Debt tax shield and firm value empirical evidence from listed companies in vietnam

Research objectiveThis first purpose aims to value the magnitude of debt tax shield, besides that there isanother tendency to test the effect of tax to debt ratio in the scope of this re

UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DEBT TAX SHIELD AND FIRM VALUE: EMPIRICAL EVIDENCE FROM LISTED

COMPANIES IN VIETNAM

BY

NGUYEN THI HONG HOA

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DEBT TAX SHIELD AND FIRM VALUE: EMPIRICAL EVIDENCE FROM LISTED

COMPANIES IN VIETNAM

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

Finally, thanks are also due to my classmates for providing me with unfailingsupport and continuous encouragement throughout my years of study and through theprocess of researching and writing this thesis This accomplishment would not havebeen possible without them Thank you.

Nguyen Thi Hong Hoa

Ho Chi Minh City, October 2017

In the present study, panel data in fiscal year from 2008 to 2015 has been collected toreveal the interaction between debt tax shield and firm value The main purpose is toexamine the value of debt tax shield and its effect on firm value toward taxation Thereverse approach is employed in which the future profitability is regressed on firmvalue and debt using non-linear least square The advantage of reverse method is toshift measurement bias in future operating income to the regression residual and toenhance the usefulness of market factors to control for risk and expected growth Thisway also includes nontax information in the market value variable As a result, debttax shield has negative effect on firm value The predicted value for debt tax shieldapproximately gets 37 percent of debt or gets 9.5 percent of firm value

TABLE OF CONTENT

Acknowledgement i

Abstract ii

Table of content iii

List of tables v

List of figures vi

1 Introduction 1

1.1 Research problem 1

1.2 Research objective 2

1.3 Scope of study 2

1.4 Thesis structure 3

2 Literature review 4

2.1 Theoretical review 4

2.1.1 Modigliani and Miller and capital structure theory (MM Model) 4

2.1.2 Trade-off theory 5

2.1.3 Theory of Agency costs 9

2.2 Empirical review 11

2.3 Hypothesis development 18

3 Research methodology 21

3.1 Conceptual framework 21

3.2 Estimation method 22

3.3 Variables and measures 29

3.4 Data Collection 36

4.2.1 Linear estimation 41

4.2.2 Nonlinear estimation 46

5 Conclusion 55

Reference vii

Appendix xi

LIST OF TABLES Table 3.1 Variable description 36

Table 4.1 Descriptive statistics 37

Table 4.2 Correlation 39

Table 4.3 Correlation (divided by total assets) 40

Table 4.4 Summary statistics from linear regression explaining the Value of firm (un-deflated intercept) 42

Table 4.5 Summary statistics from linear regression explaining the Value of firm with deflated intercept 43

Table 4.6 Valuation of debt tax shield ( ) from reverse regression, No Control for Capitalization Rates 44

Table 4.7 Valuation of debt tax shield ( ) from quantile regression according to industry effect 45

Table 4.8 Valuation of the debt tax shield ( ) from nonlinear Regression .49

Table 4.9 Summary statistics from Nonlinear regression with interest expense .50 Table 4.10 State ownership and firm performance from nonlinear Regression .51

LIST OF FIGURES

Figure 2.1 The optimal capital structure and the value of the firm 8Figure 3.1 Conceptual framework 22Figure 4.1 Distribution of future operating income 38

CHAPTER 1: INTRODUCTION

1.1 Problem statement

In corporate finance’s perspective, one of the most important decisions of a particularfirm is to determine the optimal level of its capital structure or financial leverage.However, the issue of firm’s capital structure has been controversially argued amongresearchers (Akhtar & Oliver, 2009) In addition, financial leverage has become moreimportant since there are a large number of corporations using debt as a main instrument

to raise its capital

The relationship between taxation and capital structure has been empirically examinedfrom a large number of developed countries such as the U.S and European countries withmany institutional similarities It is necessary for a research about enterprise taxationinfluences to operating income in Asian countries Vietnam context would be selected foranalysis because Vietnam is an Asian developing country with a low income and freshstock exchange compared to other economies in Asia

At the aim of maximizing benefit and minimizing risk, a firm will choose the suitablecapital structure to balance the costs and the benefits Therefore, the notion of decidingthe ratio between debt and equity is always concerned at high level It is believed that thetax policy affect the firm’s financing Indeed tax is an essential component in firm’sactivities and affects firm’s debt policy basing on deduction from interest expense Itseems like that the only channel for firms to obtain funds is through bank borrowing inVietnam Discovering how big magnitude tax affects firm profitability to find out therelationship between firm value, debt and corporate tax By this investigation, it ishopeful that there is appropriate guidance for effective application of debt Thus, aboveresearch context creates two research questions:

(1) Does debt give impacts on performance of Vietnamese firms?

(2) How big does the magnitude of net debt tax shield affect firm value?

1.2 Research objective

This first purpose aims to value the magnitude of debt tax shield, besides that there isanother tendency to test the effect of tax to debt ratio in the scope of this research ofVietnamese enterprise in the stock market Many researches build firm value as function

of debt and unrecognized measures of future operating income, yet this study is based on

an approach by regressing future operating income on firm value, debt and controlling forfirm-level capitalization rates (Kemsley & Nissim, 2002) According to Kemsley andNissim (2002) relying on reversed approach of future operating income, any unexpectedresult of profitability is collected to the regression residual without effecting on debt;simultaneously, the market value as independent variable hold nontax information fromdebt In addition, considering the market value as market-based variable is useful tocontrol for the risk and expected growth by Kemsley and Nissim (2002) We use interestexpense to investigate the magnitude of debt In case enterprises receive benefit fromcorporate tax of debt, it is expected that there will have useful measures from revealingthis relationship It is essential to find out the limitation sourcing from debt to restrict thislimitation of debt Therefore, the main objectives of this study are:

(1) Examining the impact of debt on firm performance

(2) Value the magnitude of net debt tax shield Giving some implications for Vietnamese firms to improve their performance

(3) Revealing the role of state ownership on firm performance

1.3 Scope of study

This study examines the effects of taxation on firm performance in the context ofVietnamese companies The firm data is collected from 262 companies in Ho Chi MinhStock Exchange in fiscal year 2008 to 2015 on the following required variables: totalassets, net operating assets, interest expense, debt, future operating income, total market

panel dataset is collected from Orbit database and Ho Chi Minh Stock Exchange databaseand data from Vietstock.

This study attempts to follow quantitative analysis by applying nonlinear least squareregression model on the panel data of Vietnamese firms, which are listed in Ho Chi MinhStock Exchange (HOSE) The panel data would be employed to review the operation offirm performance when putting tax across years At the aspect of econometric model, thisstudy utilizes the nonlinear least square regression model to examine the value of debt taxshield relative to firm value

1.4 Thesis structure

The remaining of this study includes four chapters First, chapter 2 discusses thetheoretical and empirical literature related to taxation and its relationship with firmperformance This section primarily introduces the definitions of key concepts in thisstudy, main theories about taxation and debt and lists out main empirical findings ofprominent studies on taxation relationship This background would be the basis to formthe conceptual framework utilized in this study Second, chapter 3 reveals the researchmethodology including conceptual framework, estimation method and variabledescription to establish the econometric models based on the conceptual framework.Third, chapter 4 presents data and the descriptive statistics, regression results anddiscussions on the main findings of the study Finally, chapter 5 expresses theconclusions, policy implementations based on the main findings In addition, this partalso discusses the research limitations and future development of the topic

CHAPTER 2: LITERATURE REVIEW

This chapter comprises the theoretical review and empirical review First, literaturereview is the summary of common theories of capital structure analysis such asModigliani and Miller theory, trade-off theory, and theory of agency costs Then, on theground of on those above theories, empirical review give an overview of the contribution

of previous studies on the development of capital structure analysis

2.1 Theoretical literature review

Overall, there are many theories about firm’s capital structure This study mentions threetheories: Modigliani and Miller theory, trade-off theory, and theory of agency costs.Furthermore, key determinants of leverage would also be analyzed and summarized tofortify the methodology and variables used in this paper

2.1.1 Modigliani and Miller and capital structure theory (MM Model)

MM model is developed by Modigliani and Miller (1958) and is also named the moderncapital structure theory It is based on these suppositions: (1) asymmetric information, (2)

no transaction costs, (3) there is no firm income tax, (4) without personal income tax, (5)lending interest rate and borrowing interest rate are in consistent, (6) ability to havefunding of each individuals or firms is equal, (7) no bankruptcy costs and no financialdistress costs, (8) the whole return is shared for owners, there is no share of return forinvestment

In reality, the market is not similar to the assumptions; yet, two discoveries have thesignificant impact from the consequence of Modigliani and Miller research At first,hypothesis of without taxation, this is chief discovery and the introduction for theconvenience of debt because of tax relief from interest expense Next, Modigliani andMiller theory with the finding of variability of cash flow induce the risk This helps to

(1) MM proposition I: Firm’s capital structure is not effect to the value of the firm(2) MM proposition II: The cost of equity rises with leverage.

Each proposition is considered in turn into the hypothesis of tax and no tax In the view

of no tax, the value of levered firm and value of unlevered firm are equivalent as theformula: V U V L ,

where V U is value of firm without debt is, V L is value of firm usingdebt Facing the different leverage level, the value of firms does not change Thus, thechange of capital structure does not make the gain to shareholders It means that thecapital structure is irrelevant

On the other hand, at the view of having tax, firm value equals the value of unlevered firm plus debt tax shields:

whereas, T is the corporate income tax, D is debt The outcome of the above equationexplains the value of firm increasing by using debt The value of a firm is increased byrising debt to equity ratio (the famous MM proposition I)

Analyzing the impact of the changes of capital structure on the average cost of capital,the MM proposition II concludes that the weighted average cost of capital will decreasewhen the cost of equity increases with leverage Nevertheless, MM theory ignores theimpact of some other costs such as financial distress costs These financial costs reducethe benefit of tax shield of firms increasing debt ratio Facing this situation the financialdistress costs are higher than the tax shield; consequently, the optimal capital structure isbroken down (the point that the value of firm is maximized in condition of the weightedaverage cost of capital minimized) At the point that the capital structure is higher thanthe optimal level, the weighted average cost of capital is rising and the value of firm isdecreasing The result is that gain from tax shield does not have enough magnitude tocompensate the financial distress cost Therefore, firm may be fragile and face the status

of insolvency

2.1.2 Trade-off theory

In the view of trade-off theory, capital structure is established on the relationship betweendebt and equity There is a concept of “tax-bankruptcy trade-off” that a firm relies on taxrelated gains from leverage to cover bankruptcy costs In addition, the trade-off theoryproposes the idea that a company makes decision of capital structure by balancing thecosts and benefits The advantage of debt finance is the debt tax shield while thedisadvantage is the agency costs and costs of financial distress, such as bankruptcy costs.Bankruptcy costs including direct costs (legal and administrative expenses) andindirect cost (cost incurred by a financial distressed firm and cost associated with process

to bankrupt or period of financial distress) When profitability decreases, expectedbankruptcy cost increase There is a positive relationship between bankruptcy cost andvolatile earnings, this leads to less leverage toward smaller less-diversified firms

In term of taxation, interest tax shield pushes the level of leverage higher In contrast,personal tax cost mitigates the rate of leverage The negative relationship between themarginal corporate tax saving and marginal personal tax cost affect the leverage level of afirm Fama and French (2000) express that tests of the DeAngelo and Masulis (1980)model clearly display optimal leverage based on non-debt tax shields, that is, lessleverage toward higher level of non-debt tax shield Besides that, the model alsodiscovers that higher expected payoff from the interest tax shields is paralleled with themore profitable firm; but is related to less volatile earnings

Adjustment (financing) cost - Financing cost include the transaction cost associatedwith new equity and cost originated from management’s superior information about thefirm’s outlook and the value of its risky securities A firm will set target leverage iffinancing cost does not affect other factors In contrast, Myers (1984) bases on theassumption of asymmetric information problem and other financing cost that affectoptimal leverage in trade-off model A firm would choose the level of leverage anddividend payout under their no adjustment-cost optimal values As a result, asymmetricinformation and financing cost enhance the role of trade-off theory about target leverageand dividend payout The status of less leverage and lower dividend payout is for firmwith lower expected profits, higher expected investment and heavier volatility of net cash

flow The financing cost is not the main factor that affects the target ratio in the trade-offmodel.

Figure 2.1 The optimal capital structure and the value of the firm

Source: Ross et al (2012), page540, chapter 16, figure 16.6: The static theory of capital structure: the optimal capital structure and the value of the firm

Figure 2.1 displays the trade off between tax savings from debt and financial distresscosts

VL denotes market value of firm There are three situations in that Figure The first

is the horizontal line extending from VU , this case of the firm value without capitalstructure (MM proposition I without tax) The second is presented by the upwardslopping straight line (MM proposition I with tax ) The third is the case where marketvalue rise to a maximum and fall beyond that point (illustrating in this discussion) If debtexceeds this point, financial distress cost increases VL * is the maximum value of a firm

and D * is the optimal amount of borrowing Comparing the third and the first case, thebenefit from leverage is net of distress cost Examining the third case with the secondcase, there is loss in value from the appearance of financial distress (Ross et al., 2012)Firm’s assets mainly impact to costs of financial distress If most of assets in a firm

are tangible assets, these assets can be easily sold without loss in value There is the

existence of incentive for this firm to reach high debt level In contrast, firms that havegreater intangible assets such as employee talent or growth opportunities, there is noincentive to borrow The reason is that intangible assets could not be sold In other words,the tendency of borrowing more is favorable in firms with a lower risk of experiencingfinancial distress compared with firms with greater risk of financial distress Specifically,Harris and Raviv (1990) declare that “firms with higher liquidation value, e.g., thosewith tangible assets, will have more debt, will have higher yield debt, will be more likely

to default, but will have higher market value than similar firms with lower liquidationvalue” It means that the debt level is positively related to the liquidation in value Cost ofdistress is lower in the firm with higher liquidation Andrade and Kaplan (1998) showthat hand costs of financial distress increase when leverage rises They also find out themagnitude of financial distress costs that get about 10 to 20 percent of firm value

Briefly, firm could maximize firm value by forming financial leverage to the pointthat the gain from tax shield on debt is offset by financial distress costs The trade-offtheory accents the important of the target leverage Firms have target leverage andbalance the leverage against target over time

2.1.3 Theory of agency costs

Relating to agency stories of a firm, we mention about the different criteria between themanagers and owners In reality, the interest of managers and security holders are notalways on the same direct, managers have a tendency to have bonus with the excess ofcash earnings over profitable investment In every enterprise, the capital owners(shareholders) have relationship with managers Employees, especially managers, arehired by the owners in order that the managers have responsibility to manage the firmagainst receiving salary, other income There is the existence of the relationship betweenowners and managers (Jensen and Meckling, 1976) The firm manager is always interest

in maximizing their wealth In contrast, the owner concerns in the value of company.From that, there is the derivative of big conflict between firm’s managers and firm’sowners The manager sometimes does not complete the management role in the company

In other words, manager does not care to the benefit of the owners (Eisenhardt, 1989)

The agency costs are sourced from the contradiction of interest between managers, shareholders and debtholders of the firm.

Jensen and Meckling (1976) also mentions to two kinds of conflicts The conflictbetween owners and managers is the first The second is the conflict between managersand creditors The first appears due to the different viewpoint between management andownership in modern market In this case, the owners could not control the managers andthe managers have more opportunity to enhance their benefit, simultaneously this leads tothe decrease in benefit of shareholders Richardson (1996) claims that the biggercontradiction is positively relates to free cash flow

The second conflict is in the case of company using debt At the aim of maximizingfirm value and upgrading firm, the owners need money to invest in new project Creditorslend owners of a company on behalf of managers to maximize profit of both Owners alsoagree with managers to manage projects in the high level of risk due to the greater profits.The owners would receive all profits in the case of successful firm operating but thecreditors only receive the definite profit at the accrued interest In contrast, if the firmoperates ineffectively, the creditor will loose from receiving the delayed principle andlost the whole lent amount In this case, lenders need gather members to monitor theproject disbursement Costs derived from this situation are the agency costs that theowners have to pay for using loan Agency costs could be controlled by increasing themanagement role, internal audit, regulations and the right of management board

Jensen and Meckling (1976) reveal that debt is one of the main primary factors toreduce the conflict between managers and owners Using more debts disciplines themanagers due to fixed interest payment and limits the free cash flow that useful for themanagers Jensen (1986) shows that the managers could not use cash in their ownpurpose because of the obligation of paying interest payment The firm’s agency costs offree cash flow could be controlled by using financial leverage, dividends and managerialownership to restrict unreasonable spending of managers (Jensen, 1986) Debt and

that firms commit a higher ratio of pre-interest earnings to debt payments and dividendstoward more profitable assets.

In line with agency cost theory, optimal capital structure is the case that cost ofagency related debt balances its benefit Hypothesis of all things being equal, high debtlevel is primary choice in firm with lower risky investments Firms with high level ofgrowth opportunities haves less debt by reason of the unbearable status of paying debtobstruct their reasonable investment in the future If companies often have substantialfree cash flow at high level, it should limit the use of high debt to control managementrole and to close managers’ faulty And a high debt level is also accepted by creditors offirms with great ability of liquidation

2.2 Empirical literature review

In the view of trade-off theory, capital structure is established on the relationship betweendebt and equity There is a concept of “tax-bankruptcy trade-off” that a firm rely on taxrelated gains from leverage to cover bankruptcy costs In addition, the trade-off theoryproposes the idea that a company makes decision of capital structure by balancing thecosts and benefits The advantage of debt finance is the debt tax shield while thedisadvantage is the agency costs and costs of financial distress, such as bankruptcy costs.The Modigliani and Miller (1963) investigate that tax benefit contribute to boost the firmvalue in proportion to amount of debt used and diminish the cost of debt capital That isthe MM debt tax shield hypothesis The pecking order theory implies that firms havepriority in choosing of financing sources and follow the order of retain earnings, debt andnew equity It is because asymmetric information has influences on the option of internal

or external financing and the choice of debt or equity issuing Myers (1977) infers thatthe trade off between the tax benefits of debt and cost of extra financial constraints andbankruptcy leads the rise in firm’s leverage Myers and Majluf (1984) find that managersdeclare risky security in case of overpricing However, this asymmetric informationabsorbed to the investors lead to the under-value of risky securities Therefore, managersleave profitable investment for new risky securities As a result, Myers gives conclusionthat the order choice of a firm for the investment is retailed earnings, safe debt, risky debt

and equity at last Pecking order theory means the internal financing being more favorable.

Both two theories are useful ways of recognizing the usage of debt in a firm Thetrade-off theory introduce the guidance for capital structure in long run The peckingorder theory is suitable for firm policy in shorter period, tendency toward investment byexternal funds

Recently, there are more concerns about the role of debt tax shield Many researchesreveal that tax and debt tax shield significantly impact to firm’s financial leverage such asMacKie-Mason (1990), Graham (1996, 1999), Gordon and Lee (2001), Xing (2015),Hovakimian et al (2001) Especially, the concrete investigation is that estimated value ofdebt tax shield captures approximately 10 percent of firm value (Graham, 2000),(Kemsley and Nissim, 2002) and (Vanbinsbergen, Graham & Yang, 2015) Thus, debttax shield becomes the extreme significant device for financial criteria (Schepens, 2015).Debt tax shield is highly appraised by the impact of it to debt and the magnitude of debttax shield also depends on tax policy of each country

Investigating how taxes affect to firm’s specifications is always the subject thatappeals many researchers The prominent significant study belongs to Modigliani &Miller (1958) Next, a stream of researches are Graham (1996a, 2000, 2003), Myers(1984, 1998), Fama (2011), Princen (2012), MacKinlay (2015), DeAngelo and Masulis(1980), MacKie-Mason (1990) All of these researches reach the significant level of tax

to firm specifications Perceiving the role of corporate taxation and effectiveimplementation are the great trial in economics (Fama, 2011)

Gordon and Lee (2001) analyse debt policy in response to tax incentives by USstatistics of income balance sheet for 46 years from 1950 to 1995 on the whole tocompare the debt policies of firms of different sizes, specifically, small firms facedifferent tax rates than larger firms Comparing to smaller firms, larger firms have atendency to finance 8 percent of their assets with debt This study contributes to the

Another research uses data in the time period 2001-2007 for the sample of Belgianand French companies by difference approach to study the impact of taxation on capitalstructure with the significant evidence at the rate of average 2 percent to 7 percent thattax system promotes company to apply more debt than the existence of the equal taxtreatment of debt and equity (Princen, 2012).

MacKinlay (2015) finds that in the high interest tax environments, tax rate pushes bigeffects on firms’ debt policy Tax effects not only firms’ leverage but the elementsconverged into debt as well Thus, statutory provisions on tax would have little impact onfirms’ levevage policy

The process to analyse the debt tax shield mostly includes three essential steps First,the use of debt is encouraged from the debt tax shield in the MM prediction MacKie-Mason (1990), Trezevant (1992), and Graham (1996, 1999) have researches thatconcentrate on incremental financing decisions They conclude that high marginal taxrates encourage the application of debt Princen (2012) discovers that tax rate appealsfirm in using debt larger than the existence of the equal tax treatment of debt and equity.Next, the firm value financial statement data is chosen to be the main factor to test thedebt tax shield (Graham, 2000) He predicts the mean corporate tax benefit of debt for alarge sample of Compustate firms This is not a direct way to calculate the debt taxshield, yet Graham confirm that firms get a tax advantage from applying debt

The last inquiry of valuating the debt tax shield need to be mentioned is the directmarket signal about debt tax shield Masulis (1980) induces the hypothesis of corporatedebt tax shield effect and discovers the wealth redistribution effect as a result of usingcapital structure Besides that, Fama and French (1998) apply cross sections to analysefirm value on interest expense and on various controls for profitability They discover astrong negative relation between debt and firm value and conclude: "imperfect controlsfor profitability probably drive the negative relations between debt and value andprevent the regressions from saying anything about the tax benefits of debt" (p 839)

However, the above steps make an existence of confused status This status is the casethat value of a firm’s operations is undetected, firm value could be correlated with debttogether nontax dimensions These make the survey confounded.

Particularly, at the view of pecking order theory, the debt-intensive firms have lowerearnings growth conceivability than low debt-intensive firms According to this theory,the notion of using debt in profitable firms less than the unprofitable firms because of thedecrease in the value of operations This decrease is caused by the financial distress costs

of debt, so debt is oustanding relating to the expected future operating profitability

The approach of analyzing firm value on debt has disadvantage The predictted value

of this approach could be distorted by unexpected bias of the operation value Besidesthat, this method could be bias due to the exclusion of market-based factors used torestrain for risks and expected growth

In a research of Liu, Nissim, and Thomas (2002) studying the valuation of equity byusing multiples, Kemsley and Nissim (2002) shows that Liu, Nissim, and Thomas (2002)also discover the best measure of explaining current market value This measure iscounted by the mean of consensus earnings for the next five years In addition, Liu,Nissim, and Thomas (2002) also displays that using earnings multiples for valuation ismore accurate than using free cash flow multiples because the appearance for lower freecash flow in case of investing by growth trends

In order to implement the research, Kemsley and Nissim (2002) introduce analternative approach rather than specifying firm value as a function of debt and imperfectmeasures of future operating profitability The author uses Compustat data to measure themarket value and use the future operating income (FOI) as the average operating incomefor the five year that follow the current year in way of reversing the relationship Theyspecify future operating profitability as a function of firm value, debt, and controls forfirm level capitalization rates This method has two advantages First, the future operatingprofitability in the right hand side of the equation enables to exclude measurement error

getting market value of firm out from the left hand side of regression pushes chance to apply market based factors to supervise risk and expected growth.

Additional analysis, it is indeed to mention the role of state in the performance of stateowned firms; especially for country maintaining government involvement in businesscorporations Li et al (2009) found that ownership concentration and state ownership arenegatively associated to the evidence of bankruptcy There is advantage of stateownership as the higher leverage, lower taxation, larger markets shares (Faccio, 2006) ,but the author also showed the disadvantage of this kind of ownership as the high levels

of corruption, less clear system in the SOEs Borisova et al (2012) discovered thatgovernment ownership generally leads to a higher cost of debt, consistent withinvestment distortion fostered by state influence Since the government guaranteeimplicitly, default risk of the economic recession or firm distress are solved by thedominant effect of government The higher cost of interest of lenders will push financialdistress higher The advantage and disadvantage influence to performance of stateownership enterprise is known as double-edged sword Huang et al (2011) revealed thepositive relationship between state ownership and debt ratio The explanation of thispositive interact belongs to three things First, on the background of the low probability

of bankruptcy, they have substantial advantages with respect to enter to debt market.Secondly, to preserve control and dominance, representatives of state ownership havepriority for high level of debt instead of shares Thirdly, firm with high level of stateownership has segregation between voting and cash flow rights, agency problem becomemore complicated between owners and managers The real owners of state owned sharesare the citizens; in contrast the decision in firm is depended on government departmentswhose income is not determined by their control through firm performance There is nomotivation to urge to the effective operation of a firm As consequence, state owned firmsprefer high debt to diminish agency costs of equity Another advantage of state control ismentioned, while private firms must bear high cost on capital sources, state owned firmsreceive a preferential treatment of state owned banks with low cost of loan Theprominence of SOEs is that banks support favorable loan for them because they might be

able to build up political connections with politicians to obtain lucrative contracts (Butler

et al., 2009) Lin and Tan (1999) also showed that SOE receive fund from state ownedbanks regardless of risks but they do not have to fully cover expenses from sales andincome, the government often bears the losses of unprofitable SOEs This is also theclaim for the prominence of debt usage in firms with high state ownership than others inthe research of Poyry and Maury (2010) on 95 listed Russian firms from 2000 to 2004.From above preferential treatment, state ownership enterprises tend to use more debtthan other ownership firm This means that the magnitude of debt tax shield in SOEs will

be larger than other kind of ownership The more debt usage is the more financial distress

is High leverage leads to an increase in hand costs of financial distress (Andrade andKaplan, 1998) Ding et al (2007) concluded that theory agency originated from differentconcerns of many levels of agents conflict with each other because the government isboth the regulator and the manager In adjusting the policies to deal with financialdistress, private firms are faster than state own firms Almeida and Philippon (2007) usedcredit spreads to value distress costs and concluded that there is the apparent reluctance

of firms to have higher their leverage, in spite of the benefit from debt tax shield

Before starting the study in details, we all together review the context about Vietnameconomy as followings In 1986, Vietnam reforms the economy as known as “DOIMOI”policy that creates a high jump in VietNam economy by change from a centrally plannedeconomy to a market oriented economy During liberalization process, a State-OwnedEnterprises (SOEs) reform program is implemented in 1992 at the purpose of activatingthe private ownership policy Equitization is the main core of reform program.Specifically, the regulation shows that the ownership over 50 percent shares ofgovernment is known as state-owned company Sectors as airlines, electricity andtelecommunication are still restricted by status of government control The next step inthe liberalization process stock market has been established The first stock exhange

developing of the economy and creates a high jump for firms in capital mobilization,especially for medium and small enterprises From that, small and medium enterpriseplays an important role in the economy.

The application of private ownership stimulates the market more competitive andeffective If the enterprise operates effectively, the owner has profit In contrast, theuneffective operation of firms leads owner being loss Maximize the value of firm andminimizes the cost of capital are the main purpose of a firm There are bodies ofresearches to find out the best way for purpose of maximizing profit The notion of usingdebt is one of approaches in financial decision In Vietnam, some authors study the firmperformance and internal factors such as Nguyen and Nguyen (2012), Tran andNeelakantan (2006), Tran and Tran (2008) and Nguyen et al (2012) Tran andNeelakantan (2006) study the capital structure in small and medium size enterprise in theperiod 1998-2001 This research concludes that short term liabilities are priority in firmfinancial decision Tran and Tran (2008) research on capital structure and firmperformance listed on Ho Chi Minh stock exchange with 50 non-financial listed firms.The result is that the firm performance has the negative relationship with leverage whenD/E ratio was more than 1.812 Thus firm performance has the positive relationship withleverage Firm should increase the debt ratio to raise the firm value Another research onthe effect of capital structure on 92 Vietnam’s seafood processing enterprises from 2005

to 2010, Nguyen and Nguyen (2012) result that firm value and financial leverage have anon-linear relationship that are consistent with the study of Chou and Lee (2010).Specifically, the Vietnam’s Seafood processing firm would be nearly optimal against thedebt ratio less than 59.27 percent Nguyen et al (2012) find that there is negativerelationship between leverage and profitability It is recognized that there is limitation ofthe study about Vietnam capital structure and elements relating to financial decisions.Indentifying the benefit of company’s capital structure and suitable implementationhave become more and more important in financial economics Specially, the benefitfrom the deductibility of interest expense in taxing, in other words debt tax shield isalways a remarkable problem Interest tax shield pushes the level of leverage higher In

contrast, personal tax cost mitigates the rate of leverage The negative relationshipbetween the marginal corporate tax saving and marginal personal tax cost affect theleverage level of a firm Furthermore, Princen (2012) discovers that tax system promotescompany to apply more debt than the existence of the equal tax treatment of debt andequity Considering the effect of corporate taxes, this is one of the great alternatives toform capital structure This point of view is sourced by the benefit of the tax deductibilityknown as debt tax shield The net tax saving from an additional dong in interest is offset

by the increase in expected financial distress costs that create an optimal capital structure

A firm will have a limit to the use of debt financing to generate tax shields in case they

do not apply a great amount of debt, but pay substantial taxes In brief, the tax benefitfrom leverage plays an important role to firms that are in a tax paying position Lossfirms will receive a little benefit from the interest tax shield Similarly, firms that usesubstantial tax shields will gain less benefit from leverage A tax system is considered inthe case that a firm is taxed on its end of period business excluding interest expenses Taxsystem is counted on a constant marginal tax rate Companies are taxed on their profits.The costs as the interest paid could be considered as return to the creditors These interestexpenses reduce taxable income, they are said to be tax deductible Briefly, an interest taxshield may encourage a company to finance a project through debt because dividend paid

on stock issues are never deductible The greater the tax rate is applied, the bigger thetendency to borrow is Vietnamese corporate tax system have traditional tax system, there

is the tax deductibility of interest expenses but no deductibility of the capital cost ofequity The Vietnamese corporate tax rate was 28 percent in 2007 and in 2008, 25 percentfrom 2009 to 2013, 22 percent in both year 2014 and 2015

2.3 Hypothesis development

Forthcoming from literature, I therefore believe that debt tax shield truly hassignificant effects on Vietnamese firm value Specifically, the following hypothesis about

As literature review, the existence of negative reaction of net debt tax shield to debt andfirm value is revealed by a study of Fama and French (1998) A strong negativerelationship between debt and firm value gives no conclusion about the tax benefit ofdebt.

This notion is expressed that because the high level of debt lead to high value of debt taxshield this will give negative impact on the performance of that particular firm Asliterature review, the existence of negative reaction of net debt tax shield to debt and firmvalue is revealed by a study of Fama and French (1998) A strong negative relationshipbetween debt and firm value gives no conclusion about the tax benefit of debt In aresearch of Tran and Tran (2008) on capital structure and firm performance listed on HoChi Minh stock exchange with 50 non-financial listed firms, firm performance andleverage has the negative relationship when D/E ratio was more than 1.812

The negative impact of debt to firm value is not finite in the sense that debt is not chosen

in financial strategy of any firms At the optimist aspect as many researches, debt createsthe benefit by debt tax shield that is better for firms applying leverage This relationship

is assumed to hold to a certain degree By way of using too high debt, the firm will facethe unbearable status to reimburse the interest expenses

Hypothesis 2: Interest is expected to effect on firm performance at the same direction asdebt impact on firm performance

Fama and French (1998) applied cross sections and reveal the strong negativerelationship between debt and firm value by using interest expense In recent study,Kemsley and Nissim (2002) discover the positive impact of interest on firm value Usingthe approach of Kemsley and Nissim (2002) based on FF study, I expect to find samedirection of interest on firm value as debt reaction to firm value

Hypothesis 3: State ownership is expected to moderate firm performance

Faccio (2006) revealed the advantage of state ownership as the higher leverage, lowertaxation and larger market share Boubakri and Saffar (2017) survey a large hand

collected sample of privatized firms from 62 countries about the link between residualstate ownership and bank debt There is a positively association between state ownershipand bank debt financing In fact, State support firms with soft budget constraint to befinanced at preferential rate Thus, there is the tendency of using more debt in stateownership than other ownership firm It exists the high magnitude of debt tax shield inSOEs Moreover, Yu (2013) concluded that special treatment originated from strongpolitical connection with state may help firms improve their performance when stateownership increase level of concentration Phung & Mishra (2016) revealled thatadvantage of firms with state ownership, especially high state ownership concentrationfirms, seems more than other type ownership firms sourced from the connection betweenpolitical policy and high state concentration firms The advantage of high stateconcentration can help firm improve firm performance I wait for the positive result ofgovernment involvement to firms performance compared to no control of state.

In order to accelerate reforms of tax administration and to deepen the competitiveness ofdomestic enterprises, a tax system reform strategy for 2010- 2020 period is ratified byPrime Minister Constraint interest expense is one of concerns that Vietnamese FinanceMinistry is considering Finance Ministry also reveals that dominated interest expensewill diminish ineffective operating of firm with high debt level Besides that, controllinginterest expense is corresponding with Uniform rule Many developed country such asGermany, Australia, Holland has the debt to equity ratio does not exceed 3 times (3:1),the remainders as France, United States, Canada have smaller ratios about 1.5 to 2 times.The Organization for Economic Co-operation and Development (OECD) alsorecommends that this rate be capped at three times Therefore, firm value and capitalstructure benchmark of debt tax shield are priority to be investigated Debt tax shieldempirical studies in Vietnam become important and should be researched to identifyeffects

CHAPTER 3: RESEARCH METHODOLOGY

Research methodology provides an analytical framework for this study through thediscussion of several important points First, the conceptual framework shows us thedescription of how industry effect, market value of operation, and capitalization rate giveimpacts on future operating income of firm Second, the appropriate estimation method ischosen to meet the objective of this study Finally, from the understanding of empiricalmodel, the collected financial factors of Vietnamese firms are described in the variabledescription

3.1 Conceptual framework

Alternative regression is discovered as the approach to valuate the debt tax shield(Kemsley & Nissim, 2002) The indicator is specified as a linear function of avector

X of observation instruments together with risk and growth   , X ,

beside that, adirect relation between FOI and variables in X is applied in supplemental shape y,

X Inbrief, hypothesis of market efficiency, the future operating income as dependent variable

is determined by subcomponents: market value of operations in parallel with thecapitalization rate for average operating income (by vector of variable X ), industry effect and direct relation between FOI and variables in X (by additive form

is defined as the market to book ratio of operation, and is calculated by

dividing market value of operation by net operating assets ( NOA ).

(3) size is proxy of risk and growth, and is calculated by taking logarithm of NOA

Industry effect ( )

Market value of operations

Future Operating

is linear function ofector including:

 The industry median beta of operations ( )

 Market to book ratio of operation



 Size is logarithm of Operating liabilities ()

State control ( )

(4) operating liabilities ( OL ) is known as all nondebt liabilities.

This thesis concentrate on MM postulate I (with corporate tax): the value of levered firm

Note: is the estimated value of the net debt tax shield that shows the degree

of debt tax shield effecting to firm value

Figure 3.1 Conceptual framework 3.2 Estimation method

Based on the MM theory with tax, financial distress costs from debt do not exist The valuation model is affected by tax (Modigliani & Miller, 1958) as following:

VL VU T * D (3.1)

whereas, T is the tax benefit from a dong of debt Concretely, theory of Modigliani and

Miller (1958) also predicts debt in perpetual line in the following equation:

V  U E ( FOI )

where, is the capitalization rate

defined as all expect future operating income and is perceived as influencing expectedgrowth in income Therefore, the fixed

E(FOI

) is excluded from proxy for expect futuregrowth, due to this capitalization rate is used as proxy for growth “ ” has two effects as the increase in risk but the decrease in expected growth)

There are some different affect to VU and T due to nontax cost of debt, personal

taxes and non-debt tax shields, depreciation Weiss (1990) and Andrade and Kaplan (1998) reveal that direct costs of bankruptcy slightly effect firm value From this view ofpoint,

VU is not only considered value of unlevered firm but also is perceived as the value

of operation Substituting equation (3.2) into equation (3.1), we have

Forward regression as study of Kemsley and Nissim (2002):

E(FOI ) 

D 

(3.5)

L 1 2  3

where, 3 is the estimated value of debt tax shield

The fact that debt is correlated with the value of operation ( E(FOI )

and ‘ 

’)together with several nontax dimensions, growth, financial distress and size dimension

Therefore, 3 would be bias Accurately, market value as dependent variableprevents the application of the market to book ratio as a control for that Famaand French (1992)

find the variant of market to book ratio as common proxies for risk Besides that, Penman(1996) also reveals that market to book ratio of operation is similar to expectation aboutfuture operating earnings relating to current book value being the factor for estimatinggrowth in operating earnings

E(FOI ) The regression residual includes any random factors of above errors Secondly,market value includes all signals relating to E(FOI ) such as information about growthprospects, financial distress costs, management role, volatility, sourcing from relationbetween profitability and debt from capital structure This leads to the main function

of market value from handling ‘ ’

Hereby, the cross-sectional regressions are applied for following estimation

Linear empirical specifications:

The combination of equation (3.5) and (3.6), we have a linear empirical specification.Kemsley and Nissim (2002) base on the method of Fama and French (FF method), all

regression variables are deflated by total asset (excluding the intercept is not deflated by total asset):

The above equation consider as a definite coefficient, FOI as an

The other measure use the way of deflating the whole equation by total assets Similar to above equation, is examined as a definite coefficient, Kemsley and Nissim (2002)

show the equation as follow:

TA are animperfect representative for

U

is correlated with D The alternative of reverse

regression is considered to avoid biases from the forward method Consistent with above measure, is held an opinion as a constant component Transforming the non-linear

reverse equation in (3.6) to linear equation in (3.9), we have an extent framework for the reverse approach (Kemsley & Nissim, 2002) as following:

The 2

analogousness of equation (3.8) and (3.9) is the entire equation deflated by total assets

The discrepancy of equation (3.9) to (3.8) is the reverse FOI for VL By applying the

reverse approach, any accidental error in FOI is moved to the regression residuals;

simultaneously, VL on the right hand side of the equation relating to any derivable

non-tax information from debt composes to future operating earnings that could be managed Specifically, size effect composed to market value shall distort the value of beta in theequation (3.8)

The special point being mentioned is that the deflated or un-deflated intercept is available for the prediction If the equation (3.9) is with the un-deflated intercept(equivalent to TA

TA ), the entire equation would be similar to be adding the deflator totalassets (Miller & Modigliani, 1966) Nevertheless, total assets are different from otherexplanatory variables, it includes the past operating income and net investment; thiscreates the correlation with the measurement error in FOI that leads to distortions of

estimation Specifically, FOI is the future operating income including of imperfect

criteria constructing expected earnings with error These errors could origin from thegrowth trends and expected future financial distress costs These measurement errors in

FOI not only relate to most of explanatory variables but also distort all regression

coefficients Exactly, in the nature of efficiency market, the market value of firm is notinfluenced by accounting errors, and the book value of debt frequently represent the

market value of debt The distortion in measurement of FOI rarely affect the

measurement of debt due to the structure of debt is determined across firms The equation(3.9) specified in the deflated intercept, the uncertainty of accounting measurement in

FOI should be orthogonal to explanatory variables In empirical study, Kemsley and

Nissim (2002) declared that the un-deflated case pushes the value of debt tax shieldhigher than the result of study in 2002 because of derivative unreasonable levels Hence,the deflated intercept specification should be priority

At the aspect of role of the capitalization rate for future operating income, isnot actually a cross sectional constant We specify capitalization rate for futureoperating income into following factors such as: industry median beta of operation (