The impact of credit ratings on capital structure (the case of listed companies on hose)

Abstract This research aims to examine the impact of credit ratings influencing the capital structure of listed enterprises on Hochiminh Stock Exchange.. The thesis has two empirical mod

THE IMPACT OF CREDIT RATINGS

ON CAPITAL STRUCTURE (THE CASE OF LISTED COMPANIES ON HOSE)

In Partial Fulfillment of the Requirements of the Degree of

MASTER OF BUSINESS ADMINISTRATION

In Finance

By Ms: Nguyen Thi Tuong Van ID: MBA06044 Advisor: Dr Nguyen Kim Thu

International University - Vietnam National University HCMC

August 2014

THE IMPACT OF CREDIT RATINGS

ON CAPITAL STRUCTURE

In Partial Fulfillment of the Requirements of the Degree of

MASTER OF BUSINESS ADMINISTRATION

In Finance

By Ms: Nguyen Thi Tuong Van ID: MBA06044 International University - Vietnam National University HCMC

Acknowledge

To complete this thesis, I have been benefited from the following people:

First of all, I would like to express my sincere gratitude to my advisor, Dr Nguyen Kim Thu, who inspired and recommended me the research idea and always instructed me dedicatedly and enthusiastically during the time I conducted this thesis Whenever I meet difficulty, she always gives me the solutions, provide me the necessary documents and raise up my knowledge to continue doing my thesis

Secondly, I want to show my gratefulness to the professors and lecturers for giving us their valuable knowledge during the study period This is the foundation for this thesis completion

Next, a sincere thank you is sent my family who always stand beside me Thanks for their continuously encouraging and supporting me to follow and complete the MBA program

of International University I cannot finish my thesis on time without their contribution

Last but not least, I want to thank all my friends in MBA06 and MBA07, especially Ms Tran Hong Quynh, Ms Do Thi Hoang Anh, Mr Nguyen Thanh Tuan, Mr Tran Le Duy,

Ms Le Tran Nguyen Nhung, Mr Nguyen Quy Vu for your share and encouragement

Ho Chi Minh City, August 2014,

Nguyen Thi Tuong Van

Plagiarism Statements

I would like to declare that, apart from the acknowledged references, this thesis either does not use language, ideas, or other original material from anyone; or has not been previously submitted to any other educational and research programs or institutions I fully understand that any writings in this thesis contradicted to the above statement will automatically lead to the rejection from the MBA program at the International University – Vietnam National University Hochiminh City

Copyright Statement

This copy of the thesis has been supplied on condition that anyone who consults it is understood to recognize that its copyright rests with its author and that no quotation from the thesis and no information derived from it may be published without the author‘s prior consent

© Nguyen Thi Tuong Van/ MBA 06044/ 2014

Table of Contents

CHAPTER I: INTRODUCTION 1

1.1 Background and research problems 1

1.2 Research Questions 2

1.3 Contributions of the research 3

1.4 Research Methodology 3

1.5 Scope and Limitation 4

1.6 Structure of Research 4

CHAPTER 2: LITERATURE REVIEW 5

2.1 Credit ratings 5

2.1.1 Introduction of credit ratings 5

2.1.2 Credit ratings agencies 7

2.1.2.1.Foreign market 7

2.1.2.2.Vietnam market 9

2.2 Capital structure 11

2.2.1 Theories of capital structure 11

2.2.1.1.The Irrelevance Theory of Capital Structure 11

2.2.1.2.The Taxes theory of Capital Structure 12

2.2.1.3.The Trade-off Theory 13

2.2.1.4.Pecking Order Theory 15

2.2.1.5.Agency Cost Theory 16

2.2.2 Previous empirical studies of determinant of capital structure17 2.2.2.1 Size 17

2.2.2.2.Growth Opportunities 18

2.2.2.3.Tangibility 19

2.2.2.4.Profitability 19

2.2.2.5 Industry level factor 20

2.3 The impact of credit ratings on capital structure 23

2.3.1 Foreign researches 23

2.3.1.1 Kisgen Darren J (2003, 2006, 2009) 23

2.3.1.2 Berlekom, Bojmar and Linnard (2012)and Kemper and

Rao (2013) 25

2.3.1.3 Agha (2011) 25

2.3.1.4 Helene and Hårstad (2012) 26

2.3.1.5 Drobetz and Heller (2014) 29

2.3.1.6 Naeem, Shammyla (2012) 30

2.3.2 Vietnam researches 33

CHAPTER 3: COLLECTION AND RESEARCH METHODOLOGY 40

3.1 Data collection 40

3.2 Reason for selecting CRVC credit ratings 40

3.3 Choosing Variable and Description 41

3.3.1 Dependent variable 41

3.3.2 Credit ratings 43

3.3.2 Control variable 43

3.4 Methodology 47

3.4.1 Model 1: The Impact of Credit rating score on Capital Structure47 3.4.2.Model 2: The impact of Credit Rating changes on Capital

Structure 48

3.4.3 Rung regression model 49

CHAPTER 4:DATA ANALYSIS 52

4.1Descriptive Analysis 52

4.2 Result analysis 53

4.2.1 Correlation Matrix 53

4.2.2 Test for Heteroskedasticity 54

4.2.3 Panel regression model analysis 54

4.2.4 Empirical Results 56

CHAPTER 5: CONCLUSION 59

5.1 Main finding of the thesis 59

5.2 Limitations of The Thesis 60

5.3 Recommendations 60

5.4 Suggestion for future research 61 REFERENCE 62 APPENDICES 70

List of Abbreviation

CRVC Credit Ratings Vietnamnet Center

S&P Standard & Poor's

Vietnam Credit Vietnam Credit Information and Rating Company

List of Tables

Table 1: The Credit Ratings description 6

Table 2: Credit Rating Definition by the Big Three CRAs 9

Table 3: Classification criteria1 11

Table 4: M&M (1963): A correction of irrelevance model of capital structure 12

Table 5: Summary of previous empirical studies 20

Table 6: Summary of previous empirical studies 34

Table 7: Credit ratings transform 43

Table 8: Industry level factor for each industry 46

Table 9: Fixed Versus Random Effect 50

Table 10: Model 1 summary statistics 52

Table 11: Model 2 summary statistics 52

Table 12: Correlation Matrix 53

Table 13: The result of test for Heteroskedasticity 54

Table 14: Analysis result of Pool OLS FEM, REM 54

Table 15: The result of F-test 55

Table 16: The result of Hausman test 56

Abstract

This research aims to examine the impact of credit ratings influencing the capital structure of listed enterprises on Hochiminh Stock Exchange The research data were collected from 239 listed enterprises over the period of 4 years in the period between

2009 and 2012 to use for Panel data method The research would conduct test assumptions to define the optimal regression model among Pooled OLS, Fixed Effects Models and Random Effect Model

The thesis has two empirical models :

- The first empirical model investigates whether the firm which has a higher credit rating, have lower financial leverage than those with lower credit ratings The study finds that credit ratings are an important determinant of the capital structures of firms and that there is a strong relationship between credit ratings and capital structures

- The second empirical model examines the influence of the change of credit ratings between each year on the short term debt to equity of listed firms on Hochiminh stock exchange Consistent with the predictions, the results indicate that firms‘ change of credit rating significantly influenced on the following year‘s short term debt of the firm

Keywords: credit ratings, capital structure

CHAPTER 1: INTRODUCTION

This section provides the content of the study, section 1.1 discusses research’s background and research problems Based on that, section 1.2, 1.3 and section 1.4 present the research questions, contribution of the research and research methodology are specified Next, the scope and significance are as well listed out in section 1.4 Finally, section 1.5 provides the organization of the thesis

1.1 Background and research problems

Credit ratings is a terminology that has become a widely accepted measure of firms‘ creditworthiness in financial markets They like a tool that has established credit standards in the market, which have received regulatory attention in several countries as well (Pinto, 2006) For corporations that need to raise funds in the financial market, credit ratings have important implications, since lower ratings lead to higher funding costs, and vice versa (Boot and Milbourn, 2002) Moreover, credit ratings are also an important part

of investment decisions of institutional investors Cantor & Packer (2007) state that 86%

of fund managers explicitly use ratings in their investment guidelines Similarly, the research of Graham and Harvey (2001) demonstrates that the credit rating is one of the most important factors affecting capital structure decisions Kisgen & Strahan (2010) argued that the credit ratings matter because it serves as a signal of firm quality for investors and therefore affects the company‘s capital structure

Despite a continuous reliance on rating agencies by regulators, investors and firms along with the significant growth of rating agencies globally, academic studies generally tend to underestimate the relevance of credit ratings for firms‘ financial structure decision-making After the recent financial crisis of 2008, it becomes imperative to investigate the role and significance of their output for the firms‘ financing decisions to assess the importance of credit rating agencies in the financial markets (Naeem, Shammyla, 2012)

A recent study by Bacon, Grout & O‘donovan (2009) of 43 senior treasury professionals from nonfinancial UK firms, indicates that ratings have become more important during the recent crisis, while the firms without ratings sought to obtain them during this period

necessitates further exploration of how this factor can be influential in determining the financial structure of firms

The number of previous studies exploring the relationship between credit ratings and capital structure are limited Kisgen is said to be a pioneer in the study of this relationship Kisgen et al (2006, 2009, 2010) Michelsen and Klein (2011), Kemper and Rao (2013) used credit ratings – capital structure model to test the relevance of credit ratings with capital structure in the US market However, the result of Kemper and Rao (2013)‘s study contrast to two previous studies Sundheim and Hårstad (2012) used multiple regression models to test the effect of credit ratings, among other factors , on capital structure in the Norwegian market The study had the same result with Kisgen (2006), Michelsen and Klein (2011) To our knowledge, there has been a research on the effect of credit rating changes in stock returns and capital structure of listed companies in Vietnam by Ms Pham Quynh Chau (2011) Her data base on Credit Information Center and the model‘s variable are different from this research and she choose long-term debt/total assets as her model‘s proxy Moreover, she did not examine the impact of credit ratings on capital structure Base for some reasons above, this opens a new direction for determining the impact of credit ratings on capital structure

1.2 Research questions

Research questions As stated earlier, this research aims at examining the relationship between credit ratings and capital structure for listed firms on HOSE In particular, the research examines if the firms that have high credit ratings will have lower financial leverage than those with low credit ratings In addition, the thesis will verify if firm has a positive change of credit rating will borrow less than others

Based on the research objectives, the following two questions will be answered in the research:

Do firms with higher credit ratings have lower financial leverage than those with lower credit ratings ?

The firm have a high credit ratings that providing them with a higher incentive to maintain their credit ratings than other rated firms in the market Therefore, high rated

firms are expected to have a high concern for benefits enjoyed by their credit ratings and thus have low levels of gearing

- Is there a negative relationship between the range of credit ratings changes of the firm and the following short term debt to equity ratio?

The implications of the credit rating – capital structure hypothesis are tested by examining whether firms follow a pattern of leverage change behavior after they have been changed in credit ratings

1.3 Contributions of the research

Capital structure remains one of the most well researched topics in finance literature, where several key aspects of the subject have already been explored Currently, in Vietnamese market, there have been a number of researches on capital structure and the determinants of capital structure However, there is little research on credit ratings in general as well as on the relationship between credit rating and capital structure Kisgen (2006) stated that ―future capital structure research would benefit from including credit ratings as part of the capital structure framework, both to ensure correct inferences in capital structure empirical tests, and more generally, to obtain a more comprehensive depiction of capital structure behavior‖ (p.1069) This thesis offers, an in depth analysis

of the relevance of credit ratings to the financial structure of HOSE firms, and thus makes

a number of contributions to finance literature The findings of this study suggests that credit ratings are important for firms in getting access to the Vietnamese debt markets For the rated firms specifically, credit ratings are one of the important factors in determining the level of leverage

1.4 Research methodology

This research uses quantitative research methods to examine the relationship between credit ratings and capital structure Literature review with relating theories and empirical researches provide orientation for the study and determine factors to investigate in the regression model Quantitative methods with the support of analyzing tools including Eviews, Stata and Excel are applied for the regressions, and statistical tests Data sources

of this thesis are from financial statements of listed firms on Hochiminh Stock Exchange and credit rating results of Credit Ratings Vietnamnet Center (CRVC)

1.5 Scope and limitation

This study focuses on testing the relationship between credit ratings and capital structure

of companies listed on HOSE within 4 years, from 2009 to 2012 Therefore, this study has just conducted research on listed companies in HOSE, so the results cannot be applied to all unlisted companies and companies listed on HNX

1.6 Structure of research

Besides the Introduction, the thesis has four more chapter:

- Chapter 2 provides details of the general background of the rating agencies in the world and Vietnam credit rating agencies, their operations and their significance This chapter also reviews the important theories of capital structure and presents the relevant empirical evidence about the relationship between credit rating and capital structure

- Chapter 3 discusses the methodology adopted in the present study Specifically, it presents the data collection procedures, models and the variables for the two empirical chapters of the thesis

- Chapter 4 investigates the relationship between the level of credit ratings and the leverage structure of listed firm on HOSE Specifically, it presents the descriptive statistics of the sample used in the analysis and the empirical results The section applies quantitative method with the support of analyzing tools including Excel

2007, Eviews 8.0 and Sata 12.0

- Finally, Chapter 5 concludes the thesis by summarizing the key findings,

discussing the limitations of the study and offers recommendations for future research

CHAPTER 2: LITERATURE REVIEW

2.1.Credit ratings

2.1.1 Introduction of credit ratings

According to Naeem, Shammyla (2012), credit rating is an economic term, which estimates the credit worthiness of a borrower in general terms or with respect to a particular debt or financial obligation A credit rating helps in the assessment of the solvency of the particular entity that seeks to borrow money such as an individual, corporation, state or provincial authority, or sovereign government Regulatory bodies and rating agencies define themselves in their own ways These ratings based on detailed analysis of various credit rating agencies (CRAs) CRAs does not rely on mathematical formulas to evaluate credit rating, instead, they use their judgment and experience in determining what public and private information should be considered in giving a rating

In other words, credit rating analysis of a corporate issuer typically considers many financial and non-financial factors, both qualitative and quantitative Credit ratings evaluation base on economic, regulatory, and geopolitical influences; management and corporate governance attributes; key performance indicators; competitive trends; product-mix considerations; R&D prospects; patents rights; and labor relations (Meinna G – 2013)

Credit ratings are a set of alphabetic codes assigned in descending order according to the rising likelihood of default They may also include numerical codes or symbols, depending on the rating agencies, to show the relative standing within each set of broad category of alphabetic codes (Naeem, Shammyla,2012) For example, Standard and Poor‘s assigns alphabetic codes such as AAA, AA, A, BBB, BB and so on, with ‗+‘ or ‗-‘ modifiers (AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB- and so on) to show the respective creditworthiness within the broad rating category, whereas Moody‘s assign numerical modifiers (Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3 and so on) to the alphabetic codes (Aaa, Aa, A, Baa and so on)

Nguyen Duc Huong (2012) claim that credit ratings represent riskiness of the companies and bonds, thus they have been extensively used by bond investors, debt issuers, and government officials Lower credit ratings result in higher borrowing costs because the

corporate credit ratings play a critical role in the provision of information to evaluate and decide the credit problems, when enterprises want to have a frequent need for loans and want to set up a long-term relationships with banks or investors Thus building a corporate credit rating system is not only helpful for the banks and investors in evaluating the possibility of loan recovery, but also helpful for enterprises in evaluating its position compared with other businesses Despite the importance of credit ratings Vietnam has not promulgated in any legal documents regarding corporate credit rating

Caa3 CCC- Default imminent with little

Ca CC prospect for recovery

Table 1: The Credit Ratings description

Source: Boehm Kristina (2013)

2.1.2 Credit ratings agencies

Sylla (2002) presented that credit rating agencies originated in the US market, in the early

20th century, due to the expansion of financial activities in the US and globally, apart from investors, financial regulators were also demanding wider disclosure in terms of firms‘ financial standings Moody‘s, recognizing the need, formed the first formal rating agency in 1909 (Sinclair, 2005) Following Moody‘s, Standard Statistics Company and Fitch Publishing Company also emerged in this period Since their inception, credit rating agencies gradually became an important intermediary specializing in the provision of reliable appraisals of the creditworthiness of the firms and countries Due to the desired attributes and general acceptability of credit rating agencies within the financial markets, they soon gained recognition from regulatory bodies (Naeem, 2012)

According to Jacob de Haan and Fabian Tenbrink (2011) CRAs essentially provide two services First, they offer an independent assessment of the ability of issuers to meet their debt obligations, thereby providing ―information services‖ that reduce information costs, increase the pool of potential borrowers, and promote liquid markets Second, they offer

―monitoring services‖ through which they influence issuers to take corrective actions to avert downgrades via ―watch‖ procedures

A Moody‘s research in 2002 said that in the case of upgrades, that can mean greater capital market access and interest cost savings for issuers, and improved securities prices for investors In the case of downgrades, it can mean higher capital costs for issuers, and portfolio turnover and losses for investors; most dramatically, however, it can terminate

an issuer‘s access to capital, possibly even leading to default Especially in the case of

downgrades, the potentially self-fulfilling nature of ratings requires that CRAs particularly endeavor to avoid ―false‖ negative predictions (Jerome S Fons, Richard Cantor and Christopher Mahoney – 2002)

2.1.2.1 Foreign market

In an analysis by Claire A (2002), The World Big Three of credit rating agencies (CRA) are Standard & Poor‘s (S&P), Moody‘s, and Fitch Group They cover approximately 96% of the world market S & P and Moody‘s are the United State companies and account for 44.82% and 38.25% market share respectively Meanwhile, Fitch Group is operated by a French and accounts for about 13.25% of market share

Figure 1: Market share of credit ratings agencies

Source: US Securities and Exchange Commission (SEC) website, http://www.sec.gov/ (Accessed 18 Apr 2011)

Standard

& Poor's 45%

Moody's 38%

Fitch Group 13%

Other 4%

Table 2: Credit Rating Definition by the Big Three CRAs

Source: Boehm Kristina (2013)

Fitch Ratings Definition Moody‘s Ratings Definition Standard & Poor Ratings

Definition

―Fitch Ratings‘ credit

ratings provide an opinion

on the relative ability of an

entity to meet financial

agency‘s published default

histories that may be

measured against ratings at

the time of default Credit

ratings are opinions on

relative credit quality and

not a predictive measure of

probability.‖ Fitch, 2013)

Moody‘s rates and publishes independent credit opinions on fixed income securities, issuers of securities and other credit obligations

Investors use Moody‘s ratings to help price the credit risk of fixed income securities or debts they may buy, sell or lend.‖ (Moody‘s 2013)

‖ a forward-looking opinion about the creditworthiness

of an obligor with respect to

a specific financial obligation, a specific class

of financial obligations, or a specific financial program.‖ (Standard & Poor‘s 2013a)

2.1.2.2 Vietnamese market

According to Nguyen Duc Huong (2012), Vietnam CRAs are still very young, they are still in the process of building database and the credit rating system Theirs credit rating system are borrowed from other CRAs around the world and have not been unified for

Vietnamese market yet Moreover, the lack of expert is also a weak point for the credit rating industry in Vietnam Currently, there are several CRAs in Vietnam, including :

Credit Information Center (CIC) is a credit rating agency of the State Bank of Vietnam

The CIC‘s database is a unique database in Vietnam, which contains more than 600,000 business records and 20 million individual records CIC mainly provides credit ratings of non-financial companies and their reports are used by both the State Bank of Vietnam and financial institutions

Vietnam Credit Information and Rating Company (Vietnam Credit) is the first rating

agency in Vietnam They have worked with corporate credit profile since 1996 Their reports based on the standards of the world‘s major institutions such as Standard & Poor‘s, Moody‘s, Fitch … VietnamCredit is a member of Asian Credit Information Gateway (ASIAGATE)

Credit Ratings Vietnamnet Center (CRVC) started operations from June 2005 CRVC are

sponsored by government offices and they refer to the evaluation process of the Big Three to build a consistent credit rating system in Vietnam The Center recruits professional, researchers deep understanding of credit ratings According to CRVC, on 09/08/2012 CRVC has signed an agreement with Risk Management Institute of the National University of Singapore (RMI), which is the leading research and training organization within the region in the fields of risk management, including credit ratings

To estimate credit ratings,: CRVC use 54 financial indicators, calculated from financial statements of the company After that, they choose the most significant indicator and base

on discriminant function and classification criteria to make CRVC‘ Credit ratings For example they use the following function to determine the credit rating (the Z score) of firms:

Z= -0,352 – 3,118X4 + 2,763 X 8 – 0,55X22 – 0,163X24 + 6,543X29 + 0,12X53

In which:

 X4 is the ratio of total loans / total assets

 X 8 is the ratio of working capital / total assets

 X22 is the ratio of receivables / net sales

 X24 is the ratio of receivables / liabilities

 X29 is the ratio of profit before interest and taxes / total assets

 X53 is the ratio of profit after tax / equity

Table 3: Classification criteria

2.2.1 Theories of capital structure

To date, capital structure remains one of the most chosen research topics in the finance literature Most researches base on several outstanding theories which explain the relevance of capital structure, including tax related theories (Modigliani and Miller, 1963; Miller, 1977; DeAngelo and Masulis, 1980), trade-off theories (Kraus and Litzenberger, 1973; Scott, 1976; Kim, 1978), pecking order theory (Myers, 1984; Myers and Majluf, 1984) and agency cost theories (Jensen and Meckling, 1976; Jensen, 1986) This section will discuss the major theories of capital structure and some factors that have impacts on capital structure

2.2.1.1.The Irrelevance Theory of Capital Structure

Before Modigliani and Miller (MM) (1958), there was no accepted theory of capital structure They argued that the choice of debt or equity to finance assets does not impact

on firm value, shareholders can replicate the firm‘s capital structure without incurring

any additional costs and any change in the firm‘s capital structure is irrelevant to the shareholders Hence, according to this theory, the optimal capital structure of the firm does not exist Noted that this theory was based on a set of assumptions including perfect and frictionless markets with perfect substitution of financing types, where there was no transaction cost, constraining regulation, default risk, taxation or information asymmetry and the firms are homogeneous in nature (Naeem, Shammyla, 2012)

2.2.1.2.The Taxes theory of Capital Structure

In 1963, Modigliani and Miller loosened the assumption of no corporate income tax Accordingly, they recognized the value of the tax deductibility of the interest payments for the capital structure Modigliani and Miller (1963) argue that given the value of the tax shield, an optimal decision for firms would be to use as much debt as the firm can get,

as this would lead to increased value of the firm This would imply a near exclusion of equity financing The value of the levered firm would therefore be equal to that of the unlevered firm plus the value of the debt tax shield, thus, the value of corporation can be maximized value when it has 100% debt In reality, personal taxes, bankruptcy costs, information asymmetry and agency costs can be quite onerous and can be incurred, especially firm that are experiencing bankruptcy issues have high legal and accounting related expenses, costs of debt covenants as well as the potential loss of clients or suppliers, impaired ability to conduct business (Tran Thanh Huy, 2013)

Without Taxes With Taxes

Table 4: M&M (1963): A correction of irrelevance model of capital structure

Source: Corporate Finance (Ross, Westerfield, Jaffe and Jordan, 2008)

Where

- Rd: the interest rate (cost of debt)

- Re: the return on equity (cost of equity)

- Ro: the return on unlevered equity (cost of capital)

- D: the value of debt

- E: the value of levered equity

- T: the corporate tax rate

2.2.1.3.The Trade-off Theory

According to Luigi P and Sorin V (2009), the original version of the trade-off theory grew out of the debate over the Modigliani Miller (1963) Following the telling of Naeem, Shammyla (2012), studies by Kraus and Litzenberger (1973), Scott (1976) and Kim (1978) formally introduce bankruptcy cost into their models to explain a firm‘s choice of capital structure These studies suggest that firms can achieve a finite and an optimal capital structure by offsetting the present value of the tax shields and the expected cost of bankruptcy Trade off theory by Scott (1977) demonstrated that as the increase of the ratio of bonds, the risk of the company will also increase, thus raising the bankruptcy cost and decreasing firm value

Scott proposed that firms can issue more debt as long as it is backed up by collateral since these collaterals can serve as security for lenders as well as the fact that in the case

of default, debt can be recovered through liquidating or selling off the assets

Myers (1984) recognized that firms may have different capital structures, firms with fairly high profit income levels and safe fixed assets may have high target debt/equity ratios as they have larger profits to service interest payments without incurring adverse financial distress costs, whereas firms that are experiencing losses or a slump in earnings and risky assets may choose to rely more heavily on equity funding The studies of Deanglo and Masulis, (1980); Fischer el al., (1989), Warner (1977) and Altman, (1984) support for this theory

Figure 2: Trade-off theory’s Capital structure (The Optimal Capital Structure, the Value

of the Firm and the Cost of Capital)

Source: Ross, Westerfield, Jaffe and Jordan (2008)

Figure 2 above shows the flat value of an all equity financed firm in contrast with the sharply rising value of a firm with debt financing under MM (1963) The difference in value between the all equity financed firm and the firm that utilizes debt finance being the present value of the tax deductibility of interest payments Trade-off theory, however incorporates the effects of financial distress costs, which MM (1963) neglects Trade-off theory shows that at point X0 financial distress costs become material for increasing levels of debt and start showing adverse impacts on the firms rate of value growth The value of the firm is maximized at point X0 and it is at this point that the level of debt financing is at an optimum For levels of debt financing beyond point X0 the costs of financial distress become so onerous that the value of the firm starts to decline The point X0 as the level of debt where the value of the firm is maximized as also the level at which the Weighted Average Cost Of Capital (WACC) is minimized Thus, per trade-off theory, a financial manager seeking to maximize the value of their firm should seek to minimize the WACC of that firm

2.2.1.4.Pecking Order Theory

In the process of the development of capital structure theory, Donaldson (1961) elaborated the Pecking order theory and this theory was clearly articulated by Myers (1984) There are some main point of this theory:

Asymmetric information: Pecking order theory indicates that managers can use capital structure as a mean with which to communicate information to outsiders about their superior quality of the firms (Naeem, Shammyla, 2012) Ross (1977) explained that managers have better information about the true quality of their firms and by issuing high levels of debt, they signal their firms‘ superior quality to the outsiders If managers have unfavorable information regarding the prospects of the firm, they are likely not to take on more debt, which would otherwise expose them to bankruptcy risks This can result in a separating equilibrium because the low quality firms cannot imitate the highest quality firms by issuing more debt as the low quality firms have higher marginal expected bankruptcy costs Narayanan (1988) also supports the argument that debt has an advantage over equity as it serves as a barrier for the inferior firms to enter the market

Pecking order theory predicts that more profitable firms will have less leverage The signs on firm size variables are ambiguous On the one hand, larger firms might have more assets and thus a greater damage is inflicted by adverse selection as in Myers and Majluf (1984)

In Shyam-Sunder and Myers (1999), dividends are part of the financing deficit thus a more dividend-paying firm will use more debt A credit rating involves a process of information therefore a firm with an investment grade debt rating has a less adverse selection problem Accordingly, firms with such ratings should use less debt and more equity

Managements strongly favor internal generation as a source of new funds even to the exclusion of external sources, except for the occasional unavoidable bulge in the need for funds (Donaldson 1961) Myers (1984) said that an outside investor will demand a higher rate of return on equity than on debt From the perspective of those inside the firm, retained earnings are a better source of funds than debt and debt is a better deal than equity financing However the theory did not indicate a target capital structure Indeed, managers will decide how much they need from external sources based on their business strategy

2.2.1.5.Agency cost Theory

Jensen and Meckling (1976) were the first to develop the capital structure theory based

on the agency theory The agency theory starts with the hypothesis that stakeholders (managers, shareholders, creditors, employees, customers, suppliers, state and so on) have specific objectives and interests that are not necessarily spontaneous reconcilable; in consequence there are conflicts between them, especially in the large companies, based

on the separation between ownership and management

There are two main types of conflicts:

 Conflicts between the management and the shareholders: The former agency problem can arise because management has a smaller stake in the residual claims compared to equity holders This may lead to the behavior, which is less than optimal for maximizing the firm‘s value (Jensen, 1986)

 Conflicts between the bondholders and the shareholders: the equity holders have

an incentive to invest sub-optimally Equity holders will follow courses of action, which benefit themselves at the expense of debt holders, thus transferring the wealth from bondholders to shareholders Jensen and Meckling argued that shareholders of geared firms capture investment yield above the debt holders‘ fixed claim, but they will not suffer any loss above their basic investment in the firms, due to their limited liability in the firm Therefore, shareholders will be

more inclined towards investing in risky projects with higher returns Myer (1977)

Grigore M.Z and Ştefan-duicu V.M (?) concluded that debt can lessen the conflict between shareholders and managers The structure of the capital can affect the value of the company, by acting in the ways of managerial motivation and inciting the shareholders and creditors to supervise the managers and limit their abuses

2.2.2 Previous empirical studies of determinant of capital structure:

Capital structure of a firm is determined by various factors This section presents how the factors affect the capital structure of a firm with reference to the relevant capital structure theories stated earlier

a lower ratio of bankruptcy costs to firm value compared with small firms

(Warner, 1977) Titman and Wessels (1988) pointed out that larger firms are less prone to bankruptcy and this implies the less probability of bankruptcy and lower bankruptcy costs This was proven through research of Manos (2001) and Huang

& Song (2001), Frank and Goyal (2009), Tran Thanh Huy (2013)

- On the other hand, Pecking Order theory argued that for large companies, stock issuance will be more beneficial than borrowing Rajan and Zingales (1995) said that the effect of size on equilibrium leverage is more ambiguous so size may be

an inverse proxy for the probability of bankruptcy Study of Thu L.T.K (2012) and Helene and Hårstad (2012) support for this theory, while Toy et al (1974) and Kim and Sorensen (1986) do not find size to be significant in explaining the debt structure of US firms

2.2.2.2.Growth opportunities

Trade-off theory and agency costs theory, were explaining the negative sign of the correlation between growth rate and leverage ratio Bevan and Danbolt (2002) argued that a high growth rate firm suggests positive business results therefore shareholders do not want to share this privilege with lenders or engage in a contractual obligation against

it According to Scott (1977); Titman and Wessels (1988); Ozkan(2001); Booth et al (2001); Bevan and Danbolt (2002), investment opportunities are seen as capital assets adding value to the firms but they cannot be mortgaged for obtaining debt This theoretical result is also backed up by the empirical studies carried out by Kim and Sorensen (1986), Rajan and Zingales (1995)

However, Pecking Order theory suggests a positive relationship between two factors In the case that a corporation is operating stably with appropriate ownership structure, it would accept to bear interest payments to avoid volatility in that structure Fama and French (2002) also confirm that leverage is positively related to growth opportunities when measured by market to book ratio and Research & development budget by total assets, respectively, whereas the book ratios show a positive relationship with investment opportunities Briefly, it is more efficient to use debt instead of other sources of fund to maintain ownership structure in growing enterprises (Tran Thanh Huy 2013) Manos

(2001), Huang & Song (2001), Nguyen, T.D.K (2006) and Thu N.T.K (2012) found the positive correlation which supports Pecking Order theory

2.2.2.3.Tangibility

According to trade-off and pecking order theory, when tangibility increases, collateral increases and firms should be able to find more debt Smith and Warner (1979) argued that the secured debt may also reduce the total cost of lending to the creditors by precluding the assets substitution problem Scott (1997) also presented that if firms do not have collateral, they either have to bear high borrowing costs or have to issue equity instead of debt A firm invests largely in land, equipment and other tangible assets, it will have smaller costs of financial distress than a firm relies on intangible assets (Berryman, 1982) The tangibility of firms‘ assets may also help in reducing information asymmetries

as the payoffs of tangible assets are more easily observed (Almeida and Campello, 2007) Empirical studies Rajan and Zingales (1995); Helene and Hårstad (2012), Wald (1999), Bevan and Danbolt (2002), Jong et al (2008) show a positive relationship between tangible assets

On the other hand, Titman and Wessels (1988) argue that debt may also have a negative relationship with collateral assets An indirect explanation of Naeem, Shammyla (2012) for a negative relationship could be that firms with a higher amount of tangible assets are more likely to have a stable and constant source of earnings Such internally generated funds are more likely to be reinvested, therefore, the reliance on external sources is minimized

2.2.2.4.Profitability

According to Trade-off theory, debt ratios are expected to have a positive relationship with profitability (Modigliani and Miller, 1963) Profitable firms have higher income to shelter, higher marginal tax rates, and have less probability of bankruptcy It follows that profitable firms‘ capital structures will comprise of more debt to gain the added advantages of tax shields, apart from the other benefits of higher debt Helene and Hårstad (2012) argued that the higher debt ratios are also consistent with the agency cost

of free cash flow, where debt are used as a motivation for managers, employees and other stakeholders to be efficient and avoid low-return projects

In contrast, the pecking order theory suggests a negative relationship between profitability and gearing Myers and Majluf‘s (1984) pecking order theory rely on the 20apitaliz and information asymmetry problems associated with the issue of specific types of external financing, and the transaction costs of issuing equity Consequently, firms follow a hierarchy in their financial policies, where internal sources are given preference over external sources The empirical studies (Titman and Wessels, 1988; Kester, 1986; Huang & Song, 2001) have strongly substantiated Pecking Order theory suggesting a negative association between profitability and the gearing of firms

2.2.2.5.Industry level factor

According to Naeem, Shammyla (2012), the industry class can potentially be another important determinant of the capital structure Firm characteristics may vary in terms of assets structure, type of assets and requirement for external financing between different firms across industries and so too may the leverage which is dependent on such characteristics Similarly, Helene and Hårstad (2012) supported that various industries experience unlike business environments and are subject to different challenges Some industries are more capital intensive than other, requiring a greater share of fixed assets in order to operate Talberg et al (2008) confirm a significant difference in capital structure depending on the industry where the company operates High industry leverage should therefore result in higher debt ratios Empirical evidence of Scott and Martin (1975); Bradley et al (1984) substantiate the industry effect on leverage Following to Naeem, Shammyla (2012) industry level factors are included in the model to reduce any misspecification bias of the model

Table 5: Summary of previous empirical studies

Variables Sign Explanation Supporting empirical studies

Bankruptcy cost theory (*)

The large firms are more diversified that have easy access to the capital market, receive higher credit ratings for debt issues, and pay lower interest rate on debt capital

Kurshev and Strebulaev (2005); Warner (1977); Titman and Wessels (1988); Manos (2001) and Huang & Song (2001), Frank and Goyal (2009), Tran Thanh Huy (2013)

(-) Pecking Order Theory

Stock issuance will be more beneficial than borrowing

The effect of size on equilibrium leverage is more ambiguous so size may be an inverse proxy for the probability of bankruptcy

Rajan and Zingales (1995); Thu L.T.K (2012)

Helene and Hårstad (2012)

Growth

opportunities

(+) Pecking Order theory (*)

In growing firms owners and managers usually have similar goals so they dislike volatility in ownership structure

Research & development budget need more debt

Fama and French (2002); Tran Thanh Huy (2013); ;Manos (2001), Huang & Song (2001), Nguyen, T.D.K (2006) and Thu N.T.K (2012)

(-) Trade – off

Agency Costs theory

A high growth rate firm suggests positive business results therefore shareholders do not

want to share this privilege with lenders

Bevan and Danbolt (2002); Scott (1977); Titman and Wessels (1988); Ozkan(2001); Booth et al (2001); Bevan and Danbolt (2002),

Sorensen (1986), Rajan and Zingales (1995)

(-) Firms with a higher amount of tangible assets are

more likely to have a stable and constant source

of earnings Such internally generated funds are more likely to be reinvested, therefore, the reliance on external sources is minimized

Titman and Wessels (1988)

Profitability (-) Pecking Order

theory (*)

The higher profitability of the enterprise implies the internal financing of investment and less

reliance on debt financing

Myers and Majluf‘s (1984); Titman and Wessels (1988), Kester (1986), Huang & Song

(2001)

(+) Trade-off theory

The higher profitability of firms implies higher debt capacity and less risky to the debt holders

Helene and Hårstad (2012)

Industry level

factor

(+) Some industries are more capital intensive than

other, requiring a greater share of fixed assets in order to operate

Helene and Hårstad (2012), Talberg et al (2008); Scott and Martin (1975); Bradley et al (1984)

(*) we base predictions on this theory

2.3.The impact of credit ratings on capital structure

Graham and Harvey (2001) was the first to highlight that credit ratings is an important consideration when firms make their capital structure decisions Their survey of 392 US firms‘ CFOs shows that they consider credit ratings as the second most important concern when they make their capital structure decisions (57% of the respondents consider credit ratings, while 59% of the respondents consider financial flexibility as their foremost concern) Following Graham and Harvey (2001), Brounen et al.(2004) and Bancel and Mittoo (2004) also report that European firms‘ managers, similar to US firms‘ CFOs, rate credit ratings as one of the most important concerns when they make financial structure decisions That means investors, specifically institutional investors and regulatory bodies, have been actively dependent on these ratings as a source of independent judgement on the firm‘s‘ credit worthiness Norden and Weber (2004) also pointed out that investors do not only rely on credit ratings for fund allocations, but also for pricing, monitoring and future risk evaluation This section will review some empirical researches of the impact of credit ratings on capital structure

2.3.1. Foreign researches

2.3.1.1 Kisgen Darren J (2003, 2006, 2009)

Around the world, there are some research for the relationship between credit rating changes and capital structure decisions According to Kisgen Darren J (2003), credit rating can provide information to investors and thus act as a signal of firm It can make the decision change and bring benefits or risk to the firm such as a change in bond yields

or loss of contracts Kisgen (2006) is the first paper that formally tests the impact of credit ratings on capital structure decisions utilizing a Credit Rating-Capital Structure (CR-CS) hypothesis based on rating-dependent costs The CR-CS hypothesis points that there are discrete costs and benefits associated with different levels of credit ratings These rating-dependent costs and benefits directly influence managers‘ capital structure decisions In addition, there are some differences between the plus and minus signs (e.g A+ or A-) and flat rating categories (e.g A) For example, a A- or downgrade firms have

downgrade, downgraded firms issue approximately 1.5-2.0% less net debt relative to net equity as a percentage of assets compared to other firms

Kisgen designed Pooled time-series cross-sectional regressions to analysis on a sample

of 12,336 firm–year observations by rating from 1986 to 2011 in the US Kisgen designed two kinds of tests: Plus or Minus tests (POM tests)

NetDIssit = α + β1CRplus + β2CRminus+ ΦKit+ εit (2)

In which:

- NetDIssit = (ΔDit – ΔEit)/ Ait

- ΔDit = book long-term debt issuance minus book long-term debt payment plus changes in current debt for firm i from time t to time t+1

- ΔEit = sale of common and preferred stock minus purchases of common and preferred stock for firm i from time t to time t+1

- Ait = beginning –of –year total assets for firm i at time t

- CRPOM: dummy for firms with a rating followed by ―+‖ or ―-―, then POM CR= 1;

These results strongly support CR-CS hypothesis Capital structure decisions are

affected by the potential for both an upgrade as well as a downgrade

2.3.1.2.Berlekom, Bojmar and Linnard (2012)and Kemper and Rao (2013)

Berlekom, Bojmar and Linnard (2012) and Kemper and Rao (2013 )replicated the methodology in Kisgen (2006,) However they got different results Berlekom, Bojmar and Linnard (2012) support the hypothesis of credit ratings as a determinant in firms‘ choice of capital structure They find that firms with a credit rating followed by a plus or minus subsequently issue less net debt relative to net equity in the following financial year than the middle Broad Rating firms and firms on the borderline between investment grade and speculative grade assigned BBB, BBB-, BB+ and BB ratings less debt relative

to equity than other firms Meanwhile, Kemper and Rao (2013) showed some contrasting results, indicating that credit ratings do not always relate to capital structure decisions Kemper and Rao (2013) argued that the impact of credit ratings close to either

a downgrade or upgrade depends on the subsample

2.3.1.3 Agha (2011)

Agha (2011) analyzed the effect of financial flexibility and credit re-ratings on corporate investment and financing decisions His data sample included 954 non-financial US listed firms which composed of small as well as medium and large firms The sample covers the period from 1985 to 2009 His equations:

Kdit = β0 + β1 ∆ credit rating

Keit = β0 + β1 ∆ credit rating

Kcit = Kdit + Keit

Which

- Kdit : Cost of debt

- Keit : Cost of equity

- Kcit : Cost of capital

- ∆ credit rating = credit rating score(t) – credit rating(t-1)

- Credit ratings: the credit ratings are transformed into numerical values (scores) ranging from 1 assigned to the lowest credit rating (D) to 21 assigned to the highest credit rating (AAA)

The study found that both costs of debt and equity are negative functions of the change

in credit ratings A positive change in the credit rating (upgrade) causes a reduction in the firm‘s costs of debt and equity, whilst a negative change in the firm‘s credit rating (downgrade) causes an increase in the costs of debt and equity Furthermore, the results above show that cost of equity is more sensitive to credit re-ratings than is the cost of debt He explained that equity holders are the residual claimants on the firm‘s assets in the event of bankruptcy, so they bear more risk than debt holders In addition, a credit rating upgrade is not followed by a significant change in the cost of capital, capital expenditures and net debt issuance of financially inflexible firms, whilst a downgrade is followed by an increase in the cost of capital, and a reduction in the capital expenditures and net debt issuance of financially inflexible firms, suggesting that these firms reduce their capital expenditures after a downgrade to retire some of their debt and resume their former credit rating

2.3.1.4.Helene and Hårstad (2012)

Helene and Hårstad (2012) examine how credit ratings affect credit ratings on capital structure of 216 Norwegian listed firms from 2004 to 2010 Their research aims to analyze three main contents:

The impact of credit rating on capital structure (BMP test)

LTDit/TDit = α + β1RATINGit + β2SIZEit + β3TANGit + β4PROFit + β5INDltdit / INDtdit + β6LTDi(t-1) / TDi(t-1) + εit

LTDit/TDit = α + β1IGit + β2HYit + β3SIZEit + β4TANGit + β5PROFit + β6INDltdit/INDtdit+ β7LTDi(t-1) / TDi(t-1) + εit

Where:

- LTD: level of leverage is defined as a companies‘ debt over total assets and are the static debt ratios for the companies

- TD: Total debt of the firm

- SIZE: Size – Natural logarithm of revenues

- TANG: Tangibility – Tangible assets over total assets

- PROF : Profitability – EBIT + financial income over total assets

- IND_ltd/IND_td: Industry leverage – Yearly average of each industry‘s leverage

- LTDi(t-1): Last year‘s level of leverage – Debt over asset in t-1

- RATING : Participating in the bond market – Dummy variable (equal to 1) for company i having a credit rating in year t

- IG: Investment grade rating - Dummy variable (equal to 1) for company i having

an investment grade rating in year t

- HY: High yield rating – Dummy variable (equal to 1) for company i having a high yield rating in year t

The study identified a positive and significant effect of the credit rating dummy variable for the long term debt ratio This result confirmed that acquiring a bond provide access

to more capital and hence lead to a higher long term debt ratio for the issuing firm For companies having an investment grade rating, the results show an insignificant influence

on both long term debt ratio and total debt ratio This states that there is no effect on leverage for these firms compared to non-issuing firms However, the authors also added that the number of observations for investment grade ratings is minor compared to number of high yield ratings thus these results may be less reliable

Capital structure decisions when being near a change in rating level (NAC test): LTDit/ΔLTDit = α + β1POMt-1+ β2SIZEit + β3TANGit + β4PROFit + β5INDltdit +

β6LTDi(t.-1) + εit

LTDit/ΔLTDit = α + βpPLUSt-1 + βmMINUSt-1 + β1SIZE it + β2TANGit + β3PROFit + β4IND_ltdit + β4LTDi(t.-1) + εit

In which: