Determinants of capital structure of listed construction companies in vietnam”

LIST OF FIGURESFigure 1.1: Debt to Total Assets and Market Value of the Firm...10 Figure 1.2: Debt to Equity ratio and Cost of Capital...11 Figure 1.3: The value of the firm V and level

I owe a deep sense of gratitude to all those who made me able to write thisreport I would like to thank the staff of Advanced Education Program, NEU for theirprecious help and relentless effort in allowing me to access research data

It is my privilege to thank all the staff at Cong ty xay dung phat trien nha JointStock Company for helping me experience this happy three-month internship,especially my internship guide Mr Nguyen Anh Hao for taking good care of me.More importantly, it is a genuine pleasure to express my deepest sense ofthank and gratitude to my supervisor PhD Le Duc Hoang, whose dedication,encouragement, and support gave me a lot of strength and advice to completethis report

TABLE OF CONTENTS

ACKNOWLEDGEMENT i

TABLE OF CONTENTS ii

STATUTORY DECLARATION iv

ABBREVIATIONS v

LIST OF FIGURES vi

LIST OF TABLES vii

EXECUTIVE SUMMARY viii

INTRODUCTION 1

CHAPTER 1: THEORETICAL FRAMEWORK AND DETERMINANTS OF CAPITAL STRUCTURE 6

1.1 Basis concepts of Capital Structure 6

1.1.1 Definition of Capital Structure 6

1.1.2 Theories of Capital Structure 6

1.1.2.1 Modigliani-Miller Theorem (MM) 6

1.1.2.2 Trade-off Theory of Capital Structure 9

1.1.2.3 Agency Theory of Capital Structure 12

1.1.2.4 Pecking Oder Theory 17

1.2 Determinants of Capital Structure 18

1.2.1 Firm size 21

1.2.2 Tangibility 21

1.2.3 Growth opportunity 22

1.2.4 Liquidity 23

1.2.5 Market index 23

1.2.6 Corporate tax 24

1.2.7 Profitability 25

1.2.8 Non-debt tax shield 25

CHAPTER 2: REAL SITUATION OF CAPITAL STRUCTURE OF THE CONSTRUCTION INDUSTRY IN VIETNAM 27

2.1 Overview of the Construction Industry in Vietnam 27

2.2 Determinants of Capital Structure of the Construction Enterprises in Vietnam 29

2.2.1 Methods and Data 29

2.2.2 Data collection and Correlation matrix of the sample 32

2.2.3 Results of regression analysis 36

2.2.3.1 Debt to Asset model 36

2.2.3.2 Long-term Debt to Asset model 39

2.2.3.3 Debt to Equity model 42

2.2.3.4 Long-term Debt to Equity model 43

CHAPTER 3: RESEARCH OUTCOME AND RECOMMENDATIONS 45

3.1 Research outcome 45

3.2 Development and Orientation 46

3.2.1 Opportunities 46

3.2.2 Challenges 47

3.3 Recommendations for the authorities 47

3.4 Solutions for firms in the industry 48

CONCLUSION 50

REFERENCES 51

APPENDIX 57

STATUTORY DECLARATION

I herewith formally declare that I myself have written the submitted Bachelor’sThesis independently I did not use any outside support except for the quotedliterature and other sources mentioned at the end of this paper

Hanoi, 31/5/2016

FTA: Free Trade Agreement

LIST OF FIGURES

Figure 1.1: Debt to Total Assets and Market Value of the Firm 10

Figure 1.2: Debt to Equity ratio and Cost of Capital 11

Figure 1.3: The value of the firm (V) and level of non-pecuniary benefits consumed (F) 14

Figure 1.4: Total Agency Costs to Total Outside Financing 16

Figure 2.1: Construction value by segments (trillion VND) 26

Figure 2.2 below presents the construction value by funding sources 27

EXECUTIVE SUMMARY

This study aims to examine capital structure determinants of 55 listedconstruction companies in Vietnam from 2011 to 2014 by using panel data regressionanalysis The result suggests that there are six determinants, which are firm’s size,growth opportunity, tangibility, liquidity, non-debt tax shield and profitability havestrong impacts on capital structure Firm’s size, growth opportunity, tangibility, andliquidity determinants reveal positive relation with leverage ratios The studyindicates that larger firms, firms with higher tangibility, liquidity, and growthopportunity tend to use more debt to finance On the contrary, firms with highprofitability and non-debt tax shield would consume less debt in the capital structure.The result indicates negative impacts of the capital structure or leverage ratio onprofitability, suggesting that profitbale firms prefer retained earnings to externalfinancial resources in order to avoid risks Meanwhile, non-debt tax shield move inthe opposite direction to leverage ratio, implying that businesses with large non-debttax shields have fewer incentives to use debt The study outcome supports peckingorder theory and trade-off theory Construction industry has contributed significantly

to Vietnam economy and is expected to grow in upcoming years due to governmentregulations, stable economy, high urbanization rate, and new trade agreements.Hence, the paper come up with some some recommendations and solutions forconstruction companies in order to approach the optimal capital structure andincrease firm’s value

1 Rationale

Since the ultimate goal of any enterprise is to maximize its value and operateeffectively, managers always ponder over many methods to find the optimal leverageratio, which is considered to be one of the most important features influencingcompany performance Although there are many different lending resources forenterprises, for example, bank loans, borrowing from credit institutions, or stocks andbonds, managers still find it tough to figure out the optimal capital structure for thefirm Therefore, in order to get a closer approach of how to implement an appropriateleverage ratio, managers need to understand capital structure’s determinants and itsimpacts on firm performance

Despite many capital structure research papers gave empirical proofs regardingdeterminants of capital structure in the real business world, the results of thesestudies about the relationship between determinants of capital structure and leverageratio are varied In addition, there are very limited studies conducted to assess theimpacts of determinants of capital structure on leverage ratio of construction industry

in Vietnam The assets and investments of these companies in the sector areespecially large compared to other sector, hence, they need to be analyzed to operatemore productively According to General Statistics Office of Vietnam’s 2015industry report, construction sector has shown a positive perspective with continuousgrowth rate during the last five years, reaching the highest increase of 10.82% in

2015 Construction industry also contributes significantly to Vietnam economy, asthis is the third highest growing sector last year In addition, although most ofVietnam construction companies are small and medium enterprises, they constitute alarge proportion of long-term capital The amended housing law No 65/2014/QH13,which was passed on November 25, 2014, and has taken effect from July 1, 2015,allows foreign individuals, organizations to buy and own residential houses inVietnam The new law is expected to have positive impact on real estate andinfrastructure development With the stable economy growth rate, increasingurbanization rate, and amendment to housing law, construction industry is forecasted

to expand rigorously in the upcoming years Nonetheless, the sector has to deal withmany other obstacles such as rising cost of raw material, unqualified managementskills, and employee quality Thus, an optimal capital structure will improvecompany operation, bringing competitive advantages For those reasons, the topic

“Determinants of capital structure of listed construction companies in Vietnam” ischosen so as to assess the factors that affect capital structure.

2 Research objectives

The paper aims to understand the idea of four basic theories of corporate capitalstructure, to firgure out the factors that affect capital structure and their impacts ofconstruction companies in Vietnam Then, several solutions and recommendationsare proposed for the companies in the industry

There are 165 observations in the sample The data are provided from theaudited financial statements of these firms, including balance sheets and incomestatements The data are reliable as they are collected from audited financialstatements of the listed construction enterprises on two websites namely hnx.vn andhsx.vn

5 Research scope and scale

The study focuses on analyzing the determinants of capital structure of 55 listedconstruction companies on HNX and HOSE from 2012 to 2014, and I will proposesome recommendations and solutions for the whole industry

6 Research structure

The thesis is organized into three chapters The first chapter gives an overview

of theoritical framework and determinants of capital structure Then, I go over thecurrent situation of capital structure of construction firms in Vietnam and runregression models to analyze the relationship among determinants of capital structureand leverage ratios The thesis is ended by the conclusion in which I come up with

several solutions and recommendations Details are as follows:

Chapter 1: Theoretical overview and determinants of capital structure

Chapter 2: Situation of capital structure of the construction industry in

Vietnam

Chapter 3: Conclusion and Recommendations

7 Literature review

7.1 International research papers

The research paper of Zarariah S et al (2011) was conducted to find theimpacts of determinants on capital structure of 43 listed Malaysian constructioncompanies in the period of 8 years from 2001 to 2008 Both fixed effect model andrandom effect model were run, showing that growth opportunity factor has negativeimpact on leverage ratio while company size moves in the same direction withleverage ratio The results support the trade-off theory and pecking order theory Theempirical finding interprets that larger construction companies tend to have higherleverage ratio Whereas, companies that need to expand business are more likely touse their own equity, as the shareholders do not want to share the benefit of growingbusiness with creditors Moreover, according to trade-off theory, growth opportunityfactor is considered to be intangible asset, which could not be pledged as collateral.Hence, companies with high growth opportunity would probably constrain theamount of debt However, the paper did not take other variables into considerationssuch as revenue growth, profitability, and tax

Samiran (2010) examined the determinants of capital structure or leverage ratio

of 37 listed Malaysian construction companies from 2003 to 2008 The panel datawas enacted with seven independent variables, including profitability, growthopportunity, liquidity, tax changes, tangibility, non-debt tax shield and businessscale The empirical finding indicates highly negative associations among liquidityand growth opportunity with leverage ratio In other words, the study also iscompatible with the pecking order theory However, other variables are found to beinsignificantly affect capital structure

A study of Buferna F et al (2008) on capital structure of Libyan companiesshows that company profitability, size and asset tangible asset move in the samedirection with leverage ratio while there is a negative relationship between growthopportunity and the ratio The paper outcome supports the trade-off theory and theagency cost theory

Nurul S B et al (2011) in their study on 22 listed construction companies inBursa stock exchange from 2001 to 2007, concluded that company size, growthopportunity, and tangible asset are positively related to total debt to total asset ratiowhile profitability is negatively related to the leverage ratio Meanwhile, tangibleasset variable shows the strongest impact on capital structure of the constructioncompanies The study implies that larger companies and companies purchasing moretangible assets are more dependent on debts On the other hand, highly profitablecompanies tend to consume less debt and more internal financial resources However,the paper still has limitation of variables, as other important factors, such as liquidity,non-debt tax shield, interest rate, and market, were not considered.

In the study of Huang et al (2002) on 1000 listed companies in China from

1994 to 2000, positive associations between leverage and firm size, tangibility,volatility of profitability, and intitutional shareholdings were found whileprofitability and non-debt tax shield move in the oppostive direction with the levergeratio The authors also argued that the static trade-off theory is better than thepecking order theory in explaining the capital structure determinants of these 1000listed companies

7.2 Vietnamese research papers

Truong et al (2008) empirically analyzed capital structure determinants of

56 listed companies on Hochiminh stock exchange from 2003 to 2006 Theordinary least squares regression was run in order to examine the relationshipsbetween leverage or total debts to total asset ratio with company size,profitability, growth of revenues, and amount of member of the Board ofDirectors Company sector is also considered to be a dummy variable added to themodel The result indicated a positive relationship between leverage ratio andcompany size, company sector, and growth of revenues while the profitability ispositively associated with the leverage ratio Due to data limitation, the study didnot conclude the optimal capital structure for those 56 listed companies

Le (2013) examined the determinants of capital structure of listed companies inVietnam from 2007 to 2010 Fixed effect model was run with the dependent variable

is leverage ratio, and six independent variables, which are tax rate, inflation, market ratio, industry leverage, return on asset, and behavior of managers Tax rate,industry leverage, and manager behavior affect leverage ratio positively On thecontrary, inflation, book-to-market ratio, and return on asset ratio are negativelyrelated to the leverage Although the behavior of managers variable is used under the

book-to-form of number is a new approach, the study needs to verify the appropriacy of thedata collection

Dang et al (2014) studied capital structure determinants among 180 financial companies listed on Hochiminh stock exchange from 2010 to 2013 Fixedeffect model was enacted, showing a positive association between leverage andcompany size, profitability and a negative relation with tax rate

non-Doan (2010) employed the path analysis by running AMOS program in order tofind the capital structure determinants of 428 listed companies from 2007 to 2009.According to the paper result, profitability and business risk have negativerelationship with leverage ratio while company size impacts the leverage ratiopositively

In conclusion, although several research papers have been enacted in order tofind the capital structure determinants of different industries in Vietnam, the timeperiods of those studies are short Hence, researches have not resolved the problem ofthe whole economy, especially in the recession or in the boom In addition, data arelimited Besides familiar factors, others have not taken into consideration such as taxpolicy, legacy, or interest rate

CHAPTER 1: THEORETICAL FRAMEWORK AND DETERMINANTS OF CAPITAL STRUCTURE

This chapter presents four theories of capital structure and determinants ofcapital structure Although many researches have been conducted to analyzedeterminants of capital structure and its impacts on firm performance, the followingfour theories are the most prevalent, as they provide the fundamental understanding

of capital structure

1.1 Basis concepts of Capital Structure

1.1.1 Definition of Capital Structure

“In finance, capital refers to the sources of long-term financing Capitalstructure is the combination of long-term debt, common equity and preferred equity,indicating how a firm finances its overall operations and growth by using differentsources of funds (Al-Najjar et al 2008, Hsiao et al 2009, and Ross et al 2005) Debt

is the amount of money that the enterprise borrows from credit institutions, investors,

or other lenders to finance the company Examples of debt are bonds, loans, payablesand commercial paper that make it able for the company to operate and usually payback later with interest Equity is used when stating the ownership of the business,including common stocks, preferred stocks, and retain earnings Equity is equal totalassets less total liabilities

Finding an optimal capital structure is still a contentious matter that any firmmanagers need to deal with, as capital structure plays a crucial role in any firmoperations The optimal capital structure is a strategy which brings minimum capitalcosts and maximum market value to company, related to trade-off between costs andbenefits.”

1.1.2 Theories of Capital Structure

1.1.2.1 Modigliani-Miller Theorem (MM)

“Prior to the middle of the 1950s, theoretical analysis was not popular, so thestudies of corporate finance primarily based on explanation of methods and

institutions In this context, Franco Modigliani and Merton Miller, who Ire professors

at the Graduate School of Industrial Administration of Carnegie Mellon University,originated basic theory and dedicated their inventive article Initially, although theydid not have any previous experience in corporate finance, they Ire assigned to teachcorporate finance Unexpectedly, the materials analysis of F Modigliani and M.Miller found out crucial inconsistency, then they recorded it into an article in theAmerican Economic Review Later, this article was the beginning of the Modigliani-Miller (MM) theorem This theory developed quickly, becoming a cornerstone ofcorporate finance and arguably forming the fundament for modern thinking oncapital structure MM theorem is a fundamental financial theory of capital structurewhich proposed the basis for modern theories, supporting to firm valuation

MM’s Capital Structure Irrelevance Proposition

According to MM, the basic theorem is applied under a specific market processknown as classic random walk which includes the non-appearance of taxes,transaction costs, bankruptcy costs, information asymmetry and other marketimperfections This means that there is an equality between companies andindividuals, both companies and individuals can access same market information,equivalent borrowing costs, and debts have no effect on firm’s earnings beforeinterest and taxes In this case, capital structure of firm does not impact the valuation

of firms In other words, unlevered firm with only equity in capital structure andlevered financed partly by equity and partly by debt have the same value

Proposition I:

where are the value of unlevered and levered firm respectively

Regarding this proposition of MM, the price to purchase an unlevered firmshould equal the price of levered firm

Proposition II:

where is the expected return on levered equity, or cost of levered equity; is

the expected return on equity of unlevered firm, or cost of unlevered equity; is

debt-equity ratio; is the expected return on debt, or cost of debt

MM proposition II states that the cost of equity has linear relationship withdebt-equity ratio A higher expected rate of return on equity of a levered firm reflects

a higher debt-equity ratio, expressed in market values of common stock With theunlevered firm, return of is required by investors Due to the extra risk from

borrowing capital of levered firm, return of must plus as a riskpremium

Consequently, it can be seen that the capital structure is irrelevant to stock price

of any firms The debt-equity ratio does not have any impact on weighted averagecost of capital (WACC) of firm because more of cheaper source of capital leads tothe increase in return on equity It seems to be not meaningful because theassumptions of this theorem are unrealistic However, these propositions are stillcrucial and beneficial This is because the real market violates most of the condition

of theory, which conversely indicates the significant role of capital structure in thecompanies As a result, the determinants are identified to optimize the capitalstructure

Modigliani and Miller's Tradeoff Theory of Leverage

The tradeoff theory of MM was developed with the presence of tax shield.Notwithstanding, there are still some assumptions applied to these propositions,which are the absence of transaction costs, deductible on dividend payment,inequality between firms and investors when borrowing; and there is tax deduction

on interest payment on debt

Proposition I:

where is corporate tax, is the value of debt (assumed perpetual debt)

It is easy to see that the value of levered firm is directly proportional to thevalue of debt Hence, the larger proportion of debt capital involves, the more valuablethe firm is Levered firms can get advantages from interest deduction to reduce thetax payment

Proposition II:

where is the expected return on equity, or cost of levered equity = unlevered

equity + financing premium; is expected return on unlevered equity, or cost of

equity capital with no leverage, or unlevered cost of equity; is theexpected return

on debt, or cost of debt

Similar to the conclusion above, the increase in leverage rises the cost of equitybecause of riskier investment coming from the debt level However, in this case, the firmcan save tax payment from interest tax deduction, thereby the ratio between debt andequity influences the firm’s WACC The higher the debt level, the lower the WACC

To sum up, related to capital structure, MM theorem states that there is nooptimal capital structure in a perfect market with the absence of taxes, transactioncosts, bankruptcy cost, and information asymmetry Besides, the optimal capitalstructure of a firm with the same conditions above but under corporate tax is 99.99percent debt level In reality, figuring out an optimal capital structure is quite hard,However, the determinants of capital structure can be identified.”

1.1.2.2 Trade-off Theory of Capital Structure

“The trade-off theory refers to a decision that a firm can find out an optimalcapital structure to maximize the market value of firm by balancing benefits andcosts of using debt The original hypothesis established by Kraus and Litzenberger(1973) was a classic static trade-off theory According to them, the deadweight costs

of financial distress and bankruptcy and the benefits from tax saving of debt Ireconsidered to the trade-off between costs and benefits The tax benefits come fromthe tax deduction of interest, so that the firm prefers loan rather than equity to getadvantage from tax shield and increase firm value On the other hand, borrowing loanalso rises the probability of default and financial distress According to Haugen andSenbet (1978), the cost of bankruptcy and financial distress belong to both direct andindirect costs The direct costs include administrative costs, credit costs, costs ofrestructuring company, other legal fee of loan Indirect costs evolve losses ofintangible assets such as losses of reputation, reduction of customers’ loyalty, andeven the losses of investors, workers, and employees The manager of a firm mustbalance the benefits and costs to optimize operation In trade-off theory, agency cost

is normally referred to Agency cost, which is different from two main kinds of costsmentioned above, should be weighed against the tax saving This theory helps toexplain why the firms always use partly debt and partly owners’ equity According totrade-off theory, the optimal capital structure can be find out by balancing themarginal benefit of debt from tax saving of interest tax deduction and the marginaldistress cost of debt as Ill as the risk of debt (see Figure 2.1)

Figure 1.1: Debt to Total Assets and Market Value of the Firm

Source: Clayman et al (2012)

While Modigliani-Miller theorem states that there is no optimal capital structure oroptimal structure with full debt under tax shield, with trade-off theory a firm can use anappropriate proportion of debt to create optimal capital structure The optimal debt-equity ratio is a point where any additional debt would cause the costs of financialdistress lower than the extra tax advantage None of firms can affirm that they reach theiroptimal capital structure Nevertheless, the factors impacting optimal capital structuremay be used to determine the appropriate choice of management The business risks, taxregulations, costs of financial distress, corporate governance, among other factors should

be considered as a tool to choose best debt level

Figure 1.2: Debt to Equity ratio and Cost of Capital

Source: Clayman et al (2012)

As can be seen from Figure 2.2, the growth of proportion of debt in capitalstructure leads to the increase of costs of both debt and equity as a risk premium ofhigh level of debt, which also reduces cost advantage due to greater amounts of loanknown as cheaper financial source Because of these changes, the weighted averagecost of capital curve has a U shape Besides, the decisions of using debt of a firmshould fit the target capital structure, based on the current company’s financialsituation, transparency as Ill as market conditions The market actually fluctuatescontinuously, requiring the managers of any firms must make the appropriatedecisions to adapt the changes and get maximum firms’ value and profit.”

1.1.2.3 Agency Theory of Capital Structure

“The agency theory integrates elements from the theory of agency, the theory

of property rights and the theory of finance to generate the concept of ownershipstructure, whose main objective is to issue the optimal agreement amongstakeholders of the company (Jensen and Meckling, 1976) Agency theory is acompromise between two parties, in which, one is called principal, who is theshareholder, creditor or the owner of the company, and the other is agent, who isdelegated to work on behalf of the principal Many agency relationships are built

up in every company, for example, creditor and manager, or employer andemployee Hence, agency costs arise due to conflicts between two parties The

dilemma occurs as the agent acts for his own best benefits rather than those of theprincipal, and the agent has more information than the principal does Both partiesaim to maximize their own benefits, but the conditions of their utmost benefits aredifferent For instance, the investors need the managers to make decisions whichwill increase the firm’s value and share price while managers, themselves, wouldprefer to expand the business and receive higher salaries, which may notnecessarily increase the firm’s value In addition, the asymmetric informationbetween two parties also leads to disagreement and the company, hence, fails toperform at the best procedures

In order to constrain deviation from the principals’ interest, firstly, Jensenand Meckling (1976) create appropriate incentives for the agents and spend more

on monitoring costs Monitoring costs, such as cost of the annual report, cost ofindependent auditors, and cost of having securities rated are triggered to limitaberrant activities of the agents that might harm the company or prevent theprincipal from satisfying and maximizing his benefits Obviously, the better thecorporate governance, the lower the agency costs Moreover, in some othercircumstances, the company might pay bonding costs to assure that the agent willnot go against the principal’s benefits, and the principal will be compensated incase the agent takes any dishonest actions Last but not least, the principal alsohas to bear residual loss since the agent’s decisions do not maximize theprincipal’s interests Hence, agency costs are the sum of the monitoring expenses,the bonding costs, and the residual loss

The research analyzes the incentives faced by both parties and thedeterminations of the equilibrium contractual form between manager or the agent andthe outside equity, and debt holders or the principals Jesen and Meckling (1976)made a comparison of behaviors in two different capital structures: one is when themanager owns total shares of the firm versus when shares are sold to otherstakeholders or outsiders In the former scenario, the manager always behaves tomaximize the firm’s value, since he works for his own as Ill as his own interest.Moreover, the decisions in this situation include both pecuniary returns and non-pecuniary returns such as the level of employee discipline, charitable contribution,

and personal relations In the other case when the manager owns just a proportion oftotal equity, since the manager’s ownership reduces, he will be more willing to spendresources for agency cost The inclusion of outside equity will incur agency costsbecause of the conflict of interests between two parties due to the fact that themanager or the agent now only hold a fraction of the costs of any non-pecuniarybenefits taken out in maximizing his own utility.

Jesen and Meckling (1976) developed some structure for the analysis bymaking two sets of assumptions, which are permanent assumptions and temporaryassumptions

Permanent assumptions:

(P.1) All taxes are zero

(P.2) No trade credit is available

(P.3) All outside equity shares are non-voting

(P.4) No complex financial claims such as convertible bonds or preferred stock

or warrants can be issued

(P.5) No outside owners gains utility from ownership in a firm in any way otherthan through its effects on his wealth or cash flows

(P.6) All dynamic aspects of the multi-period nature of the problem are ignored

by assuming there is only one production-financing decision to be made by theentrepreneur

(P.7) The entrepreneur-manager’s money wages are held constant throughoutthe analysis

(P.8) There exists a single manager (the peak coordinator) with ownershipinterest in the firm

Temporary assumptions:

(T.1) The size of the firm is fixed

(T.2) No monitoring or bonding activities are possible

(T.3) No debt financing through bond, preferred stock, or personal borrowing ispossible

(T.4) All element of the manager’s decision problem included by the presence

of uncertainty and the existence of diversifiable risk are ignored

X = {x1, x2, , xn} = vector of quantities of all factors and activitieswithin the firm from which the manager derives non-pecuniary benefits; xi aredefined such that his marginal utility is positive for each of them

C(X) = total dollar cost of providing any given amount of these items;P(X) = total dollar value to the firm of the productive benefits of X;B(X) = P(X) - C(X) = net dollar benefit to the firm of X ignoring any effects of

X on the equilibrium wage of the manger

Ignoring the effects of X on the manager’s utility and therefore on his equilibriumwage rate, the optimal levels of the factors and activities X are defined by X* such that

For any X >= X*, F = B(X*) – B(X) > 0 measures the dollar cost the firm ofproviding the increment X – X* of the factors and activities which generate utility tothe manager

The owner-manager’s tastes for wealth and non-pecuniary benefits isrepresented in figure 2.3 by a system of indifference curves, U1, U2, U3

Figure 1.3: The value of the firm (V) and level of non-pecuniary benefits

consumed (F)

Source: Jesen & Meckling (1976)

Where the fraction of outside equity is (1 - ) × V, and Uj (j=1, 2, 3) representsowner’s indifference curves between wealth and non-pecuniary benefits

When the manager owns total equity, the firm’s value will be V* whereindifference curve U2 is tangent to VF, and the level of non-pecuniary benefitsconsumed is F* In the other context, the manager sells a proportion total shares ofthe company, 1-, (0<<1) and maintains  shares If other shareholders supposethat the manager will consume the same level of non-pecuniary benefits as he did asthe sole equity holder, they will definitely pay (1-)V* for the fraction of shares theyown, and the cost of the manager of consuming $1 of non-pecuniary benefits is .Hence the buyer’s budget constraint will be V1P1, and has a slope – If the owner-manager can freely choose the level of perquisites, F, he will move to point A where

V1P1 is tangent to U1 reaching higher level of utility The firm’s value declines fromV* TO V0 by the amount of the cost of increasing non-pecuniary expenses, and theconsumption of its benefits goes up to F0

The research pointed out that lower the proportion of total equity the managerholds, the stronger his incentive to engage in risky investments is due to the fact thatthe creditors or other shareholders will bear most of the costs incurred if theinvestment fails to gain profitability The issuance of debt triggers agency cost, which

is the responsibility of owner-manager.

Si: Inside equity (held by the manager)

S0: Outside equity (held by anyone outside of the firm)

B: Debt (held by anyone outside of the firm)

S = SI + A0 Total market value of the equity

V = S + B Total market value of the firm

(B + S0) Total amount of outside financing

E* = S0*/ (B + S0) Optimal fraction to be financed with outside equity

The optimal proportion of outside funds for a given level of internal equityresults in minimum agency costs from the owner-manager’s point of view,illustrating in Figure 2.4

Figure 1.4: Total Agency Costs to Total Outside Financing

Source: Jesen & Meckling (1976)

Ar(E) : Total agency costs

E : Ratio of outside equity to total outside financing

The study is believed to be applicable to a wide range of corporations, it is still in

an incomplete state One of the main drawback is that the authors have not worked outapplication for very large modern companies whose managers own little or no equity.Jesen and Fama (1983) explored the theory of how decision processes are split

up The research result shows that decision making has four processes, which areinitiation of proposals of resource utilization and structuring of contracts,ratification (choosing which initiatives will be implemented), implementation ofratified decisions, and monitoring the performance of the decisions agents andimplementation of rewards.”

1.1.2.4 Pecking Oder Theory

“Pecking order theory was developed to explain investment decisions andcorporate’s financing based on asymmetric information (Myers and Majluf, 1984)

As the fact that managers know the firm’s situation better than exterior investors,asymmetric information between two parties influences financing decisions ofusing internal or external funds, and the issuance of debt or equity There are twomain sources of funding firms including internal and external financing, also known

as debt and equity In term of equity, retained earnings have no adverse selectionproblem while paid-in capital has drawbacks A firm is said to follow a peckingorder if it prefers internal to external financing debt to equity if external financing

is used (Myers, 1984) However, this definition can be perceived differently Onemay interpret that firms want to use internal finance sources before issuing equity

or debt Others may understand that in the case all other things being equal, firmsuse internal finance sources more than external ones In addition, the definitionsupposes that firms are more likely to issue debt than equity

One of the most important stimulus of the theory is the adverse selection Thekey idea is that the manager always knows the true value of the firm and itsopportunities to grow while outside investors can only predict the value From theoutside point of view of investors, equity is rigorously riskier than debt As a result,investors require a higher return on equity than debt On the other hand, managersuppose that retained earnings are better than debt, and debt is better than equity infinancing the firm Any decisions of managers of buying or selling equity wonders

the investor, as they must ask the reason for that activity When the firm isovervalued, the manger is willing to sell equity, whereas, the manager of anundervalued firm is not.

Assuming that both parties are risk-neutral, no transaction cost anddiscounting exist, and all financing sources are from equity, the firm has someassets and considers whether or not to conduct a project If the project is carriedout, prospective investors will have to compete in an auction to fund the company’sproject Therefore, financing is considered to be break-even given the investors’trust of the company The firm has assets (Ai) and access to a positive net presentvalue project that offers a net payoff (Bi) The firm’s type is either type H (high) ortype L (low) The sum of the assets plus the net value of the project is greater for atype H firm than it is for a type L firm The two types are equally likely Managerknows the true type of the company, but the investors do not So as to carry on theproject, the firm would need to raise I > 0 from the investor If the project is notundertaken, the firm’s value is Vi = A, but if the project is accepted, the firm’svalue will be shared with other investors, and the manager will receive (1-)V Theequilibrium for both types of the firm to conduct the project is met under thecondition that (I/ VL) < (BH + I)/ VH, and investors hold s* = I/ (0.5VH + 0.5VL) Nonetheless, testing the pecking order theory has not shown the importanceorder in determining a firm’s capital structure.”

1.2 Determinants of Capital Structure

Since the Modigliani and Miller theory (1958) was published, many researchershave been studying the optimal capital structure or, in other words, leverage ratio byfinding determinants of capital structure There are four most common leverage ratioswhich are debt to asset ratio, debt to equity ratio, long-term debt to asset ratio, andlong-term debt to equity ratio Choi et al (2013) conducted a study to empiricallyanalyze the capital structure determinants of listed companies in Korea usingmultiple regression analysis The paper found that company size and not-debt taxshield positively related to leverage, whereas profitability, growth, tangibility, andliquidity negatively related to leverage

Zaleha et al (2011) found the determinants of capital structure of Malaysianconstruction companies to examine the relationship between size, profitability,growth and tangibility towards debt ratio Using the panel data method, the papershows that size, growth, and tangibility have positive associations with debt ratio,but the profitability of the construction companies affect negatively on theleverage ratio The study indicates that Malaysian construction companies tend toconsume more debt to finance for expansion and growth while using more debtcauses declined return.

Ali et al (2011) also worked on a research to examine the determinants ofcapital structure of 146 listed companies on Tehran stock exchange from 2003 to

2008, concluding that profitability, liquidity, and tangibility have negative impacts onleverage ratio, and growth opportunity, and company size are positively associatedwith debt ratio

Sayilgan et al (2006) found the determinants of capital structure of 123 Turkishmanufacturing firms listed on the Istanbul Stock Exchange (ISE) in the period from

1993 to 2002 Using the panel data methodology with six variables, namely size,profitability, growth opportunity in plant, property and equipment, growthopportunity in total assets, non-debt tax shields and tangibility The analysis revealsthat there is a positive relation among capital structure or debt to equity ratio withsize and growth opportunity in total assets Nonetheless, growth opportunity in plant,property and equipment, non-debt tax shields, profitability, and tangibility exposesnegative relation with debt level

Reza et al (2015) studied the corporate capital structure and performance oflisted construction companies in Malaysia over the period from 2005 to 2009 Theempirical analysis revealed that profitability, growth, firm size, and non-debt taxshield had significant relationship with leverage However, tangibility has nosignificant connection with debt ratio

Laura et al (2013) investigated the importance of five factors, which areprofitability, company size, tangibility, liquidity and asset turnover, upon the capitalstructure choices of Romanian enterprises listed on Bucharest Stock Exchange andoperating in the construction sector The paperwork is based on panel data regression

on a sample of 20 firms over the period of 2009 to 2011 The analysis indicates thatprofitability, tangibility and liquidity move in opposite direction with total debt ratiowhile the company size and asset turnover have positive effects on leverage.

Songul (2015) did the research on determinants of capital structure for Turkishmanufacturing sector Growth opportunity, size, profitability, tangibility and non-debt tax shields are used as the firm-specific variables that affect a firm’s debt toequity ratio Empirical findings suggest that growth opportunity’ impact is consistentwith some studies on the pecking order theory, showing that high future growthcompanies would like to use debt financing But firm’s size, profitability, andtangibility are negatively correlated with leverage ratio Non-debt tax shield is found

to be insignificant to the firm’s capital structure

In Vietnam, finding the optimal capital structure is also a struggle for everycompany The study by Le (2014) was conducted by running regression model for 40listed construction companies in Hanoi Exchange Stock from 2009 to 2011, findingthat liquidity and business risk are negatively related to debt ratio while companysize has positive impact on leverage ratio

Biger, Nguyen, and Hoang (2008) have tested the relationship between leverageratio and collateralized assets, profitability, income tax, non-debt tax shield, firmsize, and growth opportunity of Vietnamese firms Then, the result indicates thatfirm’s profitability is negatively related to leverage

From previous researches and theories, to have a profound analysis, I conductfour panel data regression models with four dependent variables are debt to equityratio, debt to asset ratio, long-term debt to asset ratio, and long-term debt to equityratio as the proxy of capital structure, which is influenced by eight factors namelyfirm’s size, liquidity, tangibility, tax, net income, non-debt tax shield, market index,and growth opportunity

1.2.1 Firm size

Firm size seems to be the initial proxy which investors are interested in aspecific company in the market Large firm size implies that the probability of

bankruptcy is quite low, indicating good financial health and stable economicgrowth Hence, most companies tend to expand their scale to take advantage oflarge size According to sentiment of investors, they prefer the larger firm withwell-known brand and good reputation than the smaller one, especially riskaverters Generally, the large firms diversify their business lines, investing indifferent projects of various industries to minimize risk of default, like an investordiversifying portfolio As mentioned above, large size decreases probability ofbankruptcy, referring high financial leverage Capital market prefers the large firmsrather than the small ones; thereby commercial banks provide larger amount ofcredit at preferential interest rate Moreover, the small firms must incur higherexpenses of using debt, so they tend to use less debt in their capital structure.According to the Agency Cost theory, the larger the firm size, the larger the amount

of free cash flow

Several researchers worked on projects to find out the impact of firm’s size onleverage ratio Ang et al (1982) and Warner (1977) prove that larger firms tend tohave more diversified capital structure and less probability to go bankrupt Hence,they recommend that large enterprises should have high leverage ratio Someauthors such as Rajan and Zingales (1995), Friend and Lang (1988), and Huang andSong (2002), also supposed that there was a positive relation between size andleverage ratio In contrast, other studies by Kester (1986), Kim and Sorensen(1986), and Titman and Issels (1988) shows that firm size and debt to equity ratio

go in an opposite way

1.2.2 Tangibility

The tangible assets play a crucial role on debt proportion of a firm,influencing significantly on capital structure decision When tangible assets accountfor a large percentage in structure of assets, the firm can use them as collateral toaccess external financing The higher the tangibility, the lower the volatility It iseasier for a firm with more tangible valued assets to issue more debts as Ill as toreceive a larger amount of loan from commercial banks and from other financialinstitutions In the case of bankruptcy, the creditors of the firm can be compensated

more from the high value of firm’s assets which means that the costs of default arelower Thus, it can be seen that there is a positive relation between tangibility andleverage On the other hand, if the firm has more tangible assets than intangibleone, information asymmetry will be lower, which reduces the costs of equity Inthis case, the firm will use less debt, lowering the leverage.

Rajan and Zingale, Bradley et al (1984) suggested a positive relation betweentangibility and leverage ratio, which is consistent with findings of Titman andWessels (1988) Booth et al (2001) stated that the more tangible assets the firmshave, the greater probability to issue secured debts will be Nonetheless, a number

of studies such as Huang and Song (2002) pointed out a negative relation betweentangibility and debt to equity ratio

1.2.3 Growth opportunity

A firm with high growth opportunity has less financial difficulties, which brings

to a low level of leverage usage According to the Agency Cost theory, the highgrowth opportunity reflects a positive operating efficiency In this case, shareholders

do not want to share benefits with other creditors, leading to a negative relationbetween growth opportunity and leverage A potential company will tend to use morecapital sources from stockholders rather than increasing the amount of loan in order

to reduce interest payments Using equity financing means that the profit from firm’soperation will be paid to shareholders instead of to creditors or to debtholders.Besides, given the pecking order theory, a firm with high growth opportunity alwayshave high demand of capital, meanwhile retained earnings are not adequate to meetthe demand Therefore, loan will be used more to satisfy the requirement of capital tooperate effectively It states the positive relation between growth opportunity anddebt ratio in the capital structure

Huang and Song (2002) suggested that firms with higher future growthopportunity should have higher leverage because a higher leveraged company ismore likely to be successful in earning profit for lenders, or debt-holders.Modigliani and Miller (1958) also uncovered a positive relation between growthopportunity and the preference for debt in choosing capital structure The authors

claimed that firms would be willing to finance the potential growth by using debt,

as when the projects have profitability, debt could be paid back later by issuingequity with higher prices or through greater retained earnings Pandey (2001)proved that high growth firms required more funds and increase retain earnings,hence, they would issue more debt to maintain the target leverage ratio as derivedfrom trade-off theory and pecking order theory On the other hand, Bevan andDanbolt (2002), Myers (1977), and Titman & Issel (1988) found a negativerelationship between leverage and growth opportunity, expecting firms with highgrowth opportunity to sustain low-risk debt capacity to avoid risky securities

1.2.4 Liquidity

According to the pecking order theory, firms require a strong capital turnover

to avoid using external financial sources Therefore, a company with high level ofliquidity can use its liquid assets to finance its own other investments, leading to anegative relation between liquidity and leverage The firm can use its current assetsinstead of borrowing from other financial institutions, lowering the debt proportion

It can be explained that the high liquidity can help a firm to pay the short-term debt

on its maturity, reflecting a positive relation between liquidity and debt ratio incapital structure

Hennessy and Whited (2005), Iston et al (2005) claimed that the firm’sliquidity is positively related to the ease that firm would raise external capital, andthe lower the liquidity is, the less motivated the firm will be to issue equity.Consistent with this result, the studies by Frieder and Martell (2006) and by Lipsonand Mortal (2010) asserted that firms with high liquidity are considerably moreleveraged However, the two papers are based on the United State firms, and maynot applicable in other developing markets

1.2.6 Corporate tax

MM theorem (1950s) states that in the perfect competition capital market, firmvalue is independent on its capital structure In other words, usage of debt andfinancial leverage has no effect on value of company According to the trade-offtheory, if a company must incur a high tax rate, it will tend to use more debts to getadvantages from tax shield, increasing leverage in capital structure This can beexplained that the interest payment from loan is one of the expenses in deductionfrom income tax, but the dividend payment and retained earnings are still in taxableaccount In details, if company chooses a capital structure with both debt and equityinstead of only equity, payment to creditors will be deducted out of the taxableincome Hence, using debt helps the firm decrease taxable revenue, thereby theafter-taxes value of firm will increase by an amount which equals present values oftax shield As a result, theoretically, 100 percent of debt in capital structure willmaximize firm value and optimize capital structure Moreover, average capitalexpenditures will decline when a firm has higher leverage However, the largeramount of loan the firm uses, the riskier the financial situation it faces to as theprofit gained by the firm cannot cover the interest payment, increasing theprobability of bankruptcy Therefore, many other factors should be considered todetermine the structure of capital

Fama and French (1998), Mackie-Mason (1990) pointed out that debt has nonet tax benefits, as very little support in empirical analysis Additionally, DeAngeloand Masulis (1980) agreed with that claim, supposing that companies with other taxshield such as depreciation would not take advantage of interest tax shield On theother hand, Graham (2000) asserted firms can add value by increasing leverageratio, as tax benefits of debt are considerable Graham and Harvey (2001)conducted a survey, showing that firms consider interest tax savings to be rathercrucial Modigliani and Miller (1963) also argued that enterprises with high profitmay prefer higher leverage ratio due to tax deductibility of interest payment.However, the study has limitations in considering the effect of personal taxation

1.2.7 Profitability

Tradeoff theory (1984) contends that the higher the profit the company couldearn, the larger the tax burdens will be Hence, in order to obtain benefit of tax,companies tend to borrow from outside sources to finance the operation The theorysupposes that profitability and leverage move in the same direction In contrast, thepecking order theory (1984) suggests that the relationship between profitability andleverage is negative, stating that firms prefer internal financing over debt, and debtover equity According to the pecking order theory, higher profitability will lead tolarger internal financing of investment and less debt financing

However, there are many paperwork support the pecking order theory Titman

et al (1988), Friend et al (1988), Rajan and Zingales (1995), Booth et al (2001),Huang and Song (2002), and Kester (1986) found out a negative association betweenleverage and profitability In contrast, a few other studies show different finding thatstates a positive relationship Jesen (1986) and Willamson (1988) claimed that highprofitability companies are more likely to increase leverage ratio, implying a positiveassociation between leverage and profitability

1.2.8 Non-debt tax shield

Miller and Modigliani (1963) asserted that firms have strong incentive toincrease leverage in order to gain benefit deductible interest tax shield Nonetheless,depreciation also reduces tax for companies, and it is considered as non-debt tax shield.DeAngelo and Masulis (1980) contend that non-debt tax shield would lead to greaterlikelihood of no taxable income, reducing corporate tax rate Titman and Wessels (1988)asserted that non-debt tax shield and debt ratio move in the opposite direction, or in otherwords, companies with large non-debt tax shield tend to borrow less from outsidesources In addition, pecking order theory also supports this finding

Kim and Sorensen (1986), Titman and Wessels (1988), Mackie-Mason (1990),Demirguc et al (1996), De Miguel et al (2001) concluded in their findings that therelationship between leverage and non-debt tax shield is negative However, theempirical researches of Scott (1977), Moore (1986), Kale et al (1991), and Ramlall(2009) observe a negative association, as substantial non-debt tax shield might beused as collateral to borrow more debt