Determinants of capital structure: an emperical research of listed companies in Hose

Table 2.1: Propositions of the theory with regard to capital structure Decisions Trade-off Theory A firm borrows to the point where the marginal value of tax shield on additional debt

MAI THI PHUONG THAO

DETERMINANTS OF CAPITAL

STRUCTURE: AN EMPERICAL

RESEARCH OF LISTED COMPANIES IN

HOSE

MASTER THESIS OF BUSINESS ADMINISTRATOR

HO CHI MINH CITY – 2013

MAI THI PHUONG THAO

Finally, the business factors also affect to the determinants of leverage will emphasis the difference in decision of capital structure in each industry

I would like to express my gratitude to all those who gave me the possibility to complete this thesis

I want to thanks all my lecturers in course at University of Economics

Ho Chi Minh City, who have empowered me with considerably useful knowledge during the time I studied, especially Dr Vo Xuan Vinh, who support in this thesis, thanks for his patience, motivation, enthusiasm, and immense knowledge to judge and comment on the contents of the subject Besides my advisor, I would like to thank the rest of my friend in eMBA class, for kindly helping me during my study and thesis processing Last but not the least; I would like to thank my family for supporting

me spiritually throughout my life

Although I has tried the best to complete the thesis, but errors could not

be comprehensively avoided Therefore, I am also looking forward to receiving the inputs and comments from respectful lecturers and friends, so that the thesis could be extended and improved

Mai Thi Phuong Thao

Ho Chi Minh, November 2013

COMMITMENT

I would like to commit that this thesis, “DETERMINANTS OF CAPITAL STRUCTURE: A EMPERICAL RESEARCH OF LISTED COMPANIES IN HOSE”, was accomplished based on my individual study and research The data was collected based on the secure sources

Mai Thi Phuong Thao

Table of Contents

TABLE OF CONTENTS 1

CHAPTER 1 INTRODUCTION 4

1.1 Background 4

1.2 Problem Statement 5

1.3 Purpose of Research 7

1.4 Organisation of the Study 7

CHAPTER 2 LITERATURE REVIEW AND HYPOTHESIS 8

2.1 Definition: 8

2.2 Theories 8

2.2.1 Modigliani and Miller 10

2.2.2 Trade-off theory and Pecking order theory 13

2.2.3 Agency cost models 17

2.2.4 Other models 19

2.3 Empirical study on Capital Structure in Vietnam 24

CHAPTER 3 METHODOLOGY 26

3.1 Data Collection 27

3.2 Developing Hypotheses 27

3.2.1 Dependent Variables 28

3.2.2 Independent Variables: 30

3.2.3 Hypotheses: 30

a PE and EPS: 30

b Tangibility (TANG) 31

c Profitability (PROFIT) 32

d Firm Size (SIZE) 33

e Liquidity (LIQD) 35

3.3 Methods of Analysis 37

3.3.1 Descriptive analysis 38

3.3.2 Pearson correlation 38

3.3.3 Multiple regression analysis 38

CHAPTER 4 DATA ANALYSIS AND FINDING 41

4.1 Descriptive statistic 41

4.2 Correlations between Variables 44

4.3 Multiple Regression Analysis 45

4.4 Testing on Regression Result 48

4.5 Conclusion 49

4.5.1 EPS with leverage 50

4.5.2 PE with leverage 51

4.5.3 Tangibility to leverage 52

4.5.4 Profit to leverage 53

4.5.5 Size to leverage 54

4.5.6 Liquidity to leverage 56

4.5.7 Determinants of capital structure from 2007 to 2012 57

4.5.8 Determinants of capital structure in observing in business sectors 59

CHAPTER 5 IMPLICATION 61

5.1 Summary of finding and discussion 61

5.2 Limitation of thesis 64

5.3 Recommendation for future study 64

REFERENCES 66

CHAPTER 1 INTRODUCTION

Capital structure decisions have been agued amongst theorists and practitioners in finance for many years The underlying question of such research is how and why companies come to the debt-equity ratios in their decision for capital structures and which determinants would affect their decision

There are varying ways to define the debt ratio Some of companies prefer self financing while the others want to utilize the leverage To see how much a company relies on debt financing, the comparison between two companies is the good example: the cash-rich Microsoft (MSFT), and the hugely leveraged Amazon (AMZN)

Microsoft, in 2000, claimed earnings before interest, taxes, depreciation and amortization, or EBITDA, of $11.8 billion, had a negative cash flow of $340.7 million

in the same year That very low ratio reflects that Microsoft has zero long-term debt, and its short-term debts are relative to its massive assets In comparison with ultra-solvent Microsoft, Amazon looks positively deficit The extremely high debt ratio (2,723.6 divided by 1,852, or 1,470.2) reflects that its total debts significantly outstrip its total assets (Swanson, 2001)

This example could show that there are differences of the decision in defining the appropriate capital structure The reason could be based on the difference in business activity or some determinants could affect to the debt ratio

For a long time it has been believed that an optimal debt-equity choice exists for any firm, and that this optimal capital structure is a tradeoff between the advantages of debt financing and the disadvantages of bankruptcy risks From a firm’s perspective, debt is

often a cheaper source of finance than equity because of tax advantages to be gained Debt is preferred over equity, especially where the firm does not face financial distress Since the publication of Modigliani and Miller’s (1958; 1963) seminal article, this argument had been developed by many theories try to explain variation in debt ratio across the firm Until now, the analysts don’t argue about which theories are the best use for company but they start to find which factor that will affect to the financial decision and performance of the company

Modigliani and Miller (1958) stated their famous irrelevance theory, where under perfect conditions, the choice of debt or equity is irrelevant When other research irrelevant, such as Myers and Majluf (1984) run the test, which is result of agency cost,

as the underlying theory of how a firm comes to decide the debt-equity distribution Many other theories have been proposed and tested, but the Tradeoff Theory, including agency costs as part of the tradeoff, is still often applied and discussed in literature

It seems that no perfect theory exists, and many theories explain only a part of the story Perhaps one theory cannot be sufficient for one firm’s capital structure determination (S.C Myers, 2001)

In many years later, through the empirical work among the world and each country, financial economics has yet to provide agreement about which factors affect the selection of a specific leverage position The empirical evidence on capital structure in developed countries found that the choice of debt-equity ratio can be modeled subject

to the agency cost (Marsh, 1982; Titman & Wessels, 1988) With the similar method, data from industrialized countries help explaining the differences in firms’ capital structure (Rajan & Zingales, 1995)

In the next decade, those studies approach to UK firms and interestingly, those empirical studies indicate that the determinant of capital structure are the size, asset structure, growth opportunities, profitability and non-debt tax shields (Bennett & Donnelly, 1993; Lasfer, 1995; Ozkan, 2001) However, other studies suggest that highly leveraged firms are likely to borrow more because they can afford the debt (Castanias, 1983; DeAngelo & Masulis, 1980; Gilson, 1997; Peyer & Shivdasani, 2001) In such cases, the firm specific factors may exert a different impact on the capital structure choice of firms depending on their level of leverage

Finally, not all determinants are consistent with those predictions advanced by theories

of finance Indeed, there are some contrary results on the relationship between some determinants and capital structure among firms in some countries (Heshmati, 1997)

In Vietnam, the decision for debt ratio is recently a critical question to all companies After affecting from economics recession in 2007, Vietnamese corporation began to worry about decision of financing for their own company This will lead to one of the most important factor on managing the risk of company

Many studies explain the different way to construct the debt ratio but it also show that there are some determinants have the strong relationship with capital structure However, very few of empirical researches could perform in each industry that can prove the significant influences to capital structure The research of (T D K Nguyen

& Ramachandran, 2006) show the proof in comparing the financing policies between state-owned companies and private corporation which are very different (Biger, N., & Hoang, 2007)

Then the research also requires separating into each business to examine the influence

of specific determinants in their own industry including economics period which affect

to company’s debt ratio This study has combined data from financial statements of listed companies to examine the determinants as earning per share, price to EPS ratio, tangibility ratio, profitability, size, and liquidity

The panel regression model is used as the technique to determine statistical significance

of the variables The sample comprises of 271 public listed companies on the Hochiminh Stock Exchange (HOSE) for the period from 2007 to 2012 Along with database and methodologies, the result could support the hypothesis and reconfirm the finding on the previous theories subject to the data of listed companies in HOSE

1.4 Organisation of the Study:

The next section explores the range of theoretical determinants of capital structure along with a summary of the findings of the previous influential empirical studies Section 3 put forwards the research methodology of the study, provides a description of the data set, and discusses the variables formulated and tested and the limitations inherent in the research methodology The fourth chapter presents the results and

analysis of the regression models and concludes the dissertation

CHAPTER 2 LITERATURE REVIEW AND HYPOTHESIS

2.1 Definition:

Capital structure is how a firm finances its overall operations and growth by using different sources of funds There are many ways to finance its assets by combination of equity, debt, or hybrid securities A firm's capital structure is then the composition or structure of its liabilities

In order to measure the capital structure, we use the leverage ratio to see how each company react with their capital In finance, we define three ratios related to debt: total debt ratio, long-term debt ratio and short-term debt ratio

Total debt to total assets is a leverage ratio that defines the total amount of debt relative

to assets This enables comparisons of leverage to be made across different companies This is a broad ratio that includes long-term and short-term debt (borrowings maturing within one year), as well as all assets – tangible and intangible

However, in this research, we only use two debt ratios as the dependent variables for

my model: total debt ratio and short-term debt ratio

There are some determinants that affect the capital structure In the next part, we will define those determinants by reviewing the majorities of theories in related

purpose of this chapter is to examine the available theories and to discuss their significance in the quest to offer a solution to the capital structure debate Moreover, the chapter also discusses the results of influential studies to provide empirical evidences that have been gained so far by the researchers

Before moving into the detail of these theories the following table will illustrate the basic concepts behind the existing theories

Table 2.1: Propositions of the theory with regard to capital structure Decisions

Trade-off Theory

A firm borrows to the point where the marginal value of tax shield on additional debt just offset the increase in the present value of costs of financial distress (S.C Myers, 2001)

Pecking Order

Theory

The theory states that firms prefer internal finance If external financing is required firm first opt for safest security that is debt and equity is raised as a last resort (S.C Myers, 1984)

Agency Cost Model

According to the theory, raising debt has the potential to reduce agency problems (M S Jensen, 1986)

Market of Corporate

Control

The choice of optimal debt level is based on trading off a decrease

in profitability of acquisition against an increase in the share of the expected gain for target’s shareholders (Israel, 1991)

Product/Input Model

A firm which will ignore the importance of financial structure will face a lower value than a firm which realizes the importance of financial decisions The model suggests that the structure of credit market may impact the economic performance of output markets and also that the advantage of using debt that is interest deductibility may lead to higher debt levels (Israel, 1991)

2.2.1 Modigliani and Miller

Capital structure is defined as the relative amount of debt and equity used to finance a firm Theories explaining capital structure and the variation of debt ratios across firms range from the irrelevance of capital structure, proposed by Modigliani and Miller (1958)

“If leverage can increase a firm's value in the MM tax model (F Modigliani & Miller, 1963), firms have to trade off between the costs of financial distress, agency costs (M

C Jensen & Meckling, 1976) and tax benefits, so as to have an optimal capital structure However, asymmetric information and the pecking order theory (S.C Myers, 1984; S.C Myers & Majluf, 1984) state that there is no well defined target debt ratio The latter model suggests that there tends to be a hierarchy in firms' preferences for financing: first using internally available funds, followed by debt, and finally external equity.”

These theories identify a large number of attributes influencing a firm's capital structure Although the theories have not considered firm size, this section will attempt

to apply the theories of capital structure in the small business sector, and develop testable hypotheses that examine the determinants of capital structure in Vietnamese firms

In almost every paper relating to capital structure, the framework produced by Modigliani and Miller is discussed first as they are known for the most acknowledged, criticized or most researched paper Given the differences in the opinion by the academic world in accepting or challenging the propositions of these two economists, the fact remains that their ‘The cost of capital, corporation finance and the theory of investment’ gave birth to the most important debate in the corporate finance literature which further produced huge amount of theoretical and empirical research

As in every model, Modigliani and Miller (1958) framework was also operational under certain assumptions The basic assumption was of perfect capital markets and zero transaction costs and tax They further assumed that individuals and corporations borrow at the risk free rate, firms issue only two types of claims; risk free debt and risky equity, there is neutral or no enterprise or individual income tax, no bankruptcy costs are associated with raising debt, investors have same homogenous expectation for the payoff and rate of risk, all firms belong to the same risk class, all cash flows are perpetuities with constant growth and assumed a world without information costs and agency costs (Berry, 2006)

According to this proposition financial leverage that is the amount of debt in the capital structure of the firm is irrelevant Moreover, financial leverage remains irrelevant even when the debt maturity is short term, long term or the debt is callable or call protected, straight or convertible or in any denomination (S.C Myers, 2001) It is also important

to identify the factors that can change the value of the firm when there are changes in growth opportunities First of all, when there are sudden changes in the growth of the firm, the working capital will also reflect these changes and so will the liquidity ratio, debt service ratio, fixed assets of the firm and which will drive the value of the firm

According to their second proposition the expected rate of return on the common stock

of a levered firm increases in proportion to the debt (D) to equity (E) ratio (from figure 2.1 that is market values) Moreover, the rate of increase depends on the spread between the expected rate of return on a portfolio of all securities and the expected return on the debt Thus, in view of this proposition the rate of return the shareholders’ receives depends on the firm’s debt to equity ratio (Brealey, et al., 2006)

To sum up Modigliani and Miller (1958) proposed that the value of the firm is determined by the left-hand side of the balance sheet that its real assets and they remain unaffected whether the liability side of the firm’s balance sheet is sliced into more or less debt Therefore, to increase the value of the firm investment should be done in projects with positive net-present values (Brealey, et al., 2006)

Modigliani and Miller (1958) propositions were based on strict assumptions which further produced results which were highly criticized by the researchers and in academics According to Brealey, Myers and Allen (2006), Modigliani and Miller opponents argue that market imperfections makes personal borrowing excessively costly and risky which creates a natural clientele willing to pay a premium for shares of leveraged firms Thus, the opponents argue that firms have to borrow to realize the premium Secondly, Brealey, Myers and Allen (2006) also points out that according to the two American economists the overall cost of capital of a firm known as weighted average cost of capital (WACC) does not depend on the capital structure which further raises questions with the introduction of taxes When we introduce taxes, it is also

important to note that debt interest is tax-deductible, and WACC is also computed on after tax interest rate Thus, given the tax advantage on debt, a firm may be inclined to use more debt in capital structure

2.2.2 Trade-off theory and Pecking order theory

Pecking order theory suggests that a firm's growth is negatively related to its capital structure According to Myers and Majluf (1984), information asymmetry demands an extra premium for firms to raise external funds, irrespective of the true quality of their investment project In the case of issuing debt, the extra premium is reflected in the higher required yield High-growth firms may find it too costly to rely on debt to finance growth

Trade-off Theory

The second important theory in corporate finance literature is the trade-off theory, According to the theory; a firm borrows to the point where the marginal value of tax shields on additional debt just offset the increase in the present value of costs of financial distress (S.C Myers, 2001) Before moving forward with the definition, at this point some elaborations are important Consider a company that utilizes debt in its capital structure By raising debt, the first advantage that the company makes is that of interest payments which are treated as a tax deductible expense also known as the tax shield However, there is another side of debt which is that the firm is now exposed to bankruptcy risk or financial distress The reason being that if the company is unable to generate cash from its operating, financing or investing activities to service its debt obligations than the firm is likely to go bankrupt

Modigliani and Miller (1958) points out that a company that heavily relies on debt in the capital structure commits a company to pay out considerable portion of its income

in the form interest payments However, a debt free company can reinvest all of its net income in its business The objective here is not to indulge in the debate of raising debt

or equity but to appreciate the relative advantages and associated disadvantages of both Moreover, it is also important to note that it is highly unlikely to find a firm which relies only on one source of capital However, the question still arises as to how would a value maximizing firm constructs its capital structure in other words is there an ideal debt to equity ratio? According to the trade-off theory a value maximizing firm would compare benefit and cost at the margin and operate at the top of the curve in Figure 2.1 The curve would top out at high debt ratios for safe, profitable firms with taxes to shield and assets whose value will not deteriorate in financial distress Moreover, the theory also predicts reversion of the actual debt ratio towards a target or optimum, and a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type (Shyam-Sunder & Myers, 1999)

Figure 2.1: The Static-tradeoff Theory of Capital Structure Source: Myers (1984)

One major cost associated with debt is the cost of financial distress which makes firm’s reluctant to highly depend on debt as a source of finance Figure 2.1 above shows that

at moderate debt levels the probability of financial distress is negligible but at later point of time the probability of financial distress increases rapidly with additional borrowings Moreover, if the firm keeps on raising debt and is not sure of gaining from the corporate tax shield, the advantage of tax eventually disappears as the firm is likely

to go bankrupt (Brealey, et al., 2006)

Modigliani and Miller (1958) model was built on the assumption of zero taxation Later, in order to capture the implication of corporate tax and its effect on cost of capital Modigliani and Miller offered a new article to the corporate finance literature

‘Corporate Income Taxes and the Cost of Capital’ Thus, now they proposed that value

of firm becomes the value if all equity financed plus the present value of tax shield minus the present value of costs of financial distress (Brealey, et al., 2006)

It is also important to note that the costs of financial distress may directly or indirectly affect a firm According to Ang, Chua, McConnell (1982), the literature identifies three types of bankruptcy costs (1) the direct administrative costs paid to different third party involvement in the bankruptcy proceedings, (2) the loss or shortfall when assets are sold in liquidation or in the indirect costs of reorganization and (3) the loss of tax credits when the firm is bankrupt

Pecking Order Theory

The next competing theory in the corporate literature is pecking order theory of finance which resulted from the study done by Donaldson (1961) and was later developed by Myers and Majluf (1984) Donaldson (1961) in his paper observed that management prefer internal funds as a source of new finance and were reluctant to issue common stock Based on the new set of result of the study that managers prefer internal source

of finance, Myers and Majluf (1984) further investigated the results by considering a firm that must issue common stock to raise cash to undertake a positive net present value investment opportunity Thus, using set of assumptions the researchers built an equilibrium model of the issue-invest decision

The pecking order theory starts with asymmetric information which indicates that manager know more about their companies’ future potential, risks and value than do outside investors (Brealey, et al., 2006) This fact (information asymmetry) is one of the basic assumptions of the model of Myers and Majluf (1984) who insist that managers may take advantage of the inside information that they possess Giving an example, the researches explain that in some cases managers may act in the interest of old stockholders and may refuse to issue shares even if this would lead to losing a positive net present value project At this point potential investors who are ignorant may reason this decision as good news which as a result affects the issue-invest decision Moreover, Myers and Majluf (1984) also notes that managers find it costly to convey information to the market and the problem will vanish once special information can be put across with no cost Some of the other assumptions of their model includes (1) perfect capital markets, (2) zero transaction costs in issuing stock, (3) market value

of the firm’s shares are equal to their expected future value based on the information the market possess (4) the firm has one existing asset and one opportunity requiring investment which can be financed by issuing stock, using cash balance or selling marketable securities which is known as financial slack in the model (S.C Myers & Majluf, 1984)

Given the assumptions, the theory implies that

- (1) firms prefer internal finance

- (2) Firms also adapt their target dividends payout ratios to its investment opportunities and target payout ratios are gradually adjusted to shift in the direct

of valuable investment opportunities while dividend payout decisions are not exposed to sudden changes

- (3) Given the sticky dividend policies and unpredictable fluctuations in profitability and investment opportunities, internally generated cash flows may

be more or less than capital expenditures In case it is less, the firm first utilizes its internal cash balances or marketable securities portfolio

- (4) If external finance is required, firms first prefer to issue the safest security that is, it starts with debt, then possibly hybrid securities which includes convertible bonds and uses equity as a last resort (S.C Myers & Majluf, 1984)

2.2.3 Agency cost models

The agency problem also suggests a negative relationship between capital structure and

a firm's growth Myers (1977) argued that high-growth firms might have more options for future investment than low-growth firms Thus, highly leveraged firms are more likely to pass up profitable investment opportunities, because such an investment will effectively transfer wealth from the firm's owners to its debt holders As a result, firms with high growth opportunities may not issue debt in the first place, and leverage is expected to be negatively related to growth opportunities

The principle-agent relationship remains one of the crucial areas for the researchers where the basic issue is the costs associated with the relationship when the authority is delegated to the agents by the owners The research with regard to this topic not only supports the finance literature but also includes in context of managing organization, economics, politics etc The aim over here is to provide empirical and theoretical literature on agency theory with the point of finance in general and capital structure in particular

The relationship between a principle and agent is delicate in nature and especially come

at odds with the association of their interests with the organization An owner views the organization as an investment vehicle and his utility is maximized when the value of the equity is maximized On the other hand, managers or agents controls the decision making process of the organization and sees the corporation as source of salary, perks, self-esteem and as a vehicle that can create value of their human capital (Byrd & al, 1998) Given the assumption that both parties are utility maximizes; it is likely that managers may show more commitment towards their personal interests (M C Jensen

& Meckling, 1976) Moreover, considering the likelihood of diverge interests of managers there are certain internal and external forces that has the potential to limit the interests of managers These forces have been widely discussed by researchers and many suggests that (a) making senior management stock holders (M C Jensen & Meckling, 1976), (b) depending on an outside board of directors (Byrd et al., 1998), (c) basing the remuneration of managers on performance (Byrd et al., 1998) can be some

of the measures that can be implemented The external forces that manages the relationship are the (a) outside managerial labor force (Fama, 1980), (b) takeover threat (Manne, 1965) and (c) product market competition (Berry, 2006) However, it is important to note that these forces are not perfect and managers are capable of bypassing these forces to achieve their interests

In such a scenario where agency costs cannot be completely eliminated from this relationship according to Jensen (1986) debt in the capital structure can be one way of reducing agency problems In his paper, Jensen (1986) is of the opinions that debt creation enables managers’ to effectively bonding their promise to payout future cash flows as debt in the capital structure gives right to the debt holders to take firm into bankruptcy court if they don’t keep up their promise to make interest and principal payments Secondly, debt also acts as a control function for the firms that are able to

generate large cash flows but with low growth opportunities and also in organization that must shrink, In such organization the pressures on cash flows is most serious and scrutiny from debt holders will be quite high

Another type of conflict that exists in an organization is between debt and equity holders This conflict arises when there is a risk of default, as when default occurs shareholders can gain at the expense of debt holders Considering a scenario where managers of the company favors stockholders and the risk of default is significant, it is likely that managers may take actions that may result in value transfer to stockholders from creditors This can be done in four ways Firstly, managers can invest in riskier assets or in riskier projects as higher risks is beneficial for stockholders Secondly, the managers may increase borrowing and pay out cash to stockholders that will result in constant value for firm but decline in value of debt Thirdly, managers may reduce raising equity for investment projects In other words, when the risk of default is high

in a firm the new investment projects benefits the debt holders which is likely to increase the market value of debt The increase in market value of debt acts like a tax

on new investment as the cash from this investment will now also go to debt holders Thus, if the tax is high managers will shrink the firm and pay cash to stockholders This problem is also known as underinvestment or debt overhang problem Lastly, managers may conceal problems to prevent creditors from forcing bankruptcy or reorganization

This strategy increases the maturity of debt and makes it risky (Myers, 2001)

2.2.4 Other models

This part discusses the other two important theories of capital structure that is based on the market of corporate control and the product/input market model One important point that was mentioned under the agency cost models when discussing the potential external forces for that limits the diverging interests of managers from that of owners of

the corporation was the threat of takeover target The theory of market of corporate control deals with takeover in particular which theory emerged in 1980s when the US economy experienced a number of takeover transactions Some of the main work in this area has been done by Harris and Raviv (1988), Stulz (1988) and Israel (1991), Harris and Raviv (1991) The main aim with regard to this theory is to present the model of Israel (1991) in detail and differentiate it with other two but similar models

The model of Israel (1991) revolves around management of the company with an objective to maximize the value for its shareholders and structure its capital structure

by considering the possibility of acquisition target Once the capital structure is selected then only the potential acquirer is known as by now the company will be aware of its true value and those who can participate in the takeover contest given the costs involved in the acquisition process Thus, an acquirer with a high ability will be able to pay the acquisition costs and may also participate in the acquisition process Moreover, the outcome of any acquisition deal will be the division of the increase in equity value between the acquiring and the target firms According to the theory, assuming that management is highly capable, the presence of risky debt in the capital structure will impact the division of the three parties which are the debt holders, acquirer and shareholders of the target company High level of risky debt will lead to large appreciation in debt value which will benefit the target company’s debt holders Moreover, as debt can be sold at fair value, the post takeover profits will be shared between acquirer and target shareholders The model of Israel (1991) shows that capital structure affects the outcome of takeover process as it has the potential to effect the distribution of cash flows Secondly, high levels of debt in capital structure of target firm may result in low profitability for the acquirer Thus, according to the model, the choice of optimal debt level is based by trading off a decrease in profitability of

acquisition against an increase in the share of the expected gain for target’s shareholders (Israel, 1991)

The other two models that are of Harris and Raviv (1988) and Stulz (1988) are similar but different with the model of Israel (1991) The difference lies in the assumption of the other two models that is their model deals with the distribution of votes that may impact the outcome of takeover contests (Israel, 1991)

The second theory of capital structure dealt in this topic is that or product and input model According to the theory financial market and product/input market have important linkages Brander and Lewis (1986), in their paper examine the relationship between financial market and output decision in an oligopoly and are of the opinion that the financial structure can affect the output market in a number of ways Firstly, as firm take on more debt there is an incentive to pursue output strategies that will increase returns under positive states and lower returns in negative states Thus, in negative states the shareholders of the company will tend to ignore reductions on returns as the bond holders will have claim on the residuals incase of bankruptcy Therefore, any changes in debt levels will impact the changes in the return to the shareholders and ultimately on the output strategy favored by shareholders Secondly,

in an oligopoly one company’s profit is dependent on other company’s losses which imply that the output of firms will also depend with the chances of driving their rivals into insolvency Thus, in an oligopoly owner of firms will use financial structure as to take advantage from the output market Thirdly, considering the strategies which can be used by rivals in the industry, a firm which will ignore the importance of financial structure will face a lower value than a firm which realizes the importance of financial decisions Lastly, the model suggests that the structure of credit market may impact the economic performance of output markets and also that the advantage of using debt that

is of interest deductibility may lead to higher debt levels (Brander and Lewis, 1986)

The relationship between firm inputs with the formation of capital structure has been dealt by Titman (1984) The paper examines an agency relationship between a firm (agent) and customers (principals) who bear the costs if the firm liquidates There model suggests that the firm indirectly suffers the liquidation costs which is ultimately transferred to the customers in the form of lower prices for its products in the current period A value maximizing firm will be motivated to liquidate when the liquidation exceeds the value of not liquidated by an amount which is greater than the costs imposed on its customers and other associates However, a non value maximizing firm will liquidate when the assets value exceeds the value if not liquidated by any positive amount Thus, the model implies that the firm’s capital structure controls the liquidation decision and the terms of trade with which the firm does business with its customers, workers and suppliers An increase in debt level worsens the terms of trade and increases the probability of liquidation Therefore, these worsen terms of trade are the resultant of usage of debt in capital structure which is relevant when deciding between debt and equity (Titman, 1984)

Evidence about difference in decision of capital in each industry:

Getting back to the example of Microsoft and Amazon corporation Microsoft shown the low ratio on total debt ratio, only 0.1932 That very low ratio reflects that Microsoft has zero long-term debt, and its short-term debts are minimal relative to its massive assets

In comparison with ultrasolvent Microsoft, Amazon looks positively decrepit Its extremely high debt ratio which has 1,470.2, reflects that its total debts significantly outstrip its total assets

Because of that unusual imbalance, Amazon's debt ratio isn't all that meaningful except to confirm that it's deeply indebted According to Morningstar, interest from

Amazon's $2 billion in debts consumes 3% of its annual revenue, putting a lid on future profits(Swanson, 2001)

As said by Michael Thomsett, the author of several investing books , there are no fundamental to analyse the behavior of capital decision over the unsual case of Amazon One of the reasons for this high debt ratio is that they've never shown a profit

In this case, the debt ratios of profitable companies are more meaningful, he says

A part of the reason is that the business activities of Amazon tend to use more debt ratio than others As mentioned earlier, though, debt ratios should always be looked at

in relation to the industry averages, which are presented in the table below

Average Debt Ratio for Different Sectors

Advertising 73.74%

Aerospace/defense 58.81 Auto and truck 64.89 Beverage (soft drink) 53.65 Computer software 47.78 Educational services 31.89 Electronics 46.75 Entertainment 49.15 Environmental 53.67 Food processing 47.3 Grocery 64.05 Health care information systems 34.05

Home appliance 53.73

Home building 58.14 Hotel/gaming 49.23 Industrial services 49.66 Internet 51.32 Medical services 25.24 Newspaper 50.77 Paper/forest products 50.24 Restaurant 50.45 Retail store 58.59 Telecom services 53.23 Textile 59.12 Tobacco 40.46 Water utilities 52.63

Source: Value Line, March 1999

2.3 Empirical study on Capital Structure in Vietnam

Some studies investigated the determinants which influence the capital structure of Vietnamese companies

Nguyen and Ramachandran (2006) has a research for small and medium enterprises (SMEs) and see which factor they had decided to form their capital structure over the period 1998-2001 Compared with similar studies, this research not only examines the effects of determinants related to firm characteristics, but also investigates the aspects

of management behavior in making capital structure decisions

The research offers some important implications for policy-makers in Vietnam It should be recognized that there is an unfair treatment for private SMEs in accessing

bank loans, and the challenge is to ensure that all business sectors enjoy the same opportunity to access credit from commercial banks A positive relationship between business risk and debt ratios also reveals that the government should deregulate interest rates, with the aim of not only creating a safe banking system, but also forcing SMEs to set up financing structures that are appropriate for their specific degree of business risk This study also provides some implications for SME managers Managers in the private sector should recognize that asymmetric information is a main reason for their difficulties in accessing bank loans Once the asymmetric information between SMEs and lenders is reduced, private SMEs can receive larger levels of credit from networks

in general, and from commercial banks in particular Therefore, managers of private SMEs should be aware of the importance of disclosing well-prepared financial statements, with the aim of building up levels of trust by banks, through increased transparency In addition, SMEs have to build up strong business networks through discipline in prompt payment, and maintaining close ties with suppliers Such actions can assist SMEs in obtaining other financial liabilities from networks

The availability and reliability of financial data was a major limitation for this research Financial statements of most SMEs in Vietnam are not audited In addition, over the period 1998-2001, Vietnamese accounting standards had not yet been issued In the future, as company financial data becomes more reliable and easily available, subsequent studies could cover a longer period in order to examine the capital structure

of Vietnamese SMEs in different stages of the economic cycle Future research could also consider the effect of specific industries and structural models, with the aim of examining the causal effect of such variables in the capital structure of firms in Vietnam

CHAPTER 3 METHODOLOGY

This chapter introduces the method adopted in the study to find the determinants of capital structure It also highlights the process of constructing the data set and the regression model to produce empirical evidences

To illustrate the theory in practice, I measure the model with two dependent variables and six independent variables to formulate the study

The two dependent variables include total debt, short term debt ratio The reason for using two dependent variables is because many previous researches have warned against using only the total debt ratio According to Bennet and Donnely (1993) there is

a likelihood that firms may have separate policies with regard to short and long term debt Thus, by the limitation of this study, the debt ratio and short term debt are examined separately Then, the similar and differing factors that may influence debt ratio and short term debt can be identified

The capital structure theories suggest certain attribute that determines the capital structure decision of the firm In this consequence, the selection of the independent variables was carefully done as to include the various attributes that have been proposed by the theoretical models of capital structure Moreover, in order to add to the empirical evidences variables were selected which has been statistically tested by majority of the researchers Secondly, the other consideration is to include variables for which few empirical evidences are available in Vietnam (C H Nguyen, 2008; T V Nguyen, 2012) The variables for this study include earning per share, P/E ratio, firm size, profitability, liquidity and asset tangibility which reflect the above theories to the dependent variable

This chapter will clarify the data collection in the first part In the second part, we discuss about all the variables are joint to this research and the hypothesis The last part

is the measurement method

3.1 Data Collection

The data in this report is made up of market data of public listed companies of Vietnam

Ho Chi Minh stock exchange There are 314 listed companies in HOSE based on the website of Vietstock However, there are some companies have to be excluded from this survey

In this survey, the financial company such as bank, Securities Company, investment fund company and related to financial services will be omitted from the model The reason is that those company have their special financial behavior and nature of business (Rajan & Zingales, 1995) and the capital decision of those companies should

be considered in other model

Thus, there are 271 companies will be chosen to evaluate in this survey to support for

my research The data is selected from balance sheet and income statement and converted to ratios to represent the dependent variable as debt ratio, short-term debt ratio and the five determinants: EPS, P/F, profitability, liquidity, firm size, and tangibility

3.2 Developing Hypotheses

A major purpose of this research is to estimate the determinant of capital structure in HOSE listed companies Financial theory and empirical results identify a number of variables that influence a firm’s debt

In order to explore more in sample, the dependent variables and independent variables are discussed as following part

3.2.1 Dependent Variables

The dependent variables are computed by using book values The primary rationale behind foregoing the market values for constructing the dependent leverage ratios has been data and time limitations Secondly, many researches available in the literature have used book values for their studies The theory prefers a market based measurement for example the seminal paper of Modigliani and Miller (1958) also shows that the gearing does not affect market values of firm Moreover, the tax shield bankruptcy argument also shows how the market value of firm is affected by different levels of gearing Thus, on a theoretical basis capital structure choices have always taken into consideration where it tends to affect the market value of the firm that is the sum of market value of debt and equity (Bennett & Donnelly, 1993) According to Titman and Wessels (1988), there is no reason to believe that the cross-sectional differences between market and book values of debt are correlated with the determinants of capital structure Moreover, Myers (1984) is in line with the argument

as according to him the book values are proxies for the assets Thus, it is reasonable enough, considering the time limitations to use the book values for computing dependent variables

Rajan and Zingales (1995) point out that the broadest definition of leverage is the total liabilities divided by total assets, which represents the share left for shareholders after the firm pays what it owes to outsiders in case of liquidation However, according to the writers taking this ratio alone does not provide a good indication of whether the firm is at risk of default in near future Moreover, the amount of total liabilities in financial statements also includes items like accounts payable, which may be used for

transactions purpose rather than financing needs of the firm, it may overstate the amount of leverage Regarding to this research, the ratio of both short and long term debt to total assets is more appropriate

Bennett and Donnelly (1993), Bevan and Danbolt (2002, 2004) are of the opinion that there is possibility that leverage costs of short term debt may differ from those of long term debt It may be the case in firms where short term debt is used as a buffer where a firm decides to change its capital structure and firm may have different policies with regard short term debt and long term debt, though some interaction is also possible (Bennett & Donnelly, 1993) When long term capital does not cover the capital required firms raise short term capital to fulfill the need Thus, by observing both short and long term debt ratio the analysis between the interaction between the level of short and long term debt will be more powerful

However, in this research, I focus on the dependent variables as the total debt and short term debt ratio to simplify the model

Short term debt is defined as the part of the company’s total debt repayable within one year which includes bank overdraft, bank loans payable within a year and other current liabilities

More specifically, the two dependent variables were:

Debt ratio = Total debt to total assets (DEBT)

Short-term liabilities ratio = Short-term liabilities to total assets (STDTA)

3.2.2 Independent Variables:

Based on literature and theories, six determinants that influent to Capital Structure are selected and calculated by six ratios below:

a P/E = Price divide to Earning per share at 31/12 of each year

b EPS = Earnings per share

c Tangibility = Ratio of fixed assets to total assets

d Profitability = return on asset after taxes to revenues (S.C Myers & Majluf, 1984)

e Size = Natural logarithm of total asset

f Liquidity = current asset/current liability

EPS is used as the indicator to represent to the growth opportunities while P/E is to show what the market response to the actual profitability of the firm The asset tangibility is defined by ratio of fixed assets to total asset The firm size in the other hand will come to serve as the size of company throughout years I also use ROR to indicate to profitability of the company and liquidity ratio for liquidity

effect of debt issuance on the firm’s EPS Management should not make decision based solely on the effect on EPS

However, the reality is that the effect of a decision on EPS does influence choices that businesses make Bierman has given a result from the analysis that could conclude that

a high P/E firm will tend to be more reluctant to issue debt in substitution for stock knowing that the effect on EPS will not be favorable (Bierman, 2003)

The study can given us the hypotheses as:

HOSE listed companies

ii Hypothesis 2: There is a positive relationship between P/E to leverage ratio in

HOSE listed companies

Bradley et al (1984), Titman and Wessels (1988) and Rajan and Zingales (1995), Marsh (1982) and Walsh and Ryan (1997) found a positive relationship between tangibility and leverage However, Chittenden, Hall and Hutchinson (1996) and Bevan and Danbolt (2002) found the relationship between tangibility and leverage to depend

on the measure of debt applied

Bennett and Donnelly (1993) found a positive correlation between leverage and collateral value for total and short-term debt, but not for long-term debt Despite some inconsistency in the prior evidence, based on theoretical evidences and majority of evidences it is expected that the levels of gearing are positively related to the level of tangibility

In the other hand, Van der Wijst and Thurik (1993) found a significant and negative coefficient between tangible asset as percentage of total assets and leverage Chittenden

et al (1996), Jordan et al (1998), Michaelas et al (1999) also found a negative relationship between asset structure and debt ratio

In order to calculate the tangibility of assets, there are some references in those prior empirical studies The ratio of fixed assets to total assets is used which is adopted from the work of Bevan and Danbolt (2004) is chosen to use in this study

Hypothesis 3: There is a negative relationship between tangibility and leverage ratio in

HOSE listed companies

According to the pecking order theory firm prefer using retained earnings, then debt and decides to issue equity as a last resort Myers and Majluf (1984) points out that equity is used as last resort due to the costs associated with asymmetric information and transaction costs (Titman and Wessels, 1988) The theory suggests that an unusually profitable firm with a slow growth rate will use low leverage than the firms in that industry and an unprofitable firm will rely heavily on debt financing than the other industry players (Ozkan, 2001) Ozkan (2001) found profitability to be negatively related to the gearing Bennet and Donnely (1993) concludes that profitability is negatively associated with leverage when market based measures of gearing are used Therefore, according to the theory a negative relationship should hold between debt and profitability Titman and Wessels (1988), Bennett and Donnelly (1993), Rajan and Zingales (1995), Bevan and Danbolt (2002) and Ozkan (2001) all found an inverse relationship between level of gearing and profitability

The preference for internally generated funds leads to the hypotheses that firms which have been profitable in the immediate past will have high retained earnings and low borrowings (Bennett and Donnelly, 1993) Therefore, the level of gearing is expected

to be negatively related to the level of profitability Following Titman and Wessels (1988), Bevan and Danbolt (2004), Ozkan (2001) and Whited (1992) the ratio of operating income to total assets and operating income to sales will represent profitability

Hypothesis 4: There is a negative relationship between Profitability and leverage ratio

in HOSE listed companies

In terms of the asset variables (asset size - the natural log of total assets, and asset growth - the ratio of the natural log of total assets in time period t, to the natural log of total assets in time period t-1), prior research findings show that larger firms are usually more diversified in terms of lines of business and less susceptible to failure than smaller firms The trade-off theory proposes a positive relationship between firm size and debt According to Titman and Wessels (1988), small firms tend to rely on low leverage as they face high costs when they issue long term debt or equity and also because of risk factors underlying the small firm effect From the perspective of the lenders, small firms are risky and they maintain low business with the financial institutions which makes them less preferable clients and also in some cases when they are preferred they are charged with high interest rates However, large firms are important corporate clients or financial institutions and are thus offered competitive rates

Deesomsak, Paudyal, Pesccetto (2004) also argues that large firms have lower agency costs of debt, relatively smaller monitoring costs, less volatile cash flows, easier access

to credit market which increases their dependence on debt Moreover, they also point out that due to higher bankruptcy risk and bankruptcy costs and also due to agency costs associated with the asset substitution and the underinvestment problem (Chung, 1993) that result in restriction on the length of maturity of debt for small firms

Ferri and Jones (1979) also suggest that large firms have easier access to the capital market and are able to borrow at favorable interest rates than small firms as they are considered to be much more credible with their financial decisions Moreover, small companies are more sensitive to economic downturn and faces high chance of liquidation when in financial distress (Ozkan, 2001) as they have few resources available to get out of the financial distress Therefore, small companies are expected to have less long-term debt but possibly more short-term debt than larger companies However, the pecking order theory suggests that a negative relationship holds between size and gearing as large companies are capable of issuing equity to raise funds

The rationale behind taking size as a potential firm specific determinant is important for a number of reasons Firm size (the natural log of sales) as an explanatory variable

is related to risk and bankruptcy costs (Bennett & Donnelly, 1993) Moreover, size is one of the operational characters of firm that has the potential to determine debt and equity choice of firms This measure is in line with many other studies and some of which includes Titman and Wessels (1988), Whited (1992) and Rajan and Zingales (1995)

Despite some contradictory evidence most of the available empirical evidence finds debt to be positively correlated with company size In view of the theory and the majority of empirical evidences it is expected and hypothesized that long term debt to

be positively related to company size and short term debt to be negatively related to company size

Hypothesis 5: There is a positive relationship between firm size and leverage ratio in

HOSE listed companies

In this study the proxy for growth opportunities is the annual percentage change in the total assets (Titman and Wessels, 1988) of the firms during the period selected This proxy determines the growth level as it captures the changes in total assets of the firm The empirical evidences regarding the relationship between growth and leverage in the literature is predominantly negative The studies by Lang, Ofek and Stulz (1996) suggests that leverage is negatively related to growth for firms with low Tobin’s q ratio, that is for firms whose growth opportunities are not recognized by the capital market

Consistent with these predictions, Titman and Wessels (1988), Chung (1993), Rajan and Zingales (1995), Barclay and Smith (1996) and Chen et al (1997) all found a negative relationship between growth opportunities and the level of either long-term or total debt On the other hand, Bevan and Danbolt (2002) found a negative correlation between gearing and long term debt; they found total gearing and short term gearing to

be positively related to the level of growth

In view of theoretical predictions and empirical evidences we expect and hypothesize that gearing to be negatively related to the level of growth opportunities

There is lack of evidences for liquidity in the literature According to Ozkan (2001) liquidity ratios may have a mixed impact on the capital structure decision As firms with higher liquidity ratios might use a relatively higher debt ratio due to greater ability

to meet short term obligations when they fall due This implies a positive relationship