Determinants of debt to equity ratio (financial leverage) vietnamese firms case study

This study points out determinants of debt-equity ratio financial leverage of 396 Vietnamese firms listed on Stock Exchange HOSE and HNX during 2006-2010.. Chapter 2 Literature Review2.1

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DETERMINANTS OF DEBT-TO-EQUITY RATIO (FINANCIAL LEVERAGE)-VIETNAMESE

FIRMS CASE STUDY

BY

NGUYEN THANH BIEN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, September 2012

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DETERMINANTS OF DEBT-TO-EQUITY RATIO (FINANCIAL LEVERAGE)-VIETNAMESE

FIRMS CASE STUDY

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

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

Table of Contents

List of Tables……… 6

List of Figure……… 7

Abstract……… 8

Chapter 1 Introduction…… 9

1.1 Problem Statement……… 9

1.2 Research Objectives……… 10

1.3 Research Questions……… 11

1.4 Research Scope……… 11

1.5 Research Contribution 12

1.6 Research Structure……… 12

Chapter 2 Literature Review 13

2.1 Theoretical Review 13

2.1.1 Static Trade Off Theory 13

2.1.2 Pecking Order Theory … 15

2.1.3 Agency Cost Theory … 16

2.2 Empirical Studies 17

2.2.1 Bevan, A and Danbolt, J., 2002 17

2.2.2 Deesomsak, R., Paudyal, K., and Pescetto, G (2004) 18

2.2.3 Buferna, F., Bangassa, K., and Hodgkinson, L (2005) 19

2.2.4 Um, T (2010), Capital structure determinants of Thai listed companies 20

Chapter 3 Research Methodology 22

3.1 An Overview - Vietnamese Firm 22

3.2 Conceptual Framework 23

3.2.1 Dependent Variable 23

3.2.2 Explanatory Variable 23

3.2.2.1 Tangibility of firm 23

3.2.2.2 Size of firm 24

3.2.2.3 Profitability of firm 24

3.2.2.4 Growth of firm 25

3.2.3 The Regression Model 25

3.3 Data Collection 26

Chapter 4 Data Analysis 28

4.1 Data Description 28

4.1.1 Variable Descriptive Statistic 28

4.1.2 Correlation Matrix … 29

4.2 Regression Result … 30

4.2.1 Fixed-effects and Random-effects Regression Result 30

4.2.2 Hausman Test … 30

4.3 Regression Result Discussion 31

4.3.1 Regression Equation 31

4.3.2 Coefficients Significance 32

4.3.3 Coefficients Sign 32

4.3.4 Multicollinearity and Auto Correlation … 33

4.3.5 Heteroscedasticity … 34

4.3.6 Industrial Groups Effect 34

4.3.7 Public and Private Firm Comparison … 35

4.3.7.1 Financial Leverage Degree … 35

4.3.7.2 Determinants of Financial Leverage 35

Chapter 5 Conclusion and Recommendation 37

5.1 Conclusion 37

5.2 Recommendation 38 5.3 Research Limitation 39 REFERENCE 41

List of Tables

Table 1 Descriptive Statistics of Leverage and Explanatory Variables … 28

Table 2 Correlation Matrix of Leverage and Explanatory Variables … 29

Table 3 Fixed-effects and Random-effects Regression Result 30

Table 4 Hausman Test 31

Table 5 Coefficients of Variables -FEM Model 32

Table 6 Sign of Variables-FEM Model 32

Table 7 VIF Value of Variables 34

Table 8 Wald Test for Heteroscedasticity 34

Table 9 Descriptive Statistics of Public and Private Firms 35

Table 10 Regression Result of Public and Private Firms … 35

List of Figures

Figure 1 Market Value of Firm – Debt Relation 14

This study points out determinants of debt-equity ratio (financial leverage) of 396 Vietnamese firms listed on Stock Exchange (HOSE and HNX) during 2006-2010 The result of regression indicates consistence of Vietnamese case with capital structure theories including trade-off, pecking order and agency The study also investigates differences between public and private companies related to tangibility

Chapter 1 Introduction

1.1 Problem Statement

Financial leverage and operating leverage are two popular ways of getting leverage to improve profitability of companies However, operating leverage is only applied for several specific industries, such as metallurgical, pharmaceutical industry, and is not suitable for tourism or services industries Thus, operating leverage is limited in reality when firms want to improve their profit On the contrary, financial leverage can be applied for every types of firms due to its alternative characteristics and therefore, it is preferred than operating leverage In fact, financial leverage appears in every capital structures of firms with different degrees

Depending on the degree of financial leverage, the firm decides the level of debt equivalent to the degree and thus, debt-to-equity ratio is also named as financial leverage When a firm decides to issue debt, the firm has to refer to several internal elements, for example, how much fixed assets the firm has, how much revenue the firm gets And the firm must consider some external conditions at the same time, for example, government policies and macroeconomic conditions It means that there are several factors that influence the degree of financial leverage of each firm and therefore, determinants of financial leverage are needed to understand and estimate the difference in the degree of financial leverage These determinants may be different depending on each industry

When Vietnam joined the WTO in 2007, it seemed that new East Asian export powerhouse was on the scene The country’s mix of young demographics with 27-year-old average age and political, macroeconomic stability was a perfect set-up for manufacturing exports Credit growth during 2006-2010 was 35% on average, which almost doubled the country’s nominal GDP growth As a result, thousands of enterprises have been established and these firms have been operating under market economy disciplines Therefore, capital structure of Vietnamese companies has changed in the trend similar to capital structure of companies in developed countries

or even more aggressively Private and joint-stock companies have substituted owned companies thanks to having better and effect operation Consequently, financial leverage is used frequently as a main financial instrument to lift profit especially as Vietnam economy has had symptoms indicating overheat in recent years Thus, it is necessary to study financial leverage and its determinants in Vietnamese company cases

public-In summary, Vietnamese firms are using debt as a major instrument to invest and increase its capital Financial leverage has become an important issue in Vietnam economy and thus, determinants of financial leverage and their relationship need to be clarified The correlation between financial leverage and determinants is also estimated to predict the trend of capital structure of Vietnamese firms The difference

among degree of leverage of different industries is also considered

1.2 Research Objectives

The research is implemented to study and identify both internal and external factors that affect debt-to-equity ratio, or financial leverage of firms, including both public and private In addition to identifying the determinants of financial leverage, the relationship between leverage and its determinants will also be clarified in this study These relationships will be explained in details to assess the significance of these determinants on financial leverage

In addition, the difference between financial leverage degree of public and private firms, and the leverage level of different industries need to observed and compared, to understand why the difference exists Moreover, macro elements are also considered

to answer how external factors impact the leverage of firm Assessing external aspects

is important because firms are controlled not only by internal factors but also external ones

As part of globalization process, the Vietnamese government has conducted open policies to develop economy and improve living standard As a result, Vietnamese

firms has approached and learned many innovative things in term of knowledge,

technologies and managements Consequently, capital structures of Vietnamese firms

also changes to be suitable with globalization conditions This study shows

Vietnamese firms are similar to others in developed countries in terms of financial

leverage and its determinants

1.3 Research Questions

In overall, in order to clarify important issues associated to financial leverage of firm,

it is necessary for the research to answer several critical questions below

Question1: Which determinants impact on financial leverage of firm?

Question2: Are there any differences between public firms and private firms?

Question3: What is the difference of financial leverage among industrial groups?

Question4: How do macro factors influence leverage of firm?

The answers to four questions above will support various parties, including the

government in making policies, financial institutions in assessing financial ability of

firms and investors in making investment decisions

1.4 Research Scope

The research investigates determinants of financial leverage of 369 firms listed on

HOSE and HNX, which are categorized into four industrial groups during 2007-2010

periods The relationship between leverage and its determinants will be identified,

examined and explained in specific details In addition, the difference of leverage

degree between private and public companies, and among industries are also

considered in this research However, financial firms and unlisted firms are excluded

in the research due to specific features in their capital structure The research utilize

panel data and thus, fixed effects model and random effects model regression are

implemented and compared to choose the better model for the dataset

1.5 Research Contribution

The contribution of this research is to provide an empirical evidence to test the financial theory involving trade-off theory, pecking order theory and agency cost theory In Vietnamese firms circumstance, the research proves the consistency between capital structure theory and actual financial leverage of firms on HOSE and HNX The research provides useful financial information for government agencies, financial institutions and individual investors in considering financial status of firms

on the stock exchanges, and reference documentary for further studies about

Vietnamese enterprises’ financing

1.6 Research Structure

The content of this research is divided into five chapters and this item belongs to the beginning chapter The first chapter introduces overall issues of the research and presents several critical questions that related to the nature of research purposes The second chapter reviews major theoretical studies and empirical studies associated to capital structure of a firm The third chapter presents research methodology from theory framework to data collection method The next chapter shows how to analyze data and result of econometric regressions The final chapter is conclusions and implications of the research

Chapter 2 Literature Review

2.1 Theoretical review

Based on the theory of Modigliani and Miller (1958) on capital structure, there are three popular theories on capital structure that have been developed including static trade-off, pecking order and agency cost theories These theories have the same objective, that is maximizing firm value, but their financial leverage levels are totally different Consequently, a firm leverage targets and capital structure are different by

adopting those theories

2.1.1 Static trade-off theory

The static trade-off theory of capital structure states that a firm considers between debt finance and equity finance in order to optimize capital structure by balancing the cost and benefit According to the static trade-off theory, firm managers believe to set

up an optimal debt-to-equity ratio to maximize firm value The costs include the financial distress cost and bankruptcy cost, and the benefits are the tax saving benefits

of debt, the interest tax shield It is a trade off of costs and benefits of borrowing, holding the firm’s assets and investment plans constant The firm is guessed to substitute debt for equity or equity for debt until its firm value is maximized As shown in figure 1, at the optimal capital structure, optimal financial leverage, the benefit of tax shield offsets the cost

Figure 1 Market Value of Firm – Debt Relation

Market value of firm

PV costs of financial distress

PV Interest tax shields Firm value under all equity financing

Optimal Debt

As random events happen to either debt or equity of the firm, the optimal structure capital will move away Hence, managers try to bring the capital structure back to its optimal level Therefore, leverage ratio is static as the target of the firm

Myers (1984) debates that three factors including costs of adjustment, debt and taxes, and cost of financial distress would impact financial behavior of firms under static trade-off theory First, adjustment cost always exists following modification of firms

in order to optimize leverage target Second, interest tax shield is an advantage for firms when issuing debt compared with issuing equity and that explains why several firms are awash in debt Finally, associated with financial distress cost, risky firms and tangible asset were concerned in Myers’s study Risky firms ought to borrow less because cost of financial distress would threaten the safety of firms Firms holding tangible assets will borrow less than other firms with intangible assets or valuable growth opportunities In case firms encounter financial distress, intangible assets and growth opportunities may lose expected value

In the study of Myers (1984),’the capital structure puzzle’, firms following the static trade-off theory should set a target debt-to-equity ratio and try to achieve it step by step However, according to Myers, managers do not want to issue equity if they

predict that it is undervalued in the market As a result, investors should be aware that issuing equity will happen if equity is over-priced Consequently, investors appear to have a negative opinion of new equity issue of firms and thus board of managers

should limit new equity issue as much as possible

2.1.2 Pecking order theory

On the contrary to static trade-off theory, Pecking order theory was first studied by

the theory, firms prefer financing from internal as retained earnings to financing from external funds as debt and finally from an issue of new equity At the top of the model, internal finance is chosen even with sticky dividend policies If internally generated cash flow is less than investment outlays, firms would move away from marketable securities portfolio At the bottom, external finance is required in the following order from debt, hybrid securities to issuing equity at last Myers debates that it is difficult for a firm to achieve an optimal capital structure with its equity at the top and the bottom of the ‘pecking order’ Moreover, the leverage target of firms

is difficult to approach if the firms have two types of equity as internal and external There are several advantages including no flotation costs and no disclosure of the firm’s proprietary financial information when the firm follows internal funds In addition, using internal funds may make new potential investment chances for the firms and increase profitability as a result of undertaking such investments

Firms with reliance on internal finance want to avoid the separation of ownership and control If firms rely on external finance, they have to follow strict discipline of financial market Over the decade 1973-1982, most of capital expenditures of non-financial firm came from internal finance However, it is not so obvious that firms following the pecking order model do not direct towards maximizing shareholders interests The basic reason is to avoid issue costs and effects of requirements of external financial market on the firms

According to pecking order theory of capital structure, firm managers are reluctant to disclose private information about the attributes of the firm’s return stream In addition, insiders may hide good investment opportunities to take advantages comparing to common investors That is the asymmetric information between insiders (managers of firms) and common investors (outside of firms) as external financing

On the contrary to the prediction of static trade-off theory, internal funds and external funds are used orderly following the criteria as first internally with retained earnings, debt, and finally with an issue of new equity

Following the pecking order theory, profitable firms prefer internal finance than external finance and thus, these firms were predicted to hold less debt than less profitable firms As a result, there is a negative relation between profitability and financial leverage

However, the relationship between financial leverage and tangible assets is the same

to that in trade-off theory According to Myers (1984), a high tangible assets level may mitigate the asymmetric information associated to financing cost thanks to being secured by collateral As a result, a positive relationship is expected between financial

leverage ratio and tangible assets level

2.1.3 The agency cost theory

According Jensen and Meckling (1976), conflicts between benefit of lenders on one side and benefit of shareholders and managers on the other side lead to an increase of debt agency cost including the monitoring expenditures by the principal, the bonding expenditures by the agent and the residual loss Normally, managers are willing to invest funds in risky business for shareholders’ gains If the business fails, the lenders are able to incur the cost while the shareholders only have limited liability

The agency cost theory of capital structure is an economic concept associated to the costs arising from conflicts between the parties involved According to this theory, the firm will obtain its optimal capital structure by minimizing this cost, Jensen and

Meckling (1976) show that agency costs influence strongly financing decisions via the conflicts between shareholders and debtholders Therefore, while companies are confronting financial distress, shareholders can prefer managers to take decisions to capitalize more funds from debtholders to equityholders Debtholders that have a good understanding of financial markets will require a higher return for their money if there is a potential gain of wealth, debt issue with interest payments may decrease the agency conflict between shareholders and managers Debtholders are compensated legally, if risks happen, by getting interest payments Managers of the firm will be able to operate the firm as well as possible in order to maximize wealth of shareholders

The debt agency cost may be reflected by the firm size according to the approach of agency theory Therefore, the financial leverage of larger firms with higher debt agency costs will be higher than smaller firms with lower debt agency costs It means

that there is a positive relationship between firm size and financial leverage of firms

In details, the study determines four elements that influence the leverage of firms including tangibility, firm size (logarithm of sales), profitability and growth (market-to-book) According to the regression result, correlation between leverage and

tangibility is significantly positive and the same for relation between leverage and size These relationships are consistent with description of trade-off theory and agency cost theory In contrarst, correlations between leverage and profitability, leverage and growth are negative These relationships are similar to pecking order theory The finding of Bevan and Danbolt is in line with the prior empirical studies and theory of capital structure as applied data of UK companies

This study utilizes data of firms at a developed country to examine determinants of capital structure and firm financial behavior, and how that behavior affects financial leverage of firm As a result, four basic determinants are admitted including tangibility, firm size, profitability and growth opportunities of firms Although, business environment and financial institutions between Vietnam, a developing country, and United Kingdom, a developed country, are definitely different but factors that affect on the capital structure are still same However, relationships among capital

structure and its determinants are likely to be not similar to UK firms

2.2.2 Deesomsak, R., Paudyal, K., and Pescetto, G (2004), The determinants of capital structure: evidence from the Asia Pacific region Journal of Multinational Financial Management, 14, 387-405

This study was conducted in 2004 to investigate determinants of capital structure, meaning financial leverage level of firms Authors of the study used data from 4 countries in the Asia Pacific region, namely Thailand, Malaysia, Singapore and Australia in 1993-2001 periods It shows that financial leverage (debt-to-equity ratio)

of firms depends on firm-specific characteristics, meaning inside factors of firms However, severe events as the financial crisis of 1997 have had a significant influence

on capital structure decisions of firms The study provides significant evidence about relationship between financial leverage and its determinants and consistency with capital structure theories including trade-off, pecking order and agency cost theory

The determinants of capital structure are identified in this study as tangibility, firm size, profitability, growth opportunity and volatility of earnings Firstly, the relationship between leverage and tangibility is positive and statistically significant in Thailand, Malaysia and Singapore This result is definitely consistent with the prediction of capital structure theories Secondly, the negative relation between profitability and leverage also is found as predicted of the pecking order theory in this study and this relationship is statistically significant in Thailand, Singapore and Australia Thirdly, there is a positive relation between firm size and leverage for all countries involving Thailand, Malaysia and Australia This finding is consistent with trade-off and agency cost theories Fourthly, growth opportunity has a negative impact on financial leverage and this influence is statistically significant for Thailand

It is consistent with the results of the trade-off and agency theories Finally, volatility

of earnings is found that have no significant impact on leverage for all countries According to the result of this study, capital structure of Thai firms is mostly consistent with static trade-off theory and pecking order theory Vietnam has conditions in term of business environment, social and culture similar to those of Thailand Therefore, the study of Thai company capital structure is a lesson for Vietnam situation and can be applied for Vietnam companies Consequently, five determinants above also are chosen to examine the relationship between the leverage and firms attributes involving tangibility, firm size, profitability, growth and volatility

of earnings

2.2.3 Buferna, F., Bangassa, K., and Hodgkinson, L (2005), Determinants of capital structure: evidence from Libya, Research Paper Series, 8, University of Liverpool

The empirical study provided further understanding related to capital structure or financial leverage in a developing country In details, the study conducted analyzing data of Libyan firms in the lack of a secondary market As a result, authors recognized

the relevancy between capital structures of Libyan companies and the capital structure theories including static trade-off and agency cost theories

In this study, four determinants of capital structure are identified in both private companies and public companies and they are similar to previous empirical studies as Rajan and Zingales (1995) and Bevan and Danbolt (2000) These determinants involve tangibility, firm size, profitability and growth In addition, relationships among them and leverage of firm are pointed out by the result of cross-sectional OLS regressions First of all, tangibility influences positively on leverage of firms with significant positive slope coefficient in both private and public firms Second of all, size and profitability also affect positive impacts on leverage of firms

Lastly, there is a negative relation between growth and leverage in both private and public firms, implying that growing firms prefer internal finance to external finance like debts Relationships observed in this study are in line with predictions of capital structure theories

Vietnam is a developing country like Libya and opened market from 1986 However, financial market of Vietnam has had a secondary market while Libya still lacks this market

Consequently, firm capital structure of Vietnam is a little different from Libya, meaning the result of this study can be used for reference only in Vietnam circumstance The factors that impact on capital structure in Libya are same as prior empirical studies and thus can definitely be utilized to observe capital structure of

Vietnamese companies

2.2.4 Um, T (2010), Capital structure determinants of Thai listed companies

The study of Um (2010) concentrates on companies listed on the Stock Exchange of Thailand over period from 2004 to 2008 to examine the determinants of capital structure The study shows the effects of internal independent variables on firm

capital structure and supplies further empirical evidences of the capital theories in developing countries

Vietnam is a developing country and similar to Thailand in terms of the economy Thus, this study provides particularly useful information in studying capital structure

of Vietnamese firms that listed on Ho Chi Minh Stock Exchange (HOSE)

In this study, five determinants of financial leverage that affect mainly capital structure of Thai companies were found to be tangibility, firm size, profitability, growth and volatility of the firm The relationships between financial leverage and five above independent variables were examined in this study It was found that three variables including tangibility, size and profitability effects are statistical significantly

leverage of the firms and this relationship is relevant with the asymmetric information theory Secondly, size of firm affects positively on leverage and the relationship between us is in line with the agency theory Thirdly, profitability negatively affects leverage of firms and this relationship is in line with the pecking order theory Moreover, growth and volatility of firms do not impact leverage of firms, however growth affects negatively while volatility affects positively

The study of Um (2010) contributes mainly to analyzing capital structure of Vietnamese firms in my study due to the similar research conditions in terms of micro and macroeconomics Ho Chi Minh Stock Exchange of Vietnam possesses characteristics similar to Thai Stock Exchange and thus, studying ofthe leverage of Vietnamese firms listed on HOSE should refer deeply to the study of Um Therefore, determinants of financial leverage include tangibility, firm size, profitability, growth and volatility of earnings

Chapter 3 Research Methodology

3.1 An Overview - Vietnamese Firm

In 2006-2010 periods, Vietnam developed strongly in many fields in terms of economics, culture and technology In economic sector, credit growth achieved 34%

in 2010 and property market was over heat in that time GDP growth was 7% on average during 2006-2010 and credit-GDP ratio increases from 0.71 in 2006 to 1.16

in 2010 In addition, establishing a firm is so easy with loose conditions in borrowing capital from banks and credit institutions As a result, a lot of firms have been established and doing business in high risk conditions Financial market also developed rapidly and lots of firms listed on stock market rapidly due to advantages from listing on stock market such as financing easily and having better image of firm

To be accepted on stock market, firm has to adapt several important requirements related to financial statement disclose and its profit also is positive before listed on stock market These conditions were a little bit easy for almost firms doing business

in period of 2006-2010 due to advantage productivity and business activity Firms listed on stock market join in property market besides main performance and possess high tangible asset ratio in capital structure Several firms have conducted financial investment activities and other investment that they really have not enough experiment However, in developing economics situation of 2006-2010 periods, sale and product activity of firms on listed were so good and most of them had positive profit during that time

Financing of firms on listed are so flexible thank to loosing credit policy of government to boost economic growth When interest rate is low, firm will borrow money from the banking system with collateral and if not, firm will call capital from stock market or financial funds In general, a lot of firms doing business in that time want to be listed on stock exchange to improve image and increase capital easily Firms listed had good growth and profit in many years They often invest multi-fields