Capital structure and its determinants evidence from vietnam

The management of a firm sets its capital structure depending on attributes that determine the various costs and benefits associated with debt and equity financing.. In addition, due to

BANKING ACADEMY

INFORMATION RESEARCH RESULTS OF RESEARCH

1 General information:

- Topic name: Capital Structure and Its Determinants: Evidence from Vietnam

- Name of student: 1 Nguyen Gia Tan – 21A4010507 – K21CLCC

2 Le Duc Viet – 21A4011018 – K21CLCA

3 Nguyen Xuan Thu – 21A4020544 – K21CLCD

4 Dang Quang Minh – 21A4030322 – K21CLCE

- Majors: Finance Year: 3 Year of training: 3

- Instructor: PhD Nguyen Thi Le Thanh – Head of Auditing Department (Banking Academy)

2 Topic goal:

+ Determinants of capital Structure of Vietnamese-listed firms on the stock market

+ Forming calculation methods, financial-related ratios to finalize statistical results

+ Proxy variables will show a positive or negative impact on capital structures like theoretically predicted signs in Table 2 Consequently, the two variables representing the Non-debt tax shield have a negative effect on the firm’s leverage and are different from the predicted signs

3 Novelty and creativity:

Choosing evidence from Vietnam because the institutional environment for Vietnamese firms has some salient features, is divergent concerning high–developed countries where the state still maintains its controlling right in a large number of major firms

Instead of just considering the impact of financial ratios, research has not only changed how impacts are calculated but also identified the debt maturity structure calculated based on the

book value and market value of equity Synonymously, the collection of big data and updating

it in the recent 4 years from 2017 to 2020, has influenced the outcome of the factors affecting financing decisions in developed capital markets in Vietnam

4 Research results:

The study proves that Vietnam has 2 outstanding and different characteristics compared to developed countries, so Vietnam has a different institutional structure compared to those countries In addition, the results also show that the variables D/TA, NDTs and Industry have a positive effect on financial leverage, from which we see that businesses need a large amount of money to buy shares to implement their projects Therefore, they borrow from banks to meet their capital needs, so loans account for the majority of capital structure of Vietnamese enterprises

5 Contribution in terms of socio-economic, education and training, security, defenestrate own and applicability of the topic

6 Scientific publication of students from the research results of the topic (specify the name

of the journal if any) or comments and assessments of the institution that applied the research results (if any)

The instructor's remarks regarding the scientific contributions of the students who have made the document (the instructor records this section):

May 19, 2021

Instructor

(Sign and write full name)

BANKING ACADEMY

INFORMATION ABOUT STUDENTS RESPONSIBILITIES FOR IMPLEMENTATION OF THE TOPIC

I STUDENT SUMMARY:

Full name: Nguyen Gia Tan

Date of birth: June 24, 2000

Birthplace: Ha Noi

Student code: 21A4010507 Class: K21CLCC Course: 5 Major: Finance

Address: No.18, 88 Lane, Hoang Nhu Tiep Street, Bo De Ward, Long Bien District, Ha Noi

II LEARNING PROCESS (student performance from year 1 to now)

*First year: Finance Major: Finance

Study result: System 10: 7.95/10

System 4: 3.04/4

*Second year: Finance Major: Finance

Study result: System 10: 7.92/10

System 4: 3.02/4

* Third year: Finance Major: Finance

Study result: System 10: 8.14/10

DECLARATION OF AUTHORSHIP

We hereby declare that this thesis was carried out by ourselves under the guidance and supervision of PhD Nguyen Thi Le Thanh; and that the work contained and the results in

it are true by the author and have not violated research ethics The data and figures presented

in this thesis are for analysis, comments, evaluation and are consistent with the reality of Vietnam by our work and have been duly acknowledged in the reference part In addition, other comments, reviews and data used by other authors, and organizations have been acknowledged, and explicitly cited I will take full responsibility for any fraud detected in

my thesis Banking Academy is unrelated to any copyright infringement caused on our work (if any)

Author Leader

ACKNOWLEDGMENT

We sincerely thank the instructors and teachers in the Accounting-Auditing

Department of Banking Academy for creating the best conditions for us to carry out

this research

Specifically, we would like to express our sincerest gratitude to the businesses

for which the author has removed conditions, surveys and other experts in related

fields, who contributed extremely valuable and reliable knowledge, for the author to be

able to complete our research

Author

Leader

CONTENTS

DECLARATION OF AUTHORSHIP 1

ACKNOWLEDGMENT 7

CONTENTS 8

LIST OF TABLES 10

ABBREVIATIONS 11

INFORMATION RESEARCH RESULTS OF RESEARCH 1

INTRODUCTION 13

CHAPTER 1 LITERATURE REVIEW 16

1.1 Theories on the determinants of the capital structure 16

1.1.1 Model Based on Trade-off theory 16

1.1.1.1 Trade-off hypothesis 16

1.1.1.2 Agency Theory 18

1.1.2 Asymmetric Information 25

1.1.2.1 Interaction of Investment and Capital Structure 25

1.1.2.2 Signaling with Proportion of Debt 30

1.1.2.3 Models Based on Managerial Risk Aversion 32

1.1.3 Summary 34

1.2 The measurements of capital structure 35

1.3 The Determinants of Capital Structure 36

CHAPTER 2 DATA AND METHODOLOGY 42

2.1 Data Source 42

2.2 The Empirical Model 42

CHAPTER 3 RESEARCH RESULT 45

3.1 Descriptive Statistics 45

3.2 Empirical Analysis 49

CHAPTER 4 CONCLUSIONS 62

4.1 Conclusions and discussions 62

4.2 Recommendations 63

4.3 Limitations and future directions 64

LIST OF PUBLISHED PAPERS BY AUTHOR 66

REFERENCES 85

LIST OF TABLES

Manager-Shareholder Conflicts

Table 3.3 – 3.14 Regression result and Test result

ABBREVIATIONS

ETR Effective Tax Rate

total asset

STRUCTURE AND ITS DETERMINANTS:

EVIDENCE FROM VIETNAM

INTRODUCTION

In recent decades, financial decisions and their link with optimal risk exposure are central to the financial welfare of the firms (Leland, 1998) A false decision about the capital structure may lead to financial distress and eventually to bankruptcy The management of a firm sets its capital structure depending on attributes that determine the various costs and benefits associated with debt and equity financing Therefore, selecting capital structure plays a vital role in maximizing the firm value and resorting to various means of external funding The majority of the capital structure paper, however, has focused on understanding the driver that influences corporate financing behaviour in United States firms; while few existing papers have been done to further knowledge of capital structure within developing countries (Chen, 2004) Thus, this paper aims to provide the empirical results of capital structure decisions in the Vietnamese context where its practice is unclear and controversial

The institutional environment for Vietnamese firms has some salient features and

is divergent concerning high–developed countries First, Vietnam is in a transitional period from a command economy to a market economy Second, the state still maintains its controlling rights in a large number of major firms It is not difficult to understand that Vietnam has institutional structures different from high–developed countries For instance, in the context of the M&M model, a firm’s capital structure is not affected by tax authorities because the state or government is the owner of firms or banks (Huang and Song, 2006) Furthermore, state-owned enterprises are often not value – maximisers; firm size (proxy for bankruptcy cost), tangible assets (collateral) and even profitability, may not affect their capital structure Controlling right firms belonging to the state, on the other hand, will be less likely to run into the financial crisis than are their counterparts whose controlling shareholders are individuals or private institutes With such salient

features, this paper will provide empirical results to explain whether the factors that affect financing decisions in developed capital markets have similar effects in the Vietnamese context

The modern theory of capital structure has significantly developed Since Modigliant and Miller's paper issued in 1958, many researchers have followed and extended this literature to explain capital structure choice as well as providing empirical support to model's applications among different companies and countries in the world (Fama and French, 2002; Booth et al., 2001; Harris and Raviv, 1991; Myers, 1984; DeAngelo and Masulis, 1980; Myers, 1977) With the numerous theoretical studies, however, two widely acknowledged dimensions are aligned with capital structure decision, which is the static trade-off hypothesis, and the pecking order theory

Theoretically, the trade-off model, initially introduced by Modigliant and Miller (1958), had strong assumptions that in a perfect capital market, there are neither tax, agency costs nor transaction costs and the capital structure decision has no effect on the value of the company In addition, due to deductive interest from taxable profits, thus cost

of debt is less than the cost of equity, which implies that firms may have an incentive to use debt rather than equity, and increase firm value by altering their capital structures (Modigliani and Miller, 1963) According to trade-off theory, any increase in the level of debt causes an increase in bankruptcy, financial distress and agency costs, which lead to a decrease in firm value (Harris and Raviv, 1991) Hence, there always exists an optimal debt level of the firms (Miller, 1977), achieved by establishing equilibrium between the value of interest tax shield and various bankruptcy or financial embarrassment

On the other hand, the pecking order theory, first suggested by Myers and Majluf (1984), based on asymmetry information creates a hierarchy of cost in the use of external financing This asymmetric information cost also refers to a term known as “lemon premium” that external investors generally have less information than insiders (Akerlof, 1970), thus common stocks would be undervalued by the market Moreover, the financing cost that produces pecking order behaviour includes the transaction costs related to new

issues and the costs that arise due to management’s superior information about the firms’ prospects and the value of its risky securities (Myers, 1984) Hence, it is argued that firms prefer to retained earnings (internal equity) as their main source of funds for investment, then by less risky debts and last comes risky external equity financing (Myers and Majluf, 1984) As a result, variation in a firm’s leverage is driven not by optimal capital structure and benefits of debt, but rather by the firm’s net cash flows (Fama and French, 2002) Although Modigliani and Miller’s original article is released more than five decades, the theoretical debate is still centred on the importance of testing which hypothesis, trade-off static or pecking order, is more relevant in explaining firms’ financing behaviour Titman and Wessels (1988), show that the theoretical research has been lagged by attempting to test various models, including all hypotheses jointly in the empirical model Instead, by viewing the theories as contending hypotheses, the pecking order theory is more likely to have greater time–series explanatory power than the trade-off theory (Shyam-Sunder and Myers, 1999) On the other hand, Shyam-Sunder and Myers’s paper may generate misleading inferences when evaluating plausible patterns of external financing and neither the pecking order nor static trade-off model is assessed in empirical results (Chirinko and Singha, 2000) Indeed, Fama and French (2002) point out that none

of the pecking order and trade-off models can be rejected and they both play an important role in explaining a firm’s financing behaviour Furthermore, variables in one model can also be classified as other models; thus, providing the distinguishing between these two different models is unnecessary (Booth et al., 2001) From this, a sub-stream of papers provides the empirical tests and numerous variables in these two models can be used interchangeably (Chen, 2004; Deesomsak et al., 2004; Huang and Song, 2006; Delcoure, 2007)

The paper will use the database from the State Securities Commission of Vietnam to examine the determinants of the capital structure of Vietnamese firms (from 2017 to 2020) In this study, we examine a variety of firm’s attributes such as collateralized assets, profitability, corporate income tax, non – debt tax shield, size, growth

opportunities, uniqueness, industry classification, and ownership structure that have been stated to affect capital structure decisions

The study is organized as follows: the related literature for determinants of capital structure in Section 2, is followed by the data, main variables, and research methodology

in Section 3 In Section 4, we provide the statistics of our sample along with the empirical results from the econometric analysis Section 5 concludes the paper and suggests some unexplored avenues of research in the field

CHAPTER 1 LITERATURE REVIEW

1.1 Theories on the determinants of the capital structure

1.1.1 Model Based on Trade-off theory

1.1.1.1 Trade-off hypothesis

One of the key assumptions of the MM (1958) model was the absence of taxation Modigliani and Miller (1963) and Miller (1977) extend the original framework by including tax impacts This newer study had the implication that corporations should fund their operations entirely with debt in order to maximize corporate value Clearly, this contradicts reality, as debt accounts for just a small portion of a firm's overall capital Subsequent theoretical work attempts an ideal capital structure as a result of a trade-off between the benefits of debt tax shield and the costs of debt financial distress

The benefits of debt, according to this idea, stem from the fact that it is tax-free, implying that a larger debt ratio will raise the firm's valuation However, the gains may be countered by the costs of financial turmoil, which may undermine the firm's values As a

result, the best capital structure is defined by the trade-off between debt's tax-free advantages and debt's distress costs (see Figure 1)

In the presence of taxes, DeAngelo and Masulis (1980), Ross (1985), and Leland (1994) have shown that a corporation with safe, physical assets and enough taxable income can benefit from a high debt-equity ratio to avoid huge tax payments It is preferable to rely on equity financing for a company with poor performance and more intangible assets

One limitation of theories based on tax-shield benefits is that they cannot explain why capital structures differ between enterprises subject to the same taxation rates U.S empirical research (Copelands and Westons 1992) reveals that once corporate income tax was applied, the capital structure of firms did not alter considerably In Australia, where there are no dual income taxes, capital structure is similar to that of other economies (Rajan and Zingales,14 1995) Booth et al (2001) discovered that benefits differ among developing nations and had little impact on capital structure choice

Market

value

Optimal debt ratio

Value if all-equity financed

PV (cost of financial

distress) PV(tax

shield)

1.1.1.2 Agency Theory

Over the last decade, many researchers have conducted papers to determine the capital structure by agency costs Jensen and Meckling (1976) pioneered research in this field, building on the earlier work of Fama and Miller (1972)

Jensen and Meckling identify two potential sources of conflicts On the one hand, the conflicts between shareholders and managers arise because managers hold less than 100% of the residual claim As a result, managers cannot take the entire interest benefit from their profit enhancement activities, rather they will bear the burden of these activities Managers thus may be able to transfer firm resources to their benefit by making less effort in managing firm resources, for instance, building empires and consuming perquisites The manager bears the entire costs of refraining from these activities but only receives a part of the revenue As a consequence, managers tend to expropriate wealth from shareholders in comparison to the amount required to consume more than the optimal level of perquisites, this tendency thus will decrease the fraction of the firm's equity owned by the manager Holding constant the manager's absolute investment in the business rises in the fraction of the firm financed by debt, increases the manager's share of the equity and reduces the loss from the manager–shareholder conflict Furthermore, as Jensen (1986) pointed out, since debt commits the firm to pay out cash, it decreases the amount of "free" cash available to managers to engage in the above-mentioned activities The advantage of debt financing is the reduction of conflicts between managers and equity holders

On the other hand, the conflicts between debt holders and equity holders occur because the debt contract encourages equity holders to invest sub-optimally More specifically, the debt contract provides that if an investment generates large returns that exceed the face value of the debt, equity holders will receive the majority of the profit However, if the investment fails due to limited liability, debt holders bear the consequences As a result, equity holders can benefit from "going for broke," i.e., investing in extremely risky projects, even if they have a negative impact on value The

value of the debt is decreased as a result of such investments The decrease in equity value caused by the poor investment can be more than offset by the increase in equity value realized at the expense of debt holders However, if debt holders correctly predict equity holders future behaviour, equity holders bear this cost to debt holders when the debt is issued In this case, the equity holders' debt is received less than they would otherwise As a result, the equity holders who issue the debt bear the cost of the opportunity to invest in value-decreasing projects created by debt This effect, commonly known as the "asset substitution effect," is a cost of debt financing imposed by the agency

An optimum capital structure can be achieved by trading off the agency cost of debt against the benefit of debt (Jensen and Meckling, 1976) For instance, one would expect bond contracts to include features designed to prevent asset substitution, such as interest coverage criteria, prohibitions on investments in new, unrelated lines of business, and so on Second, industries with fewer opportunities for asset substitution would, ceteris paribus, have higher debt levels Thus, the theory assumes that regulated public utilities, banks, and firms in established industries with little opportunities for growth would be more highly levered Third, firms with large cash inflows which are from operations, slow

or even negative growth should have more debt, without good investment prospects create the resources to consume perquisites, build empires, overpay subordinates, etc Increasing debt reduces "free cash" while growing the manager's fractional control of the residual claim Steel, chemicals, brewing, tobacco, television and radio broadcasting, and wood and paper products are examples of industries that have these characteristics today, according to Jensen (1989) According to the theory, these industries would be characterized by high leverage

All of the theories based on agency problems discussed in the following section start with one of the Jensen and Meckling conflicts As a result, we split these papers into two parts, one for the conflict between equity holders and managers and one for the conflict between equity holders and debt holders

a Conflicts between Equity holders and Managers

The two papers discussed in this subsection share a similar concern with shareholder conflicts, but they vary in the way in which this conflict arises More significantly, they differ in how debt alleviates the issue as well as the drawbacks of debt

manager-Managers and investors disagree with Harris and Raviv (1990a) and Stulz (1990) Managers in Harris and Raviv are assumed to still want the firm's current activities to continue even though investors prefer the liquidation of the corporation Stulz believes that managers still want to invest all available funds even though investors should pay cash In both cases, it is assumed that contracts based on cash flow and investment expenditure cannot settle this conflict In Harris and Raviv the debt mitigates the problems by allowing investors (debtholders) the option to force liquidation if cash flows are poor Debt payments in Stulz as in Jensen (1986), reduce free cash flows Trading off these debt advantages against debt costs is determined by the capital structure The assertion of investor control by bankruptcy in Harris and Raviv implies the production of information about the firm's prospects, as used in a liquidation decision Stulz's model costs of debt, which reduces the funding available for profitable investments, are that the

payment of a debt can be more than "free" cash In table 1, the similarity of these two

models with Jensen and Meckling (1976) and Jensen (1986), is also summarized in this comparison between Harris-Raviv and Stulz

In Harris and Raviv, the optimum capital structure offers better decision-making compared with higher investigative costs A larger level of debt improves the liquidation decision since defaults are more likely In the absence of a default, management shall not liquidate the firm except through the assets being worth more in their next best alternative use

Table I Comparison of Agency Models Based on Manager-Shareholder Conflicts

Jensen and

Meckling (1976)

Managerial perquisites

Increase

Harris and Raviv

Allows investors the option to liquidate

Investigation costs

Source: Harris and Raviv (1991)

However, after a default, investors control the liquidation decision and spend resources to obtain additional information relevant to this decision Since investors have chosen an optimum liquidation decision based on their information, this decision is improved by default However, the most frequent default is costlier, since the company is investigated by resources when it is the default The Harris and Raviv model predicts that firms with higher liquidation values, such as those with tangible assets, will have greater debt and are more likely to default but will have higher market value than comparable firms with lower liquidation value and/or higher investigation costs The higher debt level intuition is that increases in the liquidation value make liquidation the best option more likely Information is, therefore, more useful and a higher level of debt is required Similarly, reductions in investigative costs often raise the default value, which leads to increased debt The debt rise leads to a higher probability of default Harris and Raviv also achieve results on the reorganization or liquidation of a bankruptcy firm They demonstrate that the probability of reorganization decreases with liquidation value, regardless of investigation costs Using a constant-returns-to-scale assumption the debt level concerning expected firm income, the probability of default, the return on bond yield and the probability of restructuring are irrespective of the firm size In combination

with these results, Harris and Raviv argue that higher leverage can be expected to be combined with larger firm value, higher debt level than expected income and lower reorganization possibility after default

To prevent investment in projects, the optimal capital structure in Stulz depends on trading off the benefit of debt against the lower cost of debt Such as Jensen in 1986, therefore, firms with plenty of good investment opportunities can expect to have low levels of debt about firms in mature, slow-growing, cash-rich industries Moreover, Stulz argued that managers are generally reluctant to implement the optimum level of debt, but that the greater the threat of takeover Thus, firms that are more likely to be targeted for takeovers may be expected to have more debt, ceteris paribus In the opposite case, firms whose value-increasing investment opportunities generate more value than value-decreasing ones destroy will have less debt than firms The explanation is that such firms are concerned above all with not losing the opportunities to create value

b Conflicts between Equity holders and Debt holders

The section surveys two articles in which reputation moderates the problem of asset replacement, i.e the motivation for leveraged shareholders to select risky, negative net-present-value investments Diamond (1989) and Hirshleifer and Thakor (1989) show how managers or firms have an incentive to pursue relatively safe projects out of reputational considerations

Diamond's model concerned with the reputation of a firm for the choice of debt repayment projects Two potential investment projects are available: a safe, positive NPV and a risky, negative NPV One of two payouts for the risky project ("success" or

"failure") The initial investment needed to be financed by debt for both projects is the same A firm can have three forms, initially similar to observational ones One type has safe project access only, one type only has access to the risky project and one type can access both Since investors cannot distinguish firm ex-ante, the initial credit rate reflects their belief in the projects selected by firms on average Returns from a safe project are sufficient to pay the debtors (even if investors are convinced that the firm has only one

risky project), but returns from a risky project only allow repayment if the project succeeds Due to the asset replacement issue, if a firm has a choice of projects, the firm will be led to choose a risky project using myopic maximization of equity value (for example in a one-period situation) However, if the firm can convince lenders that it will just have a safe project, the lending will be at a lower rate Because lenders can only observe a firm's default history, a firm can create a reputation by not failing to have only a safe project The longer the firm has a history of debt repaying its debt, the higher its reputation, and the lower its cost of borrowing Older, more established firms, therefore, find it best not to substitute assets, i.e choose a safe project, to avoid losing a reputation The risky project can be chosen by young firms with little reputation They will eventually switch to the safe project if they live without a default In consequence, firms with a long history have lower defaults and lower debt costs than firms with a short history Although debt amounts are fixed by the Diamond model, an extension of the model would lead to younger firms being less debt than older firms, other things being equal

Managers may also be encouraged to undertake relatively safe projects because of their reputation Hirshleifer and Thakor (1989) consider a manager who has a choice of two projects, each with only two outcomes-success or failure which means the same for both projects, but from the point of view of the shareholders, the high-risk-high-return project yields both higher expected returns and higher returns if it succeeds But suppose that success on the two projects is equal from the point of view of the manager's reputation, that being that the managerial labour market only can distinguish “success” versus

“failure” The manager thus maximizes the probability of success while shareholders favour expected returns If the safer project has a greater probability of success, the manager would prefer it, while for the equity holders, the other project is better Managers' behaviour reduces the debt cost of their agencies Thus the firm may expect to have more debt than otherwise if managers are sensitive to such an effect Hirshleifer and Thakor (1989) argued that managers of firms more likely to be takeover targets are more

susceptible to the reputation effect; such firms can be expected to have more debt, ceteris

paribus Conversely, firms that have taken anti-takeover measures will use less debt,

which is equal in other aspects

c Summary of Section I

Models of agencies were one of the most successful in generating important implications In particular, Hirshleifer and Thakor (1989), Harris and Raviv (1990a), Stulz (1990) said these models predict that leverage is positively associated with firm value, default probability (Harris and Raviv (1990a)), the extent of the regulation (Jensen and Meckling (1976), Stulz (1990)), free cash flow (Jensen (1986), Stulz (1990)), liquidation value (Williamson (1988), Harris and Raviv (1990a)), the extent to which the firm is a takeover target (Hirshleifer and Thakor (1989), Stulz (1990)), and the importance of managerial reputation (Hirshleifer and Thakor (1989)) Also, leverage is expected to be negatively associated with the extent of growth opportunities (Jensen and Meckling (1976), Stulz (1990)), interest coverage, the cost of investigating firm prospects, and the probability of reorganization following default (Harris and Raviv (1990a)) Some other implications include the prediction that bonds will have covenants that attempt to restrict the extent to which equity holders can pursue risky projects that reduce the value of the debt Others include predicting that bonds will have contracts restricting the extent to which equity holders can undertake risky projects which reduce the value of debt (Jensen and Meckling (1976)) and Diamond (1989) pointed out that older firms with longer credit histories will tend to have lower default rates and costs of debt The fact that both endogenous variables move in the same direction with changes in exogenous factors results in that they are positive about their value and leverage (Hirshleifer and Thakor (1989), Harris and Raviv (1990a), Stulz (1990)) The increase in (decreasing) changes in the capital structure caused by a change in one of these exogenous factors will therefore be accompanied by increases in the stock price (decreases)

1.1.2 Asymmetric Information

A variety of approaches to explaining capital structure have been made possible by the introduction to the economics of the express modelled private information These theories are assumed that company managers or insiders have private information on the return stream characteristics or investment opportunities of the firm In one set of approaches, the choice of the firm's capital structure signals to outside investors the information of insiders This stream of research began with the work of Ross (1977) and Leland and Pyle (1977) In another, the capital structure aims to mitigate inefficiencies caused by asymmetry of the information in the firm's investment decisions This branch of the literature starts with Myers and Majluf (1984) and Myers (1984) We examine the following parts of the different approaches

1.1.2.1 Interaction of Investment and Capital Structure

Myers and Majluf (1984) demonstrated in their seminal work that if investors are less well informed of the firm's value than current insiders, equity can be mispriced on the market In the event firms are expected to finance new projects through the issuance of equities, under-pricing could be so severe that new investors can capture a net loss to existing shareholders over the new project's NPV In this case, even though its NPV is positive, the project is rejected This underinvestment can be avoided if the firm can finance the new project with security which the market does not underestimate too severely In this case, for instance, internal funds and/or riskless debt do not include undervaluation and, therefore, firms would prefer equity Even risky debt (not too) is preferred to equity Myers (1984) refers here to the "peck order" financing approach, which is that the capital structure is driven first internally, then by low-risk debt and, eventually, only last resort by firms' will to finance new investments

To understand why firms can pass positive NPV projects, only two forms of firms are supposed to exist Depending on the form, the firm's current assets are either H or L <

H At first, the form of the firm is only known to managers of the business whose objective is to maximize the true value of the current shareholder's claim External

investors believe that the company is H in probability p and L in probability 1 − 𝑝 Both firms have access to a new project requiring I investment and NPV v (I and v can be assumed to be common knowledge) The firm has to decide if the project is accepted The investment that I would finance to new shareholders by issuing equity to new shareholders if the project is accepted Take into consideration this candidate's equilibrium A firm of type H rejects the project and does not have equity while a firm of type L accepts the project and issues equity worth I The issuance of equity signals that the firm is of the type L, believe investors To verify that this is an equilibrium, first consider that investor beliefs are rational Secondly, given these beliefs, the equity issued

by the firm's Form L has fair market prices, i.e current shareholders hand out to new shareholders a portion of the company 𝛽 = 𝐼/(𝐿 + 𝑣 + 𝐼) Their salary is (1 − 𝛽)(𝐿 +

𝑣 + 𝐼) = 𝐿 + 𝑉 for the project and the issuing of equity The current shareholders of Type

L firms, therefore, capture the NPV of v by issuing equity in the new project They would not choose type H firms because it would require the project to proceed along with its positive NPV without a compensatory gain for the valuation of existing assets, i.e their payoff would be L Third, the payoff to current shareholders shall simply be H if a type H firm passes on the project On the contrary, if a type H firm imitates the type L firm by issuing equity, it is priced by the market as if the firm was a type L firm By taking the project, they are also worse off This is if it is less than H, or (𝐻 − 𝐿)𝛽 > 𝑣 in the above expression Accordingly, only types L firms can accept the positive NPV project for parameters that satisfy this inequality in equilibrium The left side of the inequality is the value allocated to new equity holders who purchase fraction, B of the firm at the bargain price of L rather than the true value H The inequality states that there is underinvestment when the transfer is higher than the project's NPV

What does the "pecking order" theory of Myers have empiric implications? The most important implication probably is that the market value of the existing shareholders will decline once the equity issue is announced The market value of the firm (current share) before the announcement is 𝑝𝐻 + (1 − 𝑝)(𝐿 + 𝑣), reflecting prior views on the

firm type and firm's equilibrium When an equity issue is announced, the investor realizes that the firm is type L so the firm value becomes 𝐿 + 𝑣 The announcement of the equity issue results in a fall in the current equity price for parameter values satisfying the above, inequality 𝑝𝐻 + (1 − 𝑝)(𝐿 + 𝑣) > 𝐿 + 𝑣 Furthermore, financing by internal funds or riskless debt (or any security whose value is not private information) does not convey data and does not result in stock price reactions Secondly, new investments are mainly financed from internal sources of revenues from low-risk debt issues Third, Korajczyk

et al (1990b, c) argue that, following information releases including annual reports and announcements of earnings, the underinvestment problem is least severe Therefore, after such releases, stock problems arise and the decrease in prices is negatively related to the period between the release and the issue announcement

Several authors extended the fundamental concept of Myers-Majluf Krasker (1986) gives firms the choice of size and the accompanying equity issue of the new investment project He confirms Myers and Majluf results in this relation and shows also that the larger the stock issue the worse the signal and the decrease in the firm stock price

Similar results to Myers' and Majluf are obtained by Narayanan (1988) and Heinkel and Zechner (1990) They show that if information asymmetry only concerns the value of the new project, overinvestment will occur, i.e some negative NPV projects are taken That is because full separation of firms by project NPV is impossible when the only observable signal is whether the project is taken The equilibrium includes pooling firms with different NPV projects and prices at average value from the equity issued by all these firms Firms with low NPV would benefit from overpriced equity sales This could compensate more than for a negative NPV project As a result, all firms with project NPV above the cut-off accept the project The result is a negative cut-off NPV In Narayanan's model, the cut-off level is higher when projects are financed by debt issues since (risky) debt is lower than equity

Existing debt makes investments less attractive both at Heinkel and Zechner (as in Myers (1977)) and increases the cut-off level This reduces the overinvestment problem

relative to all equity financing by new (Narayanan) or existing debt (Heinkel and Zechner) The models imply that the stock price of the firm will increase when it accepts

a new project, as the market finds that the new NPV of the firm is higher than the cut-off level Narayanan shows that all firms either issue debt or reject projects when firms can issue equity His findings are also inconsistent with the theory of "pecking order” As the acceptance of the project is associated with debt issuing, debt issues are positive news, which means that the firm's stock prices are increased This is the opposite of Myers and Majluf (1984) Debt in Heinkel and Zechner is not a signal since it is issued before private information is provided to firms In Heinkel and Zechner, internal funds may also replace debt It is crucial to results that acceptance or rejection of the project is a signal both for Narayanan and Heinkel-Zechner If investors could only observe if the firm issues shares, firms with negative NPV projects can imitate successful firms with the same security, but invest the proceeds in Treasury bills

The theory of the "pecking order" was doubted by Brennan and Kraus (1987), Noe (1988), and Constantinides and Grundy (1989) These reports enrich the set of financing options a firm can make in the model of the Myers and Majluf situations (1984) The conclusions are that firms do not necessarily prefer direct debt to equity and that a signal with richer financing options can resolve the underinvestment choices

A similar method as in Myers and Majluf is offered by Brennan and Kraus Two types of firms are included L and H Each type of firm here initially has debt outstanding

In equilibrium, the firm type H provide enough equity to finance the new project and to withdraw its debt at face value The new project is issued with only enough equity to finance by firm size L In this case, the debt of type H firms is risk-free Thus, both the equity issue and debt repurchase are "fair" decided by type H firms Firms of Type H should not imitate firms of type L, so the equity of type H will be under-priced Type L firms are not imitating type H firms because buying back debt in full value means overpaid (i.e., for type L firms, the debt is risky) The cost of this debt overpayment exceeds the benefits of an overpriced equity sale In equilibrium, both firms issue equity

and accept the positive NPV project Of course, this example does not produce the underinvestment outcome of Myers and Majluf In addition, but not firms are permitted to issue debt This is inconsistent with the theory of "pecking order." Finally, it's a negative signal to issue equity under in the Brennan and Kraus model is a negative signal but, simultaneously, it is a positive signal to issue equity and use part of debt repurchase proceeds

Constantinides and Grundy (1989) allow firms to issue all types of security and rebuy existing equity Another variation to the basic MyersMajluf setup is that managers are supposed to have an equity stake in a firm that maximizes their true value Constantinides and Grundy demonstrate that there is a fully separating equilibrium (including the continuum of firms types) in which all types of firms accept positive NPV investment financed by an equity issue that is not direct debt or equity A sufficient amount would be issued for the new project to be financed and to repurchasing some of the existing equity of the firm This security issued is convex at the true value in the locally concave, at least for some firm value below the true value (see their theorem (1989)) These characteristics are described as convertible debt by Constantinides and Grundy The fundamental theory is that repurchasing equity makes it costly for firms to overestimate their true value while issuing securities that are sensitive to value makes understating true value costly The design and size of the new issue so that these consequences balance on the margin at the true value of the firm In this model, the problem of underinvestment is solved without cost Although firms can issue some form of debt, the model does not support the 'pecking order' rule In other words, the use

of internal funds or riskless debt is not overriding

Noe (1988) allows firms to issue either debt or equity, he presents an example with three firm types, say L, M, and H In equilibrium, all types accept the positive NPV project, but types L and H issue debt while type M issues equity Investors revise their firm belief using the rule of Bayes (e.g., they correctly identify type M) As a result of confusing either type M or type H security issued by type L is overpriced In this

example, debt is less affect firm type than equity., however, since firm type H is much better than firm type M, L's debt is much overpriced than its equity As a result, type L chooses to "imitate" type H The debts issued by type M are true without risk but are considered risky by investors if confused with debts of type L Therefore, the debt will be under-priced if type M issues debt Type M, therefore, prefers equity that is fairly priced Either type H security would be under-priced In this scenario, the debt of firm type H is less under-priced both because it is less sensitive to firm quality and because a firm of type L (the only type in which it has risky debt), has a low probability

Brennan and Kraus, Constantinides and Grundy, and Noe show that allowing firms

a wider range of financing choices can invalidate the Myers-Majluf results in some cases

It is an open question whether the types of examples identified in these papers are empirically more important than the ones in Myers-Majluf However, we note that Noe shows that the average quality of firms issuing debt is higher than that of equity-emitting firms issuing equity Therefore Noe's model forecasts a negative stock market response to

an announcement of an equity issue like Myers-Majluf Noe also foresees a positive market response to a debt issue announcement In addition, if Constantinides and Grundy extend the model even further so that different firm types can have different optimal levels of investment and assume that investment can be observed, they can show that firms can separate their investments by using the size of a bond issue (with some stock repurchase) for signals

1.1.2.2 Signaling with Proportion of Debt

As part of the solution to problems of over-and-under investments, the capital structure came into being in the previous subsection Now we turn to fixed investment models and capital structure as a signal of information from the private insider

In this area, Ross's major contribution (1977) whose model that managers know the true distribution of firm returns, but investors do not The first order of stochastic dominance is the order of firm return distributions Managers benefit from the higher

a signal of higher quality, investors accept higher levels of debt Because lower-quality firms are expected to have higher marginal expected bankruptcy costs for any debt level, low-quality firm’s managers are not imitating high-quality firms with more debt A simple formal model is as follows Suppose the returned date-one 𝑥̃ is distributed uniformly by a firm type t on [0, 𝑡] The manager is informed privately of t He selected the debt D face-value to maximize a weighted average of the firm's market value at date zero and its expected value at date one, net of a bankruptcy penalty L By VO(D), we indicate the market value at zero if the debt level is D If the value is not at zero, the manager's objective function of the manager is then

𝑉𝑜(𝐷) = 𝑎(𝐷)/2

It gives the first-order condition to substitute this in the objective function and take the derivative concerning D If D(t) is a manager's optimal debt level choice to firm type t, then D(t) t is the right inference in equilibrium The first order and resolution of the resulting differential equation

𝐷(𝑡) = 𝑐𝑡2/𝐿 + 𝑏, where c and b are constants

The main empirical result is the positive relationship between firm value (or profitability) and the debt-equity ratio The above formula also shows easily that the penalties for bankruptcy are increased, other things are equal, debt and the probability

of bankruptcy are decreased Ross also shows that the probability in firm type t grows So

in this model, firm value, debt level and probability of bankruptcy are all related positively

Heinkel (1982) considers a model similar to Ross but does not assume that firm returns are ordered by stochastic dominance of the first order The distribution of the return is supposed instead to have "higher" quality firms, but have lower bonds in total value and therefore a higher equity value (lower market value for the given value) This allows the firm to separate without any cost when insiders maximize their residual claims

to the extent that a given amount of external capital is raised It is due to an overvaluing

of one security and loss of the undervaluation of the other that any firm attempting to persuade the market that it is a type other than the true type The amounts issued by the two securities for every type of firm in balance are such that the margin is the balance of gains and losses More debt is issued by high-value firms A lower-value firm should issue more low-price debt and decrease overpriced equity to imitate a high-value firm A higher value firm must also issue less overpriced debt and lower cost equity to imitate a low-value firm Because higher-quality firms have a better total value, it is consistent with Ross's result that they issue more debt

The Poitevin model (1989), which involves potential competitiveness between the incumbent and an incumbent, is another model that uses debt as a signal The entrant is privately aware of the marginal costs Low-cost entrants in equilibrium signalize this fact with debt, while incoming entrants with high costs issue equity only The cost of issuing debt for a firm is that it makes the firm vulnerable to predation by the other corporation, which could cause the debt-financed firm to bankrupt The advantage of indebtedness is the fact that the financial market values the debt-financed firm as it considers that such a firm is of a low cost High-cost debt entrants will not be issued, since bankruptcy will be probable due to predation from the incumbent (incumbents prey equally on all debt-financed firms, even if thought to be a low cost) Like the other models in this subsection, the principal result is that debt issuance is good news on the financial market Since predation will only be used to lead the opponent into bankruptcy, only debt-financed firms will be predated

Managerial risk aversion is used in several studies to achieve a signalling equilibrium for determining capital structures The basic idea is for managers to keep a greater fraction of the (risky) equity in increased firm leverage The greater share of equity decreases management welfare due to risk average, but for managers of better quality projects, the decrease is smaller This can be signalled by managers of higher-quality firms with more equilibrium debt The following is a simple formal Leland and Pyle model from 1977 Consider the contractor who returns the project 𝑥̃ = 𝜇 + 𝜖̃ 𝐸𝜖̃ = 0 and who needs I from outside sources The entrepreneur observer expectations of return, but investors do not To maximize the expected benefit of the end-of-period wealth 𝐸𝑢(𝑊̌), he chooses the fraction of the equity that he retains and the face value of the default-free debt D where:

The first condition for an order is to differentiate 𝐸𝑢(𝑊̌) from a, replacing the condition of equilibrium that V (𝛼 (𝜇)) = 𝜇 it (in which 𝛼 (𝜇) is an optimal share of the entrepreneur's ownership if its expected return is it), and setting the result to zero This condition can show that the equilibrium of ownership of the entrepreneur increases with firm quality To translate this into a theory of capital structure, changes in the quality of the firm must be calculated by using the external funds limit on debt level D Increases in

𝜇 result in increases in 𝛼 as just shown; however, the increase in 𝛼 has two opposite effects on D The increased ownership, otherwise equal, of the entrepreneur would require the collection of more debt funds However, the firm value V is greater for

a larger value, so that the smaller portion of the firm it receives may be paid for more Thus, D may not have to be increased to finance the entrepreneur's increased ownership share The parameters of an example, Leland and Pyle (1977), are certain conditions that ensure that the debt increases with α Under these conditions, firms with higher debt also own a greater proportion of insiders' equity and are more quality-conscious

1.1.3 Summary

The principal predictions of asymmetric information theories concern stock price reactions to securities issue and exchange, leverage amounts, and whether firms comply with a security order

Stock Price Effects of Security Issues

● Debt: The absence of any price effects upon (riskless) debt issuance is predicted by Myers and Majluf (1984) and Krasker (1986) A positive price effect of (risky) debt is forecast by Noe (1988) and Narayanan (1988)

● Equity: Krasker (1986), Korajczyk and others (1990c) and Lucas and McDonald (1990) have predicted that a share issue will have a negative price effect The greater the information asymmetry and the greater the equity issue will be this decline in the price Moreover, the fact that stock issues will on average precede abnormal stock pricing, according to Lucas and McDonald (1990)

Stock Price Effects of Exchange Offers

● Debt Increasing Offers: The positive stock price reaction of Constantinides and Grundy (1989), the larger the stock exchange, is predicted

● Equity Increasing Offers: the positive stock price reaction is forecast by Brennan and Kraus (1987)

Is There a Pecking Order?

● No: the dispute about the pecking order results in the models similar to those of Myers and Majluf between Brennan and Kraus (1987), Noe (1988), Constantinides and Grundy (1989) No result in the pecking order is obtained from other signalling models, such as Ross (1977), Leland and Pyle (1977) and Heinkel

Leverage

Myers and Majluf (1984) imply that the extent of information asymmetry increases leverage The positive relations between leverage and value in a cross-section of otherwise similar firms are found in Ross (1977), Leland, and Pyle (1977), Heinkel (1982), Blazenko (1987), John (1987), Poitevin (1989), and Ravid and Sarig (1989) Ross (1977) also predicts a positive correlation between leverage or value and bankruptcy probability, while Leland and Pyle (1977) predict a positive correlation between value and equity ownership of insiders

1.2 The measurements of capital structure

The six measures of leverage shown in Table 2 are included in this research Book long-term debt (LD) is calculated by long-term debt divided by long-term debt plus book value of equity Book total debt ratio (TD) is calculated by total debt (short-term plus long-term) divided by total debt plus book value of equity Book total liabilities ratio (TL)

is calculated by total liabilities divided by total liabilities plus the book value of equity When the market value of equity, book total debt ratio, book long-term debt ratio and book total liabilities ratio replace book value of equity, the market long-term debt ratio (MLD), market total debt ratio (MTD) and market total liabilities ratio (MTL), respectively Since the prices of H- or B-shares differ significantly from public A-shares for the same companies, determining the market value of these companies is hard As a result, when measuring stock ratios, companies with H or B shares are removed

The main measures of leverage use are the Total liabilities ratio (TL) and market total liabilities ratio (MTL) and the others are used for robustness checks The reason why

we believe that total liabilities ratio a more appropriate measure for capital structure; we

argue that the first point is the time a firm wants to obtain more debt, not only how much the firm’s long-term debt is but also how much the firm’s current debt and total liabilities are will be considered by the debtor As a result, the proportion of other liabilities affects

a company's debt capability Second, current liabilities are a quite steady part of total assets (Gibson, 2001) for US firms which also seems to be the case for Vietnamese companies

1.3 The Determinants of Capital Structure

Collateral Value of Assets

Most capital structure theories argue that the composition of assets owned by a firm affects its capital structure choice Titman and Wessels (1988) suggest the firms with

a high level of assets can be used as collateral forgiven debt, and the borrower is forced to use resources in the predetermined project, thus curtailing the lender's risk of suffering such agency costs of debts Their findings support the agency theory that the stockholders

of highly leveraged firms have an incentive to invest suboptimally to transfer wealth from the firm’s bondholders to the firm’s shareholders (Myers and Majluf, 1984; Jensen and Meckling, 1976) Hence, a high fraction of tangible assets tends to increase leverage Besides, in the presence of information asymmetry, firms with a high level of asset that can be used as collateral may be expected to sell secured debt as it reduces the information premium (Scott, 1977) The tendency of firm’s managers to consume more than the optimal level of perquisites, which reduces the value of the firms However, Grossman and Hart (1982) suggest that firms with less collateralizable assets are more vulnerable to agency cost since monitoring the capital outlays is difficult for such firms The high debt level of firms would mitigate this tendency because of the increased threat

of bankruptcy Therefore, it is expected that the firms with less collateralizable assets will choose higher debt levels to limit a managers’ consumption of perquisites

In this study, the collateralized value of assets is measured as fixed assets scaled by total assets As the non – debt portion of liabilities does not need collateral, the

Profitability

The pecking order theory and trade-off theory have opposite implications about the relationship between profitability and capital structure choice (Harris and Raviv, 1991; Booth et al., 2001) Especially, the pecking order theory states that firms prefer retained earnings as the main source of the investment project, which is a consequence of information asymmetries existing between insiders and outside investors More precisely, managers prefer to use internal equity to minimize the associated costs and avoid potential dilution of ownerships (Myers and Majluf, 1984; Myers, 1984) Thus, pecking order theory suggests an inverse relationship between profitability and debt ratio The trade-off theory, on the other hand, suggests the positive relationship between two variables, since the firms that have great profitability have less bankruptcy risk and relatively lower bankruptcy cost, may opt for the debt to fully benefit from tax shield (Modigliani and Miller, 1963) Moreover, the existence of free cash flow problems and in these circumstances debt may act as a management tool to prevent managers from not pursuing individual objectives, which implies a positive relationship for liquidity (Jensen, 1986) In this study, profitability will be defined as earnings before interest and tax scaled

by total assets, denoted as ROA

Effective Tax Rate

According to trade-off theory, the corporate tax has played an important role in capital structure choice The firms with high effective corporate tax should use more debt

to attract the tax shield benefit and also maximize the tax deduction of the debt interest (Modigliant and Miller, 1958) The gains from borrowing increase the effective tax rate (Antoniou et al., 2008); thus, there is a positive relationship between effective tax rate and debt level However, many studies found the opposite result to the Modigliani and Miller theorem is due to two main reasons MacKie-Mason (1990) suggested examining debt-equity choice based on incremental decisions is more consistent with MM theorem because the most tax shield has a negligible effect on the marginal tax rates Moreover, the tax policy can lead to different results on the implication of tax on capital structure,

especially when the tax system is designed to favour the retention of earnings against dividend payout, or vice versa (Antoniou et al., 2008) The average effective income tax rate will be used as a proxy for tax rates to examine the effect of tax on leverage

Non-debt Tax Shield

The tax deduction for depreciation and investment tax credits are non – debt tax shields DeAngelo and Masulis (1980) present a capital structure model where non – debt tax shields serve as a substitute for the tax benefit of debt financing As a result, firms with larger non – debt tax shields, ceteris paribus, are expected to have an inverse relationship between the amount of non – debt tax shields and leverage Following the Titman and Wessels (1988), we use the sum of depreciation and amortization expenses scaled by total assets and a direct estimate of non – debt tax shields over total assets (NDT/TA) as a proxy for non – debt tax shields, by using the following equation:

0, 2

T NDT OI i

Including:

equity or long–term debt, as a result, they prefer to rely on short–term debt and be more highly leveraged than larger firms (Smith Jr, 1977) On the other hand, the pecking order theory implies the negative correlation between a firm’s size and debt ratio Large-sized companies tend to disclose more information to outside investors than small firms, and asymmetric information is a less severe issue in large firms (Rajan and Zingales, 1995) Thus, large firms will prefer to use more equity than debt

Empirical studies generally found a positive relationship that leverage is positively related to a firm’s size, and hence support for the trade-off hypothesis (Rajan and Zingales, 1995; Wald, 1999; Booth et al., 2001; Huang and Song, 2006) Following the sub-stream papers, a natural logarithm of total assets is used to measure the firms’ size in this study

Growth opportunities

Theoretically, most studies suggest leverage is inversely related to growth opportunities consisting of future investment opportunities (Jensen and Meckling, 1976; Myers, 1977; Stulz, 1990) It is argued that firms in growing industries incur higher debt, and have their agency costs since the firms have more flexibility in future investment options (Myers, 1977) Furthermore, under agency theory debt serves as a tool to avoid the managerial discretion for the firms lacking investment projects It is also suggested that growth opportunities are capital assets that add value to a firm, but cannot be collateralized and do not generate current taxable income They are intangible due to the high financial distress costs this implies, and the fact that intangible assets would be valueless in the case of bankruptcy; thus the firms with high-growth opportunity prefer to not issue debt in the first place (Titman and Wessels, 1988) The pecking order theory, however, requires a positive correlation between growth opportunities and the debt ratio

of a firm (DeAngelo and Masulis, 1980; Myers, 1984; Myers and Majluf, 1984; Jensen, 1986) This is because growing firms place a greater demand on the internally generated funds from the firms Therefore, the firms can reduce the costs of asymmetric information

by funding resources, which have more growth opportunities than the assets owned by

firms (Myers, 1984) Particularly, firms would prefer using retained earnings, then risk debt, high-risk debt and, as the last resource, new equity (Myers and Majluf, 1984) It

low-is argued that the high-growth firms will have more options in their choice of future investment (Myers, 1977), however, a lack of internal cash flow will lead the firms to prefer to issue debt as the first option for funding projects Moreover, as companies with high–growth opportunities present greater information asymmetries, this high level of debt is a form of signalling the quality of their investments and high leverage is the result

in such companies (Myers, 1984) Following the previous studies, we use Tobin’s Q as a proxy to measure growth opportunities as suggested by Huang and Song (2006)

to uniqueness because the firms that manufacture close substitutes are less likely to do research and development due to the ease of duplication Moreover, RD/S will affect the capital structure choice, since the unique product is the result of successful research and development projects that will give the firms the competitive advantage of its products which differ from those existing in the market Nevertheless, firms with new products tend to advertise more and spend more on promoting and selling products Thus, the SE/S have a positive correlation with uniqueness

Industry Classification

The concept of industry classification is related to the concept of an individual firm’s business risk It is argued that the larger the business risk, the smaller the firm's