders rights. In general, it is commonly acknowledged that companies incorporated in countries which favor creditor rights exhibit higher leverage levels and have better access to long term financing (De Jong et al. 2008).
Prior literature rarely does examine the international sample as a whole and is in general concerned with particular countries or regions. For this reason the study focuses on international companies and the empirical investigation covers the period from 2011 to 2016. This particular time frame is meant to revisit the already established framework of the capital structure topic while using a relatively recent period. The data is obtained from ASSET4 database. Both firm level and country level capital structure determinants are used during empirical tests. As suggested by Rajan and Zingales (1995), this study takes into consideration internal exogenous
variables: profitability which henceforth is attributable to the pecking order theory, and asset tangibility determining the prevalence of the static tradeoff theory. Aforementioned corporate governance is introduced as a firm level interaction term, whereas creditor protection is used as a country level interaction variable.
Both the academic and practical relevance of this study resides in the fact that it complements the expanding literature on firm and country specific determinants of corporate capital structure with a relatively recent dataset and, specifically, by studying determinants of corporate leverage. The research, in its analyses, comprises moderating effects which allow to gain an enhanced understanding about the interactions between the determinants. Furthermore, practical relevance of this study bears some implications for managers and other stakeholders, namely, the research provides evidence on how asset tangibility and profitability can impact leverage.
The results of the study suggest that firms within a sample tend to follow the pecking order, that is, they tend to first make use of their retained earnings and given an insufficient amount of these the firms would turn to debt, followed by equity financing. The results of the regression analyses show that asset tangibility becomes statistically insignificant or even negative. This is while controlling for key firm characteristics. Therefore, based on the findings of this paper, it might be implied that asset tangibility has little explanatory power as a determinant of a capital structure. Also, there is a significant support found in terms of both, the moderating role of corporate governance and degree of creditor protection.
This paper is organized as follows. Section 2 elaborates on the determinants of the capital structure, relevant theories and related empirical evidence. Section 3, in further detail, introduces the determinants of the capital structure and discusses the hypotheses being developed. Section 4 describes the data, variables and methodology of the research. Section 5 provides the descriptives, correlation matrix and final results of the study, which is followed by Section 6 concerned with a general conclusion.
2. Literature review
Over many decades, the topic of the capital structure has been the subject of extant studies attempting to examine key corporate leverage decisions of firms’ executives. Among the research, a couple of theories commonly studied in the literature have emerged. These include the irrelevance theory of the capital structure (Miller and Modigliani, 1958), the static tradeoff theory (Kraus and Litzenberger, 1973) and the pecking order theory (Myers and Majluf, 1984). In general, the irrelevance theory of the capital structure states that in an environment with no market imperfections such as taxes, bankruptcy costs, and transaction costs, the capital structure of a firm, and hence associated levels of debt, would not have any effect on the value of a firm (Miller and Modigliani, 1958; Chen, 2004). What comes alongside this hypothesis is that given perfectly competitive markets, a company’s performance would not be affected by the capital structure, which simultaneously implies no significant relationship between these two. The irrelevance theory of capital structure serves as a basis for subsequently developed theories, that is, the static tradeoff theory and pecking order theory which will be introduced in the following sections.
2.1. The static tradeoff theory
The static tradeoff theory argues that in order to identify an optimal capital structure, companies would tradeoff leverage related costs and benefits of different financing possibilities simultaneously taking into account the existing market imperfections (Bradley, Jarrell, and Kim, 1984). According to Kraus and Litzenberger (1973), the aim is to balance the tax savings gained from debt with the financial distress costs (Hillier et al., 2011). What comes along, is the assumption that a higher tax rate induces a significantly higher incentive to borrow (Shyam-Sunder and Myers, 1999). Nevertheless, it is worth mentioning that the costs of the financial distress are highly dependent on a company’s assets, that is, these costs would be determined by the ease of transferring the ownership of the assets. In terms of the tax savings gained from using debt, they mainly arise because debt alleviates the potential problem concerning free cash flow availability and, in addition, it allows interest payments to be tax deductible (López-Gracia and Sogorb-Mira, 2008). Other researchers add to the static tradeoff
theory by suggesting that besides determining the optimal structure of marginal benefits and costs of each unit of financing employed, the form of the capital structure itself ought to be determined, so as to equate these benefits and costs (Tong and Green, 2005).
The static tradeoff theory suggests that large and profitable companies are prone to use more debt than their smaller in size and less profitable counterparts. In general, one might claim this notion to run counterintuitive, although the rationale behind it lies in the assumption that these large and profitable firms are less likely to encounter financial distress and are better able to benefit from the available tax shield advantages (Bowen, Daley, and Huber, 1982). Therefore, the overall hypothesis of the static tradeoff theory implies a positive relationship between the profitability and corporate leverage, i.e., a company running a risk of facing financial distress would borrow less (Chen, 2004).
2.1.1. Empirical results on the static tradeoff theory
The static tradeoff theory and its underlying hypothesis have been empirically supported by a number of the researchers. In their study, Antonious, Guney, and Paudyal (2002) indicate that the size of a firm and leverage levels are positively correlated. The authors also argue that asset tangibility plays a significant role in countries exhibiting a significant reliance on bank lending. Furthermore, Mesquita and Lara (2003) validate these results additionally concluding that, in the short run, there is a positive and significant relationship between debt and corporate leverage levels, whereas this relationship turns inverse provided long run timeframe. Moreover, Rajan and Zingales (1995) document that companies holding sufficient tangible assets which serve as debt collateral are less likely to face insolvency issues, hence they are prone to acquire more debt. Also, as larger firms tend to have better access to the capital markets, Bevan and Danbolt (2002) argue that these companies would utilize more debt financing.
Consistent with prior work, Bradley et al. (1984) document both empirical and theoretical support for the static tradeoff theory arguing that leverage ratio is negatively associated to the amount of non-debt tax shields, agency costs and costs of financial distress. In terms of
non-debt tax shields, Myers (1977) points out that depreciation and tax credit deductions might create assets that may induce growth options which, in turn, increase the agency costs of debt. In general, deferred tax losses, investment tax credits and depreciation might be viewed against taxes such as debt interest (DeAngelo and Masulis, 1980). To elaborate, these may reduce cash outflows simultaneously decreasing a company's need for financing, hence also leading to lower cost of capital. This implies that the non-debt tax shield can alleviate the dilemma of a too low debt tax shield. According to DeAngelo and Masulis (1980) a decrease in investment-related tax shields resulting from changes in inflation level or corporate tax rates which, in turn, leads to a decrease in a real value of a tax shield, would increase the amount of debt of a given company. Therefore, the preference for debt financing will increase provided a low investment-related tax shield of a company (Kim and Sorensen 1986; Titman and Wessels, 1988; Hung, 2002).
In favor of the static tradeoff theory, Burlacu (2000) insist that the results of the study conducted on French companies are in line with the static tradeoff model. Furthermore, Delcoure (2007) carries out the research on Central and Eastern European countries so as to examine whether the corporations of these countries follow the static tradeoff theory or if they exhibit the pecking order behavior. The study documents that neither or the theories explain the capital structure policies of companies incorporated in Central and Eastern European countries. This result is due to the differences in factors influencing the corporate leverage decision making such as, for instance, creditor and shareholder protection rights, banking system regulations, sophistication and development of the stock markets, and corporate governance practices. On the other hand, Dević and Krstić (2001) conduct an empirical study on Poland and Hungary. The analysis indicates that the size of a company is among the most significant determinants of the capital structure in Poland, whereas profitability turns out to be the most important variable explaining Hungarian leverage patterns.
2.2. The pecking order theory
Myers (1984) propose the pecking order theory which, instead of being focused on the optimal capital structure, takes into consideration the hierarchy of financing choices. The pecking order
theory implies that while following this hierarchy, one can minimize the information asymmetry issues, i.e., from a firm’s perspective, internal financing is superior to debt or equity use, whereas equity would serve as a last resort. Myers and Majluf (1984) argue that the level of uncertainty of the issued equity price is significant enough to trigger off information asymmetry issues while financing a positive net present value project. Hence, a positive net present value project might turn negative provided an overpriced equity raise. For this reason, having investment opportunities carrying positive net present value and simultaneously having insufficient internal financing, a company might not be willing to raise undervalued securities. In line with the aforementioned, Shyam-Sunder and Myers (1999) in their paper on the pecking order theory
claim that debt is a safer security than the equity is. According to them, this is due to the fact, that future values of debt are more likely to change less. The debt values would not be affected by a manager’s revelation of an inside information to the market, or at least the impact of this revelation would affect debt values to a lesser extent than the equity values. Therefore, the underlying argument of the pecking order theory is that the asymmetric information is a main contributor to the creation of the costs hierarchy within the external financing use (Tong and Green, 2005).
In comparison to the static tradeoff theory which is primarily concerned with target adjustments leading to an optimal capital structure, the pecking order theory is deemed to be more likely to explain the time series variance in the leverage levels of a company. The theory predicts that the companies generating high cash flows would use relatively less debt than their less profitable counterparts. This is mainly due to the greater amount of the retained earnings at the disposal of the firms generating these high cash flows. In addition, following from the hierarchy of costs, debt would take precedence over the equity use since the latter involves the issuance of a firm’s additional stock which, in turn, implies a higher level of the external ownership over a firm, and is seen as a cost. In general, the pecking order theory suggests a negative relationship between profitability and leverage of a firm, i.e., low leverage levels are associated with high profitability since profitable firms have sufficient funds available and therefore are better able to avoid using debt.
2.2.1. Empirical results on the pecking order theory
The pecking order theory and its hypothesis has been empirically supported by, inter alia, Rajan and Zingales (1995), Booth et al. (2001), Fama and French, (2002), and De Jong et al. (2008). The study of Rajan and Zingales (1995) examines the leverage structures across companies headquartered in G-7 countries. The authors find out that the extent to which companies are levered is similar, with little deviation concerning the United Kingdom and Germany, which are substantially less levered than others. They also indicate that the relationship between asset tangibility, firm size and leverage is significant for the majority of G-7 countries. In their study, Rajan and Zingales (1995) argue that the level of leverage tends to increase with a firm size and that there is a negative relationship between aforementioned profitability and leverage.
Having employed different approach by incorporating information asymmetry between the management and investors into the analysis, Cadsby, Frank and Maksimovic (1998) focus on investigating whether there are several other possible equilibriums of the financing choices involving debt and equity. In their study they argue that provided the availability of debt which has equity characteristics such as these attributable to, for instance, hybrid bonds and convertibles, the overall advantage of the preference for the debt over equity financing might not be as obvious as stated (Cadsby et al., 1998). Interestingly, Halov and Heider (2004) conclude that debt financing would be preferred once there is no information asymmetry on a company’s riskiness, and vice versa, equity would be chosen provided information asymmetry is present. With regard to the fact of being a large (small) and financially stable (financially distressed) company, Fama and French (2002) argue that firms which pay dividends, i.e., financially stable firms, would opt for debt financing provided insufficient retained earnings at their disposal. The study concludes that debt is preferred in case of a requirement for a short term financing for firms which pay no dividends, i.e., smaller firms, whereas in terms of a long term financing needs of these companies, equity financing would be utilized. Thereby, according to Fama and French (2002), the risk factor provides the reasoning for the preference for the equity over debt use of the companies with significantly weaker financial stability, which simultaneously means that this preference is in line with the pecking order behavior. This
hypothesis concerning the risk factor is also supported by Halov and Heider (2004) as previously mentioned. Prior literature advise to employ liquidity variable as a firm-specific determinant of the presence of the pecking order behavior in place (De Jong et al. 2008). The researchers suggest a negative relationship between corporate leverage and liquidity since highly liquid companies are prone to borrow less. This is due to the fact of having more internal funds at the disposal of these companies.
Among empirical tests on the pecking order theory, the most renowned one of Shyam-Sunder and Myers (1999) tests the pecking order theory against the static tradeoff theory. The authors developed a model which assumes that there should be an even change in the level of firm debt provided each additional unit of the financing deficit. As a consequence, in the presence of the pecking order theory the slope coefficient would be one. Based on the sample of 157 US companies with continuous data from 1971 to 1989, Shyam-Sunder and Myers (1999) indicate the slope coefficient to vary between 0.69 and 0.85 and therefore they argue that a company’s financing deficit is primarily financed with debt which runs as a supportive evidence for the theory. Having studied the pecking order theory on a larger scale, Frank and Goyal (2003) attempt to conduct a similar study to the research of Shyam-Sunder and Myers (1999). Despite the fact of a significantly greater sample of firms, the results of the empirical tests run contrary to those of other researchers. Frank and Goyal (2003) find that there is no evident preference for debt and they suggest that the pecking order theory is best attributable to the largest companies. Moreover, concerning the data from 1990s onwards, the study implies that the explanatory power of the pecking order theory weakens over time. This argument is also supported by Shyam-Sunder and Myers (1999) who suggest that this is mainly due to the fact of the leveraged restructurings undertaken by the companies under investigation. In order to combat the explanatory dilemma, Bharath, Pasquariello, and Wu (2009) add an information asymmetry index to the financial deficit based model used by, inter alia, Shyam-Sunder and Myers (1999) and Frank and Goyal (2003). The authors find that the explanatory power of the pecking order model becomes enhanced while adding the variable
which seems to be in line with the assumption of the information asymmetry importance within the theory itself (Myers and Majluf, 1984).
In terms of Europe, there is little evidence supportive for the critical prevalence of either of the theories within the capital structure patterns of European companies. Gaud et al. (2007) conducting a study on a sample of more than 5,000 European companies and controlling for national patterns and dynamics concludes that the capital structure policies in Europe cannot be explained by either of the theories. The authors further suggest that there is a strong influence of the market timing and corporate governance policies on the capital structure patterns within European firms, also implying that these corporations limit themselves to the upper leverage bound. A couple of researchers claim to find sufficient support for the presence of the pecking order theory in the capital structure decisions made by the companies incorporated in the United Kingdom (Watson and Wilson, 2002; Tucker and Stoja, 2011). While testing the central implication of the pecking order theory, namely, the precedence of debt over equity financing, Watson and Wilson (2002) suggest that the pecking order could be found in debt structures of small and medium UK enterprises. Additionally, Tucker and Stoja (2011), accounting for the industry membership, conclude that both the static tradeoff theory and pecking order theory might have, to some extent, an explanatory power with regard to the capital structure policies of UK companies, although neither of them supply a sufficient reasoning behind the general behavior of these. To elaborate, the authors indicate that in the short run, companies which are newly set up tend to switch to the equity use, as opposed to the old economy firms following a standard pecking order behavior.
3. Determinants of the capital structure and hypotheses development
The following section provides a brief discussion of the firm level and country level determinants of a company’s capital structure and develops hypotheses related to those factors simultaneously incorporating two different theoretical perspectives discussed in previous chapters. The firm level and country level explanatory variables used in this study are denoted as profitability, asset tangibility, corporate governance, and degree of creditor protection.
3.1. Firm and country level determinants
3.1.1. Profitability
According to the static tradeoff theory, there is a positive relationship between a firm’s profitability and its leverage. This relationship is partially an effect of the 'signaling’ (Chen, 2004), i.e., investors tend to infer a significantly greater firm value given high levels of debt employed. High profitability of a company also implies less probability of going bankrupt and significantly lower bankruptcy costs. Furthermore, as a result of higher taxable earnings firms benefit from available tax shields. This argument is supported by, inter alia, Um (2001) and Bowen, Daley, and Huber (1982), who indeed indicate that due to a higher debt capacity of highly profitable companies, a firm is able to take advantage of tax deductions. Scott (1977) confirms that tax deduction advantage leads to the preference for debt finance.
H1a: There is a significant and positive relationship between profitability and leverage.
On the other hand, the pecking order theory predicts that the companies generating high cash flows would use relatively less debt than their less profitable counterparts. This is mainly due to the greater amount of the retained earnings at the disposal of the firms generating these high cash flows. In addition, following from the hierarchy of costs, debt would take precedence over the equity use (Booth et al. 2001; De Jong et al. 2006) since the latter involves the issuance of a firm’s additional stock which, in turn, implies a higher level of the external ownership over a firm, and is seen as a cost. In general, the pecking order theory suggests a negative relationship between the profitability and leverage of a firm, i.e., low leverage levels are associated with high profitability since profitable firms have sufficient funds available and therefore are better able to avoid using debt. For these reasons:
H1b: There is a significant and negative relationship between profitability and leverage.
3.1.2. Tangibility
In line with the static tradeoff theory, researchers argue that asset tangibility and leverage are positively correlated (Jensen et al. 1992; Rajan and Zingales, 1995; Booth et al. 2001). The reasoning behind this relationship is that creditors require more collateral assets to finance new projects due to the asset substitution problem. It is argued that while a company has a larger collateral value of its assets, it is simultaneously more likely to have better access to bank credit as opposed to firms having large intangible assets at their disposal. It is mainly due to the fact of the reduction in the riskiness of investments involving assets as they are readily market disposable. According to this, is it also expected that manufacturing companies should have larger leverage levels than firms providing services (Thornhill et al. 2004). Also, while being unable to provide collateral assets, companies might be paying higher interest or will have to switch into equity use instead of debt use (Deesomsak et al. 2004) . From the static tradeoff theory perspective, it is expected that firms with greater tangible assets are more likely to face lower financial distress costs, as the loss of value of those tangible assets in case of bankruptcy is way smaller and the liquidation capacity of the tangible assets is higher. Also, outsiders are better able to easily infer the value of the tangible assets which results in reduced information asymmetry, and more pronounced debt capacity.
H2a: There is a significant and positive relationship between asset tangibility and leverage.
The pecking order theory suggests that asset tangibility and leverage are negatively related (Song, et al. 2006; Oztekin and Flannery, 2012; Dang, 2013; Chakraborty, 2013) , since a company having less collateral assets is facing more information asymmetry and associated costs, thus it prefers to use debt to equity financing. To the detriment of the external financing, sufficiently large tangible assets create an opportunity for greater depreciation funds, in turn, generating internal funds at the disposal of a company. Prior research indicate that negative relationship between tangibility of assets and leverage might be also due to the risk associated with greater access to liquid tangibles (Morellec, 2001). To elaborate, there is an exploitation of
debt by managers, whereas shareholders tend to sell underpriced and uncollateralized assets in order to obtain short term financing.
H2b: There is a significant and negative relationship between asset tangibility and leverage.
3.1.3. Corporate governance
For the purpose of this paper, corporate governance is used as a proxy for a firm level moderating variable which may influence the relationship between particular determinant of each of the theories and leverage level.
Corporate governance is seen as a mean to managerial incentive schemes, ownership allocation and capital structure. Prior studies have provided evidence that the quality of corporate governance on a firm level influences the capital structure of companies (Jensen and Meckling, 1976; Titman et al. 2006). In response to the developments in the financial markets and the urge to increase minority shareholders protection companies restructure their corporate governance mechanisms which simultaneously affects the liquidity and equity-debt mix within financial markets (Jensen and Meckling, 1976). This, in turn, has an impact on the capital structure and tradeoffs that firms need to make.
In terms of the static tradeoff theory, there is little prior research on the relationship between asset tangibility and corporate governance. In general, this relationship is deemed to be concerned with the liquidation threat. The reasoning behind this lies in the assumption that debt is already disciplining managers in companies with a large share of tangible assets (Sauvagnat, 2013). Therefore, for firms with a great number of intangibles, debt would not act as an appropriate disciplinary force. These arguments are associated with the liquidation threat which is a proxy for disciplinary mechanism and implies that good corporate governance induces high performance of firms holding a significant share of intangible assets. Asset redeployability and liquidation values of intangible firms tend to be significantly lower, hence these companies are
less prone to use debt, delegating the monitoring to the corporate control market. (Cremers and Nair, 2005; Sauvagnat, 2013).
H3a: Corporate governance moderates the relationship between asset tangibility and leverage.
Regarding the pecking order theory, the relationship between profitability and corporate governance of a firm has been frequently studied in the literature. In general, this relationship is meant to be positive, ie., the better the corporate governance of a company the higher its profitability (Drobetz et al., 2003; Klapper and Love, 2004; Garay and González, 2008; Varshney et al., 2012). Among many factors contributing to the overall corporate governance, researchers have found that there is a positive impact of the board size and audit committee size on a firm performance. Also, the board composition is deemed to positively impact the financial performance of firms. On the other hand, prior literature argues that the frequency of the board’s meetings exerts a negative influence on a company’s profitability (Mathur and Gill, 2011; Danoshana and Ravivathani, 2013).
H3b: Corporate governance moderates the relationship between profitability and leverage.
3.1.4. Degree of creditor protection
In terms of the country level variable used in the present paper, it is commonly discussed that the degree of creditor protection has an impact on corporate leverage decisions across countries as well it influences the financial markets. The role of this variable has been recently investigated in more detail by Bae and Goyal (2009), Houston et al. (2010), and Miller and Reisel (2012).
In general, it has been commonly acknowledged that better creditor protection alleviates agency costs related to value shifting issues. To elaborate, bondholders defending their own goals against shareholders and managers might attempt to do so by additional debt covenants or higher interest rates. The general assumption is that provided high creditor protection and
punishment for any possible misconduct, the incentive to lower the cost of debt is much higher. According to De Jong et al. (2008), high creditor protection in a country results in greater preference for debt financing. Hall (2012), in his empirical analysis, indicates that the relationship between asset tangibility and corporate leverage significantly deviates in countries in which there are fewer collateral assets restrictions. Furthermore, prior study by Bradley, Jarrell and Kim (1984) suggest that firms having a greater amount of intangible assets at their disposal tend to face reduced borrowing capacity, since they lack tangibles for collateral purposes.
H4a: The degree of creditor protection moderates the relationship between asset tangibility and leverage.
In terms of the relationship between creditor protection and profitability, the literature is generally supportive for the fact that reduced creditor protection results in firms undertaking more risky investments which are value enhancing (Giannetti, 2003; Houston et al., 2010; Kind et al., 2018). Recent study by Kind et al. (2018) stresses the fact that a decrease in creditor rights incentivises companies to reduce protection mechanisms which are applied in order to prevent adverse bankruptcy provisions. According to Kind et al. (2018), this channel regarding protection mechanisms is due to the previously mentioned, that is the fact of companies taking on substantially greater levels of risk, which in turn is value improving and enhances the profitability of a firm.
H4b: The degree of creditor protection moderates the relationship between profitability and leverage.
4. Data, variables and methodology
This section introduces the data used to perform regression analyses which is followed by the discussion about the dependent variable, independent and control variables employed in the empirical investigation. The methodology of the research is described at the end of this section.
4.1. Data
The annual data on firm specific factors and leverage of the companies over the period from 2011 to 2016 is obtained from ASSET4 database. The reason for choosing this particular time frame is that, among others, this paper aims at revisiting already established findings on the capital structure topic while using a relatively recent dataset. In terms of the variables employed, country level variable, that is, the degree of creditor protection is derived from the research by Djankov et al. (2007). The creditor protection index used by Djankov et al. (2007) follows from La Porta et al. (1997) and aggregates the four powers of lenders being secured in bankruptcy. It takes the value of 0 for poor creditor protection and 4 reflecting strong creditor protection. The sample set excludes financial institutions and utilities with SIC codes 6000-6999 and 4900-4949 respectively, which are subject to certain regulations affecting their profitability and leverage ratios. This restriction significantly reduces the sample. Furthermore, only firms with a continuous data available over a five year period from 2011 to 2016 are included in the sample. Due to this restriction a number of observations are excluded as many firms in the initial dataset lack key variables in particular years or a number of them. Most of the observations of the companies within the dataset are from the US which is 4731, followed by 1394 observations of Japanese firms and 1135 observations of British companies. Nevertheless the prevalence of the observations within the aforementioned countries, the dataset include a substantial number of observations of European companies as well as Asian firms. Since the data suffers from extreme and less extreme outliers, the former are deleted and the rest is winsorized at the 1st and 99th percentiles (Flannery and Rangan, 2006; Dang, 2011). The final sample consists of 15775 observations on companies from 51 countries.
4.2. Definition of variables
The following section provides the details on the variables used in this research study. At first, the dependent variable leverage is introduced and described, followed by two main independent variables, i.e., asset tangibility and profitability, relevant to the static tradeoff theory and pecking order theory, respectively. Subsequently, a firm level moderator of corporate
governance and a country specific factor, namely, the degree of creditor protection are discussed which is followed by the introduction of three control variables used in this paper.
4.2.1. Dependent variable
The main dependent variable of interest to the present research is leverage (LEV). This, in general, is the ratio which illustrates whether a company finances its operations relying more on debt or equity financing. Prior literature distinguishes a number of proxies for leverage, although for the purpose of this study it is denoted as a ratio of total debt scaled by total assets (Rajan and Zingales, 1995; Giannetti, 2003; Deesomsak et al., 2004). Book values of debt and assets are selected which allows for the maximization of the sample size.
4.2.2. Independent variables
The main independent variables of this research paper are profitability (PROF) and asset tangibility (TANG). Profitability, as suggested by Fama and French (2002) is measured as a ratio of earnings before interest and taxes scaled by total assets. This variable is chosen as a determinant supporting the presence of the pecking order theory. Asset tangibility is defined as a ratio of fixed to total assets (Rajan and Zingales, 1995; Omet and Nobanee, 2001) and it used to examine the static tradeoff behavior of the companies.
A firm level moderator, namely, the corporate governance score (CGOV) is concerned with measuring a firm’s processes and systems deemed to ensure that the behavior of executives and board members is in line and at the best interest of the shareholders of a company. This measure is obtained from the ASSET4 database. The degree of creditor protection (CRPR), a country level variable, is an index comprising various creditor rights as defined by Djankov et al. (2007), ranging from 0-4. Each country in a sample is assigned a score using a dummy variable.
4.2.3. Control variables
In order to assure the validity of the research which might be weakened due to the interactions between the dependent variable and independent variables, three control variables are introduced, i.e., size, growth opportunities and industry classification.
Previous studies have already documented the evidence of the influence of a firm’s size (SIZE) on the capital structure decisions. As investors are better informed about large companies and therefore the resources dedicated to monitoring a firm are less desirable, those companies are able to use debt at a lower cost. Rajan and Zingales (1995) and Lemmon et al. (2008) indicate that there is a positive relationship between a firm’s size and leverage. Rajan and Zingales (1995) suggest that since large companies are more diversified and their bankruptcy costs are reduced, they face lower risk as opposed to their smaller counterparts. The size of a firm is an important determinant of its leverage (Hol and Wijst, 2008; Schuster and O’Connell, 2006). In the present study, size is operationalized as the natural logarithm of total assets (Aggarwal and Zhao, 2007; Byoun, 2008).
In terms of the growth opportunities (GROWTH) as a control variable, prior literature argues that firms with high growth opportunities tend to invest suboptimally, less likely financing investments with debt due to a lack of substantial number of collateral assets. Accepting risky projects involves transferring wealth from debt holders to shareholders which, in turn, raises borrowing costs and thus companies with high growth opportunities are more willing to use internal or equity financing, rather than debt. Jensen and Meckling (1976), Rajan and Zingales (1995) and Lemmon et al. (2008) suggest that creditors are less prone to provide financing to those companies. In general, the empirical evidence concerning growth opportunities and leverage levels supports the negative relationship between these two (Titman and Wessels, 1998; Rajan and Zingales, 1995; Bevan and DanBolt, 2002). A proxy for growth opportunities commonly used in the literature is the ratio of market value of equity, also known as market capitalization, scaled by the book value of equity (Collins and Kothari, 1989; Graham and Rogers, 2002).
With regard to the industry classification (INDUSTRY), prior studies have documented strong industry effects on debt ratios (Schwartz and Aronson, 1967). Titman and Wessels (1998) indicate that manufacturing companies are utilizing less debt financing which is due to the higher liquidation cost of spare parts. Following De Jong et al. (2008) and Chang, Lee and Lee (2009), the companies within the data sample are assigned a dummy variable, 1 for equipment, machinery and other manufacturing sector firms with SIC codes ranging from 3400 to 3999, and 0 otherwise.
4.3. Methodology
Empirical testing of the hypotheses formulated in Section 3 is conducted by employing the panel data methodology. In order to estimate the models, ordinary least square regression analyses are performed. The final regression model is as follows:
LEVi,t = 𝛽0 + 𝛽1TANGi,t + 𝛽2PROFi,t + 𝛽3CGOVi,t + 𝛽4CRPR j,t + 𝛽5TANGi,t * CGOVi,t + 𝛽6TANGi,t * CRPRj,t + 𝛽7PROFi,t * CGOVi,t +𝛽8PROFi,t * CRPRj,t +𝛽9SIZEi,t +𝛽10GROWTHi,t +
𝛽11INDUSTRYi,t + 𝜀i,t (1)
Where t denotes time, i denotes a firm, and j an individual country. The first six terms (LEV, TANG, PROF, CGOV, CRPR and INTERACTIONTERMS) represent the main focus variables relevant to the present study: leverage, asset tangibility, profitability, corporate governance, degree of creditor protection and interaction terms, respectively. Asset tangibility, as stated in the previous section is used as a determinant of the static tradeoff theory, whereas profitability is employed as a factor testing the presence of the pecking order behavior. The interaction terms are employed in order to assess the moderating role of corporate governance and the degree of creditor protection. These comprise: 𝛽5TANGi,t * CGOVi,t and 𝛽5TANGi,t * CRPRj,t with a
relevance for the static tradeoff theory, and 𝛽5PROFi,t * CGOVi,tand𝛽5PROFi,t * CRPRj,t for the pecking order theory. The interaction terms are added in each model separately. SIZE, GROWTH and INDUSTRY are the terms for the firm size, growth opportunities and industry classification. The intercept is denoted by 𝛽0 and the error term is 𝜀i,t.
The main focus is to examine the impact of firm and country specific characteristics on leverage and to find supportive evidence for the expected influences of these variables of interest to the present study. In line with prior literature, the corporate structure determinants chosen for running the empirical analysis are deemed to be among the most influential ones. The empirical analysis is carried out by estimating six models. In order to combat potential heteroskedasticity issues to the data, the ordinary least square regressions with robust standard errors are estimated for each model. At first, general relationships between asset tangibility, profitability, corporate governance, creditor protection and leverage are estimated. The second model deals with the moderating effects of corporate governance and degree of creditor protection with regard to the static tradeoff theory. Similarly, the third model is concerned with the pecking order theory and the moderating role of the aforementioned variables. Subsequently, control variables are added in the fourth and fifth model, for the static tradeoff theory and pecking order theory, respectively. This is to investigate the potential changes in key relationships and moderating effects while additionally controlling for key firm characteristics. Finally, the last model delivers the pooled regression of all variables of interest.
5. Empirical findings
The following section provides the empirical finding of the study. First, the summary statistics and correlation matrix of key variables are presented and subsequently the results of the regression analyses are introduced and discussed.
5.1. Summary statistics and correlation matrix
Summary statistics are reported in Table 1. The table provides the summary statistics for the sample of companies with a total of 15775 observations over the period from 2011 to 2016. It could be observed that the median leverage level among the companies within a sample is about 29 percent with a maximum of 90 percent and minimum of 10 percent. Asset tangibility has a maximum of 6 percent which means that, at maximum, 6 percent of the assets is categorized as property, plant, and equipment. The maximum profitability of a company is around 32.5 percent while the minimum is negative 44.2 percent.
Table 1 Summary statistics of key regression variables. The table reports summary statistics for a sample
of companies over the period from 2011-2016. Extreme outliers within a sample were deleted and less
extreme outliers are winsorized.
N Mean Median Max. Min. St. Dev.
LEV 15775 0.320 0.289 0.903 0.104 0.158 TAN 15775 0.003 0.000 0.060 -0.012 0.008 PROF 15775 0.063 0.067 0.325 -0.442 0.101 CGOV 15775 0.536 0.593 0.978 0.113 0.304 CRPR 15775 1.937 2.000 4.000 0.000 1.148 SIZE 15775 7.233 6.994 10.40 5.253 1.126 GROWTH 15775 1.668 1.166 10.26 0.074 1.687 INDUSTRY 15775 0.193 0.000 1.000 0.000 0.395
An average company has a 53.67 percent score of corporate governance, with a maximum of 97.86 percent. In terms of the creditor protection, the mean of close to 2 indicates that, on average, the firms within a sample are headquartered in countries exhibiting a moderate degree of creditor protection. The maximum firm size within a sample is 10.40, whereas the average size of a firm is approximately 7.23, measured as a natural logarithm of total assets. With regard to the growth opportunities with a minimum of 0.07 percent and maximum of 10.26 percent, the companies within a sample, on average, adhere to the lower bound with a mean of 1.66 percent. Lastly, it can be observed that industry classification is 19.3 percent which means that in 19.3 percent of the cases the companies are machinery, other manufacturing and equipment firms.
Table 2 Correlation coefficients of key variables (two-tail).
LEV TAN PROF CGOV CRPR SIZE GROWTH INDUSTRY
LEV 1 TAN 0.071** 1 PROF -0.124** -0.151** 1 CGOV -0.022** 0.089** 0.033** 1 CRPR -0.104** 0.066** 0.002 -0.061** 1 SIZE -0.035** -0.375** 0.038** -0.444** 0.072** 1 GROWTH -0.077** 0.053** 0.371** 0.107** -0.078** -0.223** 1 INDUSTRY -0.136** -0.069** 0.004 -0.047** -0.085** 0.063** 0.016* 1
The p-values market with ** and * represent the significance at 1% and 5% level, respectively.
Table 2 presents correlation coefficients for the dependent and independent variables. Negative relationship between leverage and all independent variables but asset tangibility is observed. Positive relationship between asset tangibility and leverage is supported by, inter alia, Rajan and Zingales (1995), and Booth et al. (2001). On the other hand, there is also evidence for a negative relationship between profitability and leverage (Bowen, Daley and Huber, 1982; Um, 2001; Chen, 2004). Both tangibility and profitability are positively correlated with corporate governance, degree of creditor protection and growth opportunities. Positive relationship between corporate governance and profitability is in line with Drobetz et al. (2003), Klapper and Love (2004), Garay and González (2008), and Varshney et al. (2012). Bowen, Daley and Huber (1982) and De Jong et al. (2008) provide support for a positive relationship between creditor protection and asset tangibility, while positive relationship between the degree of creditor protection and profitability is not supported by, for instance, Giannetti (2003), Houston et al. (2010), Kind et al. (2018). Asset tangibility is negatively related to size and industry classification, whereas opposite relationships could be observed in terms of profitability. Moreover, there is a negative relationship between corporate governance, creditor protection, firm size, and industry classification. The degree of creditor protection is negatively correlated with growth and industry classification, but positively with firm size. Lastly, there is a negative relationship between firm size as well as growth opportunities, and growth opportunities are positively associated with industry classification.
5.2. Results of the regression analyses
In order to test the hypotheses formulated in Section 3 several ordinary least squares regression analyses with robust standard errors are estimated and conducted. The results of these regressions are reported in Table 3.
In terms of profitability, regression findings indicate that the effect of profitability on leverage is negative and significant therefore H1a is rejected in favor of H1b. This is in line with the pecking order argument that there is a negative relationship between profitability and leverage since more profitable companies have sufficient retained earnings at their disposal and hence they employ
less debt financing (Bowen, Daley, and Huber, 1982; Chen, 2004). This result is statistically significant and consistent in each model.
Table 3 Regression results. The dependent variable is leverage. Ordinary least squares method with robust
standard errors to mitigate potential heteroskedasticity is applied to estimate the regressions. Extreme outliers are
deleted, the rest of the outliers are winsorized at 1% and 99%. The panel data regressions control for firm size,
growth opportunities and industry classification as well as include year dummy variables.
Dependent variable: LEV
(1) (2) (3) (4) (5) (6) INTERCEPT 0.352 0.340 0.363 0.411 0.445 0.430 (0.000)** (0.000)** (0.000)** (0.000)** (0.000)** (0.000)** TAN 0.064 0.034 - 0.012 - -0.014 (0.000)** (0.183)* (0.638) (0.581) PROF -0.107 - -0.214 - -0.210 -0.211 (0.000)** (0.000)** (0.000)** (0.000)** CGOV -0.032 -0.046 -0.070 -0.059 -0.0103 -0.117 (0.000)** (0.000)** (0.000)** (0.000)** (0.000)** (0.000)** CRPR -0.107 -0.102 -0.085 -0.119 -0.099 -0.096 (0.000)** (0.000)** (0.000)** (0.000)** (0.000)** (0.000)** TAN*CGOV - 0.092 - 0.093 0.115 (0.000)** (0.000)** (0.000)** TAN*CRPR - -0.045 - -0.039 -0.046 (0.009)** (0.021)** (0.004)** PROF*CGOV - - 0.157 0.186 0.201 (0.000)** (0.000)** (0.000)** PROF*CRPR - - -0.048 -0.051 -0.054 (0.002)** (0.001)** (0.001)** SIZE - - - -0.036 -0.050 -0.037 (0.000)** (0.000)** (0.000)** GROWTH - - - -0.094 -0.062 -0.064 (0.000)** (0.000)** (0.000)** INDUSTRY - - - -0.140 -0.147 -0.145 (0.000)** (0.000)** (0.000)** N 15775 15775 15775 15775 15775 15775 Adjusted R2 0.035 0.034 0.035 0.054 0.062 0.066 t statistics in parentheses * p < 0.05, ** p < 0.001
Simultaneously, consistent with the static tradeoff theory, asset tangibility is positively related to leverage which provides support for H2a and leads to the rejection of H2b. This holds for every
regression result but for the model with interaction terms and the last pooled regression where the coefficient turns negative and statistically insignificant. Taking the above results into consideration, it can be concluded that within a data sample, there is support for the main relationships between each determinant and leverage although the effect attributable to the pecking order theory is much stronger based on given coefficients.
With regard to the moderating effect of corporate governance, it can be observed that a positive relationship between asset tangibility and leverage strengthens when corporate governance increases. It is in line with Sauvagnat (2013) arguing that debt is disciplining managers in companies with a large share of tangible assets. Therefore it can be concluded that an increase in corporate governance is associated with an increase in tangibles and hence with an increase in debt. On the other hand, while still investigating the moderating role of corporate governance and adding control variables to the model, asset tangibility turns highly insignificant, therefore in this case hypothesis H3a is rejected. Furthermore, a negative relationship between profitability and leverage strengthens to a greater extent while given an increase in corporate governance. This is consistent with prior literature (Drobetz et al., 2003; Klapper and Love, 2004; Garay and González, 2008; Varshney et al., 2012). The reasoning behind this is that better corporate governance of a company induces higher profitability and, in line with the pecking order, higher profitability implies less debt use. This result holds also in the presence of the control variables thus H3b is not rejected.
It can be found that the moderating effect of the degree of creditor protection interacting with both asset tangibility and profitability is similar in its coefficients and this result is valid while adding control variables to the models. Both interaction variables are negative and statistically significant. In terms of the relationship between asset tangibility and leverage, it can be implied that the relationship weakens when creditor protection decreases. This is in line with De Jong et al. (2008) and Hall (2012), the latter arguing that the relationship between asset tangibility and corporate leverage significantly deviates in countries in which there are fewer collateral assets restrictions. Nevertheless, while adding control variables to the model asset tangibility becomes
insignificant. For this reason hypothesis H4a is rejected in favor of H4b. With respect to the moderating effect of the degree of creditor protection on the relationship between profitability and leverage, the results of the regression indicate that given a decrease in creditor protection the relationship between the aforementioned strengthens. According to Giannetti (2003), Houston et al. (2010), and Kind et al. (2018) reduced creditor protection results in firms undertaking more risky investments which are value enhancing and increase profitability of a firm.
Controlling for firm size, growth opportunities and industry classification, it can be observed that each of these variables negatively affect leverage. While it is not unusual for growth opportunities since the result of the regression analyses is consistent with prior literature (Titman and Wessels, 1998; Rajan and Zingales, 1995; Bevan and DanBolt, 2002),negative coefficient of a firm size runs contradictory to most of the findings of the researchers. In general, it is argued that size should positively affect leverage due to larger companies facing lower financial distress probability and thus gaining more from debt use. This finding is also in line with the predictions of the static tradeoff theory. Nevertheless, a negative relationship between firm size and leverage is explained by the fact that large firms encounter lower information asymmetry which implies the predictions of the pecking order theory to be more applicable (Voulgaris et al., 2004; González and González, 2012; Vithessonthi and Tongurai, 2015).Indeed this might be the case of present empirical findings since the sample consists of very large companies in terms of their total assets.
6. Conclusions
Based on relatively recent data from 2011 to 2016, this study revisits various established findings on corporate capital structure decisions within an international dimension. The present research aims to reconcile and test the pecking order theory and static tradeoff theory by investigating the impact of two determinants of corporate capital structure, namely, asset tangibility and profitability and by additionally introducing interaction terms of corporate governance and creditor protection. The discussed findings reveal several conclusions to be drawn. In fact, it might be said that the companies within a sample follow a pecking order, that is, they tend to
first make use of their retained earnings and given an insufficient amount of these the firms would turn to debt, followed by equity financing. A negative relationship between firm size and leverage found as a result of the empirical analysis additionally supports the predictions of the pecking order theory. The main impact of the determinants holds in each model and does not significantly vary in its magnitude. The results of the research support the presence and significance of the moderating roles of corporate governance and degree of creditor protection with regard to the pecking order theory. Consistent with prior literature, it is found that better corporate governance induces higher profitability which, in turn, leads to less debt use. Given the presence of weak creditor protection, firms tend to undertake more risky investments in order to benefit from their value enhancing properties. The results of the study reveal that creditor protection strengthens the relationship between profitability and leverage which indeed gives support for the aforementioned argument. Both findings on the moderating effect of corporate governance and creditor protection are in line with prior literature and give support for the predictions of the pecking order theory and its prevalence within the sample set. On the other hand, the results of the regression analyses show that asset tangibility becomes statistically insignificant or even turns negative while controlling for key firm characteristics and including the moderating effects of firm and country level variables. Therefore, based on the findings of this study, it is implied that asset tangibility has little explanatory power in terms of corporate capital structure choices.
Both the academic and practical relevance of this study resides in the fact that it complements the expanding literature on firm and country specific determinants of corporate capital structure with a relatively recent dataset and, specifically, by studying determinants of corporate leverage. The research, in its analyses, comprises moderating effects which allow to gain an enhanced understanding about the interactions between the determinants. Furthermore, practical relevance of this study bears some implications for managers and other stakeholders, namely, the research provides evidence on how asset tangibility and profitability impact leverage. Also, the findings concerned with the moderating role of corporate governance and creditor protection permit
managers to enhance their decision making process regarding the financing pattern of a company.
The limitation of the present study is that it uses only book leverage and is based on total debt. In order to broaden the insights of the exact impact of particular variables it should be recommended to employ different leverage measures. This is due to the fact that prior literature indicates that the effects of some variables may vary while accounting for the differences in the measurement approach. Moreover, key control variables are few and therefore it does not allow to completely rule out the possibility of spurious correlations.
Further research on this study is encouraged by including more firm level and country level characteristics known for influencing leverage patterns of firms. In terms of generalizing the results, further research comprising SMEs into the sample could also be performed. Furthermore, the investigation on the dependent variable could be performed by diversifying between long term, convertible, and short term debt measures.
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