Finance department plays a vital role in every organization and ensure that the organization have enough resources and liquidity to meet its legal obligations as well as facilitate its shareholders. The primary goal of the finance manager is to ensure that his company has adequate supply of capital and sufficient statutory reserves. The financial manager or the chief financial officer (CFO) is responsible for financing the enterprise and acts as an intermediary between the financial system's institution and markets. Major financial decisions made by the managers of a business are either investment decisions or financing decisions (Bierman, 2008). In investment decisions, manager considers the amount invested in the assets of the business and the composition of that investment. Investment in assets are more beneficial because its produces cash flow for the entity that are needed to meet operating expenses, pay interest to lenders and taxes to government. The essence of capital structure is quite indispensable from the standpoint of an organization. The main prospective of this study is to highlight the essential determinants of the capital structure. We will see its compatibility and implications in the long run for an organization.
An ongoing debate in corporate finance concerns the question of a firm's optimal capital structure. Specifically, is there a way of dividing a firm's capital into debt and equity so as to maximize the value of the firm? From a practical standpoint, this question is of utmost importance for corporate financial officers, as it has been forcefully demonstrated in the survey results by Graham and Harvey (2001) only recently. Yet, the academic literature has not been very helpful to provide clear guidance on practical issues. Most important, with only a few exceptions, the existing empirical evidence exclusively refers to U.S. data. Subsequent to the departures from Modigliani and Miller (1958)'s irrelevance proposition, there is a long tradition in corporate finance to investigate the capital structure decisions of firms. But what determines banks' capital structures? The standard textbook answer is that there is no need to investigate banks' financing decisions since capital regulation constitutes the overriding departure from the Modigliani and Miller propositions:
"Banks also hold capital because they are required to do so by regulatory authorities.
Because of the high costs of holding capital, bank managers often want to hold less bank capital than is required by the regulatory authorities. In this case, the amount of bank capital is determined by the bank capital requirements (Mishkin, 2000, p.227)."
Taken literally, this suggests that banks' leverage ratio is a constant. In the cross-section we should observe little variation of banks' capital structures. Figure 1 shows the distribution of the ratio of book equity to assets for a sample of the 200 largest publicly traded banks in the United States and 15 EU countries from 1991 to 2004. There is a large variation in banks' capital ratios. Lemmon et al. (2007) show that while the relationship of the standard variables to capital structure may be stable, their power to explain the overall variation of firms' capital structures is low. Instead, firms' capital structures are driven by an unobserved time-invariant firm fixed effect. Is the capital structure of financial firms also driven by such fixed effects? If so then this would suggest that we should be looking for factors explaining capital structure that are not limited to firms but extend to the financial sector. This paper finds that the standard cross-sectional determinants of firms' capital structures also apply to large, publicly traded banks in the US and Europe. The sign and significance are identical and the economic magnitude of the effect of most variables on bank leverage tends to be larger compared to the results found in Frank and Goyal (2005) for US firms and Rajan and Zingales (1995) for firms in G-7 countries. We are unable to detect a first order effect of capital regulation on the capital structure of banks in our sample. This true for both book and market leverage, when controlling for risk and macro factors, when considering the effect of capital buffers, for US and EU banks examined separately, as well as when examining a series of cross-sectional regressions over time. Our results are unchanged when using regulatory Tier 1 capital ratios instead of book leverage as the dependent variable. The strength of the standard corporate finance determinants of leverage, however, weakens for those banks that are close to the minimum capital requirement.
Further, we document that beyond the standard corporate finance variables, unobserved time invariant bank fixed-effects are important in explaining the variation of banks' capital structures. Banks with high (low) levels of leverage at the beginning of our sample also tend to have high (low) levels of leverage at the end. Hence, we confirm the recent evidence on the determinants of capital structure for firms in Lemmon et al. (2007) for a different set of firms and in a different legal and institutional environment. Like non-financial firms, financial firms appear to have stable capital structures at levels that are specific to each individual bank. Such stability at the bank level stands in contrast to the uniform requirements imposed on banks by regulators based on Basel I and its subsequent modifications. We have a planned approach to complete this task, and that is the main causes why we have categorize all these things in the form of chapters. In the first chapter we have included the abstract and the introduction pertains to the study and in the 2nd chapter, a huge study of the literature review has been included followed by chapter 3 which will be the hypothesis testing section. In the 4th chapter we will include the research methodology and research design. Chapter 5 will be the analysis and findings chapter followed by chapter 6 which will be the conclusion and recommendations chapter and a huge list of references which will be presented in chapter 7 of the study. Let's start our analysis in an appropriate manner.
Determinants of Capital Structure
This section describes firm characteristics that existing theories of capital structure suggest may be related to the debt-equity choice made by firms. Our primary variables of interest are those that proxy for the tax benefits of employee stock options. In addition, we control for size, profitability, growth, collateral value of assets, non-debt tax shields from operations, and uniqueness.
- Tax Benefit Variables
- Collateral Value of Assets
- Non-Debt Tax Shields from Operations
Extrapolating from the argument in DeAngelo and Masulis (1980) that there exists a negative relation between leverage and the level of non-debt tax shields, one would expect that leverage would also be negatively related to the size of the tax deduction available from option exercise. This follows from the fact that the deduction is a non-debt tax shield. We use the ratio of options exercised to shares outstanding and the ratio of the tax benefits of options exercised to assets as measures of the tax deduction realized from option exercise. Since options granted and options outstanding can impact a firm's future tax-paying position, we also include the ratios of options granted to shares outstanding, options outstanding to shares outstanding, and the Black-Scholes value of options granted to assets in our analysis as estimates of future realizable tax benefits.
Previous literature suggests that leverage ratios may be related to firm size. Warner (1977) and Ang, Chua, and McConnell (1982) provide evidence that direct bankruptcy costs increase as firm size decreases. Further, larger firms tend to be more diversified and less prone to bankruptcy. These observations suggest that large firms should be more levered than small firms. However, size cans also proxy for asymmetric information and access to capital markets. Because of these two factors, Smith (1977) shows that issuing equity is more expensive for small firms than for large firms, suggesting that small firms may be more levered than large firms. We use the book value of assets as a measure of firm size.
The pecking order theory of Myers (1984), Myers and Majluf (1984), and Shyam- Sunder and Myers (1999) suggests that firms prefer to finance investments first from retained earnings, second from debt, and third from equity. According to this theory, more profitable firms should have lower leverage ratios than less profitable firms since they are able to finance their investment opportunities with retained earnings. This conclusion is reinforced by the argument in Titman and Wessels (1988) that more profitable firms tend to use earnings to pay down debt and would, therefore, have lower leverage than less profitable firms. In addition, Asquith and Mullins (1986) and Masulis and Korwar (1986) find that firms tend to issue equity subsequent to good stock performance, thereby causing profitable firms to be less levered. We use operating income to sales and operating income to assets as measures of a firm's profitability.
If firms with high growth opportunities have high information asymmetry, then we would expect these firms to have less debt. In addition, as suggested by Titman and Wessels (1988), if growth opportunities are viewed as capital assets that do not generate current taxable income, one would expect a negative relation between growth opportunities and leverage. Finally, as suggested by Galai and Masulis (1976), Jensen and Meckling (1976), and Myers (1977), if stockholders have the incentive to expropriate wealth from bondholders by investing in a suboptimal fashion and the cost associated with this agency problem is higher for firms with high growth opportunities, then, again, one would expect leverage to be negatively related to growth opportunities. We use the ratio of research and development to sales as a measure of a firm's growth opportunities. We also use dividends per share as a measure of growth opportunities since firms that pay dividends are less likely to be high growth firms. Following Titman and Wessels (1988), we do not use market to book to proxy for growth since it can be highly correlated with leverage when the latter variable is defined as the ratio of the book value of debt to the sum of the book value of debt and the market value of equity.
Myers and Majluf (1984) argue that if a firm's managers have better information about a security than outside shareholders, then there may be costs associated with issuing such securities. Since issuing debt that is secured by assets whose values are known would avoid these costs, firms with more collateralizable assets would tend to issue more debt. The agency arguments in the previous section, that suggest a negative relation between growth opportunities and leverage, would also imply a positive relation between collateralization and leverage. Firms with higher collateralizable assets should be able to take on more debt than other firms since there is less information asymmetry involved in these assets. We use the ratio of property, plant, and equipment to assets and the ratio of intangible assets to total assets as measures of the collateral value of assets.
DeAngelo and Masulis (1980) suggest that tax deductions for depreciation and tax-loss carry forwards are substitutes for debt, and thus firms with large non-debt tax shields should have less debt. We use the ratio of depreciation to assets and net operating loss (NOL) carry forwards to assets as measures of non-debt tax shields from operations.
Titman (1984) presents a model that implies that firms with unique or specialized products suffer higher costs in the event of liquidation, and thus will have less debt. Since uniqueness can vary across industries, we use two-digit SIC codes to control for industry effects.
Capital Structure Theories
Both theoretical and empirical capital structure studies have generated many results that attempt to explain the determinants of capital structure. As a result of these studies, some broad categories of capital structure determinants have emerged. Titman and Wessels (1988), and Harris and Raviv (1991), however, point out that the choice of suitable explanatory variables is potentially contentious. In this study, to identify which of the capital structure theories is relevant in the Libyan context, we concentrate on four key variables identified in studies by Rajan and Zingales (1995), and Bevan and Danbolt (2002). The selected explanatory variables are: tangibility, size, profitability, and the level of growth opportunities. These four explanatory variables are identified as important factors in the G-7 countries (Rajan and Zingales, 1995), as well as in ten developing countries (Booth et al,. 2001).
Gleason et al, (2000) argue that the legal environment, the tax environment, the economic system, and technological capabilities influence the capital structure in the fourteen European community member countries examined in their study. Other empirical studies at the international level, however, have reported conflicting results. Furthermore, Korajczyk and Levy (2003) argue that both macroeconomic conditions and firm-specific factors have an effect on firm's financing choices.
Antoniou et al, (2002) find that the capital structure decisions of firms are not only affected by its own characteristics, but also by its surrounding environment. The surrounding environment may affect the firm's capital structure for different reasons, such as, the deterioration or the improvement in the state of economy, the existence of a stock market and/or the size of banks sector. Rajan and Zingales (1995) suggest that future research should proceed in two ways. Firstly, by continuing to develop the relationship between theoretical models and empirical findings by widely applying the models to different situations, and secondly, by incorporating the institutional differences between countries when specifying the theoretical models.
- Static Trade-off Theory
- Information Asymmetry Theory (Pecking Order Theory)
- Agency Cost Theory
The static trade-off theory of capital structure states that optimal capital structure is obtained where the net tax advantage of debt financing balances leverage related costs such as bankruptcy. Um (2001) suggests that a high profit level gives rise to a higher debt capacity and accompanying tax shields. Hence, it is expected that a positive relationship should exist between profitability and financial leverage.
Firms with high levels of tangible assets will be in a position to provide collateral for debts. If the company then defaults on the debt, the assets will be seized but the company may be in a position to avoid bankruptcy. It is expected, therefore, that companies with high levels of tangible assets are less likely to default and will take on relatively more debt resulting in a positive relationship between tangibility and financial leverage. While the majority of empirical studies in developed countries (Titman and Wessels, 1988; Rajan and Zingales, 1995, among others) find a positive relationship between tangibility and leverage, the empirical studies in developing countries find mixed relationship.
For instance, whilst the work of Wiwattanakantang (1999) in Thailand, and work of Um (2001) in Korea report a positive relationship between tangibility and leverage, other studies such as Booth et al, (2001) in ten developing countries, and Huang and Song (2002) in China, find that tangibility is negatively related to leverage. It is argued, however, that this relation depends on the type of debt. Nuri (2000) argues that companies with a high fixed asset ratio tend to use more long-term debt. Bevan and Danbolt (2000 and 2002) also find a positive relationship between tangibility and long-term debt, whereas a negative relationship is observed for short-term debt and tangibility in the UK. Antoniou et al, (2002) argue that several studies find that the size of a firm is a good explanatory variable for its leverage ratio. Bevan and Danbolt (2002) also argue that large firms tend to hold more debt, because they are regarded as being 'too big to fail' and therefore receive better access to the capital market. Hamaifer et al, (1994) argue that large firms are able to hold more debt rather than small firms, because large firms have higher debt capacity. Empirical studies find mixed evidence. Wiwattanakantang (1999), Booth et al, (2001), Pandey (2001), Al-Sakran (2001), and Huang and Song (2002) find a significant positive relationship between leverage ratios and size in developing countries. While Rajan and Zingales (1995) find a positive relationship between size and leverage in G-7 countries, Titman and Wessels (1988) report a positive correlation between the size of the firm and the total debt ratio and the long-term debt ratio. On the other hand, Bevan and Danbolt (2002) report that size is found to be negatively related to short-term debt and positively related to long-term debt.
The information asymmetry theory of capital structure assumes that firm managers or insiders possess private information about the characteristics of the firm's return stream or investment opportunities, which is not known to common investors. In an attempt to explain some financing behavior that is not consistent with the prediction of static trade-off theory (such as a negative relationship between profitability and leverage), Myers (1984) emphasizes that internal funds and external funds are used hierarchically. Myers (1984) refers to this as a 'pecking order theory' which states that firms prefer to finance new investment, first internally with retained earnings, then with debt, and finally with an issue of new equity. Bevan and Danbolt (2002) state that the more profitable firms should hold less debt, because high levels of profits provide a high level of internal funds.
Consistent with the pecking order theory, work of Titman and Wessels (1988), Rajan and Zingales (1995), Antoniou et al, (2002) and Bevan and Danbolt (2002) in developed countries, Booth et al, (2001), Pandey (2001), Um (2001), Wiwattanakantang (1999), Chen (2004) and Al-Sakran (2001) in developing countries all find a negative relationship between leverage ratios and profitability.
Um (2001) argues that growing companies' funding pressure for investment opportunities is likely to exceed their retained earnings and, according to the 'pecking order' are likely to choose debt rather than equity. Thus, if the information asymmetry theory is pertinent in Libya, a positive relationship is expected between financial leverage and growth. Booth et al, (2001) argue that this relation is generally positive in all countries in their sample, except for South Korea and Pakistan. Pandey (2001) finds a positive relationship between growth and both long-term and short-term debt ratios in USA.
Myers (1984) suggests that issuing debt secured by collateral may reduce the asymmetric information related costs in financing. The difference in information sets between the parties involved may lead to the moral hazard problem (hidden action) and/or diverse selection (hidden information). Hence, debt secured by collateral may mitigate asymmetric information related cost in financing. Therefore, a positive relationship between tangibility and financial leverage may be expected. Titman and Wessels (1988) and Rajan and Zingales (1995) report a positive relationship between tangibility and leverage for developed countries, whilst Wiwattanakantang (1999) and Um (2001) report a positive relationship between tangibility and leverage for Thailand and South Korea, respectively.
Debt agency costs arise due to a conflict of interest between debt providers on one side and shareholders and managers on the other side (Jensen and Meckling, 1976). Managers have the motivation to invest funds in risky business for shareholders' interest, because if the investment fails, the lenders are likely to bear the cost as the shareholders have limited liability. The use of short-term sources of debt, however, may mitigate the agency problems, as any attempt by shareholders to extract wealth from debt holders is likely to restrict the firms' access to short-term debt in the immediate future. Titman and Wessels (1988) point out that the costs associated with the agency relationship between shareholders and debtholders are likely to be higher for firms in growing industries hence a negative relationship between growth and financial leverage is likely. Consistent with these predictions, Titman and Wessels (1988), Chung (1993) and Rajan and Zingales (1995) find a negative relationship between growth and the level of leverage on data from developed countries.
Jensen and Meckling (1976) argue that the use of secured debt might reduce the agency cost of debt. Um (2001), however, suggests that if a firm's level of tangible assets is low, the management for monitoring cost reasons may choose a high level of debt to mitigate equity agency costs. Therefore, a negative relationship between debt and tangibility is consistent with an equity agency cost explanation (Um, 2001). Um also argues that firm size may proxy for the debt agency costs (monitoring cost) arising from conflicts between managers and investors. Um (2001) emphasises that the monitoring cost is lower for large firms than for small firms. Therefore, larger firms will be induced to use more debt than smaller ones.
Special care has been taken to eliminate the survivorship bias inherent in the Bank scope database. Bureau van Dijk deletes historical information on banks that no longer exist in the latest release of this database. For example, the 2004 release of Bankscope does not contain information on banks that no longer exist in 2004 but did exist in previous years.5 We address the survivorship bias in Bank scope by reassembling the panel data set by hand from individual cross-sections using historical, archived releases of the database. Bureau Van Dijk provides monthly releases of the Bank scope database. We used the last release of every year from 1991 to 2004 to provide information about banks in that year only. For example, information about banks in 1999 in our sample comes from the December 1999 release of Bank scope. This procedure allows us to quantify the magnitude of the survivorship bias: 12% of the banks present in 1994 no longer appear in the 2004 release of the Bank scope dataset.
The Miller-Modigliani theorem
In their path-breaking paper in 1958 Nobel laureates Merton Miller and Franco Modigliani provided the formal proof of their now-famous M&M irrelevance proposition. They demonstrate that there would be arbitrage opportunities in perfect capital markets if the value of a firm depended on how it is financed.
They also argue that if investors and firms can borrow at the same rate, investors can neutralize any capital structure decisions the firm's management may take (home-made leverage). The underlying rationale for the M&M argument is that the value of the firm is determined solely by the left-hand side of the balance sheet, i.e., by what is usually referred to as the company's investment policy. The economic substance of the firm is unaffected whether the liability side of the firm's balance sheet is sliced into more or less debt. To increase the value of the firm, it must invest in additional projects with positive net-present values.
While the M&M capital structure irrelevance theorem clearly rests on unrealistic assumptions, it can serve as a starting point to search for the factors that influence corporate leverage policies.
The trade-off theory
The trade-off theory of the capital structure suggests that a firm's target leverage is driven by three competing forces: (i) taxes, (ii) costs of financial distress (bankruptcy costs), and (iii) agency conflicts. Taxes Adding debt to a firm's capital structure lowers its (corporate) tax liability and increases the after-tax cash flow available to the providers of capital. Thus, there is a positive relationship between the (corporate) tax shield and the value of the firm.
Bankruptcy costs when a firm raises excessive debt to finance its operations, it may default on this debt. However, it is not bankruptcy per se that is the problem. If the bond payments are not met when they become due and the bond defaults, the firm is simply transferred to the bondholders. However, there are deadweight (opportunity) costs that arise in the case of corporate bankruptcy. They come in two forms, direct and indirect deadweight costs. Direct out-of-pocket expenses for the administration of the bankruptcy process (legal fees and management time) are relatively mall compared to the market values of the firms. However, there are economies of scale with respect to direct bankruptcy costs. While they seem of less important for large firms, they can be substantial for small firms. Most obvious, the firm may decide on shortsighted cutbacks in research and development, maintenance, advertising, and educational expenditures that ultimately result in lower firm values. Besides, bankruptcy hampers conduct with customers. They are usually lost because of both fear of impaired service and loss of trust. To sum up, the trade-off theory of the capital structure posits that there is an optimal debt-equity ratio. Firms attempt to balance the tax benefits of higher leverage and the greater probability (and the possibly higher associated costs) of financial distress.
Jensen and Meckling (1976) define agency costs as the sum of the monitoring expenditures by the principal, bonding costs by the agent, and a residual loss.
In much of the corporate finance literature it is assumed that agency costs are an important determinant of firms' capital structure (see Harris and Raviv (1991)). Three forms of agency problems have received particular attraction: (i) risk shifting (or asset substituition), (ii) the underinvestment problem and (iii) the free cash flow hypothesis. Risk shifting The risk shifting or bondholder expropriation hypothesis asserts that stockholders have the incentive to exploit bondholders once the debt is issued. Managers, whose ultimate responsibility is to the stockholders, are likely to make investments that maximize stockholder wealth rather than total firm value. In particular, because equity can be viewed as a call option, managers tend to accept risky negative net present value (NPV) projects in which the value decrease consists of an decrease in the value of debt and a smaller increase in the value of equity. This is known as the overinvestment problem. It is well known from option pricing theory that the sensitivity of the value of an option with respect to volatility (i.e., the option vega) is highest for at the-money option. This implies that the stockholder-bondholder expropriation conflict is most pronounced for financially distressed firms. Therefore, the asset substitution conflict is often classified as indirect bankruptcy costs. Obviously, the expropriation potential makes it difficult for firms to raise debt at fair prices. Ex ante bond investors get their fair compensation. Because they correctly anticipate stockholders' future behavior, they demand a premium payment they would not demand if the firm could plausibly commit not to expropriate bondholders. While bondholders are ex ante equally well off, stockholders face the opportunity costs of not being able to issue debt (with its other advantages, such as tax savings). This effect, also known as the asset substitution effect, is an agency cost of debt financing. Given that the expected cost of opportunistic behavior is incorporated into the price of debt, Jensen and Mecking (1976) posit that the firm trades off these agency costs of debt against the benefits of debt. The ex ante solution to the overinvestment problem is thus that the optimal capital structure is tilted towards equity. Underinvestment problem The underinvestment problem refers to the tendency of managers to avoid safe positive net present value projects in which the value increase consists of an increase in the value of debt and a smaller decrease in the value of equity. Myers (1977) demonstrates that there is a rational basis for this shortsightedness when stockholders have no chance to receive any proceeds of a valuable project when the debt comes due. Hence, the firm will refuse to accept good investment opportunities ex post, reducing the firm value ex ante. Brealey and Myers (2000) argue that the underinvestment problem theoretically affects all firms with leverage, but it is again most pronounced for highly leveraged firms in financial distress. The greater the probability of default, the more bondholders gains from value increasing projects. In addition, companies whose value consists primarily of investment opportunities, or growth options, are most likely to suffer from the underinvestment problem. As with the asset substitution problem, the underinvestment problem tilts the capital structure towards equity. Mature firms with lots of reputation but few profitable investment opportunities, whose value comes mainly from assets in place, find it optimal to choose safer projects. In contrast, young firms with many growth opportunities and little reputation may chooses riskier projects. If they survive without default, they will eventually switch to the safe project. Due to their lower costs of debt, mature firm can thus run higher leverage ratios than firms whose value is derived primarily from growth opportunities. The free cash flow hypothesis Easterbrook (1984) and Jensen (1986) argue that for companies that largely consist of assets-in-place and that produce stable operating cash flow high leverage can add value by improving managers' financial discipline. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values. Firms with substantial free cash flow face conflicts of interest between stockholders and managers. The problem is how to motivate managers to distribute excess funds rather than investing it below the cost of capital or wasting it on organizational inefficiencies. Even worse, managers can invest less effort in managing firm resources, but transfer firm resources to their personal benefits, e.g., by consuming perquisites such as corporate planes and building"empires". Instead of investing into low-return projects, managers of firms with stable free cash flows can pay out cash by increasing dividends or repurchasing stock. However, leverage is a more effective means for addressing the free cash flow problem. This is because contractually obliged payments of interest and principal are a more credible signal than discretionary dividend payments or share repurchases in giving back excess capital to investors. Bondholders can take the firm into bankruptcy court if managers do not maintain their promise to make the interest and principal payments. Accordingly, debt reduces the agency cost of free cash flows for mature companies by reducing the cash flow available for spending at the discretion of managers.
Information costs and signaling effects
Capital structure theory has become yet another dimension with the explicit modeling of private information in financial theory. Two main strands have emerged in the literature on asymmetric information. In the first approach debt is regarded as a means to signal confidence to the firm's investors. In the second approach it is argued that the capital structure is designed to mitigate distortions in the investment decisions caused by information asymmetries.
Signaling with proportion of debt
In one set of approaches, the choice of capital structure signals to outside investors the information of insiders. Ross (1977) assumes that managers (the insiders) know the true distribution of firm returns, but investors do not. He argues that investors interpret larger levels of leverage as a signal of higher quality. The intuition behind his argument is that debt and equity differ in an important way that is crucial for signaling insider information. Debt is a contractual obligation to repay interests and the principal. Failure to make these payments can lead to bankruptcy and managers may lose their jobs. In contrast, equity is more forgiving. Although shareholder expects dividends at least to be maintained, managers have more discretion and can cut them in times of financial distress. Therefore, adding debt to the capital structure can be interpreted as a credible signal of high future cash flows and managers' confidence about their own firm. Lower quality firms will not imitate higher quality firm by issuing more debt because they have higher bankruptcy costs at any level of debt. Accordingly, Ross (1977) concludes that investors take larger levels of debt as a signal of higher quality and that profitability and leverage are thus positively related.
Pecking order theory
Myers and Majluf (1984) suggest that the capital structure can help to mitigate inefficiencies in a firm's investment program that are caused by information asymmetries. They show that managers use private information to issue risky securities when they are overpriced. This leads to an interaction between investment and financing decisions. Because market participants cannot separate information about new projects from information about whether the firm is under- or overvalued, equity will be miss priced by market participants. If firms are required to finance new projects by issuing equity, under pricing may be so severe that new investors capture more than the net present value of the new project, which would result in a net loss to existing shareholders. Even a positive net present value project will be rejected, leading to yet another underinvestment problem. The information costs associated with debt and equity issues has led Myers (1984) to argue that a firm's capital structure reflects the accumulation of past financial requirements. There is a pecking order of corporate financing: (i) firms prefer internal finance; (ii) if internal finance is not sufficient and firms require external finance, they issue the cheapest security first. In this case, they start with debt, then possibly hybrid securities such as convertible bonds, and issue equity only as a last resort.
In contrast to the trade-off theory, there is no well-defined target leverage ratio in the pecking order theory. There are two kinds of equity, internal and external, one is at the top of the pecking order and one at the bottom. A firm's leverage ratio thus reflects its past cumulative requirement for external finance. The pecking order theory can explain why the most profitable firms tend to borrow less; they simply do not need external funds. Less profitable firms issue debt because they do not have sufficient internal funds and because debt has lower flotation and information cost compared to equity. Debt is the first source of external finance on the pecking order. Equity is issued only as a last resort, when the debt capacity is fully exhausted. Tax benefits of debt are a second-order effect. The debt ratio changes when there is an imbalance between internal funds and real investment opportunities.
Standard determinants of leverage
The different corporate finance theories produce a long list of factors that drive firms' capital structures (see Harris and Raviv, 1991, and Frank and Goyal, 2007, for surveys). Beginning with Titman and Wessels (1988), then Rajan and Zingales (1995) and recently Frank and Goyal (2005), the empirical corporate finance literature has converged on the following set of variables that reliably predict leverage of non-financial firms in the cross-section. First, leverage is positively related to size. It is usually argued that larger firms are either safer, better known in the market, more exposed to agency problems (Jensen and Meckling, 1976) or enjoy market power vis--vis investors, all of which may explain why larger firms have more debt in their capital structures. Second, more profitable firms tend to have less leverage. This is consistent with the pecking-order theory (Myers and Majluf, 1984, Myers, 1984) and dynamic versions of the trade-off theory (Hennessy and Whited, 2005), while static versions of the trade-off theory predict that more profitable firms should lever up to shield their profits from corporate income tax (Bradley et al., 1984). Third, leverage is negatively related to a firm's market-to-book ratio. Firms with high market-to-book ratios have little free-cash flow as they appear to have numerous profitable investment opportunities available to them (Jensen, 1986). Such firms need less debt in their capital structure to prevent managers from investing the free cash-flow in negative NPV projects. Flannery (1994) has argued that this problem may be particularly severe for banks due to the illiquidity and opacity of their assets.
High growth firms also have more to lose in the case of bankruptcy and may suffer more from a debt-overhang problem so that they should be relatively less leveraged (Myers, 1977; see also Barclay et al., 2006). Market timing can also explain the negative relationship between leverage and the market-to-book ratio as firms issue equity when managers perceive it to be overvalued (Baker and Wurgler, 2002). Dittmar and Thakor (2007) argue that firms issue equity when their valuation is high as this indicates agreement between managers and investors about investment opportunities. Fourth, firms with more collateral have higher leverage. When more assets can be used as collateral, less is lost in distress reducing the bankruptcy costs of debt. Moreover, collateral reduces the agency cost of debt since it makes the monitoring of the use of assets easier. Finally, Frank and Goyal (2005) also find that a dummy variable indicating whether or not the firm pays dividends is negatively related to leverage. One reason could be that paying dividends exposes firms to the scrutiny of capital markets and reduces the agency cost of equity (Easterbrook, 1984). All these arguments extend naturally to banks unless one follows the textbook view that banks' capital structures are predominately determined by capital regulation (Berger et al., 1995). The textbook view is that i) bank deposits are insured to protect depositors and ensure financial stability and ii) banks must be required to hold a minimum amount of capital in order to mitigate the moral-hazard of this insurance (Dewatripont and Tirole, 1993). Therefore, the standard corporate finance determinants of the capital structure should have little or no explanatory power for banks.
Measures of leverage
Surprisingly, there is no clear-cut definition of leverage in the academic literature. The specific choice depends on the objective of the analysis. Rajan and Zingales (1995) apply four alternative definitions of leverage. Because we think their approach is the cleanest in the literature, we adopt their framework. The first and broadest definition of leverage is the ratio of total (non equity) liabilities to total assets, denoted as LVLTA. This can be viewed as a proxy of what is left for shareholders in case of liquidation. However, this measure does not provide a good indication of whether the firm is at risk of default in the near future. In addition, since total liabilities also include items like accounts payable, which are used for transaction purposes rather than for financing, it is likely to overstate the amount of leverage. In addition, this measure of leverage is potentially affected by provisions and reserves, such as pension liabilities. A second definition of leverage is the ratio of debt (both short term and long term) to total assets, denoted as LVDTA. This measure of leverage only covers debt in a narrower sense (i.e., interest-bearing debt) and excludes provisions. However, it fails to incorporate the fact that there are some assets that are offset by specific non debt liabilities. For example, an increase in the gross amount of trade credit is reflected in a reduction in this measure of leverage. Because the level of accounts payable and accounts receivable may differ across industries, Rajan and Zingales (1995) suggest using a measure of leverage unaffected by the gross level of trade credit. A third definition of leverage is the ratio of total debt to net assets, where net assets are total assets less accounts payable and other current liabilities. This measure of leverage is denoted as LVDNA and is unaffected by non-interest bearing debt and working capital management. However, it is influenced by factors that have nothing to do with financing. For example, assets held against pension liabilities may decrease this measure of leverage. In USA this should not be important because pension liabilities need not be expensed in the balance sheet. In contrast to most other continental European countries, pension money is managed in separated entities.
Our fourth and final definition of leverage is the ratio of total debt to capital, where capital is defined as total debt plus equity, denoted as LVDC. This measure of leverage looks at the capital employed and thus best represents the effects of past financing decisions. It most directly relates to the agency problems associated with debt, as suggested by Jensen and Meckling (1976) and Myers (1977). An additional issue is whether leverage should be computed as the ratio of the book or the market value of equity. Again, the correct choice is not easy. Fama and French (2000) argue that most of the theoretical predictions apply to book leverage. Similarly, Thies and Klock (1992) suggest that book ratios better reflect management's target debt ratios. The market value of equity is dependent on a number of factors which are out of direct control for the firm. Therefore, using market values may not reflect the underlying alterations within the firm. In fact, corporate treasurers often explicitly claim to use book ratios to avoid"distortions" in their financial planning caused by the volatility of market prices. A similar rational is often heard from rating agencies. From a more pragmatic point of view, the market value of debt is not readily available. However, Bowman (1980) documents a high correlation between market and book values of leverage. It should therefore come as no surprise that most previous literature relates to the book value of leverage. Nevertheless, we also report quasi-market leverage, where the book value of equity is replaced by the market value of equity, but value debt at its book value.
A final adjustment accounts for cash balances. This seems particularly important, because many USA firms hold substantial cash and short-term investments.
This needs not be inefficient, but may rather be interpreted as slack in the context of the Myers (1984), which can be used to invest in positive net present value projects that come along without approaching the capital market. Alternatively, the firm could use the funds and immediately repay debt or repurchase its own stock. As a firm outsider, it is hard to assess how much cash is needed to run a business. Following Rajan and Zingales (1995), we thus interpret cash balances as excess liquidity and compute adjusted leverage ratios by subtracting cash and cash equivalents form both the numerator and the denominator of the ratios introduced above. Below reports the four definitions of unadjusted leverage for our sample over the 1997-2001 period. Table shows the respective adjusted leverage figures. We report the median and mean leverage ratios, as well as the aggregate leverage ratio (obtained by summing total liabilities across firms and dividing by the summed assets). Before we discuss the results in detail, it seems interesting to look at some stylized facts over a longer period of time. To give a notion of the evolution of leverage over the last decade, figure 1 displays book leverage ratios and market leverage in each year since 1992. To report unbiased numbers, in both figures we limit the sample further to those firms with available data in the World scope database during the entire ten-year period. This reduces the sample size to 73 firms.
Taking a closer look at the table, it is interesting to compare our USA results with the results reported by Rajan and Zingales (1995) for their sample of G-7 countries. Specifically, given many institutional similarities, German and (to a lesser extent) French firms should provide an appropriate benchmark for USA firms. When the first definition of leverage is used (nonequity liabilities to total assets, LVLTA), they find that Anglo-American firms are considerably less levered than German and French firms. Interestingly, with this definition of leverage, USA firms are much more similar to U.S. and U.K. firms, with leverage ratios around 0.55, as opposed to Continental European firms with ratios above 0.70. Using market values does not change the results. USA firms are still considerably less levered than German and French firms.
Looking at the second definition of leverage (debt to total assets, LVDTA), USA firms are still similar to U.S. companies, with a debt to total asset ratio of approximately 25 percent. This contrasts with the finding by Rajan and Zingales (1995), who report that German firms appear to have much lower levels of leverage under this definition. Part of the low leverage for German may be because pension liabilities need to be expensed. This is not the case in USA (and in the Anglo-American countries), where pension contributions are capitalized in special purpose vehicles on the basis of defined contribution plans. Again, USA firms thus differ markedly from German firms, but this time the ranking is reversed. Our third definition of leverage, the debt to net asset ratio (LVDNA) reveals a similar picture. US firms exhibit leverage comparable to U.S. firms, while German firms seem to carry significantly lower leverage. Finally, defining leverage as debt over capital (LVDC), Rajan and Zingales (1995) report that U.S. and German firms have similar leverage around 38 percent. This number is closely replicated by our sample of US firms, both for book and market values. Finally, the aggregate ratios of leverage are also very similar to the values in the G-7 area.
When we look at the adjusted measures in table 2, however, our results change dramatically. As a first observation, the amount of leverage decreases substantially. For example, the debt to capital ratio as of 2001 drops from 38 percent to 27 percent in book values, and from 31 percent to 23 percent in market values.
Even more important, contrasting our results with the cross-section of G-7 countries, the similarity of US and Anglo-American firms with respect to leverage disappears. In fact, adjusted leverage is comparatively low in USA. Our figures are similar to those reported by Rajan and Zingales (1995) for German firms. Therefore, on adjusted basis US firms seem much less levered than U.K. firms. The evidence is even stronger for the aggregate ratios of leverage, which are substantially lower (as low as 5 percent in some instances) than those in the G-7 countries. This indicates that US firms are very conservative and hold large cash reserves, which exaggerate non-adjusted leverage ratios. To sum up, unadjusted leverage ratios of US firms are very similar to the figures reported by Rajan and Zingales (1995) for U.S. firms. Depending on the exact definition of leverage, US results can differ significantly from German figures. At first, this is a surprising result, given that the institutional framework is very similar in Germany and USA. However, adjusting for cash balances reveals two effects. First, the amount of US leverages decreasessignificantly, indicating that US firms hold relatively large amounts of financial slack. Second, adjusted leverage ratios in USA and Germany are very similar.
Factors correlated with leverage
According to Harris and Raviv (1991), the consensus is that"leverage increases with fixed assets, nondebt tax shields, investment opportunities, and firm size and decreases with volatility, advertising expenditure, the probability of bankruptcy, profitability and uniqueness of the product." In our empirical analysis we focus on six of these variables: tangibility of assets (the ratio of fixed to total assets), firm size, the market-to-book ratio (as a proxy for investment opportunities), profitability, volatility, uniqueness of the product and non debt tax shields.
Previous empirical studies by Titman and Wessels (1988), Rajan and Zingales (1995) and Fama and French (2000) argue that the ratio of fixed to total assets (tangibility) should be an important factor for leverage. The tangibility of assets represents the effect of the collateral value of assets of the firm's gearing level. However, the direction of influence is not a-priori clear. Galai and Masulis (1976), Jensen and Meckling (1976) and Myers (1977) argue that stockholders of levered firms are prone to over invest, which gives rise to the classical shareholder-bondholder conflict. However, if debt can be secured against assets, the borrower is restricted to using debt funds for specific projects. Creditors have an improved guarantee of repayment, and the recovery rate is higher, i.e., assets retain more value in liquidation. Without collateralized assets, such a guarantee does not exist, i.e., the debt capacity should increase with the proportion of tangible assets on the balance sheet. Hence, the tradeoff theory predicts a positive relationship between measures of leverage and the proportion of tangible assets. In contrast, Grossman and Hart (1982) argue that the agency costs of managers consuming more than the optimal level of perquisites is higher for firms with lower levels of assets that can be used as a collateral. Managers of highly levered firms will be less able to consume excessive perquisites, since bondholders more closely monitor such firms. The monitoring costs of this agency relationship are higher for firms with less collateralizable assets. Therefore, firms with less collateralizable assets might voluntarily choose higher debt levels to limit consumption of perquisites. This agency model predicts a negative relationship between tangibility of assets and leverage.
We use the ratio of fixed assets to total assets in our empirical tests. The more direct approach using intangible assets in the nominator cannot be applied due to a lack of data.
The effect of size on leverage is ambiguous. On the one hand, Warner (1977) and Ang, Chua and McConnel (1982) document that bankruptcy costs are relatively higher for smaller firms. In a similar vein, Titman and Wessels (1988) argue that larger firms tend to be more diversified and fail less often.
Accordingly, the trade-off theory predicts an inverse relationship between size and the probability of bankruptcy, i.e., a positive relationship between size and leverage. If diversification goes along with more stable cash flows, this prediction is also consistent with the free cash flow theory by Jensen (1986) and Easterbrook (1986). This notion implies that size has a positive impact on the supply of debt. On the other hand, size can be regarded as a proxy for information asymmetry between firm insiders and the capital markets. Large firms are more closely observed by analysts and should therefore be more capable of issuing information ally more sensitive equity, and have lower debt. Accordingly, the pecking order theory of the capital structure predicts a negative relationship between leverage and size, with larger firms exhibiting increasing preference for equity relative to debt. Following Titman and Wessels (1988), our measure of size is the natural logarithm of net sales. The logarithmic transformation accounts for the conjecture that small firms are particularly affected by a size effect. Alternatively, one could use the natural logarithm of total assets. However, we think that net sales is a better proxy for size, because many firms attempt to keep their reported size of asset as small as possible, e.g., by using lease contracts.
Galai and Masulis (1976), Jensen and Meckling (1976) and Myers (1977) argue that when a firm issues debt, managers have an incentive to engage in asset substitution and transfer wealth away from bondholders to shareholders. It is generally acknowledged that the associated agency costs are higher for firms with substantial growth opportunities. Thus, the trade-off model predicts that firms with more investment opportunities have less leverage because they have stronger incentives to avoid underinvestment and asset substitution that can arise from stockholder-bondholder agency conflicts. This prediction is strengthened by Jensen's (1986) free cash flow theory, which predicts that firms with more investment opportunities have less need for the disciplining effect of debt payments to control free cash flows.
Fama and French (2000) explain how the predictions for book leverage carry over to market leverage.12 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. Previous empirical results are mixed. For example, Titman and Wessels (1988) find a negative relationship, while Rajan and Zingales (1995) report a positive relationship between leverage and growth. In fact, the simple version of the pecking order theory supports the latter result. Debt typically grows when investment exceeds retained earnings and falls when investment is less than retained earnings. Thus, given profitability, book leverage is predicted to be higher for firms with more investment opportunities. However, in a more complex view of the model, firms are concerned with future as well as current financing costs. Balancing current and future costs, it is possible that firms with large expected growth opportunities maintain low-risk debt capacity to avoid financing future investments with new equity offerings, or foregoing the investments. Therefore the more complex version of the pecking order theory predicts that firms with larger expected investments have less current leverage. Our measure of growth opportunities is the ratio of book-to-market equity. Simple cash flow valuation models suggest that this is a forward looking measure. Another possibility would be to use research and development expenditures. As another example, Titman and Wessels (1988) use past growth rate of total assets. However, we think this measure is not appropriate because historical growth is not necessarily linked to future growth (e.g., see Chan, Karkeski and Lakonishok, 2003).
In the trade-off theory, agency costs, taxes, and bankruptcy costs push more profitable firms toward higher book leverage. First, expected bankruptcy costs decline when profitability increases. Second, the deductibility of corporate interest payments induces more profitable firms to finance with debt. Finally, in the agency models of Jensen and Meckling (1976), Easterbrook (1984), and Jensen (1986), higher leverage helps to control agency problems by forcing managers to pay out more of the firm's excess cash. The strong commitment to pay out a larger fraction of their pre-interest earnings to debt payments suggests a positive relationship between book leverage and profitability. This notion is also Consistent with the signaling hypothesis by Ross (1977), where higher levels of debt can be used by managers to signal an optimistic future for the firm. In sharp contrast, in the pecking order model, higher earnings should result in less book leverage. Firms prefer raising capital, first from retained earnings, second from debt, and third from issuing new equity. This behavior is due to the costs associated with new equity issues in the presence of information asymmetries.
Debt typically grows when investment exceeds retained earnings and fall when investment is less than retained earnings. Accordingly, the pecking order model predicts a negative relationship between book leverage and profitability. An important question is whether these predictions for book leverage carry over to market leverage. As put forth above, the trade-off theory predicts that leverage increases with profitability. Since the market value also increases with profitability, this positive relation does not necessarily apply for market leverage.
In contrast, the pecking order theory predicts that firms with a lot of profits and few investments have little debt. Since the market value increases with profitability, the negative relationship between book leverage and profitability also holds for market leverage. Again, the empirical evidence on the issue is mixed. For example, Rajan and Zingales (1995) report a negative relationship between leverage and profitability (supporting the pecking order theory), while Jensen, Solberg and Zorn (1992) find a positive one (supporting the trade-off theory). Following Titman and Wessels (1988), we use two different measures of profitability. Our first measure of profitability is the ratio of operating income over total assets (ROA), the second one is the ratio of operating income over sales (GMN). We refer to the former definition as"return on assets", and to the latter as"gross margin".
The importance of the Myers (1977) type underinvestment problem increases with the volatility of the firm's cash flow. Two issues are particularly noteworthy.
First, DeAngelo and Masulis (1980) argue that for firms which have variability in their earnings, investors will have little ability to accurately forecast future earnings based on publicly available information. The market will see the firm as a"lemon" and demand a premium to provide debt. This drives up the cost of debt. Second, to lower the chance of issuing new risky equity or being unable to realize profitable investments when cash flows are low, firms with more volatile cash flows tend to keep low leverage. Accordingly, the pecking order model predicts a negative relationship between leverage and the volatility of the firm's cash flows. The trade-off model allows the same prediction, but the reasoning is slightly different. More volatile cash flows increase the probability of default, implying a negative relationship between leverage and volatility of cash flows.
Following Bradley, Jarrell and Kim (1984), we measure variability as the standard deviation of the first difference in annual earnings, scaled by the average value of the firm's total assets over time (VOLA).
Uniqueness and industry classification
In a theoretical model, Titman (1984) shows that a firm's capital structure should depend on the uniqueness of its product. If a firm offers unique products or services, its consumers may find it difficult to find alternatives in case of liquidation, and hence, the costs of bankruptcy increase. Accordingly, the tradeoff theory predicts a negative relationship between book leverage and uniqueness.
We use data for research and development (R&D) expenditures as our measure of uniqueness. Specifically, since more detailed data is not available for US firms, we apply a dummy variable that is one if the firm reports research and development expenditures, and zero if not. Related to this prediction is the observation reported in Harris and Raviv (1991), that a firm's industrial classification is an important determinant of leverage. Reviewing previous empirical results, these "are in broad agreement and show that drugs, instruments, electronics, and food have consistently low leverage while paper, textile mill products, steel, airlines, and cement have consistently high leverage." We apply the industry classification of the Swiss Exchange (SWX) and use an additional dummy variable that is one for firms producing machines and equipment, and zero for all other sectors. Table summarizes the different predictions for the relationship between leverage and our proxy variables for both the trade-off theory and the pecking order theory. Table displays the correlations between our proxy variables. Specifically, for reasons that will become clear below, we use for each firm the mean of a variable over the period from 1997 to 2000. These measures are applied in our cross-sectional regression analysis. Several observations are noteworthy. First, there is evidence that larger firms are more profitable, as indicated by correlation coefficients of 0.23 and 0.39, depending on the definition of profitability. Second, firms with a higher return on assets (ROA) exhibit higher market-to-book ratios, while firms with higher operating margins (GMN) receive lower valuations. The latter observation seems at odds with intuition. We suspect that different capital intensities among firms and industries could affect the numerator of the market to-book ratio. Alternatively, severe competition on product markets could offer an explanation. When growth opportunities are high, many firms compete for future market shares, thereby pushing down operating margins. These growth firms tend to have little tangible assets, which also explains the negative correlation between tangibility and growth opportunities. Finally, as could be expected, small firms are more volatile. Volatile firms exhibit higher growth rates, but possess little tangible assets and generate lower profits.