Bank credit appraisal criteria for borrowing firms in vietnam

LIST OFT ABLES Table 2.1: Rating symbols long-term and short-term debt II Table 2.2: Weighted points of non-financial criteria 14 Table 2.3: Weighted points of financial ratios and non-

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

BANK CREDIT APPRAISAL CRITERIA FOR BORROWING FIRMS IN VIETNAM

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

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

Academic Supervisor:

Asso.Prof.TRUONG QUANG THONG

HO CHI MINH CITY, DECEMBER 2010

First of all, I would like to send my deepest gratitude to my supervisor, Professor Truang Quang Thong who always gives advice and comments during my completion of the thesis

I am grateful for Professor Nguy~n TrQng Hoai and Professor Peter Calkins for their precious advice and comments from the initial ideas of the theme for my thesis

Many especially respectful thanks are sent to my family for encouraging and providing me with an opportunity to pursue my desires in higher learning and for their love, affection and sympathy that have helped me to gain more strength and motive to complete this thesis

LIST OFT ABLES

Table 2.1: Rating symbols long-term and short-term debt II Table 2.2: Weighted points of non-financial criteria 14

Table 2.3: Weighted points of financial ratios and non-financial criteria 15

Table 2.4: Weighted points of financial ratios and non-financial criteria 15

Table 2.6: Profit and tax with two different capital structure 18

Table 3.2: Business structure has ability to repay 26 Table 4.1: Following explain the meaning of variables (see appendix 1) 31

Table 4.4: Points of relations with banks factor (see appendix 3) 39 Table 4.5: Points of business environment factor 40

Table 5.5: Coefficients of models (see appendix 6) 46

ABBREVIATIONS

EU: Europe

MM: Modiglian Miller

U.S.: United States

ABSTRACT

Capital credit is very important in business activities of enterprises The ability to repay loans model in this thesis shows an important role when the bank make a lending decision This study examines and analyses credit rating criteria affecting borrowing firms on bank credit appraisal in Vietnam through applying cross-section data from Credit Information Center which concentrate on forty firms including the medium-sized enterprises that has equity capital more than five billions Vietnam dong or number labor more than two hundred people in leather-footwear industry The regression model is estimated based on the multiple linear regression function The ability to repay loans is dependent variable in the thesis model, and independent variables are current ratio, quick ratio, inventory turnover, receivable turnover, total asset turnover, debt to equity ratio, debt to total asset ratio, return on asset, return on common equity ratio, net profit margin ratio, delinquency ratio, cash flow, management quality, the relations with banks, business environment, other activities and corporate income tax (new added) As results, corporate income tax factor affecting Vietnam Moreover, the results seem to be appropriate to answer questions

of the research, borrowing firms are perceived to be information on the lending decision at banks in

;

LIST OF TABLES ABBREVIATIONS ABSTRACT

TABLE OF CONTENTS

1.1 Problem statement 1.2 Research objective 1.3 Research questions 1.4 Methodology 1.5 The structure ofthesis CHAPTER 2: LITERATURE REVIEW 2.1 Theory background

2.3.2 MM proposition I (corporate taxes)- The value of levered firm 17

4.3.1.3 Inventory turnover- IA 4.3.1.4 Receivable turnover- RT 4.3.1.5 Total asset turnover- TAT 4.3.1.6 Debt to total asset ratio - DA 4.3.1.7 Debt to equity ratio- DE 4.3.1.8 Net Profit margin- NPM 4.3.1.9 Return on assets - ROA 4.3.1.10 Return on Equity- ROE 4.3.1.11 Cash flow- CF

4.3.1.12 Management quality- MQ 4.3.1.13 Relations with banks- RB 4.3.1.14 Business environment- BE 4.3.1.15 Other activities- OA 4.3.1.16 Delinquency ratio- DR 4.3.2 Corporate income tax (new factor)- CIT 4.4 Data collection method

CHAPTER 5: DATA PROCESSING AND EMPIRICAL RESULTS 44

CHAPTER 1:

INTRODUCTION

This chapter starts with introduction to problem statement It then presents research objectives, questions and methodology in sections: 1.2, 1.3 and 1.4, respectively Finally, this chapter show thesis structure in section 1.5

- Subjectively, these are the errors in the management economy of economic times "digital" - "virtual economy", particularly in management of financial system, money and banks, namely approximately six percents of all mortgage loans in United States were in default in 2008 Historically, defaults were less than one-third of that, i.e., from 0.25% to 2%

The crisis began with the collapse of Bank Lehman Brother Investment, one ofthe largest banks in the United States, on 9 June 2008 (BBC News, 2008) As year progressed, the United States banking and financial system, followed by the

EU and Japan, were all shaken by the crash of multiple banking, corporate finance-insurance institutions

In the first three months of 2009, the situation continued to deteriorate, with GDP growth in most of developed countries dropped to around negative 2.2 percent Trade turnover reduced strong (export of Eastern Asia reduced 30%,

I •

developing countries reduced over 10%) and high rates of unemployment that had never been seen in decades such as unemployment rate of United States is 8.1 percent with over 5 million workers, unemployment rate of Japan is 4.4 percent with nearly 3 million workers, unemployment rate of EU is 7.6 percent with nearly 4 7 million workers (Nguyen Dang Hung, 2009)

With most developing economies, including Vietnam, to subjective effort, growth and development depends on two fields: export-import and capital resource Growth indicators, FDI, turnover export during the end of the year

2008 to the present, all indicated that the crisis is affected by the financial global on the economy of Vietnam: GDP in 2008 adjusted to 6% (2009 adjusted also decline 6-6.5% to 5-6%, while EU predicted about GDP increased only 0.3%); FDI in the first two months of 2009 with only 5 billion USD (by 31% in the same year 2008); unemployment increased (Ministry of Foreign Affairs Vietnam, 2009)

economic-In the banking sector, under the guidance of the Government and the Prime Minister, to stabling economic growth, the orientation of credit growth m Vietnam must maintain credit growth and ensure credit quality Hence, to achieve credit growth in years after 2008, namely banks need to search new added corporate income tax factor in credit appraisal to increase loans but ensuring repayment ability of borrowers It is the motivation for present thesis on credit appraisal criteria for borrowing firms in Vietnam banking

The main objective ofthis thesis is to determine new factor (corporate income tax factor) affect the ability to repay loans of borrowers in Vietnam Factors which banks are used in credit appraisal are: current ratio, quick ratio, inventory turnover, receivable turnover, total asset turnover, debt to equity ratio, debt to total asset, return on asset, return on common equity, net profit margin, delinquency ratio, cash flow, quality management, relations with banks, business

environment, other activities, and factor is proposed to apply in credit appraisal ofVietnam banking now is corporate income tax factor

The regression model is used to estimate ability to repay loans of the borrowers Then, banks decide to rely on repayment ability In this model of thesis, dependent variable is ability to repay loans of the firms for the banks to lending decisions

1.2 Research objective

The objective of this thesis is to analyze corporate income tax factor which is proposed to add in 16 factors are used in credit appraisal in order to determine debt repayment ability of borrowers Beside many criteria are used in banks such

as current ratio, quick ratio, inventory turnover, receivable turnover, total asset turnover, debt to equity ratio, debt to total asset ratio, return on asset ratio, return

on common equity ratio, net profit margin ratio, delinquency ratio, cash flow, management quality, the relations with banks, business environment and other activities, this thesis find out about level influence of corporate income tax factor

in credit appraisal

Because corporate income tax is an expense, on one hand, enterprises tend to find ways to set the tax shields such as increased use of debt instead of equity, on the other hand, minimizing corporate income tax and some savings will contribute to increasing business value With new factor added (corporate income tax factor), if enterprises have an optimal capital structure and saving corporate income tax, their value may be increased Then, the bank's credibility with the borrowers will increase Thus, banks may increase limit loans for enterprises to increase outstanding loans but ensuring credit quality

With new factor added (corporate income tax), banks can extend credit, credit quality, to improve business performance and bring other social benefits; this is presented clearly in the diagram below:

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GOVERNMENT

Source: Author 2009

CORPORATE INCOME TAX

INCREASE GDP & CONTRIBUTING OTHER TAXES BY OTHER INVESTMENT

The map shows that saving corporate income tax of enterprises affect lending decision of bank credit appraisal It increases limit loans of banks but securing credit quality The map framework is presented as follows:

Having equation is need for capitals of enterprises equal bank loans plus contributed capital and thence bank loans equal need for capital of enterprises minus contributed capital

In case, if enterprises have capital structure to save corporate income tax, they will use a part of contributed capital to other investment and the other investment will bring profit for businesses When enterprises use contributed capital for other investment, contributed capital of equation above reduce respectively Consequently, need for bank loans increase and it made an increase in interest loans expenses, leading enterprises to save corporate income tax

Thus, if enterprises have an optimal capital structure for saving corporate income tax, confidence level of banks with enterprises will increase in credit appraisal Since then, banks can increase limit loans for borrowers Hence, banks will improve business performance, credit growth, but ensuring credit quality Besides, while enterprises use loans to saving corporate income tax, enterprise use contribution capital for other investment and the effect of other investment brings social benefits (such as GDP growth, contribute corporate income taxes)

1.3 Research questions

For enterprises, corporate income tax is an expense It is shown on the financial report of business Thus, financial decisions are often considered and reviewed in the environment taxes Because interest expense are recorded as expenses before calculating corporate income tax, businesses tend to borrow more debt to have greater tax shield and profits for businesses will increase, ensuring the financial management objectives Therefore, research topics select corporate income tax factor to consider the impact of this new factor added to

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Bank credit rating criteria impact directly and indirectly on loans between lender and borrower by arithmetic to measure ability to repay loans of enterprises for bank

to lending decisions

4.3 The conceptual design

According to Ross (2005), financial ratios are useful indicators of a firm's performance and financial situation Most ratios can be calculated from information provided by financial statements Financial ratios can be used to analyze trends and to compare firm's financials to those of other firms So, financial ratios criteria of enterprises are essential criteria in credit appraisal for lending decision of banks

4.3.1 Criteria that banks use to appraise

4.3.1.1 Current ratio- CR

Current ratio is ratio of current assets to current liabilities:

Current Assets Current R a t i o = - - - -

Current Liabilities Short-term creditors prefer a high current ratio since it reduces their risk Shareholders may prefer a lower current ratio so that most of the firm's assets are working to grow enterprises Typical values for current ratio vary by enterprise and industry One disadvantage of the current ratio is that inventory may include many items that are difficult to liquidate quickly and have uncertain liquidation values

Current ratio reflects ability to pay liabilities of enterprises According to common expenence,

If CR < 1, the liquidity of business is low

If CR > 1, the liquidity of business is high

decide the banks' lending in credit appraisal Thus, research questions are posed as:

enterprises in credit appraisal in Vietnam?

in credit appraisal?

1.4 Methodology

The data collection will be processed by SPSS software After getting the necessary information, quantitative analysis, statistical descriptive and econometric methods will be used to analyze that information Form that analysis, we have a general understanding about 16 factors are used in credit appraisal and corporate income tax factor that affect ability to repay loans to lending decisions of banks This analysis also provides hypothesis tests of the relationships between each independent variables and the dependent variable The econometric method is OLS regression to estimate the effects all factors on ability to repay loans Also the relationships among independent variables are tested and checked for the correlations

1.5 The structure of thesis

In addition to introduction chapter, the rest of the paper consists of 5 chapters with the outline as follows:

Chapter 1 : Introduction Chapter 2: Literature review Chapter 3: Overview of leather - footwear industry in Vietnam Chapter 4: Research methodology

Chapter 5: Data analysis Chapter 6: Conclusions

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2.1.1 Credit appraisal

According to Bhattacharya (1998), credit appraisal is to use the tools and techniques to analyze the inspection, evaluation of reliability and risk of a plan or projects that the customer has to show for the lending decision

The purpose of credit appraisal is to assess accurate and true ability to repay debt of enterprises to making any lending decisions (Jonathan, 2001) Main content of a typical credit appraisal are as follows:

• Borrower status

• Financial situation of customer

• Feasibility of the investment projects

• Loan property guarantee

• Ability to manage and control risks

Thus, credit appraisal is one of the important steps in all process credit According to Nguyen Minh Kieu (2008), the importance of it is represented as follows:

• Assess the reliability of production plan or investment projects that borrowers have provided for banks when they do loan procedures

• Analyze and evaluate the level of risk of the project when banks decide to lend money

i

• Help creditors and banking leaders in lending decisions and reduce the rate of two kinds of mistakes in lending decisions: (1) lending for a bad project and (2) deny loan for a good project

2.1.2 The definition of credit rating

A credit rating is "an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed income security" (Moody's, 2004)

A credit rating is an assessment of the credit worthiness of individuals and enterprises It is an evaluation about the history of borrowing and repayment, as well as the availability of assets and extent of liabilities (Steven, 2003)

2.1.3 Objective of credit rating

Credit rating is part of credit appraisal relating to level of trust by banks for businesses The commercial banks do not use credit rating results to evaluate the value of borrowers Credit rating is basically a formed opinion based on current credit appraisal criteria which banks will examine and determine loan limits accordingly (Vietcombank, 2008)

2.1.4 Role of credit rating

Credit rating helps commercial banks to control the confidence level of clients, set interest rates for loans in accordance with the ability to predict failure

of each customer group Commercial banks can evaluate effective list for loans through monitoring the change of outstanding debts and debt classification in each group of customers who has a credit rating, thereby adjusting list of priority resources to customers safely (Nguyen Thanh Huyen, 2008)

2.1.5 Principle credit rating

Concepts of modem credit rating are focused on key principles including trustable analysis based on awareness and goodwill payment by borrowers and the loan; evaluation of long-term risk based on the influence of business cycle and trends capacity repayment in the future; and comprehensive assessment based on credit rating symbols

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In analyzing method, credit rating is essential in the use of qualitative analysis

as supplement to the quantitative analysis (United Nations, 2008) The quantitative data are the observers to be measured by number; the observations can not measure by number to be assigned to the qualitative data Those of analysis may change in accordance with changes in the level of technology requirements

2.1.6 Credit rating model

Simple model to be used in the credit rating model is a variable model The evaluation criteria should be unified in the model Financial ratios are used in the model include liquidity ratios, debt ratios, coverage ratios, activity ratios, profitability ratios and interest costs And non-financial criteria are used in the model include the operation of enterprises, number of years of quality and level

of high-level management, and industry prospects A disadvantage of a variable model is that the result is difficult to predict accurately if the analysis performed and the number of points assessed separately, many people can understand the criteria evaluated by a difference To overcome the disadvantage, these researchers have developed models to combine multiple variables to a value so the ability to repay loans of the enterprises, such as: Linear discriminant model (Lee, 2007) and Logistic regression model (Andre, 2009)

2.1 7 The basic elements of credit rating

2.1.7.1 The number ranks of credit rating

Determining the number of rank in credit rating is very important The number of rank must certain to cover all trust levels of borrowers at the banks

On the other hand, the number of rank must ensure in such a way that businesses have the same trust level must ensure the same rank and this same rank must reflect correct level of trust

In the world today, there are many organizations making credit rating for businesses Each organization has the rank to different rating Rating by Standard

•

world, including 10 rankings such as AAA, AA, A, BBB, BB, B, CCC, CC, C,

D, with AAA is highest rating (Standard & Poor's, 2006) Moody's has the ranking system such as Aaa, Aal, Aa2, Aa3, Al, A2, A3, Baal, Baa2, Baa3, Bal, Ba2, Ba3, Bl, B2, B3, Caal, Caa2, Caa3, Ca, C with Aaa rank is highest rating Fitchrating has long-term rating scales such as AAA AA, A, BBB, BB, B, CCC, CC, C, D with AAA ranking is highest rating (Fitchrating, 2006) Generally, credit rating consists of 10 levels from AAA to D and is used commonly in the trust ranking organization in the world

In Vietnam, credit rating at bank as BIDV, Vietinbank, Vietcombank including 10 ranks namely AAA, AA, A, BBB, BB, B, CCC, CC, C, D (AAA -highest grade and D - lowest grade), is evaluated from the financial and non-financial criteria, but they do not consider corporate income tax factor

2.1 7.2 Scale of criteria Generally, scale of criteria is divided into five different levels from 20 to 100 points Each criterion has a certain weight The points of each criterion are calculated as following: multiply one in five level points by weights, respectively Each weight of criteria reflects the important degree of criteria Points of businesses are calculated by plusing total points of criteria which mutiplied with the weights

2.2 Some model of credit rating 2.2.1 Moody's rating analysis According to Michel Crouhy et al (2000), Moody's is considered to have expertise in credit rating The credit rating process includes quantitative, qualitative and legal analyses The quantitative analysis is mainly based on the firm's financial reports The qualitative is concerned with management quality, reviews firm's competitive situation as well as an assessment of expected growth within firm's industry plus the vulnerability to technological changes, regulatory changes, labor relations, but criteria of Moody's does not consider corporate income tax factor

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Table 2.1 shows that long-term and short-term ratings are built by Moody's The long-term rating has 20 ranks from Aaa to C and the short-terms rating are divisible into only four notches, as Prime-1, Prime-2, Prime-3, Not-Prime

Table 2.1: Rating symbols long-term and short-term debt

ratings A3

Baal

Adequate payment capability Last Baa2 Prime-3

rating investment-grade Baa3

Bal

Ba2 Speculative Credit risk developing,

due to economic changes

Ba3

Speculative-Bl

grade Highly speculative, credit risk ratings B2 Not Prime

present, with limited margin safety B3

Caal High default risk, capacity

Caa2 depending on sustained, favourable May be m

default

recovery Source: Moody's (2004)

2.2.2 Z-score model of Altman

In order to strengthening the predicted bankruptcy of enterprises in credit rating model, commercial banks use predict models which have many variables Methods are used to predict the risk failure of businesses had been built and published However, Z-score model of Altman has been tested and widely accepted

Credit scoring model is built by Altman ( 1981 ), the first development Then Steele (1984), Morris (1997) and other researchers develop more The general model is Z = c + " L c r

Where Z > 2.99 indicate non-bankruptcy,

2.2 < Z < 2.99 indicate a gray area, And Z < 1.80 indicate bankruptcy prediction

Of which:

• X1 = (Current Assets - Current liabilities) I Total Assets: measure the density of working capital in total assets

• X2 = Retained Earnings I Total Assets: measurement ability profits

• X3 =Earnings before Interest and Taxes I Total Assets: This is the most important coefficient Profit is the top goal and is determined at the existence

of businesses Future loans added to the charges also show the ability to create income for enterprises

• X4 =Market Value of Equity I Book Value of Total Liabilities: measuring stamina of enterprises when the property of firms decline

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• X5 = Sales I Total Assets: the ability to create sales of property

* Advantages from the model mentioned above measure risk credit by scores saying that it is relatively simple But, this model has a few disadvantages as follow:

The model only allows classification borrowers with two groups as risk and no risk However, in practice the level of credit risk potential of each customers is different such as slow to repaying interest expenses, and do not pay interest expenses to lost all capital Unconvincing reasons to show that the number reflects the importance of indicators in the formula is invariant

Z-Scores model of Altman Model do not include difficult criteria to quantify, but I think it is an important role affecting level loans (reputation of customers, the relationship between long-term banks and customers or macroeconomic criteria such as fluctuations of economic cycles)

Credit Information Center of State Bank implementation ranked trust businesses under the guidelines of State Bank in Vietnam in order to standardize the assessment of financial ratios criteria can apply for Commercial Bank CIC is currently using 11 financial ratios criteria, including current ratio, quick ratio, inventory turnover ratio, receivable turnover ratio, total asset turnover ratio, debt

to equity ratio, debt to total asset ratio, return on asset ratio, return on common equity ratio, net profit margin ratio, delinquency ratio to the grading guidelines in Decision No 57/2002/QD-NHNN date 24 January, 2002 This model is clearly limited by the appraisal lack of non-financial criteria And this model do not consider corporate income tax factor

2.2.4 Credit rating VCB

Vietcombank build credit rating system with the principles of limited maximum impact financial ratios criteria by designing non-financial criteria and provide detailed instructions for the evaluation of credit rating

- - - -

-The financial ratios criteria is assessed by the instructions of State Bank and adjust a few statistics ratio by industry calculated from information VCB's credit data Those of non-financial criteria are built to supplement financial ratios criteria Each criterion was evaluated in the standard corresponding level of 5 points 20, 40, 60, 80, 100 (initial points) Depending on the importance of each criteria group and criteria have different weight Based on the total points achieved after initial points with weighted to ratings

Enterprises are classified in three groups: large, medium and small Each group size will be scoring system of 14 financial ratios criteria corresponding to the 4 group-farm forestry industries- fishing, trade and services, construction and industry Financial ratios criteria including liquidity ratios (current ratio, quick ratio); activity ratios (receivable turnover ratio, inventory turnover ratio, total asset turnover ratio); debt ratios (debt to total assets ratio, debt to equity ratio, delinquency ratio), profitability ratios (return on asset ratio, return on common equity ratio, net profit margin ratio), but credit rating criteria of VCB do not consider corporate income tax factor

Table 2.2: Weighted points of non-financial criteria

Criteria

Ability to pay debts

Source: VCB, Ernst & Young (2008)

Table 2.2 shows that weighted points of non-financial criteria including ability to repay debts from cash flow, management quality, relations with banks,

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business environment and other activities In addition, credit rating of enterprises are categorized by three groups is state-owned enterprises, enterprises with foreign investment and the other business in the weigh points of non-financial criteria And categorized companies by two groups are businesses have been audited and not audited as presented in Table 2.3 and 2.4

Table 2.3: Weighted points of financial ratios and non-financial criteria (not audited)

Criteria

Source: VCB, Ernst & Young (2008)

Table 2.4: Weighted points of financial ratios and non-financial criteria (audited)

Criteria

Source: VCB, Ernst & Young (2008)

Based on the total points achieved as the calculation is presented above, VCB usually uses the following 10 ranks" AAA, AA, A, BBB, BB, B, CCC, CC, C, D" from highest to lowest to denote the loaning enterprises credit rating classes

as presented in Table 2.5

Table 2.5: Rating symbols ofVCB

Enterprises operating effectively, the ability to self-finance 95-100 AAA good prospects of long-term development, have financial

potential well, history of loan repayment is well, risk lowest Operating effectively and stability, ability to self-finance 90-94 AA high, have development, history of loan repayment is well,

60-64 CCC Enterprises operating effectively low, lack of management

capacity, low repayment loan, risk high

55-59 cc Enterprises poor performance, weak financial ability, weak

repayment loan, risk is very high Enterprises performs poorly, extend loss, not the ability to 35-54 c self-fmance, management capacity weaknesses, debt is out of

date, risk is very high

<35 D Financial shortcomings, losses extended, creditors can require

difficult Risk particularly high, inability to repay

Source: VCB, Ernst & Young (2008)

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2.3 Corporate income tax

2.3.1 Assumptions and proposition of M&M theory

Capital structure of M&M theory is made by Modigliani and Miller in 1958, this part summarize important assumptions and proposition ofM&M theory

According to Ross (2005), M&M theory base on important assumptions the following:

Corporations are taxed at the rate Tc, on earnings after interest

No transaction costs

No financial distress costs

Corporations and individuals borrow at the same rate

Perfect market

On content, M&M theory is stated in two important propositions:

- MM proposition 1: the value of levered firm

- MM proposition II: the cost of equity rises with leverage

These propositions will be considered in turn in two cases with two assumptions under taxes and no taxes

Thesis only uses MM proposition I (corporate taxes) is: the firm's value is presented in the next section

2.3.2 MM proposition I (corporate taxes)- The value of levered firm

M & M proposition I (corporate taxes) consider that the value of the firm will change how when change debt on equity ratio (B/S), or is called the ratio of leverage To see the change now, M & M theory consider the value of the firm in case no debts or 100% of the equity (V u) and the value of the firm in case debts (VL) Additionally, firm must pay each year corporate income taxes without debt, with taxes are Tc If firm have debts (B) by issuing corporate bonds, they will pay interest loans r8 If firm have no debts or sponsor active firm with 100% equity (S), the cost of equity is r0 • M & M proposition I is expressed the following:

Under corporate income taxes, the value of firm with debt equal to the value of firm without debt plus the present value of the tax shield Equation is presented: V L = V u +TcB

To prove this proposition, we just consider the illustrated example (Ross, 2005) and use some logic and algebraic change at the same time Example Water Products Company has corporate income tax rate, T c of 25% and expected earnings before interest and taxes (EBIT) of $1000 each year Its entire earnings after taxes are paid out as dividends The firm is considering two alternative capital structure Under case 1, Water Products would have no debt Under case

2, the company would have $4000 of debt, (B) The cost of debt r8 , is 10 percent CFO calculates total cash flow to investors as follows:

Table 2.6 Profit and tax with two different capital structure

6.Total cash flow to investors 475 [375+ 100] 550 [150+400]

Source: Ross (2005), Tran Ngoc Tho (2007)

Table 2.6 show that total cash flow to investors is EBIT(l-Tc) + Tcr8B (for a firm with perpetual debt) We see that the value of firm is present cash flow at the suitable interest rate Under plan less debt, interest loans $100 and the cash flow to stockholders is earnings after corporate taxes Its value can be determined by

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discounting at the interest rate r0 with less debt:

Vu = PV [EBIT (1- Tc)] = [EBIT (1-Tc)] I ro

Under plan with debt, firm cash flow has two parts First part is the cash flow

of firm from less debt EBIT(1-T c) and second part is Tcr8B, is called the tax shield form debt

Because tax shield increases with the amount of debt, firms can raise its total cash flow and its value by substituting debt for equity Thus, firms should use as much debt as possible

In other the hand, table 2.6 is studied and applied to make thesis theory, the following:

We see that more cash flow reaches the owners of the firm (investors) under case 2 The difference is $75 = $550- $475 The WP receives less taxes under case 2 ($50) than it does case 1 ($125) The difference is $75= $125-$50, is amount of saving taxes from interest rate It does not take one long to realize the source of difference

Where as:

Case 1: firm have $1000 of debt, corporate income taxes is $125

Case 2: debt of firm increase from $1000 to $4000, corporate income taxes

2.3.3 Optimal capital structure theory

According to J.P Morgan (2004), optimal capital structure theory says that have an optimal capital structure through which can increase enterprises value by using total debt on total equity ratio First thing to consider in this theory is optimal capital structure may have to use debt to reduce weighted average cost of capital (WACC), because the cost to use debt is less than the cost to use equity Reason to the cost to use debt less than the cost to use equity is saving corporate income tax When businesses use debt, interest loans are recorded in the pre-tax cost Enterprises are reduced iprofit after interest and therefore reduce the corporate income tax

In addition, there are many empirical studies on determinants of capital structure of SMEs that consider the effect of tax on leverage, such as: Cortes and Berggren (2001), Frank and Goyal (2003), Nguyen Van Cong (2006) and Le Thi Thanh Ha, Le Hoang Vinh (2008) Based on their research and optimal capital structure and MM theory, the firms should use more debt for increasing the tax-shield benefit of debt Therefore, enterprises will be saving corporate income tax According to me, in the case, enterprises have optimal capital structure, corporate income tax is able to affect the results credit appraisal

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- - - - - - -

-Thus, from optimal capital structure theory, banks can be based on the corporate income tax that firms would pay each year to increase lending or not, because:

Enterprises can use debt to take full advantage of benefit tax contribute increasing enterprises value But high using debt levels can the benefits from savings tax are eliminated by an increase greater than financial distress cost Therefore, enterprises need to determine the sensible using debt level, both ensuring benefit from tax shield and good control of financial distress cost

Corporate income tax is a expense, enterprises tend to find ways to set tax shields such as increased use of debt instead of equity, some savings will contribute to increasing business value

2.4 Summary

From M&M theory, optimal capital structure theory, researchers and banks were determined factors to build credit ratings criteria Nowadays banks determined 16 factors, such as current ratio, quick ratio, inventory turnover, receivable turnover, total asset turnover, debt to equity ratio, debt to total asset ratio, return on asset ratio, return on common equity ratio, net profit margin ratio, delinquency ratio, cash flow, management quality, the relations with banks, business environment and other activities And they are looking for determine additional factor that influence on ability to repay loans According to logic capital structure theory (M&M theory, optimal capital structure theory) of enterprises, the thesis objective research the influence of corporate income taxes factor on ability to repay loans Because in case effective business, enterprises must pay much corporate income taxes, since enterprises are lent money by banks When businesses use loans, they must pay interest loans Since then, businesses will be reduced corporate income taxes Thus, enterprises pay less tax with more debt With more debt, enterprises have established a tax shield This

leads to businesses has made one of factors to become an enterprise with a logic capital structure

However, corporate income taxes pay less with debt will bring low profit But

in practice businesses have other profit and it also provides other social benefits (Diagram in section 1.2 of chapter 1 )

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CHAPTER3 OVERVIEW OF LEATHER- FOOTWEAR INDUSTRY

IN VIETNAM

3.1 Reasons of using data in Vietnam's leather- footwear industry

With experience working in Vietcombank, I realize that corporate income tax factor should be added to credit rating criteria are applied in the bank Since then,

I find data to assess degree of influence corporate income tax factor to repay the debt of enterprises According to information I gathered, there are statistics on credit ratings of enterprises in Vietnam leather-footwear industry Hence, I use data on leather-footwear industry to reflect degree of influence corporate income tax factor to repay debt of enterprises

Leather-footwear industry data was choosen because enterprises in footwear industry provide fairly complete information from the statistic information of Credit Center Information There are 40 observations of enterprises (they are the medium-sized enterprises that has equity capital more than five billions Vietnam dong or number labor more than two hundred people accordance with Enterprise Law of Vietnamese government, type of enterprise in leather - footwear industry is other enterprise except state owner and foreign investment enterprise, and their financial report are not audited) to be taken for sample in the survey

leather-3.2 Overview of leather - footwear industry in Vietnam

At present, Vietnam is one of 10 countries exporting leather-footwear products leading market with international growth sectors as well as export volume growth reached an average of 10% per year In 2009, export turnover reached nearly $4.8 billion It is expected to rise to $5.6 billion this year, up 17 percent against last year (GSO, 2009)

In 2009, European Union (EU) is the largest consumption market of Vietnam's footwear accounts for 52% of total export turnover of Vietnam's footwear Leather-footwear industry exports to United States account for 22% of total export value of footwear from Vietnam

Currently, 33 codes in leather footwear apply anti-dumping tax; other category is tax incentive of EU and is not limited in quantity because Vietnam leather - footwear industry still face many limitations such as importation of the main raw materials from overseas; weakness in designing models and developing new products; shifting in labor market; increasingly fierce competition with other countries in the region, especially China, Taiwan, South Korea Generally, Vietnam leather-footwear industry exports increased in growth both quantity and export turnover

In order to maintain growth and achieve plans of the year, leather - footwear industry should continue to shift to production of high quality footwear products

to increase value, enhance trade promotion, diversification of export markets In particular, enterprises need to shift gradually from the EU market to other potential markets such as Japan, Taiwan and Eastern Europe

Leather - footwear industry, Vietnam is in the process of development with existing potentials, is one of industry brings large export turnover to Vietnam With the participation of investment capital from banking system in leather-footwear industry, banks should observe an overall business operating in the leather - footwear industry over the period; the same time sticking information on import and export items in Vietnam leather - footwear industry in world market from other sources official information and on mass media to better serve Vietnam leather- footwear industry

3.3 Credit ratings data of the leather-footwear industry in year 2008

Data is collected by Credit information center in Vietnam has about 379 enterprises and organizations in leather- footwear industry Acorrding to CIC's credit rating, they have 42.3% enterprises which have good rating from AAA to

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A; 53.3% enterprises which have average ratings from BBB to B fairly and only 4.4% enterprises which have weak rantings from CCC to C Statistics show that almost all companies operating in leather - footwear industry have good ratings, operating effectively and ability to develop well

In my database, there are 40 enterprises in Vietnam leather-footwear industry

in the year 2008 were interviewed by Credit Information Center, resulting in the ability to repay loan ranks are shown under the following:

Table 3.1: Sort credit rating business

ABILITY TO REPAY

17,5%

Source: survey results 40 Leather-Footwear enterprises in Vietnam

Statistics described in table 3.1, shows in 40 medium enterprises in Vietnam leather-footwear industry is ranked credit with good results, include 09 enterprises from AA to A (22.5%), 24 enterprises (50%) from BBB to B, and only 07 enterprises (17.5%) from CCC to C And results of credit rating enterprises are classified based on criteria such as current ratio, quick ratio, inventory turnover, receivable turnover, total asset turnover, debt to equity ratio, debt to total asset ratio, return on asset ratio, return on common equity ratio, net profit margin ratio, delinquency ratio, cash flow, management quality, the relations with banks, business environment, other activities, and corporate

income tax In Vietnam, credit rating in banks such as BIDV, CIC, VCB also includes 10 ranks from AAA to D

Table 3.2: Businesses structure has ability to repay

Ability to repay

Source: survey results 40 enterprises in Vietnam Leather-Footwear industry

When I study about ability to repay of enterprises, the results see that 38 businesses have ability to repay loans of 40 companies of the samples selected at the time of study, and a number of enterprises which have ability to repay is very high, reaching 95% Need capital to do business and analyzing the ratio of repayment ability loans of businesses, banks should create conditions for enterprises development in leather-footwear industry According to other studies,

it is approximately 90% enterprise; with capital of operating business depend on loans from banks

However, credit rating results of enterprises in the leather-footwear industry are appraised by 16 factors (such as: current ratio, quick ratio, inventory turnover, receivable turnover, total asset turnover, debt to equity ratio, debt to total asset ratio, return on asset ratio, return on common equity ratio, net profit

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margin ratio, delinquency ratio, cash flow, management quality, the relations with banks, business environment and others activities), which do not corporate income tax factor Hence, I have used data on present above and put in data of corporate income tax factor to study the affect of this factor to debt capacity repayment

3.4 Summary:

Data is applied in this thesis is only limited in leather- footwear industry (if new corporate income tax factor affect repayment capacity in Vietnam leather-footwear industry, I may expand research affect of this factor to debt capacity repayment in other industry) and it is presented in Appendix 2 So, to know how

to use data in this thesis invites you to see chapter 4