CAPITAL STRUCTURE AND FIRM PERFORMANCE

This study investigates the relationship between firm capital structure and firm performance. The author explores both the effect of firm performance on firm captial structure as well as the effect of capital structure on firm market performance using crosssectional data representing of 162 Vietnamese companies in Hochiminh Stock Exchange for 2008. According to the results, a firm profitability is found to have a significant and negative impact on all firm capital structure. This finding support pecking order theory of Myers and Majluf (1984). An interesting finding is that firm size has a positive and significant impact on the leverage, which consistent with a previous study of Rajan and Zingales (1995), and indicating that a firm size is an important determinant of corporate capital structure. Firm capital structure is confirmed to have positive and significant impacts on firm market performance which is measured by Tobin’s Q. The author also finds that firm growth opportunities have a positive and significant impact on the firm value Tobin’s Q.

UNIVERSITY OF ECONOMICS HOCHIMINH CITY

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CAPITAL STRUCTURE AND FIRM PERFORMANCE:

CASE STUDY: LISTED COMPANIES IN

HOCHIMINH STOCK EXCHANGE

MASTER THESIS

Ho Chi Minh City – 2010

UNIVERSITY OF ECONOMICS HOCHIMINH CITY

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CAPITAL STRUCTURE AND FIRM PERFORMANCE:

CASE STUDY: LISTED COMPANIES IN

HOCHIMINH STOCK EXCHANGE

MAJOR: BUSINESS ADMINISTRATION

MAJOR CODE: 60.34.05

MASTER THESIS

Ho Chi Minh City – 2010

ACKNOWLEDGEMENT

I would like to express my deepest gratitude to my research Instructor, Professor Nguyen Dong Phong for his intensive support, valuable suggestions, guidance and encouragement during the course of my study

My sincere thanks are also due to Dr Vo Thi Quy and Dr Tran Ha Minh Quan for their valuable time as the members of the proposal examination committee Their comments and constructive suggestions were of great help in my completing this study

My sincere thanks is extended to Assistant Professor Nguyen Dinh Tho, Dr Tran

Ha Minh Quan, Dr Truong Tan Thanh, Dr Pham Huu Hong Thai, Dr Bui Thanh Trang for their valuable time as members of examination committee Their comments and suggestions were of great value for my study

I would like to express my sincere gratitude to all of my teachers at Faculty of Business Administration and Postgraduate Faculty, University of Econimics Hochiminh City for their teaching and guidance during my MBA course

I would like to specially express my thanks to all of my classmates, my friends from www.caohockinhte.vn for their support and encouragement

I would also like to avail this opportunity to express my appreciation to Professor Nguyen Dong Phong, UEH Board of Directors for creating MBA program in English and Dr Tran Ha Minh Quan for his support during the course

Finally, I heartily dedicate this study to my beloved parents and my wife, Vu Thi Huyen who have always sacrificed to encourage and support me during my study

ABSTRACT

This study investigates the relationship between firm capital structure and firm performance The author explores both the effect of firm performance on firm captial structure as well as the effect of capital structure on firm market performance using cross-sectional data representing of 162 Vietnamese companies

in Hochiminh Stock Exchange for 2008 According to the results, a firm profitability is found to have a significant and negative impact on all firm capital structure This finding support pecking order theory of Myers and Majluf (1984)

An interesting finding is that firm size has a positive and significant impact on the leverage, which consistent with a previous study of Rajan and Zingales (1995), and indicating that a firm size is an important determinant of corporate capital structure Firm capital structure is confirmed to have positive and significant impacts on firm market performance which is measured by Tobin’s Q The author also finds that firm growth opportunities have a positive and significant impact on the firm value Tobin’s Q

Keywords: Capital structure, corporate performance, Vietnam, HOSE

TABLE OF CONTENTS

ACKNOWLEDGEMENT i

ABSTRACT ii

TABLE OF CONTENTS iii

LIST OF FIGURES v

LIST OF TABLES vi

ABBREVIATIONS vii

CHAPTER 1: INTRODUCTION 1

1.1 BACKGROUND 1

1.2 RESEARCH PROBLEMS 3

1.3 RESEARCH OBJECTIVES 4

1.4 RESEARCH METHODOLOGY AND SCOPE 5

1.5 STRUCTURE OF THE STUDY 5

CHAPTER 2: LITERATURE REVIEW 7

2.1 INTRODUCTION 7

2.2 CAPITAL STRUCTURE 7

2.3 FIRM PERFORMANCE 11

2.4 HYPOTHESIS AND EMPIRICAL MODEL 12

2.4.1 Model 1: The Leverage Model 12

2.4.2 Model 2: The Firm Value Model 15

CHAPTER 3: RESEARCH DESIGN 18

3.1 INTRODUCTION 18

3.2 DATA 18

3.3 RESEARCH DESIGN 18

3.3.1 Research Sample 19

3.3.2 Data Analysis Method 20

3.4 VARIABLES MEASUREMENT FOR MODEL 1 20

3.4.1 Dependent Variables 20

3.4.2 Independent Variables 21

3.5 VARIABLES MEASUREMENT FOR MODEL 2 21

3.5.1 Dependent Variables 21

3.5.2 Independent Variables 22

3.6 FRAMEWORK OF THE STUDY 23

3.7 SUMMARY 24

CHAPTER 4: EMPIRICAL RESULTS OF THE RESEARCH 25

4.1 INTRODUCTION 25

4.2 CHARACTERISTICS OF RESEARCH SAMPLES 25

4.3 DESCRIPTIVE STATISTICS 26

4.4 REGRESSION ANALYSIS 29

4.4.1 Model 1: The Leverage Model 29

4.4.2 Model 2: The Firm Value Model 32

CHAPTER 5: CONCLUSIONS, RECOMMENDATIONS AND LIMITATIONS 38

5.1 INTRODUCTION 38

5.2 CONCLUSIONS 38

5.3 RECOMMENDATIONS 39

5.4 LIMITATIONS 40

REFERENCES 41

APPENDIX A 44

APPENDIX B 45

APPENDIX C 51

LIST OF FIGURES

Figure 1: The Leverage Model 14

Figure 2: The Firm Value Model 17

Figure 3: Research Process 19

Figure 4: Framework of the study 23

LIST OF TABLES

Table 1: Dependent variables for model 1 20

Table 2: Independent variables for model 1 21

Table 3: Dependent variables for model 2 22

Table 4: Independent variables for model 2 22

Table 5: Summary Statistics of the Explanatory Variables 26

Table 6: Correlation Matrix of the Explanatory Variables for Model 1 28

Table 7: Correlation Matrix of the Explanatory Variables for Model 2 28

Table 8: Estimate Results for Model 1 29

Table 9: Estimate Results for Model 2 Using TDTA 32

Table 10: Estimate Results for Model 2 Using TDTE 33

Table 11: Estimate Results for Model 2 Using LTDTA 34

Table 12: Estimate Results for Model 2 Using STDTA 35

ABBREVIATIONS

HOSE Hochiminh Stock Exchange

GROWTH Growth opportunities

LTDTA Long-term debt to total assets

STDTA Short-term debt to total assets

TDTE Total debt to total equity

TDTA Total debt to total assets

CHAPTER 1: INTRODUCTION

The theory of the capital structure is an important reference theory in firm's financing policy The capital structure refers to firm includes mixture of debt and equity financing The topic of optimal capital structure has been the subject of many studies

The modern theory of the capital structure originate from the contribution of Modigliani and Miller in 1958, under the perfect capital market assumption1

Jensen and Meckling (1976) introduce the concept of agency costs and investigate the nature of the agency costs generated by the existence of debt and outside equity When considering corporation tax, bankrupt costs and agency costs at the same time, trade-off theory can be introduced to derive the existence of the optimum capital structure Leland (1994) extends the results of Merton (1974) and Black and Cox (1976) to include taxes, bankruptcy costs to derive the optimal capital structure Deangelo and Masulis (1980) argue that the existence of non-debt corporate tax shields such as depreciation deductions is sufficient to overturn the leverages irrelevancy theorem Hovakimian, Opler, and Titman (2001) test the hypothesis that firms tend to a target ratio when they either raise new capital or retire or repurchase existing capital They found firms should use relatively more debt to finance assets in place and relatively more equity to finance growth opportunities

that if there is no bankrupt cost and capital markets are frictionless, if without taxes, the firm value is independent with the structure of the capital In 1963, under considering the corporate taxes, Modigliani and Miller modified the conclusion to recognize tax shield Because debt can reduce the tax to pay, so the best capital structure of enterprises should be 100% of the debt But this seems to be unreasonable in the real world

It has also been argued that profitable firms are less likely to depend on debt in their capital structure than less profitable ones It has been argued that firms with a high growth rate have a high debt to equity ratio Bankruptcy costs (proxied by firm size) are also found to be an important effect on capital structure (Kraus and

1

Perfect capital markets means that the following assumptions hold: (a) there are no taxes, (b) there are no transaction costs, (c) there is symmetrical information, (d) there are homogenous expectations, and (e) investors can borrow at the same rate as corporations

Litzenberger, 1973; Harris and Raviv, 1991) If these three factors are considered

as determinants of capital structure, then these factors could be used to determine the firm performance

In practice, firm managers who are able to identify the optimal capital structure are rewarded by minimizing a firm’s cost of finance thereby maximizing the firm revenue If a firm capital structure influences a firm performance, then it is reasonable to expect that the firm capital structure would affect the firm health and its likelihood of default From a creditor’s point view, it is possible that the debt to equity ratio aids in understanding banks’ risk management strategies and how banks determine the likelihood of default associated with financially distressed firms In short, the issue regarding the capital structure and firm performance are important for both academics and practitioners

There is lack of empirical evidence about the effect of firm performance on capital structure in Vietnam Then, the first objective of this study is to examine the effect which firm performance has on capital structure of listed companies in Hochiminh Stock Exchange Trần Hùng Sơn and Trần Viết Hoàng (2008) find a positive and significant impact of firm leverage on firm accounting performance, but have not used market performance measures Thus, the second objective of this study is to examine the effect which firm capital structure has on corporate market performance

This study contributes to literature in two directions: (1) by using ordinary least square regression model to investigate the relationship between capital structure and firm performance to fill the gap in corporate finance literature in Vietnam; (2)

by employing different measures of capital structure such as short-term debt to total assets, long-term debt to total assets, total debt to total assets, and total debt to total equity to investigate the effect of the debt structure on corporate market performance in Vietnam This study contributes to practical implications by investigating the effect of capital structure on corporate performance using market measures to provides evidence about whether the stock market is efficient or not It also provides managers a structure approached to plan their firm capital structure strategies and improve the firm value

1.2 RESEARCH PROBLEMS

Problem definition is essential before conducting a study, especially quantitative research Zikmund (1997, p 82) recommends that formal quantitative research should not begin until the problem has been clearly defined In Vietnam, lack of empirical evidence, that investigate the relationship between firm capital structure and firm performance, is an issue for both academics and practitioners

There is lack of empirical evidence that investigate the relationship between firm capital structure and firm performance in Vietnam In 2008, Trần Hùng Sơn and

Trần Viết Hoàng tested the relationship between capital structure and firm performance by using data sample of 50 non-financial companies in Hochiminh Stock Exchange for the period September 2008 The results show that there is a positive correlation between a firm capital structure and performance, which is measured by average of return on assets and return on equity The corporate performance has a strong quadratic or cubic correlation with the capital structure when they use the debt ratio under 100% The performance has a positive correlation with the capital structure when the debt ratio is in the range from 0.9755 to 2.799 However, they have not used market performance measures and have not explored the optimal capital structure to maximize the performance of the firm They have not tested the correlation between the distribution of debt ratio and corporate performance to each type of companies, as well as each industry Their research recommended that further research should be implemented

Margaritis and Psillaki (2007) use a sample of 12,240 firms from the 2004 New Zealand Annual Enterprise Survey to investigate the effect of leverage on firm performance as well as the reverse causality relationship They use quantitative regression analysis to show that the effect of efficiency on leverage is positive at low to mid-leverage levels and negative at high leverage ratios In Vietnam, there

is no empirical evidence related to the effect of firm performance on capital structure

Therefore, the problem to be addressed in this study is to examine the effect of firm performance on firm capital structure combined with others variables such as firm size, growth and asset tangibility on firm capital structure In addition, the author will explore the effect of firm capital structure on firm market performance, known

as firm value of listed firms in Hochiminh Stock Exchange

1.3 RESEARCH OBJECTIVES

A research objective is the researcher’s version of a business problem Objectives explain the purpose of the research in measurable terms and define standards of what the research should accomplish (Zikmund 1997, p 89) In solving the research problem mentioned previously, this study has the following objectives:

• Determine the effect of firm profitability, size, growth opportunities and asset tangibility on listed firm capital structure in Hochiminh Stock Exchange

• Determine the effect of capital structure on listed firm market performance combined with others variables such as firm size and growth opportunities

in Hochiminh Stock Exchange

Research Questions

Research questions involve the research translation of “problem” into the need for inquiry The research problems defined above leads to the following research questions:

• What are the relationship between firm capital structure and firm profitability, size, growth opportunities and asset tangibility of listed firms

in Hochiminh Stock Exchange?

• What are the relationship between firm capital structure, size, growth opportunities and firm market performance of listed firms in Hochiminh Stock Exchange?

Two research variables of the topic:

• Capital structure

• Firm performance

1.4 RESEARCH METHODOLOGY AND SCOPE

The object of this research is all listed non-financial companies in Hochiminh Stock Exchange (HOSE) at the end 2008 Sample size: 162 (See more in Chapter 3)

Quantitative research based on ordinary least square regression model to estimate the relationship between firm profitability, size, growth, asset tangibility and firm capital structure, as well as the relationship between firm leverage and firm market firm performance This model was used in the previous studies of Tian & Zeitun (2007), Margaritis & Psillaki (2007), Rajan and Zingales (1995)

The author use data analysis tools to implement the research such as: descriptive statistics, multiple regression models with Eviews 6 for Windows

The structure of the study consist five chapters:

Chapter 1: Introduction

This chapter presents research background of the study, as well as, research problems, research objectives, research methodology and scope

Chapter 2: Literature Review

In this chapter, I summary the literature review and present the fundamental ideas

on capital structure, as well as firm performance This chapter also presents a research model of the study

Chapter 3: Research Design

Based on the research objectives and scope, research methodology concerned in chapter 1, and literature review and empirical model presented in chapter 2, this chapter particularly presents the research methodology, data, research design and research process

Chapter 4: Empirical Results of the Research

Chapter 4 presents the characteristics of research samples and measures concepts

of the research I use descriptive statistics to explore the features of explanatory variables, as well as the relationship between each variable in two models

Furthermore, I use regression analysis to explore the relationship between the capital structure and market performance of listed companies in Hochiminh Stock Exchange

Chapter 5: Conclusions, Recommendations and Limitations

Chapter 5 presents main conclusions and recommendations based on the results of the previous chapters, as well as the limitations of this study

CHAPTER 2: LITERATURE REVIEW

Chapter 2 summaries the literature review and present the fundamental ideas on capital structure, as well as firm performance This chapter also presents a research model of the study

The modern theory of capital structure began with the celebrated paper of Modigliani and Miller (1958) In this paper they claim that under perfect capital market conditions, a firm value depends on its operating profitability rather than its capital structure In 1963, Modigliani and Miller argued that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal In this framework, firms target an optimal capital structure based on tax advantages and financial distress disadvantages Firms are thought to strive toward their target and can signal their future prospects by changing their structure Adding more debt increases firm value through the market’s perception of higher tax shields or lower bankruptcy costs But optimal capital structure at a 100% debt financing are clearly incompatible with observed capital structures, so their findings initiated a considerable research effort to identify costs of debt financing that would offset the corporate tax advantage

Since bankruptcy costs exist, deteriorating returns occur with further use of debt in order to get the benefits of tax deduction Therefore, there is an appropriate capital structure beyond which increases in bankruptcy costs are higher than the marginal tax-sheltering benefits associated with the additional substitution of debt for equity Firms are willing to maximize their performance, and minimize their financing cost, by maintaining the appropriate capital structure or the optimal capital structure Harris and Raviv (1991) argue that capital structure is related to the trade-off between costs of liquidation and the gain from liquidation to both shareholders and managers So firms may have more debt in their capital structure than is suitable as it gains benefits for both shareholders and managers

Since then, extensions of the Modigliani and Miller theory have been provided by the following researches Robichek and Myers (1966) argue that the negative effect

of bankruptcy costs on debt to prevent firms from having the desire to obtain more debt Jensen and Meckling (1976) emphasize the importance of the agency costs of equity in corporate finance arising from the separation of ownership and control of firms whereby managers tend to maximize their own utility rather than the value of the firms The general result of these extensions is that the combination of leverage related costs (such as bankruptcy and agency costs) and a tax advantage of debt produces an optimal capital structure at less than a 100% debt financing, as the tax advantage is traded off against the likelihood of incurring the costs This leads us to Jensen’s (1986) “free cash flow theory” where as stated by Jensen (1986, p 323)

“the problem is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it on organizational inefficiencies”

In other words complete contracts cannot be written A higher level of leverage may be used as a disciplinary device to reduce managerial cash flow waste through the threat of liquidation (Grossman and Hart, 1982) or through pressure to generate cash flows to service debt (Jensen, 1986)

Titman (1984) demonstrates an idea of indirect bankruptcy costs He argues that stakeholders did not represent at the bankruptcy bargaining table, such as customers, could suffer material costs resulting from the bankruptcy Leland (1994) demonstrates a standard trade-off model At the optimal capital structure, marginal bankruptcy costs associated with firm’s debt are equated with marginal tax benefits The static tradeoff theory is the original retort to the theory of capital structure relevance

However, as stated in the previous literature, underestimating the bankruptcy costs

of liquidation or reorganization, or the aligned interest of both managers and shareholders may lead firms to have more debt in their capital structure than they should (see, for example, Harris and Raviv, 1991) Krishnan and Moyer, (1997) find a negative and significant impact of total debt to total equity (TD/TE) on return on equity (ROE) Another study by Gleason, Mathur and Mathur, (2000) find that firm capital structure has a negative and significant impact on firm performance measures return on assets (ROA), growth in sales (Gsales), and pre- tax income (Ptax) Therefore, high levels of debt in the capital structure would decrease the firm performance

However, not only does a firm’s level of leverage affect corporate performance and failure but also its debt maturity structure (Barclay and Smith, 1995 and Ozkan, 2002) Schiantarelli and Sembenelli (1999) investigate the effects of firm’s debt maturity structure on profitability for Italy and the United Kingdom They find a positive relationship between initial debt maturity and medium term performance

A study by Barclay and Smith (1995) provide evidence that large firms and firms with low growth rates prefer to issue long-term debt Another study by Stohs and Mauer (1996) suggest that larger and less risky firms usually make greater use of long-term debt They also find that debt maturity is negatively related to corporate tax, the firm’s risk and earnings surprises In other words, the choice of debt structure could have an impact on both corporate performance and failure risk Furthermore, there are other factors, besides capital structure, that may influence firm performance such as firm size, age, growth, risk, tax rate, factors specific to the sector of economic activity, and factors specific to macroeconomic environment of the country

Dilip Ratha, et al (2003) studies the relationship between corporate performance (as measured by its profit rate or earnings before interest and taxes) and corporate finance (debt/assets ratio) in developing countries First, they find out that both profits and earnings before interest, taxes, depreciation, and amortization decline as

a percentage of assets as firms take on more debt relative to their assets This is similar to the finding of Harvey, Lins, and Roper (2001) that; while some debt may improve market discipline in firms, the effect may be overcome by increasing financial risks Second, the marginal (negative) effect of an increase in leverage on earnings is larger for firms that participate in international debt markets than for other firms However, they have not used market performance measures to study the relationship of corporate finance and corporate performance

Wei Xu, et al (2005) analyzes the relationship between corporation performance and capital structure of 1,130 listed companies in China The results show that the firm’s performance has a strong negative correlation with the capital structure It does not agree with the western empirical result for the higher debt ratio The corporation performance has a strong quadratic or cubic correlation with the capital structure when they use the debt ratio under 100% The performance has a positive correlation with the capital structure when the debt ratio is in the range from 24.52% to 51.13%

Allan N Berger, et al (2006) uses a new approach to test agency theory in US banking industry and the findings are consistent with the agency costs hypothesis - higher leverage or a lower equity capital ratio is associated with higher profit efficiency over almost the entire range of the observed data And the results are statistically significant, economically significant, and robust

Margaritis and Psillaki (2007) use a sample of 12,240 firms from the 2004 New Zealand Annual Enterprise Survey to investigate the relationship between firm

efficiency and leverage as well as the reverse causality relationship They find evidence supporting the theoretical predictions of the Jensen and Meckling (1976) agency cost model More precisely, they find support for the core prediction of the agency cost hypothesis in that higher leverage is associated with improved efficiency over the entire range of observed data They use quantitative regression analysis to show that the effect of efficiency on leverage is positive at low to mid-leverage levels and negative at high leverage ratios Thus their results suggest that

in the upper range of the leverage distribution the income effect resulting from the economic rents generated by high efficiency dominates the substitution effect of debt for equity capital They also show that the more efficient firms will choose higher debt ratios because higher efficiency acts as a buffer against the expected costs of bankruptcy or financial distress The effect of tangibles and profitability on leverage is positive Firm size has a negative effect on leverage at the lower half of the leverage distribution and a positive effect at the upper half of the distribution The effect of intangibles and other assets is estimated to be negative

Tian & Zeitun (2007) examine the impact which capital structure has had on corporate performance in Jordan in which they controlled the effect of industrial sectors, regional risk, such as the Gulf Crisis 1990-1991 and the outbreak of Intifadah in the West Bank in September 2000 They have used a cross-sectional data representing of 167 Jordanian companies during 1989-2003 The results show that a firm capital structure has a significantly negative impact on the firm performance measures, in both the accounting and market measures An interesting finding is that the short-term debt to total assets level has a significantly positive effect on the market performance measure (Tobin’s Q), which could to some extent support Myers (1977) argument that firms with high short-term debt to total assets have a high growth rate and high performance Firm size is found to have a positive impact on a firm performance, as large firms have low bankruptcy costs The insignificance of the market performance measure PE indicates that the Jordanian equity market is not efficient, so the best performance measure is the accounting performance measure ROA

In Vietnam, Trần Hùng Sơn and Trần Viết Hoàng (2008) test the relationship between firm capital structure and performance by using data sample of 50 non-financial companies in Hochiminh Stock Exchange for the period September 2008 The results show that there is a positive correlation between a firm capital structure and performance The corporation performance has a strong quadratic or cubic correlation with the capital structure when they use the debt ratio under 100% The performance has a positive correlation with the capital structure when the debt ratio

is in the range from 0.9755 to 2.799 State owned ratio has negative impact on firm

efficiency, but firm growth, size (measured by logarithm of the firm’s assets) and tangibility had no significant impact on firm performance However, they have not used market performance measures and did not explore the optimal capital structure to maximize the performance of the firm They have not test the correlation between the distribution of debt ratio and corporate performance to each type of companies, as well as each industry

The concept of performance is a controversial issue in finance largely due to its multidimensional meanings Research on firm performance emanates from organization theory and strategic management (Murphy et al., 1996) Performance measures are either financial or organizational Financial performance such as profit maximization, maximizing profit on assets, and maximizing shareholders' benefits are at the core of the firm effectiveness (Chakravarthy, 1986) Operational performance measures, such as growth in sales and growth in market share, provide

a broad definition of performance as they focus on the factors that ultimately lead

to financial performance (Hoffer and Sandberg, 1987)

The usefulness of a measure of performance may be affected by the objective of a firm that could affect its choice of performance measure and the development of the stock and capital market For example, if the stock market is not highly developed and active then the market performance measures will not provide a good result The most commonly used performance measure proxies are return on assets (ROA) and return on equity (ROE) or return on investment (ROI) These accounting measures representing the financial ratios from balance sheet and income statements have been used by many researchers (e.g., Demsetz and Lehn, 1985; Gorton and Rosen, 1995; Mehran, 1995; and Ang, Cole and Lin, 2000)

However, there are other measures of performance called market performance measures, such as price per share to the earnings per share (PE) (Abdel Shahid, 2003), market value of equity to book value of equity (MBVR), and Tobin’s Q Tobin’s Q mixes market value with accounting value and is used to measure the firm's value in many studies (e.g., Morck, Shleifer, and Vishny, 1988; McConnel and Serveas, 1990; and Zhou, 2001) The performance measure ROA is widely regarded as the most useful measure to test firm performance (Reese and Cool, 1978; Long and Ravenscraft, 1984; Abdel Shahid, 2003, among others) The stock

market efficiency and other economic and political factors could affect a firm performance and its reliability (See Abdel Shahid, 2003)

Firm performance may also affect the choice of capital structure As Berger and Bonaccorsi di Patti (2006) point out, regressions of firm performance on leverage may confound the effects of capital structure on performance with the reverse relationship from performance on capital structure This reverse causality effect is

in essence a feature of theories considering how agency costs (Jensen and Meckling, 1976; Myers, 1977; and Harris and Raviv, 1990); corporate control issues (Harris and Raviv, 1988); and in particular, asymmetric information (Myers and Majluf, 1984; Myers, 1984) and taxation (DeAngelo and Masulis, 1980; and Bradley et al., 1984) are likely to affect the value of the firm

2.4.1 Model 1: The Leverage Model

Profitability (PROF) is used to measure firm performance to test the impact of firm performance on firm capital structure Profitability is calculated by pre-interest and pre-tax operating surplus plus depreciation divided by total assets There are conflicting theoretical predictions on the effects of profitability on leverage (Harris and Raviv, 1991; Rajan and Zingales, 1995; Barclay and Smith, 2001; and Booth et al., 2001) Myers and Majluf (1984) predict a negative relationship because they argue that firms will prefer to finance new investments with internal funds rather than debt According to their pecking order theory, because of signaling and asymmetric information problems, firms financing choices follow a hierarchy in which internal cash flows (retained earnings) are preferred over external funds, and debt is preferred over equity financing Thus, they argue, we should expect a negative relationship between past profitability and leverage On the other hand, using arguments based on the trade-off and contracting cost theories we can predict

a positive relation between profitability and leverage For example, the trade-off theory suggests that the optimal capital structure for any particular firm will reflect the balance (at the margin) between the tax shield benefits of debt and the increasing agency and financial distress costs associated with high debt levels (Jensen and Meckling, 1976; Myers, 1977; and Harris and Raviv, 1990) Similarly, Jensen (1986) argue that if the market for corporate control is effective and forces firms to pay out cash by levering up, then there will be a positive correlation between profitability and leverage Thus, the hypothesis 1 is:

H1: The firm profitability has a positive correlation with firm capital structure

Growth opportunities (GROWTH) are likely to put a strain on retained earnings and push the firm into borrowing (Michaelas et al., 1999) On the other hand, Myers (1977) argues that firms with growth potential will tend to have lower leverage He argues that growth opportunities can produce moral hazard effects and can push firms to take more risk This may explain why firms with ample growth opportunities may be considered as risky and thus face difficulties in raising debt capital on favorable terms Thus, hypothesis 2 can be stated as follows:

H2: Growth opportunities decrease firm leverage

Firm size (SIZE) is measured by the logarithm of the firm’s sales (Titman and Wessels, 1988; Rajan and Zingales, 1995; and Ozkan, 2001) As larger firms are more diversified and tend to fail less often than smaller ones, I would expect that size will be positively related to leverage However, Rajan and Zingales (1995) discuss the possibility that size may also be negatively correlated with leverage They argue that size may act as a proxy for the information outside investors have, and that informational asymmetries are lower for large firms which implies that large firms should be in a better position to issue informational sensitive securities such as equity rather than debt Thus, hypothesis 3 can be stated as:

H3: Firm size is expected to have a positive influence on a firm capital structure

Asset Tangibility (TA) is measured by the ratio of fixed tangible to total assets (Titman and Wessels, 1988; Rajan and Zingales, 1995; Frank and Goyal, 2003; and Hall et al., 2004) The existence of asymmetric information and agency costs may induce lenders to require guarantees materialized in collateral (Myers, 1977; Scott, 1977; and Harris and Raviv, 1990) For example, if a firm retains large investments

in land, equipment and other tangible assets, it will normally face smaller funding costs compared to a firm that relies primarily on intangible assets Moreover, Berger and Udell (1994) show that firms with close relationship with creditors need

to provide less collateral They argue this is because the relationship (and more informed monitoring by creditors) substitutes for physical collateral If so, I should find tangibility mattering less in the “bank oriented” countries Thus, I would expect that tangibility should be positively related to debt And, hypothesis 4 is:

H4: Asset Tangibility is expected to be positively related to corporate leverage

I use the basic ordinary least squares regression model to test the hypotheses that a firm profitability, growth opportunities, size, asset tangibility influence its capital structure for my data The empirical models to be estimated as follows:

Model 1: yi = β0 + β1PROFi + β2Growthi + β3Sizei + β4TAi + u

Where i refers to the individual companies, and y is leverage for firm i The

independent variables are represented by Prof, Growth, Size and TA Four

measures of leverage are used in the study: total debt to total assets (TDTA), total debt to total equity (TDTE), long-term debt to total assets (LTDTA), short-term debt to total assets (STDTA)

i

Based on the hypotheses, the author presents the leverage model (Figure 1):

• Dependent variable: Firm Capital Structure is alternatively measured by total debt to total assets (TDTA), total debt to total equity (TDTE), long-term debt to total assets (LTDTA), short-term debt to total assets (STDTA)

• Independent variables: Firm Profitability, Firm Growth, Firm Size, Firm Asset Tangibility

2.4.2 Model 2: The Firm Value Model

A firm performance could be affected by the capital structure choice and by the structure of debt maturity Debt maturity affects a firm investment options Also, the tax rate is expected to have an impact on a firm performance So, investigating the impact of capital structure variables on a firm performance will provide evidence of the effect of capital structure on firm performance

The author uses two measures of corporate market performance, known as firm value: market value of equity plus book value of debt to the book value of assets (Tobin’s Q), and price per share to the earnings per share (PE) Tobin’s Q has been used as a major indicator of firm performance Even Tobin’s Q, as agreed by many researchers, is a noisy signal Because of the limitations of Tobin’s Q, other performance measures, PE is employed as supplementary measures Using market measures of performance may shed light on the stock market activity and if there is other factors that may affect corporate performance

If capital structure does affect a firm performance and value, then a strong correlation between the firm performance and capital structure would be found So,

I argue that a firm debt ratio affects its performance and value negatively Furthermore, it has been argued that short-term debt influences a firm performance negatively, because short-term debt exposes firms to the risk of refinancing It is expected that the debt maturity ratios (short-term debt and long-term debt) will have a significant impact on corporate performance because of the banking credit policy Thus, the hypothesis is:

H5: A firm capital structure does influence its market performance

Myers (1977) argues that firms with high growth opportunities have high agency costs of debt and will be able to borrow less In contrast, the pecking order theory suggests that high growth firms have a greater need for funds and therefore can be expected to borrow more Wei Xu (2005) shows that there is a strong positive correlation between growth and return on equity (ROE) So, it is expected that firms with high growth opportunities have a high value, as growth firms are able to generate profit from investment Growth opportunities are expected to positively affect a firm market performance Thus, hypothesis 6 can be stated as follows:

H6: Growth opportunities increase firm market performance

A firm size is measured by log of sales (SIZE) The firm size is hypothesized to be positively related to the firm performance, as bankruptcy costs decrease with size

Thus, a firm size is expected to have a positive influence on a firm performance, because potential bankruptcy costs make up a smaller proportion of value for larger firms In addition, there are economies of scale in transactions costs associated with long-term debt that are not available to smaller firms Gleason, among others, finds that firm size has a positive and significant effect on firm performance (ROA) Tian & Zeitun (2007) find that firm size has a positive and significant impact on firm performance ROA, PROF, and Tobin’s Q In contrast, many other researchers such as Mudambi and Nicosia (1998), Lauterbach and Vaninsky (1999), Durand and Coeuderoy (2001), and Tzelepis and Skuras (2004) have found an insignificant effect of firm size on the firm performance Based on this discussion, hypothesis 7 can be stated as:

H7: A firm size is expected to have a positive influence on a firm market

performance

I use the basic ordinary least squares regression model to test the hypotheses that a firm capital structures influence its market performance for my data The empirical models to be estimated as follows:

Model 2: yi = β0 + β1Leveragei+ β2Growthi + β3Sizei + u

Where i refers to the individual companies, y is alternatively Tobin’s Q, PE, for

firm i as a measure of market performance The independent variables are

represented by Leverage, Growth and Size Four measures of leverage are used in

the study: total debt to total assets (TDTA), total debt to total equity (TDTE), term debt to total assets (LTDTA), short-term debt to total assets (STDTA) I use more than one proxy for leverage as different hypotheses for leverage were developed to investigate their effect on corporate value For example, the STDTA and LTDTA are used to investigate the effect of short-term and long-term debt on a firm performance The proxy of TDTE was used in the study to validate the result

long-i

Based on the hypotheses, the author presents the empirical model (Figure 2):

• Dependent variable: Firm Value is alternatively measured by Tobin’s Q, PE

• Independent variables: Firm Leverage, Firm Growth, Firm Size

CHAPTER 3: RESEARCH DESIGN

Based on the research objectives and scope, research methodology concerned in chapter 1, and literature review and empirical model presented in chapter 2, this chapter particularly presents the research methodology, data, research design and research process

As mentioned in the chapter 1, the author was interested in examining the relationship between firm profitability, size, growth opportunities, asset tangibility and capital structure, as well as exploring the effect of capital structure on corporate market performance of listed firms in Hochiminh Stock Exchange

This study used the accounting and market data of 171 listed companies in the Hochiminh Stock Exchange (HOSE) for the period 2008 The data set contained detailed information of each firm The items of interest were: balance sheets, income statements, interest paid, depreciation, and market valuation By law, the full financial statements were available from firms This data set was collected from Vietnam Financial Information Company website (www.vinabull.com)

This study was a quantitative research based on ordinary least square regression model to estimate the relationship between firm profitability, size, growth opportunities, asset tangibility and capital structure, and the effect of capital structure on corporate market performance The research process was presented as figure 3:

3.3.1 Research Sample

As mentioned in the Chapter 1, I was interested in examining the relationship between firm profitability, size, growth opportunities, asset tangibility and capital structure, as well as explore the effect of capital structure on corporate market performance of listed firms in Hochiminh Stock Exchange

Literature Review

(Capital Structure, Firm Performance, Hypotheses, Model)

Colleting financial statement of 171 companies

in HOSE (n=171)

Test the regression model

(Adjust the sample to n=162)

Writing the report

Figure 3: Research Process

The author used a sample of 171 companies listed in Hochiminh Stock Exchange from the 2008 Annual Enterprise Financial Statements The financial statements, which I needed for the study, contained: balance sheets and income statement I also collected the market valuation of these companies stock in HOSE on 31 December 2008, in order to measure Tobin’s Q and price per share to the earnings per share (PE) of corporate market value performance

After collecting the data set, the author excluded 7 financial companies, such as banks, insurance firms, funds and financial firms, in this analysis as their characteristics are different Two manufacturing corporations, Bach Tuyet Cotton Corporation (BBT) and Tribeco Saigon Beverages Joint Stock Company (TRI), were also excluded from the data set Bach Tuyet Cotton Corporation had failed to deliver its statement for 2008, while the equity of Tribeco Saigon Beverages Joint Stock Company was negative in its balance sheets due to its bad business in 2008 Consequently, the final data set included 162 listed companies in HOSE

3.3.2 Data Analysis Method

After having the final data set, I used formulas that are defined in the Appendix A

to calculate the explanatory variables Subsequently, I encoded and input data by Eviews 6 for Windows

3.4.1 Dependent Variables

I used total debt to total assets (TDTA), total debt to total equity (TDTE), term debt to total assets (LTDTA), short-term debt to total assets (STDTA) as proxies for firm leverage These proxies could be easily collected from the balance sheet These measures were used by Zeitun and Tian (2007)

long-Table 1: Dependent variables for model 1

3.4.2 Independent Variables

Profitability was measured by pre-interest and pre-tax operating surplus plus depreciation divided by total assets Profitability was used by many researchers (Titman and Wessels, 1988; and Fama and French, 2002; Margaritis and Psillaki, 2007)

Growth opportunities were measured by growth of assets and were defined by book value of total assets minus book value of equity plus market value of equity divided

by the book value of total assets Growth opportunities were presented by Myers (1977) and were used by many researchers (e.g., Zeitun and Tian, 2007, Wei Xu,

2005, Margaritis and Psillaki, 2007)

Firm size was defined by log of sales These measures were used by many researchers (e.g., Mudambi and Nicosia, 1998, Lauterbach and Vaninsky, 1999, Durand and Coeuderoy, 2001, Tzelepis and Skuras, 2004)

Asset Tangibility was defined by the ratio of fixed tangible assets to total assets These measures were used by many researchers (e.g., Titman and Wessels, 1988, Rajan and Zingales, 1995, Frank and Goyal, 2003, Hall et al., 2004)

Table 2: Independent variables for model 1

Firm performance was defined by Profitability PROF

3.5.1 Dependent Variables

In order to investigate whether the market performance measures were explained

by capital structure, I used market value of equity plus book value of debt to the book value of assets (Tobin’s Q), and price per share to the earnings per share (PE)

as proxies for firm value These measures were used to measure firm value in many studies (e.g., Morck, Shleifer, and Vishny, 1988, McConnel and Serveas, 1990, and Zhou, 2001)

Table 3: Dependent variables for model 2

Market value of equity plus book value of debt to the

book value of assets

TOBIN Price per share to the earnings per share PE

3.5.2 Independent Variables

I used total debt to total assets (TDTA), total debt to total equity (TDTE), term debt to total assets (LTDTA), short-term debt to total assets (STDTA) as proxies for firm leverage

long-Others independent variables such as firm size (SIZE) and growth opportunities (GROWTH) were the same as independent variables in Model 1

Table 4: Independent variables for model 2

3.6 FRAMEWORK OF THE STUDY

The framework of the study was presented as figure 4:

RESEARCH PROBLEM

LITERATURE REVIEW

HYPOTHESES

REGRESSION ANALYSIS

DESCRIPTIVE STATISTICS

CONCLUSIONS, RECOMMENDATIONS AND LIMITATIONS EMPIRICAL MODEL

INTRODUCTION

RESEARCH QUESTIONS

RESEARCH OBJECTIVES

Figure 4: Framework of the study

3.7 SUMMARY

The study was done by quantitative research method with sample size 162 The object of the study was all companies listed on Hochiminh Stock Exchange for the period 2008 The performance factors were measured by market value of equity plus book value of debt to the book value of assets (Tobin’s Q) and price per share

to the earnings per share (PE) The leverage factors were measured by total debt to total assets (TDTA), total debt to total equity (TDTE), long-term debt to total assets (LTDTA), short-term debt to total assets (STDTA) The author also used other variables to investigate their effect on corporate performance and corporate capital structure: firm growth opportunities (GROWTH), firm size (SIZE) and asset tangibility (TA)