Does firm characteristic matter in capital structure decision an empirical study of listed food processing companies in vietnam

ABSTRACT The aim of this paper is to explore the firm-specific factors that affect the capital structure of food processing companies listed in Vietnamese stock exchange.. Seven factors

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DO FIRM CHARACTERISTICS MATTER IN CAPITAL STRUCTURE DECISION?

AN EMPIRICAL STUDY OF LISTED FOOD PROCESSING COMPANIES IN

VIETNAM

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

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

DINH THI THU

Academic Supervisors:

Dr NGUYEN TRONG HOAI

Mr NGUYEN XUAN THANH

HO CHI MINH CITY, October 2014

ABSTRACT

The aim of this paper is to explore the firm-specific factors that affect the capital structure

of food processing companies listed in Vietnamese stock exchange The paper firstly reviews theories of capital structure: trade-off theory, pecking-order theory and other related empirical studies Seven factors are thereinafter concluded and discussed in the studied model in respect of correlations and the determinants of capital structure by using panel data procedures for a sample of 41 food processing companies listed on the Vietnamese Stock Exchange during the period of 2007-2012 Pecking order theory dominates in explaining financial decision of these firms There are differences between the determinants of long-term fund-raising and short-term fund-raising Profitability, size, tangibility, earnings volatility and liquidity are found statically significant to short-term leverage whereas tangibility and earnings volatility is the most important factors impacting the long-term leverage Empirical findings suggest some policy recommendations for sustainable development of the private sector in Vietnam

Keywords: Capital structure; leverage; food processing; Vietnam listed companies; panel data

ACKNOWLEDGEMENT

Studying is a long and interesting journey It would be more interesting if you have a chance

to get to know the talented people and learn from them This paper could not have been completed without support from my supervisors, friends and family

I would like to convey profound appreciation to Dr Nguyen Trong Hoai, Mr Nguyen Xuan Thanh and Mr Truong Dang Thuy for their guidance in conducting this thesis My special thanks go to Mr Nguyen Xuan Thanh for his valuable guidance, critical comments and warm support which made this work possible at the crucial stages

To my family and friends, my sincere gratitude for their unconditional love, support, and encouragement

TABLE OF CONTENTS

CHAPTER 1 INTRODUCTION 1

1.1 Research background 1

1.2 Problem statement 4

1.3 Research objectives 6

1.4 Thesis structure 7

CHAPTER 2 LITERATURE REVIEW 8

2.1 Capital structure definition 8

2.2 Capital structure theory 8

2.2.1 The trade-off theory 10

2.2.2 Pecking Order theory 14

2.3 Comparative look on capital structure theories 15

2.4 Empirical evidence on determinants of capital structure 17

2.4.1 Empirical evidence around the world 17

2.4.2 Empirical studies in Vietnam 22

CHAPTER 3 OVERVIEW OF FOOD PROCESSING SECTOR IN VIETNAM 27

CHAPTER 4 CAPITAL STRUCTURE DETERMINANTS – HYPOTHESES 32

4.1 Profitability 32

4.2 Tangibility 33

4.3 Firm Size 34

4.4 Non-debt tax shields 34

4.5 Growth opportunities 35

4.6 Earnings volatility 36

4.7 Liquidity 36

CHAPTER 5 Methodology AND DATA 39

5.1 Data 39

5.2 Methods of estimation 39

CHAPTER 6 EMPIRICAL RESULTS 42

6.1 Descriptive statistics 42

6.2 Analysis of the correlation among variables 43

6.3 Empirical results 46

CHAPTER 7 CONCLUSION 53

7.1 Findings 53

7.2 Policy implications 54

7.3 Limitations 57

REFERENCES 59

CHAPTER 1 INTRODUCTION

1.1 Research background

Vietnam is a developing country in Southeast Asian region with total area of 331,210 square kilometers and population of over 91 million Recovering from the war damage and the rigidities of a centrally-planned economy, the country has become among the fastest growing economies over the past decades thanks to the Doi Moi reforms in

1986 During this period, the private sector has emerged as one of the most important driving forces in Vietnam’s economic development The Enterprise Law in 2000 is conceived as a remarkable milestone for development of the private business in Vietnam This law mainstreams the registration and operation of private companies, implements a regime of property rights and guarantees equal treatment among economic sectors As a result, the period of 2000-2005 witnessed a boom in private sector development It is estimated that 160,672 private enterprises were registered with a total combined capital of US$20 billion during the period of 2000-2005, which

is 3.2 times more than the total number of private enterprises registered during

1991-1999 The private sector has played an increasingly important role in job creation, poverty reduction and economic growth Vietnamese private enterprises annually contribute about 42% to overall GDP and provide 56.3% of the country's regular job supply Nevertheless, these private firms have been facing many challenges in their existence and competition One of the biggest challenges is financial capacity The majority of Vietnamese firms are small-sized in terms of labor and capital More than

90 percent of the local businesses are small and medium enterprises These firms have been facing tough competition from foreign companies in technology and financial capacity Vietnam joined the WTO in 2007 following a long negotiation process of more than ten years and became the member of Trans-Pacific Partnership trade agreement in 2010 These turning points have brought both opportunities and challenges to Vietnamese firms They have chances to compete in the international market and expand their markets via goods export On the other hand, they also face tough competition from foreign companies when these firms have a free access to the Vietnamese market To compete with foreign firms, the local ones need to keep high

quality products and services with lower costs It is noticed that many Vietnamese firms have recently gone bankruptcy due to two important reasons First, firms could not sell their products Second, they faced capital shortage problem The first reason can be explained by the current global crisis in which the demand for products declines

in attempts of cutting cost The second reason of capital shortage is identified as the top constraint in almost every survey on private small firms in the country Vietnam is characterized by a bank-based economy where banking sector is the main source to finance the economy activities Financial liberalization has progressed by several reform policies In 1998, Vietnam’s financial system was strengthened and readdressed toward a more market-oriented approach when the Law on the State Bank of Vietnam No.01/1997/QH10 and Law on Credit Institutions No.02/1997/QH10 came into force The reform has led to a significant increase in total credit granted to the domestic private sector by the state-owned commercial banks in the following decades (World Bank, 2005) However, the private sector still gets less preferential access to banking credit than state-owned enterprises (SOEs) Most small businesses continue to finance their operations through retained earnings or informal sources of credit The recent global financial crisis together with macroeconomic instability due to rapid credit growth has forced Vietnamese government to pursue a tighter monetary policy Vietnamese banks are required to adopt conservative credit policies in 2011 As the result, local firms have limited financing resources for their operation and investment and face with bankruptcy Several local firms have chosen alternative channels for capital mobilization such as bond market or stock market

Vietnam bond market: Vietnam bond market is in a nascent stage even though its

formation dated in the early 1990s Local currency bonds are mainly issued by the government or government sponsored institutions such as Vietnam Development Bank, Vietnam Bank for Social Policy and Vietnam Expressway Corporation According to Vuong and Tran (2010), the overall bond market accounts for about 15% of the total GDP in comparison with the average percentage of 65% in East Asian region The corporate bonds, 92% of which have maturities of 1-3 years, are traded on both HOSE and HNX and account for 1.4% of GDP Currently, primary market for corporate bond

is weak while the secondary market is virtually nonexistent Vietnamese companies,

most of which are small- and medium- sized, would hardly raise fund for their operations through the bond market

Vietnamese stock market: The historical development of Vietnamese stock market

can be traced back with the establishment of Ho Chi Minh Stock Exchange (HOSE) in July 2000 and Hanoi Stock Market (HNX) in March 2005 Starting with five listed companies in 2000 with market capitalization of 0.2% of GDP, the number of listed companies increases to 311 in the year of 2012 with market capitalization of more than 21% of the country's GDP Even though Vietnamese stock market has nowadays become an increasingly important channel for medium and long term capital, it is still far from international standards in terms of market size and market capitalization

Table 1 Market capitalization of Vietnam’s stock market (2004 – 2012)

Year

Total of listed

domestic companies

Market capitalization of listed companies (US$)

Market capitalization of listed companies (% of GDP)

(Source: World Bank)

The Vietnamese stock market has been facing fundamental weaknesses that need to be resolved properly During its development, Vietnamese stock market experienced high volatility For example, in the period 2006-2007 there was a boom in this market due to over-expectation of the country’s economy growth and WTO accession Market capitalization in 2007 reached 25,24% of GDP Affected by the global financial crisis, Vietnamese stock market took a deep plunge in 2008: VN-Index fell down sharply and

market lost around two-third of its value when foreign investors withdrew their investment from Vietnamese stock market The root weakness relates to dismal transparency, predictability and information clarity for investment decisions Many listed companies frequently adjust their business results Annual reports do not provide much useful information for investors and the discrepancy before and after auditing are large With high information asymmetry, investors have to bear the brunt when punishment for these practices is not strong enough Moreover, information on the macro-economy is unpredictable and uncertain Consequently, the Vietnamese stock market can only attracts short-term and unstable funds instead of long-term players such as retirement funds, public savings funds and becomes a playground for day traders or hit-and-run investors

Despite the above-mentioned weaknesses, Vietnamese stock market still plays an increasingly important role in the national economic development with the increasing numbers of listed companies and becomes the second important channel in capital mobilization Vietnamese firms can choose debt finance via the banking system or raise equity in the stock market Therefore, it is worthwhile to study the financing practices

of the listed firms on Vietnamese Stock Market The general purpose of this paper is to extend our knowledge of how Vietnamese listed companies choose their capital structure and to what extent their financing behaviors are consistent with the theoretical explanations, namely the trade-off theory and pecking order theory

1.2 Problem statement

There are three major motivations for the study First, being not a new research area, capital structure remains one of the most interesting and puzzling ones Capital structure refers how a firm uses different sources

of funds to finance its operations and growth It is recognized that financial capital plays a crucially important role in the existence and growth of a firm Good capital structure decisions not only lead to higher profitability or lower risk but also help firms

to allocate risk as well as control power among various groups of shareholders Since first paper of capital research by Miller and Modigliani in 1958, there has been a vast amount of research on firm capital structure However, empirical results are

inconsistent in supporting the two most prominent theories of capital structure: the trade-off (Modigliani & Miller, 1963) and the pecking order theory (Myers & Majluf, 1984; Myers, 1984) For instance, Hovakimian (2006) shows that the timing of equity issuance does not have any significant long-lasting impact on capital structure as the counter-evidence against the pecking order theory The classic question

“How do firms choose their capital structure?” raised by Myers (1984) remains unanswered

Second, there has been an upward trend in bankruptcy as well as acquisition of the local food processing companies by the foreign ones Vietnam’s integration into WTO

in has provided the local food processing with a greater access to outside markets However, limited capital capacity has put Vietnamese food processing companies the disadvantage in technology and financial capacity in comparison with the foreign multinational ones such as Unilever, CP-Meiji and Nestle These local firms have been facing the increased competition from foreign firms and being acquired or forced out of business by the big foreign companies For example, Kravis Roberts & Co (KKR) acquired a 10% stake in Masan Consumer for US $159 million in April 2011 Jollibee Worldwide invested US $25mn to acquire a 50% stake of the SuperFoods business in early 2012 and has given a US$35mn loan to its partner Viet Thai International Joint Stock Company Charoen Pokphand Foods acquired a 74.18% stake of CK Pokphand

in late 2011 Thus, it is worthwhile to study the financial practices of Vietnamese food processing companies prior to giving any suggestions for their financial capacity improvement

Third, the food processing sector of Vietnam has not been yet analyzed independently given this sector is the top manufacturing industry in Viet Nam As one of traditional industry in Viet Nam, the food-processing sector annually accounts for a sizeable proportion of industrial output and GDP According to Vietnamese General Statistics Office, the output of food processing sector is 859,472.5 billion Vietnam dong, contributing 18.79% of industrial output and 6.2% of GDP in the year 2012 So far, there have been some studies on capital structure using Vietnamese data such as Nguyen and Ramachandran (2006); Biger et al (2008); Nguyen et al (2012) focusing

on financial behaviors of SMEs or listed firms in all industries This paper presents an empirical analysis of capital structure of food processing sector in Vietnam with most recent available data

The puzzling question of capital structure together with local food processing firms’ disadvantage of financial capacity as well as the lack of research using data in Vietnam motivates the conduct of research on financing practices of Vietnamese listed food processing companies

The paper aims to identify determinants of capital structure and to gain a practical insight into the financing practices of Vietnamese firms in food processing sector so that corporate managers and policy makers can have optimal capital policy to minimize financial risk To this end, this paper will discover how Vietnamese listed food- processing firms set their capital structure and to what extent the financing behavior is consistent with the theoretical explanations

1.3 Research objectives

The primary objectives of this study are as follows:

(a) To identify firm-level determinants of the capital structure of food processing companies listed in Vietnamese stock market by including variables based on different capital structure theories From the result, we can identify factors that significantly influence the financing decision in these firms

(b) To recommend some polices for corporate managers and policy makers

Specifically, the paper addresses the three following research questions:

1 What are the firm-specific variables that determine capital structure of Vietnamese food processing companies listed on Vietnam Stock Market?

2 Does the empirical evidence support the predictions of the trade-off theory or the pecking order theory?

3 Based on the empirical evidence, what are the policy implications for firms’ access to finance in Vietnam’s financial system?

1.4 Thesis structure

The thesis is organized as follows:

Chapter I provides an introduction to the thesis including background, motivation, objective, methodology and structure of the study

Chapter II summarizes the most prominent theories of capital structure and relevant empirical studies that provide a rationale for explaining financial decisions of firms Chapter III discusses methodology, descriptions of variables in the studied model and data to conduct the analysis

Chapter IV presents the overview of food processing industry and the results of the analysis including descriptive and econometric findings

Chapter V provides a summary of issues covered in this thesis and well as policy implication Limitations of the study and suggestions for further research are also mentioned

CHAPTER 2 LITERATURE REVIEW

This chapter provides a review of the literature related to the capital structure of firms

to lay the foundation of the analysis First, capital structure definition is introduced and the most influential theories of capital structure are summarized Then, the paper presents the empirical researches of capital structure choice in respect of firm-specific characteristics representing taxation, bankruptcy costs, agency costs, information asymmetries

2.1 Capital structure definition

As the core element in this research, it is worth to define the concept of firm capital structure Different definitions have been used in the capital structure literature According to Miller and Modigliani (1958), capital structure is the mix of debt and equity used by a company which is financing their assets Brealey, Myers, & Marcus (2009) defines capital structure as the ’mix of long-term debt and equity financing’ As such, the capital structure can be defined as the mix of equity (common equity and preferred equity) and financial debt (long term debt, short term debt and convertible debt)

The most relevant measure of capital structure is the ratio of leverage However, the extent of leverage depends on the research purpose; for example, the leverage ratio can

be stock of debt relative to firm value (Jensen and Meckling, 1976) or interest coverage ratio (Aghion and Bolton, 1992) or long-term liabilities by total assets (Frank and Goyal, 2009; Welch, 2011) In this paper, we use three variables as proxy for firm capital structure, namely, ratio of total debt to total assets debt; ratio of long-term debt

to total assets and ratio of short-term debt to total assets

2.2 Capital structure theory

Different theories of capital structure have been developed by many researchers These theories include: Net income, net operating income, traditional ap proach theory, Miller and Modigliani theory, trade-off theory, pecking order theory and recently the market timing theory

The net income approach of capital structure, propounded by David Durand in 1952, states that firm value can be increased or cost of capital can be lowered by the debt capital: the higher ratio of debt in capital structure, the lower capital expenditure Net operating income states the opposite: firm value and cost of the capital are not correlated with capital structure because there exists the hidden cost of debt which fades the benefits of using debt as a cheaper source of finance

In 1963, Solomon developed the intermediate approach: firm value is positive with debt capital to a certain level, then remain constant with a moderate use of debt capital, and finally become negative with debt capital

Modigliani and Miller (1958) are pioneers in the modern theory of capital structure With lots of assumptions of a perfect capital market in which there exist no transaction costs, no symmetric information, no default risk, no taxation, Modigliani and Miller claim that firm value depends upon its asset profitability, not on the way in which such assets are financed or capital structure of a firm

They have two propositions under these conditions

Suppose D and E are respectively market values of the firm's debt and equity; V is total firm value; rA is weighted average cost of capital-the expected return on a portfolio of all the firm's outstanding securities; rD and rE are respectively the cost of debt and the cost of equity, defined as the expected rates of return demanded by debt investors and equity investors

Proposition 1: r A = rDD/V + rEE/ V

According to Modigliani and Miller, total firm value V and the weighted average cost

of capital rA are constants, regardless of the debt ratio, given that firm asset and growth opportunities are unchanged

Proposition 2: rE= rA+ (rA- rD)D/E, derived from Proposition 1, shows that the cost of equity has positive relationship with the debt-equity ratio D/E It also shows that financial leverage does not matter due to unchanged overall cost of capital because the

company with debt is involved with higher risk Thus, a leveraged firm has the same cost of equity of an unleveraged firm plus an added premium financial risk

They come to the conclusion that the value of a company is independent of its capital structure in a perfect capital market

Nevertheless, the unrealistic assumptions of a perfect capital market suggest that firm’s capital structure choice becomes relevant when these fundamental assumptions are removed Modigliani and Miller themselves also break down one the assumptions in their seminal paper in 1963 When taking taxation into consideration, they argue that debt brings a tax benefit shield and firm value can be maximized by using as much debt

as possible They contend that the value of the levered firm equals the value of the unlevered firm plus the value of the generated tax benefit Therefore, capital structure does matter the value of firms

Following Modigliani and Miller’s papers, the study of capital structure has attracted much interest among financial researchers In general, these theories describe the consequences when Modigliani and Miller’s assumptions of perfect markets do not hold The most prominent theories of capital structure are the trade-off and the pecking order theory

2.2.1 The trade-off theory

The trade-off theory suggests that the optimal debt level is determined by balancing the corporate tax benefits of debt with the cost of bankruptcy (Kraus and Litzenberger, 1973) The advantage in financing with debt is the tax shield Firms with higher debt finance can pay lower tax because the interest on debt is tax-deductible expense On the contrary, debt also brings higher financial risk that creates costly debt-financing choice, especially when firms have too high level of debt

Trade-off theory is grouped into two categories: static and dynamic trade-off models According to the static trade-off theory by Kraus and Litzenberger (1973), firms have their target optimal capital structure based on which firms’ financial decisions will be adjusted Firms will borrow more or less so that the debt-equity ratio is at the optimal level where the debt tax shield is offset by the bankruptcy cost One major shortcoming

of the static trade-off theory is not taking into account the transactions for the adjustment Later, Fischer et al (1989) present the dynamic model that incorporates the costs associated with capital structure adjustment If the adjustment costs are higher than the values lost from achieving the optimal capital structure, firms will not adjust the ratio towards the target

In what follows, we will discuss in further details the benefits and costs of debt

2.2.1.1 Benefits of Debt

A Tax shield

The most significant reason that induces firms to raise debts is that interest payments are deducted from the corporate taxable income, in other words, interest is a tax-deductible expense By getting more debt, a firm can enjoy lower expected tax liability and higher after-tax cash flow However, Miller (1977) claims that the debt level is independent of tax rate when both personal and corporate taxes are considered He argues that personal income taxes paid by investors in corporate debt offset the corporate tax shield that the firm enjoys when being in debt, thus the firm optimal level

of debt does not exist

According to Graham (2003), with the presence of a personal income tax, investors will demand premiums as the compensation for net income reduction As a result, the debt leverage has a negative relationship with the personal income tax rate and positive one with the company income tax rate However, the influence of the debt tax shield on firm leverage depends on whether firms are entitled to carry their loss forward or backward for tax deduction Papers by Ashton (1989) and Adedeji (1998) document that firms prefer use less debt in the UK tax system than in the US tax system Different from the UK tax system, the US tax system entitles firms to carry forward or backward their sustaining loss Firms can receive cash refunds of previously-paid taxes

or future tax reductions Therefore, US companies tend to borrow more for their investment needs

It is noted that the benefit of debt tax-shield is also influenced by such non-debt tax shield including investment tax credits, research expenses and depreciation Firms with

more debt might face higher bankruptcy risks when firms are not able to meet their debt obligation on time Non-debt tax shields is consider as an alternative options, which is less costly, to reduce income taxes Given the limited total deductible expense

to income, firms with greater level of non-debt tax shields might find debt more costly when an extra unit of debt will save less tax in comparison with firms with lower ones Thus, these firms tend to borrow less, implying the negative relationship between debt and non-debt tax shields

B Reduction of free cash flow agency costs

Debt financing is not only for the purpose of tax shield but also for mitigating managerial agency cost (Jensen and Meckling, 1976; Jensen, 1986) The separation between shareholders’ ownership and managers’ control might bring in manager – shareholder conflicts Managers might attempt to benefit themselves at the loss of the shareholders They may consume excessive perquisites or invest in unprofitable project when they have excess cash flow to finance all of the available projects (Jensen, 1986)

By using more debt, shareholders can mitigate the problem of overinvestment in unprofitable projects and discipline managers’ behaviors It is noted that firms with debt financing are obligated to pay back principals as well as loan interests to debt-holders, which subsequently reduce the funds available for unprofitable projects Lasfer (1995) argues that debt finance motivates managers to be more responsible for their investment decisions However, debt finance is not effective in the cases of fast-growing companies with no free cash flow for their valuable projects (Jensen, 1986) Such companies frequently mobilize investment capital via the financial market The proposed projects will be independently assessed and monitored by bankers and analysts in this market As a result, these firms will pay extra financial claims for the market assessment

2.2.1.2 Cost of debt

A Costs of Financial Distress

Even though debt finance brings advantages of tax-shield and reduction in free cash flow agency costs, it is not always the case Using too much debt in the capital

structure, the firm might face the challenge of meeting its financial obligation Warner (1977) and Barclay et al (1995) state that financial distress has two types of costs: direct and indirect cost Direct costs are costs associated with bankruptcy and reorganization such as cost incurred with selling the liquidated assets and shutting down operations It is also noted that the overall firm value will be clear off when it goes bankrupt and the difference between the firms operating value and its liquidation value is considered as bankruptcy costs (Wijist and Thurik, 1993) Indirect costs of financial distress arising from the reluctance to do business with a firm in financial distress (Brealey and Myers, 2002) such as costs of losing or retaining customers and firm employees It also includes the distress costs of the suppliers who will raise input price, remove discount and demand cash payment in concern of firm’s payment default risk Moreover, excessive debt also creates so-called ‘debt overhang’ costs (Myers, 1977) The ‘debt overhang’ problem arises when a firm’s outstanding debt is at some risk of default and covenants give current debt priority for debt repayment at the expense of shareholders because a portion of value created by new investments will be paid for the current outstanding debt to reduce risk of default The higher probability

of debt default is, the more severe the debt overhang problem becomes In many cases, firms might be forced to forgo value-maximizing investments and this will lead to underinvestment problem (Myers, 1977 and Calomiris, et al., 1994)

B Agency Costs of Debt

As discussed above, debt can be used as a tool to mitigate the agency costs of shareholder conflicts Nevertheless, debt brings about the conflict between debt holders and shareholders because the debt contract induces shareholders to invest sub-optimally According to Jensen and Meckling (1976), shareholders can take wealth from debt holders by using existing debt funds to invest in risky projects This overinvestment problem originates from the fact that shareholders have limited liability By investing in high-risk projects, they have larger opportunity to gain more profits at the expense of larger potential losses that are expected to be absorbed by bond holders Creditors, in anticipation of this kind of shareholders’ behavior, will demand higher premiums for compensation by raising the cost of debt

manager-On the other hand, during the period of financial distress, firms might face the problem

of underinvestment when positive net present value projects are rejected if the bondholders have higher advantages over the shareholders in terms of received benefits The reason behind this phenomenon is that shareholders only have the rights

in claiming of the value of a firm after the debt is paid and debt holders benefit more from a safe positive net value project than shareholders (Lasfer, 1995) There are two solutions to alleviate the underinvestment problem First, firm should finance its investment with equity rather than debt when investing in positive net present value projects Second, firm should issue short term debt instead of long term debt

2.2.2 Pecking Order Theory

Being initially suggested by Myers and Majluf (1984), the pecking order theory works

on the idea of asymmetry information between a firm and outside investors regarding the firm’s real value of both current operations and future prospects The pecking order theory states that there is no well-defined target debt ratio Managers avoid issuing undervalued new shares to finance new projects by using internal funds such as undistributed earnings As managers are more knowledgeable of their companies than outsiders, the adverse selection problem might arise Outside investors usually find it hard to discriminate between good and bad projects because managers cannot often credibly convey their existing assets quality and available investment opportunities to potential investors Thus outside investors will demand a premium for their investment

In other words, the firm information discrepancy leads to under-pricing of firm’s equity

in the market as well as the undervaluation the existing shareholders’ wealth Aware of the dilution of shareholders’ wealth, firms tend to borrow through debt instruments as a substitute for equity to mitigate the investment inefficiencies caused by information asymmetry

Myers (1984) argues that firms prefer internal financial sources such as retained earnings because retained earnings have no adverse selection cost In case more funds are required, debt financing will be the next option, then hybrid securities like convertible bonds, and then equity as a last resort due to accelerating information cost

or adverse selection costs

The pecking order theory behavior in reality is due to the transaction costs related with raising funds externally (debt/equity) The two parts of these costs are the compensation for dealer and the legal plus administrative costs which are estimated to account 20% gross proceeds of small stock issue This fact implies that small firms are more prone to follow the pecking order theory than large firms as the transactions cost make up of a significant financing hierarchy for them

The agency cost between firm stakeholders is another cost that might also affect the pecking order Agency theory suggests manager-shareholder-bondholder conflicts will lead to the incentive problems arising from increasing costs of external funding and consequently driving firms toward the internal created funds to reduce the agency costs As the result, firms might have to face underinvestment problem by giving up some profitable investment opportunities, reducing their profitability as well as firm value Thus, firms having higher agency costs tend to rely on internal funds rather than external financial support

2.3 Comparative look on capital structure theories

Despite being regarded as among the most important contributions in the theory of corporate finance, it is widely believed that the predictions of Miller and Modigliani theory are incompatible with empirical evidence due to unrealistic assumptions of a perfect capital market

As mentioned above, the trade-off theory and the pecking order theory are the two major theories dominating the decision of capital structure in almost empirical studies The trade-off theory assumes that firms have their own target capital structures Firms with higher profit and tangible asset will have higher debt ratio than ones with less profit Firm will take into consideration the trade-off between benefit of debt tax shield and the cost of financial distress to decide whether debt or equity will be used for their financial needs The trade-off theory works well in explaining the capital structure behaviors among various industries For example, high technology firms with large tangible assets often borrow heavily However, trade-off theory cannot justify the fact

that firms with high taxable income borrow less instead of borrowing more to get tax shelter

The pecking order theory takes into consideration adverse selection cost that arises from asymmetric information The most significant contribution of the pecking order theory is the explanation for the relationship between leverage decreasing events (i.e., new stock offerings) and equity-for-debt exchange schemes with firm’s stock price decline Given the assumption of asymmetric information, retained earnings has no adverse selection cost while debt is associated with less adverse selection cost than equity

According to Ross et al (2012), there are three conflicting implications between the pecking order theory and the trade off theory

First, firms do not have a target level of leverage According to the trade off theory, there exists an optimal level of leverage where the marginal benefit of debt (e.g tax shield) equals its marginal cost (e.g bankruptcy costs) On the contrary, the pecking order theory states that the target debt ratio does not exist Firms will choose their debt ratio in accordance with their financial needs, first with retained earnings, then debt issuance and lastly equity

Second, profitable firms use less debt Pecking order suggests that profitable firms generate liquidity internally, thus they depend less on debt and external financing The trade off theory does not include this implication: profitable firm will increase its debt capacity to enjoy the tax shield and other advantages of leverage

Third, firms desire financial slack for future investment The pecking order theory states that firm has difficulty in finding financing sources at a reasonable price New share issuance is often underpriced since investors believe that stocks are being overpriced if managers try to issue more shares Bond issuance faces the same rational thought which is definitely lower As a result, firm will rely on debt as the first priority However, bankruptcy costs limit firm from issuing too much debt Financial slack would be a proper solution for this case When companies know that they will have to finance profitable projects in the near future, they could start accumulating liquidity

today to avoid being much dependent on external financing when investment opportunities come On the contrary, the trade off theory suggests that there is a limit in the financial slack a firm should keep Jensen (1986) claims that interest conflicts between shareholders and managers over payout policies are severe free cash flow is substantial The problem is how to motivate managers to disgorge the cash rather than investing money in inefficient projects According to his study, increasing firm debt ratio can significantly reduce agency costs of free cash flows

We have so far discussed the pecking order theory and the trade-off theory as two main theories of capital structure Both theories provide alternative views on how firms choose their capital structures We also take a comparative look and present conflict implications between these two theories The next section elaborates on the empirical findings and supporting evidences for the two theories

2.4 Empirical evidence on determinants of capital structure

The empirical studies have found mixed evidence for the pecking order theory and trade-off theory Researchers have attempted to test the explanatory power of capital structure models on corporate behavior in both developed and developing countries The research outcome would be interpreted in favor of a certain capital structure theory In most of the cases, it is a contest between the pecking order theory and the trade-off theory

In what follows, we will discuss about empirical studies on determinants of capital structure from other countries and Vietnam so that we can have a general overview before proposing our research models

2.4.1 Empirical evidence around the world

Frank and Goyal (2003) test the pecking order theory of corporate leverage on a broad cross-section of publicly traded American firms for 1971 to 1998, exclusive of financial firms, regulated utilities and firms involved in major mergers In their regression of leverage, they use five factors of tangibility of assets, market-to-book ratio (growth), log sales (size), profitability and cumulated past financing deficit (representing the pecking order) Leverage is defined as the ratio of total debt to market

capitalization They found that coefficient signs are negative on the market-to-book ratio and profitability and positive on tangibility and log of sales The effect of the financing deficit is significant but it does not have much effect on the magnitudes and significance of the coefficients on the other conventional variables, meaning pecking order theory is not supported in this case In another testing regression similar to Shyam-Sunder and Myers (1999), they find that small high-growth firms do not behave according to the pecking order theory In fact, the pecking order works best in samples

of large firms but the support of pecking order theory is declining over time They conclude that many aspects of the evidence pose serious problems for the pecking order and pecking order theory do not explain broad patterns in the data

Deesomak et al (2004) investigates the determinants of capital structure of firms operating in the Asia Pacific region Four countries with different legal, financial and institutional environments are selected for their research: Thailand, Malaysia, Singapore and Australia Their testing data obtained from DataStream includes all non-financial firms listed in those countries for the period of 1993-2001: 294 Thai firms,

669 Malaysian firms, 345 Singaporean firms and 219 Australian firms The research model incorporates firm-specific and country-specific factors such as firm share price, size, tangibility, profitability, growth, non-debt tax shield, liquidity, earnings volatility, interest rates and ownership concentration

The empirical results are as follows:

- Tangibility is not statistically significant to leverage in most of the studied countries

- Profitability is found insignificantly negative with leverage in most of the studied countries except Malaysia

- Firm size is significantly positive with leverage in most countries except Singapore

- Growth opportunity is negative related to leverage in most countries and its impact is significant for Thailand and Singapore

- The impact of non-tax debt shield, share price performance and liquidity is significant on leverage in all studied countries

- Earnings volatility has no significant effect on leverage in any country

- The financial activity of the stock market has significant and negative impact on leverage while interest rate impact on leverage changes during crisis time: insignificant before the crisis; significant and positive after the crisis

- The index of creditor’s rights show marginally significant but negative with leverage before crisis and while it is significant and positive with leverage after the crisis

- The estimated coefficients for ownership concentration are significant and positive after the crisis but significant and negative before the crisis

From the testing results, it is found that size, growth opportunities, tax rate and asset tangibility make influence on capital structure consistently with the predictions of the trade-off theory However, the importance of capital structure determinants varies across countries in the region and the financial crisis of 1997 has a significant but diverse impact on firm’s capital structure decision across the region They conclude that “capital structure decision is not only the product of the firm’s own characteristics but also the result of the corporate governance, legal framework and institutional environment of the countries in which the firm operates.”

Frank and Goyal (2009) examine the importance of many factors in the capital structure decisions of publicly-traded American firms from 1950 to 2003.Their data sample is taken from Compustat and Center for Research in Security Prices They use four alternative definitions of leverage: (1) the ratio of total debt to market value of assets (TDM), (2) the ratio of total debt to book value of assets (TDA), (3) the ratio of long term debt to market value of assets (LDM), and (4) the ratio of long-term debt to book value of assets (LDA) Six “core factors” are used as explanatory variables, namely industry median leverage, tangibility, profits, firm size, growth (market-to-book assets ratio) and expected inflation They find that median industry leverage, tangibility, firm size and expected inflation has positive relationship with market leverage while growth and profits have negative impact on market leverage Similar results are found for book leverage; however the impact of firm size, growth and the effect of inflation are not significant They conclude that the empirical results support

the trade-off theory in terms of relationship between leverage and industry leverage, firm size, tangibility and market-to-book They argue that the negative relationship between profitability and debt, as a main weakness of the trade-off theory can be further explained by dynamic tradeoff models

Lemmon and Zender (2010) tested capital structure theories by using testing sample of 67,200 firm-year observations data on both the CRSP and Compustat databases for the period 1971-2001 They run regression analyzing five year change in leverage ratio They use the following explanatory variables: size, tangibility, growth, profitability, marginal tax rate and three interaction terms among three factors: return on assets, low debt and big firms Below are their findings:

- Profitability is significant negative with leverage

- Profitability has no different impact on leverage among small firms which are above or below their predicted leverage, as per the pecking order’s prediction

- Firms attempt to use the internal funds as the first option for their investment needs, as per the pecking order’s prediction

They conclude that the pecking order betters explain the financing behavior of large firms over the time when taking into account debt capacity

Gaud et al (2005) study the factors impacting firm capital structure by employing sample of 106 Swiss companies listed in the stock market during the period 1991-2000 The ratio of total debt-total assets and market capitalization of equity are used as two proxies for leverage Explanatory variables include growth, size, profitability, tangibility and risk Their findings are as follows:

- Firm size, business risk and tangibility have positive impact on firm leverage

- Firms are found to have their own target debt-to equity ratios

- Growth and profitability have negative relationship with leverage whereas lagged profitability has a positive one, which is consistent with the pecking order’s prediction in the short term

The results have provided both the counter-evidences and the supporting-evidences for the pecking order theory For instance, firms with higher growth use less debt than firms with lower growth firms This implies that firms prefer using equity to debt in concern of the bankruptcy costs, which is contrary to prediction of the pecking order theory In contrast, firms with higher profitability use less debt as firms prefer to use internally generated funds, which support the pecking order theory

Alves & Ferreira (2011) examine the determinants of capital structure using a large panel of 5699 firms from 31 countries, with different legal systems and different levels

of investor protection Australia, Belgium, Brazil, Canada, Chile, Denmark, Finland, France, Germany, Hong Kong, Indonesia, Ireland, Italy, Japan, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Philippines, Portugal, Singapore, South Africa, South Korea, Spain, Sweden, Switzerland, Thailand, Turkey, the UK and the US Their research model includes both institutional and firm-level variables Institutional variables include legal system origin, banking development, capital market development, and investor protections Firm-levels variables are profitability, tangibility, market-to-book, size and external finance weighted average Leverage proxies are book leverage and market leverage, short-term and long-term debt-to-assets The data are extracted from Worldscope They run the panel data with time and industry-fixed effects and find that:

- Shareholder rights have negatively significant impact on market leverage, which suggests that the more shareholder rights there are, the fewer asymmetric problems occur

- The impact of firm-level variables and country level variables on market leverage is not the same in all countries

- Firm-level determinants tend to be similar around the world Size and profitability become common determinants of capital structure in research countries Profitability, sales, and external finance weighted average market-to-book exert a positive influence on leverage Tangibility is more related with short- and long-term debt to assets than with book and market leverage

So far, we have reviewed some empirical papers related to the capital structure theories around the world Evidence is found mixed for the pecking order theory and trade-off theory For instance, Frank and Goyal (2009) found that size, growth opportunities, tax rate and asset tangibility make influence on capital structure consistently with the predictions of the trade-off theory On the other hand, the negative relationship between profitability and debt is the counter-evidence for the trade-off theory Similarly, evidence found in some studies supports the pecking order theory For example, Lemmon and Zender (2010) find significant negative interaction between profitability, the low leverage indicator and the big firm indicator is significant negative, which is consistent with the pecking order’s prediction that firms will attempt

to stockpile debt capacity by using internal funds for investment However, several studies document counter-evidence for the pecking order theory For instance, Frank and Goyal (2003) state that the pecking model does a much better job at explaining leverage ratios of large companies than it does with small companies Most studies document that the trade-off theory and the pecking order theory are complementary because each theory alone cannot fully explain the capital structure behaviors of companies Gaud et al (2005), for example, conclude that both the pecking order theory and trade off hypothesis are at work in explaining the capital structure of Swiss companies It is also noted from empirical studies that corporate financial decisions are also impacted by the environment in which firms are being operated (Deesomak et al., 2004; Alves & Ferreira, 2011)

The next section would further explore the empirical research on firm-level capital structure choices in Vietnam

2.4.2 Empirical studies in Vietnam

There have been very few researches on capital structure using Vietnam data so far Nguyen and Ramachandran (2006) conducted the first study of the determinants influencing the capital structure of small and medium-sized enterprises (SMEs) in Vietnam over the period 1998–2001 SMEs in their study are defined as firms with less than 300 employees and/or registered capital of less than 10 billion Vietnam dong, excluding financial firms, foreign-owned and joint-ventured ones The data sample is

558 SMEs, of which 176 are state-owned and 382 are private In their research model, they use three measures for leverage: Debt ratio, short-term liabilities ratio and other short-term liabilities Independents variables are growth, tangibility, business risk, profitability, size, dummy variable: 0 for private SMEs and 1 for state-owned SMEs They also incorporate determinants in terms of relationships with banks and networking in testing model Data collection is done via financial report and survey They utilized multiple regression analysis for the above-mentioned variables Below are their findings:

- Short-term liabilities account for a significant proportion of the capital structure, while long-term debts are rarely employed by SMEs in Vietnam State-owned SMEs have higher debt ratios than privately-owned SMEs

- Firm size and level of business risk have a significant and positive relationship with capital leverage Growth is also positive with leverage but not is an important determinant Profitability seems to have no significant impact on the capital structure Tangibility has negative relationship with capital structure

- Firm ownership, relationships with banks and networking is significantly positive to financial leverage and has strong impact on a firm’s capital structure They conclude that asymmetric features found in the fund mobilization process in a transitional economy like Vietnam should be noted by policy makers and SME manager

Biger et al (2008) examine the capital structure determinants of Vietnamese firms by using data from the enterprises’ census conducted by the General Statistical Office (GSO) for the years 2002–2003 They use three indicators to represent capital structure: Total liabilities divided by total assets (TL), total debt divided by total debt and equity (DE) and ratio of debt to total assets Explanatory variables are collateralized assets, profitability, effective tax rate, non-debt tax shield, size, growth, industry classification and ownership structure After taking average all variables except profitability and firm size, they run OLS regression They find that financial leverage of Vietnamese firms increases with firm size; managerial ownership and decreases with profitability; non-debt tax shield, which is consistent with evidence from other countries However,

financial leverage was negatively correlated with fixed assets and positively correlated with growth opportunities, which is contrary to finding from other countries

Okuda and Nhung (2012) investigate the capital structure of the companies listed in Vietnam Stock Market during 2006-2009 In their testing model for determinants of capital structure, they use variables of tax, size, tangibility, profit and dummy variables for the state-controlled company, industry and location of stock market Their empirical results show that the prediction of debt ratios is consistent with the financing theories However, they found that the agency cost approach better explains the leverage choice

of these firms The debt ratios are found to be negatively related with profitability and growth opportunities whereas positively related with tax payment, firm size and collateral They also remarkably conclude that the determinants of long-term financing are different from those of short-term financing Although profitability has a significant impact on short-term financing decisions, it becomes insignificant to long-term capital structure Tangibility and growth is statically significant to long-term leverage but they are not important factors in short-term financing decisions It is also found that state-owned companies have the advantage in access to external financing funds

Dzung et al (2012) explores the capital structure decision of 116 listed non-financial Vietnamese firms in the broader context of financial development for period 2007-

2010 Ratio of total liability to total asset, ratio of current liability to total asset and ratio of non-current liability to total asset leverage are used as proxies for leverage Independent variables are profitability, tangibility, size, growth, liquidity and dummy variable 1 for state-owned and 0 for non-state owned They employ a panel GMM (generalized method of moments) system estimator to run testing model and find that total leverage has a significant negative relationship with profitability and liquidity but

a positive one with growth and dummy state-owned Determinants for long-term and short-term debt are different Profitability, tangibility, size and liquidity have significantly negative impact on short-term leverage For long-term leverage, growth, tangibility and size are positive related while profitability is negatively associated They come to the conclusion that the usage of short-term financing sources dominates

the capital structure of Vietnamese enterprises and “pecking order theory better explains financing decisions in Vietnam than trade off theory”

In summary, there are inconsistent findings in empirical research on financial structure determinants in Vietnam For instance, Okuda and Nhung (2012) find that agency better explained the corporate financing behaviors for Vietnamese firms while Nguyen

et al (2012) state that firm capital structure determinants follow the pecking order theory

Detailed impact of determinants on leverage from the selected studies in Vietnam is summarized in Table 2

Table 2 A summary of selected studies on determinants of capital structure in Vietnam

Profitability Negative but

Positive with long-term leverage

Size Positive, significant Positive Positive Negative with short-term leverage

Positive with long-term leverage Non-debt tax

State

CHAPTER 3 OVERVIEW OF FOOD PROCESSING SECTOR IN VIETNAM

This chapter provides an overall picture of the food processing sector and a brief outline of its size and structure in Vietnam Chapter begins with brief overview of food processing sector role in Vietnam’s economy then discussion of the current situation of this sector

It is well recognized that food processing plays an important role in economy development across the world It not only brings employment, product value addition, export revenue but also helps in wastage reduction and enhancing manufacturing competitiveness Vietnam is principally an agricultural country, where agricultural employment currently accounts for 47.4% of total employment Being considered as a transformation of raw agricultural products into food or food into other forms, food processing sector has a significant impact on agricultural sector and economy development in Vietnam It helps agricultural produce become attractive, marketable and long shelf-life food products Food industry in Vietnam witnesses a strong increase thanks to the trade restriction removal and foreign investment after Vietnam’s accession to WTO According to Vietnamese General Statistics Office, Vietnam’s food industry annually contributes a significant portion in industrial output and GDP, approximately 18% and 6% respectively Food processing also contribute significant portion in Vietnam’s exports, as shown in Table 3

Table 3 Output and export contribution of food processing sector

Year 2008 2009 2010 2011 2012

Output of food processing

(Current price; Unit: Billion

Vietnam’s food processing industry is supported by many advantages such as large and diverse domestic agricultural output, stability of ingredient supplies and prices of input, low labor costs and large domestic market As one of traditional sectors in Vietnam’s economy, agriculture has witness a big change over the last few decades The impressive transformation in terms of land reform, de-collectivization and marker liberalization policy in agriculture has permitted Vietnam’s rise from its net importer status to the one of the world's leading exporters of coffee and rice Vietnamese agricultural products are varied: rice, coffee, tea, rubber cashew, pepper, seafood, fruit and vegetables Agricultural outputs currently achieve an annual growth to the point where the country can meet domestic demand in most areas Moreover, the large domestic market is another advantage for consumer goods players in Vietnam A youthful population of nearly 90 million people with rising income promises potential domestic consumer demand for food items

However, Vietnam food industry still faces lots of challenges and weaknesses

First, Vietnam’s infrastructure remains weak for economic growth despite many efforts

by the government It is criticized that the agricultural sector has been too slow to adapt

to new technologies for global competition

Second, the local food processing industry is still largely fragmented except for few sectors such as confectionery and dairy Most of local food processing companies are small and medium enterprises as shown in Table 4 Small and medium-size enterprises averagely accounts for 87% and 9%, respectively of the total enterprises operating in food and beverage industry

Table 4 Number of enterprises manufacturing food and beverages by size of employees and capital resources

5billion VND 863 1,049 1,214 1,380 1,647 2,274 2,333 3,113 From 5 to under

Total number of enterprises 3,592 3,954 4,114 4,484 5,076 5,437 5,982 6,980

(Source: Enterprise survey for period 2001-2008 conducted by Vietnam GSO) Third, local firms have no advantage in financial capacity and are at the risk of being acquired by the big foreign companies As the bank-based economy like Vietnam, local enterprises rely largely on bank loans According to Enterprise Survey conducted by World Bank in 2009, Vietnamese firms tend to using banks to finance the working capital and the proportion of working capital financed by banks is higher than other countries in the regions and the world Asymmetric information seems a big challenge