Empirical studies on coroorate capital structure in viet nan

The strong negative correlation between profitability and all debt ratios supports the prediction of the pecking order theory and it is considered as a serious defect of the trade-off th

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EMPIRICAL STUDIES ON CORPORATE

CAPITAL STRUCTURE IN VIETNAM

LINH, DOAN NGOC DUY1Department of Business Administration Graduate School of Soongsil University, Korea

ABSTRACT

The purpose of the study is to examine the influence of firm characteristics

(profitability, investment opportunity “market-to-book ratio”, tangibility, size,

growth) and industry effect to capital structure of stock companies in Vietnam The

study uses OLS regression method to analyze a data set consisting of 522 financial companies listed in the two stock exchanges Ho Chi Minh Stock

non-Exchange (HSX) and Ha Noi Stock non-Exchange (HNX) during the period from 2008

to 2011

The aggregate market-based leverage ratio in Vietnam is about 0.29 Despite

the differences in business environment and management, this ratio is consistent to the statement from Frank and Goyal (2007) “Over the past half century the

1 Corresponding author

Email address: doanngoc_duylinh@yahoo.com

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aggregate market-based leverage ratio has been about 0.32”

The empirical results show that profitability, tangibility, and growth are the

major three determinants to debt ratios The strong negative correlation between

profitability and all debt ratios supports the prediction of the pecking order theory

and it is considered as a serious defect of the trade-off theory Tangibility has a

strong positive correlation with long-term debt ratio but it has a negative

correlation with short-term debt ratio This result is consistent with the maturity

mismatch principle “Firms tend to use long-term debt to finance fixed assets to

prevent maturity mismatch; consequently, firms with high fraction of tangibility are

expected to have high long-term debt ratio but low short-term debt ratio” The

strong positive correlation between growth and all debt ratios is consistent to the

statement of Jensen and Meckling, 1976 “Debt disciplines managers and mitigates

agency problems to free cash flow since debt must be repaid to avoid bankruptcy”

However, the fact that firms that have cash on hand actually issue debts is

considered a serious problem of the pecking order theory (Frank and Goyal, 2007)

As per the empirical results the corporate capital structure of the whole data is

dominated by short-term debt, but the corporate capital structure at industry level is

sometimes dominated by long-term debt It is consistent with the result of Gilson

(1997) “Industry leverage is used as a proxy for target capital structure” According

to Hovakimian et al (2001), firms actively adjust their debt ratios towards the

industry average And similar persistence at firm level is reported in Lemmon et al

(2007) The differences of corporate capital structure at industry level and the

similar persistence of capital structure at firm level reflect the role of industry

effect as the crucial determinant of the target debt ratios

CHAPTER 1: Introduction

1.1 Introduction

To finance their business operations, companies have to use either equity capital or

debt capital The combination of equity and debt, called the capital structure, is

affected by many factors and keeps changing

Modigliani and Miller (1958; 1963) set a foundation for implementation of

empirical research and development of alternative theories on capital structure

These theories have been tested through a series of empirical studies to identify

which determinants have a major role on capital structure decision This study is

the first empirical test of the capital structure theories in the Vietnam market Since

it is the first empirical work on the capital structure in Vietnam, this study

introduces capital structure theories and provides empirical evidences for managers

and investors of companies in Vietnam which help them to understand how and

which determinants affect their debt policy decisions at firm level and industry

level As per Frank and Goyal (2007), industry median leverage, profitability,

tangibility, market-to-book ratio, size, and inflation are six core factors which

account for more than 27% of the variation in leverage That is the reason why the

study examines the effect of firm characteristics (profitability, tangibility,

investment opportunity, size, and growth) on debt ratios at firm level and then

expanding into industry level in order to examine the industry effect The empirical

results are reliable because they are based on the raw data of 552 firms listed in the

Stock Exchanges in the period from 2008 to 2011

The study is organized as follows Chapter 1, the study illustrates the capital

market in Vietnam and reviews the literature on capital structure The study is then

divided into two essays (chapter 2 and chapter 3) Chapter 2, which examines the

effects of a firm’s characteristics, consists of four sections: section 1 develops

hypotheses between a firm’s characteristic factors and leverage; section 2 discusses

data collection and designs model; section 3 presents empirical results; and section

4 presents the conclusion of the chapter Chapter 3, which examines the industry

effect, consists of four sections: section 1 summarizes industry groups in Vietnam;

section 2 designs model; section 3 presents empirical results; and section 4 presents

the conclusion of the chapter Chapter 4 concludes the study

1.2 The capital market in Vietnam

In 1986, Vietnam implemented “Doi Moi” policy This policy set a big change in

the concept of an economy that transformed the command economy to a market economy The privatization program was the key issue in the process of economic

transformation at that time In the process of economic transformation, the

government promoted private ownership and launched the privatization program

which transformed the State-Owned Enterprises (SOEs) to joint stocks companies

There has been an impressive reduction in the number of SOEs from 12,000 SOEs

in 1991 to 1,200 SOEs in 2010 (IMF, 2010; WB, 2012) As a result, a lot of stock

companies were created in the market at that time, which set the foundation for the

development of an equity market in the future

The Vietnam capital market is a bank-centered financial system According to the

National Financial Supervisory Committee, up until 2009, 80% of the capital of the

national economy was bank loans (Nguyen, H., 2010) According to Manh Quan

Nguyen, deputy general director of HDBank, most of the capital in the bank is

short-term funds, while the demand from the market for longer term loans is

increasing rapidly (MHB, 2009) The capital market, which is overly dependent on

bank finance, reflects the lack of stable long-term financing channels and

underdevelopment of the capital market in Vietnam

The equity market has strongly developed since the establishment of the two stock

exchanges HSX and HNX, which were founded in 2000 and 2005 respectively From the beginning in 2000, there were only 5 companies with market

capitalization, accounting for 0.2% GDP listed in the equity market Ten years later

in 2010, there were 600 companies with market capitalization of USD 35 billion,

accounting for 45% GDP, listed in the equity market

The booming of the equity market has offered a long-term financing channel to

reduce the burden on the banking system It has also offered an effective channel to

attract foreign investment capital

1.2.3 The bond market in Vietnam

Despite its recently rapid development, the size of Vietnam’s bond market remains

very small, compared to many other emerging East Asian markets such as China,

South Korea, Singapore, Thailand, Malaysia and The Philippines According to

Hoang Huy Ha, the chairman of the Vietnam Bond Association, the local bond

market now accounts for only 17% of GDP while that number in China, Thailand,

Singapore, and Malaysia is 53%, 58%, 74% and 82% respectively (Vietnam

Business Forum, 2010) Government bonds are the key instrument in the Vietnam

bond market, occupying the largest portion (86%) of the whole market The corporate bond occupies 10% and the municipal occupies 4% (Vietnam’s Ministry

of Finance, 2009, quoted in Vuong & Tran, 2010) Moreover, corporate bonds are

mainly a playing field of large and famous enterprises The fact that most small and

medium enterprises (SMEs) are unable to access this long-term finance channel

results in a definitive increase in the number of enterprises which file for bankruptcy (from 40,000 to 53,000 to 54,000 and to 61,000 in the four consecutive

years 2010, 2011, 2012, 2013 respectively)

Bolton and Freixas (2008) argue that bond financing, as a form of long-term

finance, does not expose firms to risks of bank runs and systemic crisis While

bank-financed firms are fully exposed to risks of bank loans, bond-financed firms

are shielded from adverse effects of a financial crisis, and therefore are more likely

to survive As a consequence, bond issuers in a financial crisis are more likely to

survive than non-issuers

1.3 Literature

Capital structure can be defined as the mixture of a firm’s capital with debt and

equity and it has been one of the most argumentative subjects in corporate finance,

since the outstanding study of Modigliani and Miller in 1958 (Bevan and Danbolt,

2004) Many theories have been developed in the literature for examining

determinants of capital structure and they focus on which determinants are more

likely to have a major role on the leverage decisions

How do firms finance their operations? And what factors influence their capital

structure choices? Weston (1955) raises the above questions and argues whether it

is possible to answer these questions And Steward C Myers (1984) starts the paper “Capital Structure Puzzle” by asking the question, “How do firms choose

their capital structures?” then answering it, “We don't know” In fact, it is still

debated over what the determinants of capital structure are and how they impact capital structure decisions, even though there have been various studies conducted

on the subject

As per Frank and Goyal (2007), taxes, bankruptcy costs, transaction costs,

adverse selection, and agency conflicts have all been advocated as major

explanations for the corporate use of debt financing Myers (1984) describes the

“trade-off theory” as the hypothesis that firms balance tax savings from debt

against deadweight bankruptcy costs He also describes the “pecking order theory”

as the hypothesis that due to adverse selection, firms first look to retained earnings,

then to debt, and only in extreme circumstances to equity for financing However,

no currently available model appears capable of simultaneously accounting for all

of the stylized facts

Over long periods of time, aggregate leverage is stationary (Frank and Goyal,

2007) Similar persistence at the firm level is reported in Lemmon et al (2007)

The persistence in leverage ratios places important limits on theory It means that a

satisfactory theory must account for why firms keep leverage stationary In other

words, the theory must explain why the environment serves to maintain the

leverage despite a difference in management

Over the past half century, the aggregate market-based leverage ratio has been

about 0.32 There have been surprisingly small fluctuations in this ratio from

decade to decade (Frank and Goyal, 2007) Following Myers (1984), it may seem

that the stability of aggregate leverage is consistent with the trade-off theory In

fact, there is too much stability for the simple version of tax versus bankruptcy theory For most of the 1950s and the 1960s, the top corporate tax rate was roughly

50% In the 1990s, it was around 35% Despite this large difference in tax rates, the

market leverage ratio averaged 0.32 in both the 1950s and in the 1990s, while, in

the 1960s, it averaged 0.27 Have bankruptcy costs really fluctuated in just the right

manner to account for this evidence? It seems hard to imagine This evidence,

while not a proof, is certainly a serious warning sign for the trade-off theory The

remarkable stability of leverage ratios also poses a problem for the pecking order

theory Leverage should fluctuate as the financing deficit ebbs and flows, according

to the standard pecking order theory In order to account for this evidence,

something must be added to the basic pecking order theory (see Frank and Goyal,

2007)

Thus the standard versions of both the trade-off theory and the pecking order

theory appear to be inadequate Both approaches need to be improved to account

for the known facts Recently, proponents of the trade-off approach have focused

their efforts mainly on developing dynamic structural trade-off models An

attractive feature of these models is that they try to provide a unified framework

that can simultaneously account for many facts Examples include Leary and

Roberts (2007), Hennessy and Whited (2005), Ju et al (2005), and Strebulaev

(2007) Proponents of the pecking order theory have focused recently on the development of a satisfactory notion of “debt capacity” (see, Lemmon and Zender,

2004) and on more complex adverse selection models (see Halov and Heider,

2005)

Modigliani and Miller start by assuming that the firm has a particular set of

expected cash flows When the firm chooses a certain proportion of debt and equity

to finance its assets, all that it does is to divide up the cash flows among investors

Investors and firms are assumed to have equal access to financial markets, which

allows for homemade leverage The investor can create any leverage that was

wanted but not offered, or the investor can get rid of any leverage that the firm took

on but was not wanted As a result, the leverage of the firm has no effect on the

market value of the firm

There are two fundamentally different types of capital structure irrelevance

propositions The classic arbitrage-based irrelevance propositions provide settings

in which arbitrage by investors keeps the value of the firm independent of its

leverage A second kind of capital structure irrelevance is associated with multiple

equilibria In models of this kind, equilibrium conditions pin down the aggregate

amount of debt and equity in the market

The 1958 paper stimulated serious research devoted to disproving irrelevance

as a matter of theory or as an empirical matter This research has shown that the

Modigliani-Miller theorem fails under a variety of circumstances The most

commonly used elements include consideration of taxes, transaction costs,

bankruptcy costs, agency conflicts, adverse selection, lack of separability between

financing and operations, time-varying financial market opportunities, and investing client effects

While the Modigliani-Miller theorem does not provide a realistic description of

how firms finance their operations, it provides a means of finding reasons why

financing may matter Accordingly, it influenced the early development of both the

trade-off theory and the pecking order theory (see Frank and Goyal, 2007)

Myers (1958) considers the “trade-off theory” to be the hypothesis that firms

balance tax savings from debt against deadweight bankruptcy costs The trade-off

theory states that interest tax shield and cost of bankruptcy (financial distress) play

crucial roles in a firm’s leveraged ratio This theory suggests that the total value of

a geared firm equals the value of the ungeared firm plus present value of the

interest tax shield minus the present value of financial cost (Berk and DeMarzo,

2007) Therefore, the firm looks for optimum debt ratio which offsets tax savings

benefits opposed to the cost of possible bankruptcy and agency conflict (Gajurel,

2005) According to Myers (1984), the key implication of the trade-off theory is

that leverage exhibits target adjustment so that deviations from the target are

gradually eliminated

Financial distress has an important position in capital structure theories Berk

and DeMarzo (2007, p 509) define financial distress: “When a firm has trouble

meeting its debt obligations we say the firm is in financial distress.” When a firm

increases its proportion of debt to equity for financing its operations and future investments, the probability of default on the debt will rise as well (Kraus and

Litzenberger, 1973) The cost arising from financial distress plays a crucial role on the firm’s future decisions, such as investment policy, cuts in research and

development activities, as well as advertisement and educational expenditures

(Warner, 1977) All these decisions as an outcome of financial distress will affect a firm’s value negatively and lead to decline in the firm’s value; therefore the wealth

of shareholders will decrease as well (Arnold, 2008)

There are two types of costs arising from financial distress: direct and indirect cost

Direct costs are bankruptcy fees, administrative fees and legal costs (Warner, 1977)

Indirect costs arise from a firm’s decision-making due to financial distress These

are, as mentioned above, changes in investment policy, such as postponing future

positive NPV investments or totally discarding investment opportunity, a decrease

in staff educational expenditures, reducing research and development, and reducing

marketing activities (Arnold, 2008)

According to the trade-off theory, companies that make high profits are more

likely to have higher leverage and more taxable income to shield (Barclay and

Smith, 2005) However, the Rajan and Zingales (1995) study shows that this theory

fails in some cases to illuminate why profitable firms have low debt ratio Also

Bevan and Danbolt (2002) suggest that the trade-off theory has some shortcomings

and limitations In addition to these, the empirical studies of Kester (1986), the

study of Titman and Wessels (1988) support that there is a strong inverse

correlation between profitability and debt ratios in capital structure As a result, due

to shortcomings and flaws of the trade-off theory, the theory is not adequate when

determining the ideal capital structure

1.3.2.1 Static trade-off theory

A particularly important problem for the standard static trade-off theory is provided

by the historical record In the static trade-off theory, it is the desire to limit tax

payments that motivate a firm to use debt financing (see Modigliani and Miller,

1963) It is actually quite difficult to match the observed leverage ratios in

particular decades with the corporate tax rates in those decades Even more

remarkable, corporate income taxes are only about a century old Debt financing

was common long before the introduction of corporate income taxes Thus, we

know that taxes do not provide a complete justification for the use of debt

financing

1.3.2.2 Dynamic trade-off theory

In a dynamic model, the correct financing decision typically depends on the

financing margin that the firm anticipates in the next period Some firms expect to

pay out funds in the next period, while others expect to raise funds If funds are to

be raised, they may take the form of debt or equity More generally, a firm

undertakes a combination of these actions

Given that the firm is profitable, its investment opportunities are likely to be

better than those of its shareholders This may lead to situations when it is better for a firm to retain funds even though it faces a higher tax rate than do its

shareholders Paying out money causes shareholders to pay taxes With taxes, such

circular financing can be expensive Thus, distributing funds and then raising new

equity subsequently imposes a tax liability on shareholders that could have been

avoided had the firm retained the funds Hence, taxes can directly motivate firms to

retain earnings Money paid in to the firm is not taxed, but money paid out is taxed

For reasonable parameter values, Stiglitz's basic result is that it pays to finance as

much investment as possible through retained earnings and to finance the excess of

investment over retained earnings with debt The observed leverage ratio is thus a

fortuitous outcome of the profit and investment history of the firm (Stiglitz, 1973,

page 32) In other words, the solution is essentially what we might now call the

pecking order

Myers (1984) describes “the pecking order theory” as the hypothesis that due to

adverse selection, firms first look to retained earnings, then to debt, and only in

extreme circumstances to equity for financing (see Frank and Goyal, 2007) The

pecking order theory (Myers and Majluf, 1984; and Myers, 1984) is based on the

idea of asymmetric information between managers and investors Managers know

more about the true value of the firm and the firm’s threats than less informed

outside investors To avoid the underinvestment problem, managers will seek to

finance a new project using a security that is not undervalued by the market, such

as internal funds or riskless debt Therefore, this affects the choice between internal

and external financing The pecking order theory is able to explain why firms tend

to depend on internal sources of funds and prefer debt to equity if external financing is required Thus, a firm’s leverage is not driven by the trade-off theory,

but it is simply the cumulative results of the firm’s attempts to mitigate information

asymmetry

Myers and Majluf (1984) proposed in the pecking order theory that firms

would prefer retained earnings as a primary source of internal financing If internal

financing does not meet the requirements, then firms prefer external financing by

issuing securities According to Myers (1984), if the firm is in need of using

external finance, it chooses first the safest security (debt market) to issue rather

than convertible bonds As a last choice, the firm falls back on the equity market

and issues external equity

The firm that does not have enough available internal finance would either use

equity or debt issue to finance future positive NPV investments According to

Myers and Majluf (1984), issuing external equity gives a bad signal to the market

that supporting equity is overrated Nevertheless issuing debt sends a signal that the

supporting stock is underestimated This conflict leads to an interaction between

investments and financing decisions (Gajurel, 2005, p 19) The main prediction of

the pecking order theory is that firms with high information asymmetry rely more

on issuing debt to finance their external financing needs, given that the financial

distress cost is low Short–term debt, which is less sensitive to the information asymmetry problem relative to long-term debt (Flannery (1986)), should constitute

a higher proportion of the debt financing if the information asymmetry is uniformly

distributed over time Under such assumption, we expect to find a higher impact of

information asymmetry on the proportion of short-term debt financing

1.3.3.1 Financial deficit

Changes in debt have played an important role in assessing the pecking order

theory This is because the financing deficit is supposed to drive debt according to

this theory Shyam-Sunder and Myers (1999) examine debt responses to short-term

variation in investment and earnings The theory predicts that when investments

exceed earnings, debt grows, and when earnings exceed investments, debt falls

Tests of the pecking order theory define financing deficit as investments plus

change in working capital plus dividends less internal cash flow Frank and Goyal

(2003) examine the broad applicability of the pecking order theory Their evidence

based on a large cross-section of U.S publicly traded firms over long time periods,

shows that external financing is heavily used by some firms On average, net equity

issues track the financing deficit more closely than do net debt issues These facts

do not match the claims of the pecking order theory The greatest support for

pecking order is found among large firms, which might be expected to face the

least severe adverse selection problem since they receive much better coverage by

equity analysts Even here, the support for pecking order is declining over time

They conclude that the pecking order theory does not explain broad patterns in the data

1.3.3.2 Debt capacity

Firms adjust their debt frequently Financing deficit plays a role in these decisions

According to Lemmon and Zender (2004), the idea of debt capacity is important in

understanding the rejections of the pecking order theory Consideration of debt

capacity suggests that, when unconstrained by debt capacity, firms issue debt; yet

when constrained, they issue equity These tests require a workable definition of

debt capacity If debt capacity is defined as the point when adding more leverage

reduces firm value, then debt capacity is similar to the concept of target leverage as

defined by the trade-off theory of capital structure Thus, the fact that firms use

debt to fill the financing deficit when they are below their debt capacity may not

sharply distinguish two theories Lemmon and Zender explain the concept of debt

capacity by focusing on firms with rated debt They argue that firms with debt

ratings are unconstrained by debt capacity while firms without debt ratings are

constrained Lemmon and Zender find, as expected, that the coefficient on

financing deficit in net debt regressions is significantly larger for firms with rated

debt, and it is smaller for firms with no debt rating They also show that firms with

no debt rating are small, high-growth firms, and that they use equity to finance

their deficits These results are consistent with those in Fama and French (2002)

and Frank and Goyal (2003) The interpretation, however, is different While Frank

and Goyal suggest that these firms face more asymmetric information problems and thus the pecking order predicts that they should issue equity However,

Lemmon and Zender suggest that these firms are debt capacity constrained and

therefore issue equity

Another attempt to reconcile the evidence in Frank and Goyal (2003) with the

predictions of adverse selection arguments is described in Halov and Heider (2005) The paper argues that when there is greater asymmetric information about risk,

debt has a more severe adverse selection problem and firms would only issue

equity To test these arguments, Halov and Heider use asset volatility as a proxy for

asymmetric information about risk, and divide firms into deciles based on asset

volatility They show that as asset volatility increases, firms use more equity to

finance their deficits The interpretation of these results rests on the assumption

that differences in asset volatility deciles capture differences in asymmetric

information regarding cash flow variance The mean of the distribution is common

knowledge Thus, small, young, high-growth firms will issue equity to finance their

deficits if these firms have more asymmetric information about risk and less

asymmetric information about value

1.3.3.3 The modified pecking order theory

In the pecking order theory C Meyers (1984), firms prefer internal to external

funds and debt to equity if external funds are needed Thus the debt ratio reflects

the cumulative requirement for external financing Pecking order behavior follows

from simple asymmetric information models

In the modified pecking order story, observed debt ratios will reflect the

cumulative requirement for external financing, a requirement cumulated over an

extended period For example, think of an unusually profitable firm in an industry

generating relatively slow growth That firm will end up with an unusually low

debt ratio compared to its industry's average, and it won't do much of anything

about it It won't go out of its way to issue debt and retire equity to achieve a more

normal debt ratio An unprofitable firm in the same industry will end up with a

relatively high debt ratio If it is high enough to create significant costs of financial

distress, the firm may rebalance its capital structure by issuing equity On the other

hand, it may not The same asymmetric information problems which sometimes

prevent a firm from issuing stock to finance real investment will sometimes also

block issuing stock to retire debt If this story is right, average debt ratios will vary

from industry to industry, because asset risk, asset type, and requirements for

external funds also vary by industry But a long-run industry average will not be a

meaningful target for individual firms in that industry

A particularly important problem for the standard version of the pecking order

theory concerns the use of equity financing Firms issue too much equity (Frank

and Goyal, 2003) and at the wrong times (Fama and French, 2005; Leary and

Roberts, 2007) In the pecking order, it is the financing deficit that drives debt

issues Empirically, however, other factors appear to be more important (Frank and

Goyal, 2003)

The pecking order theory suggests that there is no exact target level of leverage and interest tax shield and financial distress are considered as less effective factors

when determining capital structure decisions (Myers, 2001) Also Meyers further

advocates that the trade-off theory does not differentiate finance equities as

external and internal, and he states that there is a positive correlation between

profitability and debt ratio Nevertheless, the pecking order theory advocates a

negatively correlated relationship, as Myers and Majluf (1984) suggest less

profitable firms are more like to borrow more debt to finance future positive NPV

investments; therefore the firm will raise its profitability In addition to this, the

studies of Ozkan (2001), Kester (1986) and Titman and Wessels (1988) support an

inverse relationship between leverage and profitability As a result, the pecking

order theory is much more accurate in order to explain reverse relationship of

profitability and debt ratios rather than the trade-off theory

Jensen and Meckling (1976) defined agency costs as examining conflicts and

relationships between the agent (corporate managers) and principals (shareholders)

The opposed interests of principals and agents, along with the separation of

management and ownership in a firm, cause these conflicts For instance, managers

may be interested in taking negative NPV projects or making unnecessary

acquisitions by paying too much to increase the size and reputation of the firm

instead of maximizing the wealth of shareholders The explanation behind this is

that the agents are more likely to run and control bigger firms than smaller ones Hence the managers will receive higher salaries and remuneration packages as a

result of the increasing size of the firm (Berk and DeMarzo, 2007) In conclusion,

managers may tend to operate the firm consistent with their interests rather than

taking into consideration increasing the firm’s value and wealth of shareholders

Harris and Raviv (1991) and Jensen (1986) describe two types of conflicts, the

agency cost of equity and the agency cost of debt The agency cost of equity, as

mentioned above, is between shareholders and managers, and small firms generally

do not suffer from this cost since they are mostly operated by owners (Easterbrook,

1984) This cost emerges from the management board’s different interests, which

do not always correspond to maximizing stockholder wealth The agency cost of

debt is between equity holders and debt holders and this conflict arises from risk

shifting, which means transferring risk from debt holders to equity holders by

making risky investments with debt (Jensen, 1986)

Jensen (1986) also states that a firm, which has high levels of excess cash, is

more likely to experience agency cost When excess cash is reduced and debt is

increased, it would limit the availability of money for future investments and

spending Hence managers tend to manage firms more attentively in order not to

face financial distress, and this decreases the possibility of experiencing agency

cost According to the Harris and Raviv (1991) study, leverage is used as a tool for

providing motivation and discipline for management and minimizing agency cost

In conclusion, Harris and Raviv (1991) further state that there is a positive

relationship between leverage and free cash flow, as well as company value and liquidity The “agency” perspective is that debt disciplines managers and mitigates

agency problems of free cash flow since debt must be repaid to avoid bankruptcy

(Jensen and Meckling, 1976; Jensen, 1986) Although debt mitigates

shareholder-manager conflicts, it exacerbates shareholder-debtholder conflicts (Myers, 1977)

It is well known that firms are more likely to issue equity when their market values

are high, relative to book and past market values, and to repurchase equity when

their market values are low We document that the resulting effects on capital

structure are very persistent As a consequence, current capital structure is strongly

related to past market values The results suggest that capital structure is the

cumulative outcome of past attempts to time the equity market (Baker and Wurlger,

2002)

If firms time their equity issue (reduction) with favorable market conditions,

we expect to find such a behavior to affect the proportion of debt financing

(reduction) relative to the financing deficit (surplus) Lucas and MacDonald (1990)

model predicts that managers with superior private information will delay equity

issue until their stock prices rise Korajczyk, Lucas, and MacDonald (1990) find evidence supporting this prediction, as firms’ equity issuance clusters following

stock prices run up Hovakimian, Opler, and Titman (2001) find evidence that stock

prices run up (decline) play a significant role in the firms’ choice of equity issuance

and repurchase decision Baker and Wurlger (2002) also find supporting evidence for the market timing hypothesis We use the ratio of stock price (St) in the current

period relative to the previous one to test the market-timing hypothesis If firms

time their equity issue (reduction) with favorable market conditions, we expect to

find a negative sign of St for the financing deficit group and a positive sign for the

financing surplus group

Industry differences in leverage ratios have several possible meanings One

interpretation is that managers perhaps use industry median leverage as a benchmark as they contemplate their own firm’s leverage Thus, industry median

leverage is often used as a proxy for target capital structure (Gilson,1997)

Hovakimian et al (2001) provide evidence consistent with firms actively adjusting

their debt ratios towards the industry average

Another interpretation is that industry effects reflect a set of correlated, but

otherwise omitted factors Firms in an industry face common forces that affect their

financing decisions These could reflect product market interactions or the nature

of competition These could also reflect industry heterogeneity in the types of

assets, business risk, technology, or regulation Industry factors do not have a

unique interpretation

Tradeoff theory predicts that higher industry median growth should result in

less debt, while higher industry median leverage should result in more debt

Regulated firms have stable cash flows and lower expected costs of financial distress Thus, regulated firms should have more debt On the other hand, managers

have less discretion in regulated firms which reduces the severity of

shareholder-manager conflicts, and makes debt less desirable from a control perspective

Tradeoff theory makes ambiguous prediction concerning the effect of regulation on

leverage

Under a pure pecking order perspective, the industry should only matter to the

extent that it serves as a proxy for the firm’s financing deficit Under the market

timing theory, the industry should matter only if valuations are correlated across

firms in an industry Firms that compete in certain industries, in which the median

firm has high leverage, tend to have high leverage

Over long periods of time, aggregate leverage is stationary (Frank and Goyal,

2007) Similar persistence at the firm level is reported in Lemmon et al (2007)

The persistence in leverage ratios places important limits on theory It means that a

satisfactory theory must account for why firms keep leverage stationary In other

words, the theory must explain why the environment serves to maintain the

leverage despite management difference

CHAPTER 2: Firm Characteristics and Leverage

2.1 Leverage definition

There are different ways of expressing leverage which depend on the purpose of

study For studies of capital structure relevant to agency problem, leverage is

defined as the ratio of debt to firm value The interest coverage ratio is suitable for

studies of financial distress and leverage Other definitions of leverage include the

debt to equity ratio, the debt to capitalization ratio, the debt to net assets ratio, the

debt to total assets ratio, and total liabilities to total assets ratio

In our study, capital structure or leverage is simplified as the ratio of total debt

to total assets We consider three types of debt ratios consisting of the total debt

ratio, short-term debt ratio, and long-term debt ratio Short-term debt and long-term

debt are separate accounts in the balance sheet Then total debt is the sum of

short-term debt and long-short-term debt Similarly, total debt ratio is the sum of short-short-term

debt ratio and long-term debt ratio

Subsequent empirical studies have given more attention to a market-based measure of leverage although early empirical studies tended to focus on book

leverage According to Welch (2004), the book value of equity is primarily a “plug number” that is used to balance the left-hand side and the right-hand side of the

balance sheet rather than a managerially relevant number The book measure looks

backward, measuring what has taken place In contrast, the market measure is

generally assumed to be forward looking As per the results of Frank and Goyal

(2007), market-based leverage has been rather more stable over the decade than has

book leverage In this study, the leverage is calculated by the book measure and

market measure as well

Each debt ratio is then calculated by both the book value measure and the

market value measure In case of book value, debt ratio is measured as the ratio of

debt at book value to total assets In case of market value, debt ratio is measured as

the ratio of debt at book value to sum of the total liabilities and market value of

equity Consequently, we have six measures of debt ratios which are denoted as six

dependent variables

Profitable firms face lower expected costs of financial distress and find interest tax

shields more valuable Thus, the tax and the bankruptcy costs perspective predict

that profitable firms use more debt In addition, the agency costs perspective

predict that the discipline provided by debt is more valuable for profitable firms as

these firms are likely to have severe free cash flow problems (Jensen, 1986) The static trade-off theory predicts that profitable firms should have more debt

because expected bankruptcy costs are lower and interest tax shields are more

valuable for profitable firms Furthermore, firms that generate higher profits

relative to investments benefit from the discipline that debt provides in mitigating

the free cash flow problem (Jensen, 1986) According to the tax shield hypothesis,

which is derived from Modigliani and Miller (1963), firms with larger profit would

employ larger debt ratio to gain tax benefits

On the contrary, the pecking order, or asymmetric information hypothesis, of

Myers (1984) and Myers and Majluf (1984) postulates that companies prefer

internal financing to debt or equity Thus, firms with greater profit will employ

higher retained earnings and less debt

Most empirical studies confirm the pecking order hypothesis (Kester, 1986;

Titman and Wessels, 1988; Rajan and Zingales, 1995; Michaelas et al., 1999) To

investigate this relationship, the following hypothesis is tested

Profitability =

EBIT

Total assets

Null hypothesis (H0): There is no correlation between profitability and debt ratios

According to Jensen and Meckling’s (1976), if a firm has a high fraction of tangible assets, then these assets can be used as collateral, mitigating the lender’s

risk Higher tangibility of assets indicates lower risk for the lender as well as

reduces direct costs of bankruptcy With respect to the bankruptcy costs, we expect

that these costs have a negative impact on leverage Hence, a large fraction of

tangible assets is expected to be associated with high leverage Tangibility can be

used as a proxy for collateralization which is expected to be positively related to

leverage

Bennett and Donnelly (2003), Rajan and Zingales (1995) and Gaud et al (2003),

have found evidence that supports this correlation To investigate this relationship,

the following hypothesis is tested

Tangibility =

Fixed assets

Total assets

Null hypothesis (H0): There is no correlation between tangibility and debt ratios

The negative relation between the market-to-book ratio and leverage ratio is one of

the most widely documented empirical regularities in capital structure literature As

per the static trade-off theory higher investment opportunities have more risk and

then face more bankruptcy cost The theory predicts a negative relation between

investment opportunity and leverage Following the agency theory of Myers (1977), many economists argue that this negative relation confirms that higher market-to-

book ratio firms have lower optimal leverage ratios due to high financial distress

Asset substitution problems - in regards to the transfer of assets placing more risk

on the debt holders without providing them with additional compensation - become

more sever with higher market-to-book ratio firms

Firms with higher market-to-book ratios are, on average, more profitable and

then tend to have lower leverage as per the pecking order theory Investment

opportunity reflects the reaction of the market to the firm’s debt policy Adam and

Goyal (2007) show that it is also the most reliable

Higher market-to-book ratio, however, may also be influenced by stock

mispricing If market timing drives capital structure decisions, higher

market-to-book ratio should reduce leverage as firms exploit equity mispricing through equity

issuances The relation is caused by active market timing (Baker and Wurgler,

2002)

Rajan and Zingales (1995) show the negative relation between leverage and

market-to-book ratios that exist in all G7 countries To investigate this relation, the

following hypothesis is tested

Investop =

Market value of equity

Book value of equity

Null hypothesis (H0): There is no correlation between investment opportunity and

debt ratios

Firm size is an inverse proxy for the probability of bankruptcy, whereby larger

firms are less likely to face financial distress and bankruptcy The static trade-off

theory predicts positive correlation between size and leverage because larger firms

have lower agency cost of debt and lower default risk Large firms may have

greater bargaining power with lenders thereby lowering their cost of debt Further,

larger firms are less likely to be adversely affected by information asymmetry

problems than small ones as they are better known and are willing to disclose more

information to outsiders (Rajan and Zingales, 1995) While small public firms

make active use of equity financing, large public firms primarily use retained

earnings and corporate bonds (Murray Z Frank and Vidhan K Goyal, 2007)

Most international empirical research confirms theoretical propositions (e.g

Friend and Lang, 1988; Frank and Goyal, 2009) To investigate this relationship,

the following will be tested

Size = ln (sales)

Null hypothesis (H0): There is no correlation between size and debt ratios

Jensen (1986) also states that a firm, which has high levels of excess cash, is more

likely to experience agency cost When excess cash is reduced and debt is

increased, it would limit the availability of money for future investments and

spending According to the Harris and Raviv (1991) study, leverage is used as a

tool for providing motivation and discipline for management and minimizing

agency cost In conclusion, Harris and Raviv (1991) further state that there is a

positive relationship between leverage and free cash flow According to the off theory, growth companies’ retained earnings increase so they tend to issue more

trade-debt to maintain the target trade-debt ratios Thus, positive relationship between trade-debt ratios and growth is expected based on this argument To investigate the relation

between growth and leverage, the following hypothesis will be tested

The surveying time of the study is four years (2008, 2009, 2010, and 2011) The

raw data are financial reports (including balance sheets, income statements, etc.) of

listed companies available on websites of the Ho Chi Minh Stock Exchange (HSX),

Hanoi Stock Exchange (HNX), Saigon Security Incorporation (SSI)3, and Agriculture Security Company (AGR)4

All financial companies are removed out of the list of target companies There

were initially 562 companies in the study list in which 40 companies have been

removed due to missing data during the surveyed time period There are 522

companies left in the study

The study uses the OLS regression method and pools data for the period of

four years (2008, 2009, 2010, and 2011) The pooled sample consists of 1566 (522

x 3) observations Here, there is one point needs to be explained For the

2 If we declare growth rate as [sale(t) /sale(t-1)] – 1, the result will be positive when sale(t)

> sale(t-1), and negative when sale(t) < sale(t-1) Consequently, the slope coefficients of growth to all debt ratios are statistically insignificant

3 http://www.ssi.com.vn

4 http://www.agriseco.com.vn

calculation of the growth rate of 2011, the study uses data of 2 years (2011 and

2010) For the growth rate of 2010, the study uses data of 2 years (2010 and 2009)

For the growth rate of 2009, the study uses data of 2 years (2009 and 2008)

Consequently, the pooled sample only consists of 1566 (522 x 3) observations, not

2088 (522 x 4) observations It seems one year’s data of 2008 is dropped; but

actually, the data of 2008 is used to calculate the growth rate of 2009

The study uses the OLS (Ordinary Least Square) regression method to analyze the

relationship between debt ratios and the effect of the firm’s characteristics The

model of linear relationship between the dependent variable (debt ratios) and the

independent variables (firm characteristic factors) is designed as below

Di = α0 + α1Pi + α2Ti + α3IOi + α4Si +α5Gi + εi

In the model, debt ratios, denoted as Di in which the small letter i runs from 1 to 6

and represents one of six measures of the debt ratios as follows

[Table 2-1] Dependent variables list

Short-term debt market value total

assets (abbreviated as stdmvta)

Long-term debt market value total

assets (abbreviated as ltdmvta)

2.2.3 Independent variables

In the model, profitability, denoted as Pi in which the small letter i runs from 1 to 6

and represents one of six measures of the debt ratios

In the model, tangibility, denoted as Ti in which the small letter i runs from 1 to 6

and represents one of six measures of the debt ratios

In the model, investment opportunity, denoted as IOi in which the small letter i runs

from 1 to 6 and represents one of six measures of the debt ratios

In the model, size, denoted as Si in which the small letter i runs from 1 to 6 and

represents one of six measures of the debt ratios

In the model, growth, denoted as Gi in which the small letter i runs from 1 to 6 and

represents one of six measures of the debt ratios

[Table 2-2] Independent variables list

Size (denoted as S) = ln (sales)

[Figure 2-1] Debt ratios of the whole date set

[Table 2-3] Descriptive Statistics of debt ratios

Dependent variable Obs Mean Std

Dev

Min Max Skew

ness kurto sis

Total-debt book value

As per the descriptive statistics [table 2-3], the total-debt market value is 29.5%

Despite the differences in management, the aggregate of the market-based leverage

of Vietnam’s economy is 29.5% This result is consistent with the results of Frank

and Goyal (2007): “Over the past half century the aggregate market-based leverage

ratio has been about 0.32”

As per the descriptive statistics [table 2-3], the short-term debt market value

and the long-term debt market value are 20%, and 9.5% respectively The

short-5 The company receives large loss so that the equity value is negative Consequently, total debt is higher than total assets Then the ratio of total debt to total assets is higher than 1

6 The long-term debt in this case is too small Consequently, the total debt ratio equals the short-term debt ratio

term debt is twice as high as the long-term debt It proves that capital structure in

Vietnam during this time is mainly dominated by sources of short-term finance As

said in the capital market section, the Vietnam’s economy is overly dependent on

bank financing Bank loans are a short-term finance channel; therefore, corporate

capital structure in Vietnam is dominated by sources of short-term finance

Moreover, the capital market in Vietnam lacks of a deep and liquid corporate bond

market, which is a reliable source of long-term finance besides equity finance

According to Greenspan (2000) as cited in Hawkins (2002, p.43), bond markets can serve as a “spare tyre” offering an alternative source of financing when bank

financing dries up The lack of a deep and liquid corporate bond market in the

capital market results in the fact that the corporate capital structure in Vietnam is

dominated by short-term finance sources and an increasing number of Vietnamese

companies that have stopped business activities in the recent years

The market value of all debt ratios is higher than their book value, reflecting

the fact that stock prices in the stock exchange decreased during the period of study The total debt market value (29.5%) is higher than the total debt book value

(25.7%) The short-term debt market value (20%) is higher than the short-term debt

book value (17.3%) The long-term debt market value (9.5%) is higher than the

long-term debt book value (8.4%), as per the statistics [table 2-3] and [figure 2-1]

[Table 2-4] Correlation matrix

h