OUTLINE
The relationship between a firm's capital structure and its performance has long puzzled scholars in corporate finance Modigliani and Miller's (1958) influential theory, based on the assumption of a perfectly competitive capital market, claims that a firm's market value remains unaffected by its capital structure This theory has paved the way for other frameworks, such as the trade-off theory, pecking-order theory, and agency theory, which attempt to address the complexities of imperfect markets and asymmetric information However, no single theory can comprehensively explain the intricate relationship between financial leverage and firm performance, as they are all based on critical assumptions that do not fully capture the diverse and complicated nature of real-world business environments (Ardalan, 2017) Gill, Biger, and Mathur (2011) emphasize that, despite various attempts to identify the optimal capital structure, no definitive models exist in corporate finance to determine a firm's ideal capital structure.
Previous empirical research presents mixed results regarding the relationship between firms' financial leverage and performance, with some studies indicating a positive correlation while others find a negative or nonexistent link This inconsistency suggests that the impact of capital structure on performance remains uncertain Researchers attribute these contradictory findings to institutional differences across countries and shortcomings in estimation methods.
This study analyzes data from publicly listed companies in Singapore, Thailand, and Vietnam to provide new empirical evidence on corporate financing decisions, enhancing the existing literature on the subject The chapter begins with an introduction to the thesis, outlining the research motivation in Section 1.2, presenting the research questions in Section 1.3, and detailing the thesis structure in Section 1.4.
MOTIVATION OF RESEARCH
Capital markets in developed countries demonstrate greater efficiency and reduced asymmetric information compared to those in developing nations (Eldomiaty, 2007) In contrast, emerging economies face numerous challenges, including an unstable macroeconomic environment, inadequate institutional quality, insufficient protection for minority investors, high transaction costs, and underdeveloped financial markets (Chen, 2004; G Huang & Song, 2006; Keister, 2004) These varying country-level characteristics can significantly influence firms' leverage decisions and the relationship between leverage and performance (Ahrens et al., 2011).
Most empirical studies on the leverage-performance relationship predominantly focus on firms in Western developed countries and Northeast Asian nations, leaving a significant gap in research regarding Southeast Asian countries like Singapore, Thailand, and Vietnam This lack of empirical evidence raises questions about the applicability of capital structure theories, originally formulated in developed economies, to these Southeast Asian contexts This study aims to analyze firms from Singapore, Thailand, and Vietnam, as they represent varying levels of economic development While all three countries are classified as developing, Singapore boasts high income per capita and governance quality, Thailand is categorized as upper middle income, and Vietnam ranks lower in both income and governance By examining these samples, the research seeks to provide insights that may be generalized across similar developing economies.
1 The 2019 report of the World Bank can be downloaded at: https://www.un.org/development/desa/dpad/wp- content/uploads/sites/45/WESP2019_BOOK-ANNEX-en.pdf
Vietnam is classified as a lower-middle-income country, and the Worldwide Governance Indicators (WGI) from the World Bank serve as valuable proxies for assessing the quality of governance in various nations For further insights into governance quality, the WGI can be accessed through the World Bank's official website.
The author is motivated to conduct this study due to the scarcity of empirical research in Southeast Asian countries and the oversight of the potential reverse effect of performance on firms' debt levels in prior studies.
Di Patti (2006) highlights that a firm's performance can affect its leverage choice, and failing to consider this reverse causal relationship may lead to simultaneous equation bias This implies that regressing firms' performance on their leverage could obscure the true effects of leverage on performance and vice versa Therefore, this study focuses on both the causal and reverse causal relationships between capital structure and performance.
Many studies analyzing financial leverage decisions of firms in Singapore, Thailand, and Vietnam often overlook important country-level variables Instead, they primarily focus on firm-specific factors as the main determinants of leverage levels, as highlighted by Frank and Goyal.
Research indicates that econometric models focused solely on firm-specific factors account for only about 30% of variations in corporate capital structure, suggesting the influence of additional variables, particularly macroeconomic factors (Bokpin, 2009) Studies by Antoniou, Guney, and Paudyal (2008) emphasize that a firm's leverage decisions are significantly impacted by the macroeconomic and institutional environment, including aspects like tax systems, borrower-lender relationships, and the strength of investor protection in their respective countries This research incorporates country-level variables to assess their role as determinants of capital structure within the Southeast Asian context.
Although dynamic econometric models, which incorporate lagged regressors, have theoretical and empirical support for analyzing the relationship between firm-specific variables like capital structure and growth opportunities and firm performance, most studies to date have relied on static models These static models, lacking lagged regressors, may be misspecified as they do not account for the path-dependent nature of firm performance and leverage, highlighting the need for a shift towards dynamic modeling in future research.
In this study, the term "causal relationship" refers to the potential impact of capital structure on the correlation within the idiosyncratic disturbance term of static models Banerjee, Heshmati, and Wihlborg (1999) argue that including variables related to optimal capital structure and adjustment costs does not eliminate the risk of model misspecification if a dynamic adjustment model is not utilized Furthermore, using inappropriate estimators, such as OLS or fixed-effects, to analyze the relationship between firms' capital structure and performance can result in inconsistent or misleading regression outcomes (Flannery & Hankins, 2013).
The need to explore the financial leverage-performance relationship in Southeast Asian countries is crucial, utilizing a dynamic modeling framework and a suitable estimator to achieve consistent regression results.
RESEARCH QUESTIONS
This thesis aims to investigate the causal and reverse causal relationships between firms' capital structure and performance in three Southeast Asian countries, contributing new empirical insights to the field of corporate finance To achieve this goal, the research will address six specific questions outlined in the following section.
This study investigates the relationship between capital structure and firm performance in Singapore, Thailand, and Vietnam, focusing on whether financial leverage impacts performance while addressing endogeneity issues It also explores additional firm-specific factors, such as size, tangible assets, and growth opportunities, that may influence performance Furthermore, the research examines the potential reverse causal relationship between performance and leverage choices, challenging prior studies that primarily analyze the effects of leverage on performance Additionally, it assesses the speed at which firms adjust their leverage towards a target level, considering the impact of adjustment costs and various firm-specific and country-level variables on leverage decisions Finally, the study aims to identify the determinants of financing decisions and the influence of country-level factors on leverage choices in the context of these three Southeast Asian nations.
STRUCTURE OF THE THESIS
This thesis comprises six chapters, beginning with a general introduction to the study Chapter 2 examines relevant theories and empirical literature on the capital structure-performance relationship, which is essential for developing the hypotheses presented in Chapter 3.
Chapter 3 outlines the data and methodology employed in this study, detailing the criteria for data collection, sources of data, variable measurements, model specifications, and estimation techniques Furthermore, it formulates hypotheses grounded in both theoretical and empirical literature, which will be examined in the subsequent chapters.
Chapter 4 explores the relationship between financial leverage and performance, while Chapter 5 analyzes the reverse causality between these two factors The findings from these chapters will address the research questions outlined in Section 1.3.
Chapter 6 points out the contribution, and the limitations of the study, thereby suggesting some relevant recommendations for future research Relevant conclusions and policy implications are also presented
OUTLINE
Chapter 2 reviews the relationship between leverage choices and firm performance, as discussed in Section 1.4 It outlines key theories in corporate capital structure, including Modigliani and Miller's propositions, the trade-off theory, agency theory, and pecking-order theory in Section 2.2 Additionally, Section 2.3 presents empirical findings from previous studies that examine how firms' financing decisions influence their performance, highlighting two key suppositions.
The article discusses the "efficiency-risk hypothesis" and the "franchise-value hypothesis," which elucidate the potential reverse causal relationship between a firm's debt level and its performance Additionally, it presents empirical evidence in Section 2.5 regarding how firm-specific characteristics and country-level factors impact capital structure, as identified in previous research The chapter concludes with a summary in Section 2.6.
DOMINANT THEORIES IN CORPORATE CAPITAL STRUCTURE
Modigliani and Miller theories
The irrelevance proposition theorem by Modigliani and Miller (1958) asserts that in a perfect market—characterized by the absence of taxes, bankruptcy costs, agency costs, and symmetric information—a firm's capital structure does not affect its overall value This concept can be demonstrated through a balance sheet example.
Assets-in-place and growth opportunities
The market value of debt ( )D
The market value of equity ( )E
According to Modigliani and Miller, a firm's market value remains unaffected by its financing structure, as long as its existing assets and growth opportunities are maintained In this context, V represents the total of D and E on the balance sheet.
In their 1963 study, Modigliani and Miller incorporate corporate income taxes into their irrelevance model, highlighting that the tax-deductibility of interest payments on debt allows firms to lower their tax liabilities, unlike dividend payments on equity This results in firms effectively paying a lower interest rate on bonds and bank loans due to tax savings By relaxing the assumption of no corporate income taxes, they suggest that firms can enhance their value by increasingly utilizing debt to take advantage of the interest tax shield Assuming that debt usage incurs no compensating costs and that a firm's market value is directly proportional to its debt level, Modigliani and Miller conclude that a firm's optimal debt level could theoretically reach 100%.
Modigliani and Miller (1963) assert that despite the benefits of a debt tax shield, firms should not aim for maximum leverage due to several factors Personal income taxes on investors may make retained earnings a more cost-effective financing option than debt Additionally, lenders often impose strict borrowing limits relative to a firm's equity Companies may strategically choose to borrow less than their maximum capacity to retain borrowing power for urgent needs Ultimately, while a firm's capital structure may fluctuate between debt and equity in any given year, its long-term financing typically involves a blend of both.
Capital markets in the real world are often plagued by imperfections and inefficiencies, such as agency costs, transaction costs, and asymmetric information As a result, the Modigliani and Miller theorem (1963) may struggle to accurately explain these real-life scenarios.
The trade-off theory
In the trade-off theory, a firm’s market value is determined by the following formula
Where V E is the market value of a firm when it is financed by equity only, PV dts is the present value of the amount of corporate income tax that this firm saves due to the use of debt in its capital structure PV fdc stands for the present value of financial distress costs (i.e costs relating to the menace or occurrence of default or bankruptcy) The optimal financial leverage of a firm (i.e the debt level that makes the market value of a firm maximized) is obtained only when the PV dts equal to PV fdc at the margin
Kraus and Litzenberger (1973) enhance Modigliani and Miller’s model by incorporating bankruptcy costs, asserting that a firm's optimal leverage results from weighing potential bankruptcy costs against the tax benefits of debt in a perfect capital market They identify that optimal debt ratios are below 100%, noting that a firm's market value positively correlates with low debt levels, while the relationship reverses at high debt levels, indicating that market value is a concave function of financial leverage Similarly, Myers (1984) emphasizes that firms aim to balance the value of the debt tax shield with bankruptcy costs to establish a target debt ratio, gradually achieving this target by adjusting their debt and equity mix to maximize market value.
Bradley, Jarrell, and Kim (1984) develop a model based on the fundamentals of the trade- off models developed by Kraus and Litzenberger (1973), Scott Jr (1976), and Kim (1978)
The model by Bradley et al (1984) assumes risk-neutral investors who base their investment decisions solely on expected after-tax returns from debt and equity Key assumptions include a constant tax rate on equity income, while debt returns are subjected to a progressive tax rate Firms calculate tax payments on their end-of-period wealth using a constant marginal tax rate, with both interest and principal payments being fully deductible Additionally, all payments to debtholders are fully taxed, and there is a non-debt tax shield that reduces firms' tax liabilities Negative tax bills cannot be carried forward or transferred between periods or firms If a firm fails to meet its end-of-period debt obligations, it faces financial distress costs, such as agency and bankruptcy costs, which ultimately diminish the firm's value The returns for debtholders and shareholders vary based on the firm's pre-tax earnings, as illustrated in the accompanying table.
Table 2.1: Expected pre-tax earnings of a firm and returns to debtholders and shareholders
Source: Adapted from Frank and Goyal (2007a, p 9) “Trade-off and Pecking Order Theories of Debt”
In the financial context, Y_d represents the gross return to debtholders, while Y_s denotes the gross return to shareholders The earnings before taxes and debt payments are indicated by X, with B signifying the debt obligation Additionally, N refers to the total after-tax value of the non-debt tax shield when fully utilized The ratio of financial distress costs to earnings before taxes and debt payments is represented by k, which is assumed to remain constant Lastly, t_c is the constant marginal tax rate applied to corporate income.
If X is negative, both debtholders and shareholders receive nothing If X is positive but not enough to cover the indebtedness, the gross return to debtholders is X(1 – k) since the costs of financial distress are kX, the gross return to shareholders is zero If
In scenarios where the value X exceeds B, debtholders receive the amount B If the condition X – B – N/t c is less than zero, the firm is exempt from corporate income tax, allowing shareholders to receive (X – B) When the firm utilizes its entire non-debt tax shield, the return to shareholders becomes (X – B – N/t c )(1 – t c ) + N/t c, simplifying to (X – B)(1 – t c ) + N Consequently, the firm's tax payment is calculated as (X – B – N/t c )t c, which can be expressed as (X – B)t c – N.
In the context of financial analysis, D represents the market value of a firm's debt, while E signifies the market value of its equity, leading to the total market value V, expressed as V = D + E The progressive tax rate on returns to debtholders is indicated by t pd, whereas t pe denotes the constant tax rate applied to equity returns Additionally, r f refers to the return rate on risk-free, tax-exempt debt, with f(X) representing the probability density function of variable X, and F(.) serving as the cumulative probability density function for the same variable.
With the assumption of risk-neutrality, the market value of a firm’s debt and equity at the beginning of the period are computed by the following equations:
Adding D and E yields the market value of the firm at the beginning of the period
The firm's value, as outlined in Equation 2.4, is derived from the present value of three expected values at the beginning of the period The first component relates to the second state in Table 2.1, where payments to debtholders, represented as X(1 – k), are influenced by the personal tax rate (t pd) The second component pertains to the third state in Table 2.1, where pre-tax earnings exceed debt obligations but remain below the threshold for incurring corporate taxes (B + N/t c) In this scenario, while the firm avoids corporate income tax, the payments to debtholders and shareholders are still subject to personal tax rates (t pd and t pe) Lastly, the final component illustrates the after-tax earnings for debtholders and shareholders as detailed in the last line of Table 2.1.
To maximize its market value (V), a firm must strategically determine its debt payments (B), ensuring that the partial derivative of V with respect to B is equal to zero.
The first term in Equation 2.5 highlights the marginal net tax advantage of debt, while the subsequent terms represent the marginal costs associated with the firm's debt levels Specifically, the initial term reflects the increased likelihood of not fully utilizing the debt tax shield when tax shields exceed pre-tax earnings, and the latter indicates the rising costs of financial distress The firm seeks to optimize its leverage by balancing the marginal net tax benefits of debt against the marginal costs related to leverage This trade-off model leads to significant predictions derived from differentiating the first-order condition with respect to k, N, t pd, and t pe.
The firm's optimal debt level decreases with rising costs of financial distress or non-debt tax shields, as indicated by the negative values of the first two equations The third equation also shows a negative value at the optimal leverage level, particularly when the marginal tax rate on debtholders increases Conversely, a rise in the personal tax rate on equity returns enhances the value of the debt tax shield, leading to an increase in optimal leverage The effect of risk, specifically the volatility of the firm's value, on leverage remains unclear Simulation analysis by Bradley et al (1984) suggests that earnings volatility negatively impacts the debt ratio when financial distress costs are significant While proxies are used for unobservable model factors, their study finds a statistically significant positive relationship between non-debt tax shields and debt levels, challenging theoretical predictions and raising questions about the accuracy of the theory or the proxies used.
The "one-period" trade-off model is a static approach that overlooks the interconnectedness of a firm's capital structure across multiple periods Frank and Goyal (2007b) highlight the omission of retained earnings in this model, suggesting that increased retained earnings in one year may lead to reduced debt in the following year, indicating a direct relationship with the firm's leverage Empirical studies, including those by Fama & French (2002) and Graham (2000), show that more profitable firms tend to utilize less debt, contradicting the static trade-off theory, which suggests a positive correlation between profitability and debt levels Myers (1984) acknowledges the static model's limitations, noting its low R-squared and significant variations in debt ratios among similar firms As a result, the dynamic trade-off theory has emerged, demonstrating more favorable outcomes (Dudley, 2007; Flannery & Rangan, 2006).
Kane, Marcus, and McDonald (1984) along with Brennan and Schwartz (1984) introduced the first dynamic trade-off models, which incorporate factors such as taxes, bankruptcy costs, and risk, while excluding transaction costs These models suggest that firms promptly adjust their capital structure in response to negative changes, allowing for costless rebalancing Consequently, firms tend to sustain high levels of debt to capitalize on the advantages of the debt tax shield.
Fischer, Heinkel, and Zechner (1989) developed a dynamic model that incorporates transaction costs, suggesting an optimal range for debt levels rather than a single optimal financial leverage point This model allows firms' leverage to fluctuate within this range due to recapitalization costs, with discrete rebalancing occurring when debt ratios stray too far from established boundaries Profitable firms tend to reduce their leverage by paying off debt, while those facing losses see an increase in their debt levels The core premise is that firms do not immediately adjust their capital structure in response to adverse asset value shocks, as the costs of such adjustments outweigh the potential benefits Their findings indicate that smaller, riskier firms with lower tax and bankruptcy costs experience greater fluctuations in their debt ratios over time.
The agency theory
Modern firms typically separate ownership from management, where a contract empowers the agent to make decisions aimed at maximizing shareholder wealth and firm value However, agents may opportunistically prioritize personal goals over the principal's objectives, especially in scenarios of asymmetric information, making it difficult for principals to prevent detrimental actions (Jensen & Meckling, 1976) This conflict of interest between principals and agents, compounded by asymmetric information, leads to agency costs, which are critical factors influencing corporate financial leverage (Harris & Raviv, 1991) Furthermore, Jensen and Meckling (1976) emphasize that a firm's primary capital structure objective should be to minimize the potential for opportunistic behavior by managers.
Agency theory identifies two primary types of conflicts: the shareholder-manager conflict and the shareholder-debtholder conflict The shareholder-manager conflict arises from the separation of ownership and control, as highlighted by Berle and Means (1932) This conflict suggests that managers may not always act in the best interests of shareholders, as they have differing utility functions While shareholders focus primarily on dividends and share price changes, managers consider a broader range of factors, including both financial rewards and non-monetary elements like career advancement, job security, and professional reputation.
Table 2.2: Types of agency problems in the shareholder-manager conflict
Effort The agent has motives to attempt less than the principal’s expectation
Asset use As the agent does not bear fully the costs of misusing the firm’s assets and consuming excessive perquisites, he or she has motives to do such things
Over-investment Over-investment is a sub-form of misusing the firm’s assets: the agent has motives to carry out unprofitable projects to increase the firm’s size
Horizon/Time preference The agent tends to have shorter-term views to achieve investment results than the principal
Risk Preference As the agent’s wealth is tied up more in the firm’s on-going business, he tends to be more risk-averse than the principal
Source: Groò (2007, p.40) “Equity ownership and performance: An empirical study of German traded companies.”
Agency costs, as defined by Jensen and Meckling (1976), refer to the decline in a firm's value resulting from the opportunistic behavior of its managers To mitigate this conflict, firms can implement measures to control agents or reduce information asymmetry Additionally, principals may incentivize agents to utilize resources effectively, ensuring that they refrain from engaging in harmful activities, or require compensation if such activities occur However, it is important to note that these strategies come with associated costs.
To address shareholder-manager agency issues, various solutions have been proposed Jensen (1986) argues that excess free cash flow can lead managers to invest in unprofitable projects or indulge in personal perks, as they seek to avoid shareholder scrutiny by utilizing internal funds To mitigate these actions, principals can reduce free cash flow by increasing dividend payments or leveraging debt Hunsaker (1999) highlights that higher debt levels raise bankruptcy risks, which curtails managers' luxury spending and decreases free cash flow This reduction aids shareholders in monitoring managerial behavior, making leverage more advantageous (Harris & Raviv, 1991) Additionally, debtholders can initiate bankruptcy proceedings if debts are unpaid, compelling managers to adopt more prudent investment strategies to enhance firm efficiency (Frank & Goyal, 2007b).
Incorporating appropriate managerial incentives within agency contracts and leveraging the managerial labor market are effective strategies to reduce conflicts between shareholders and managers (Warokka, 2008) The threat of takeovers from the managerial labor market, competition in the product market, and oversight from the board of directors can deter managers from engaging in opportunistic behavior Conversely, successful management can lead to increased compensation and greater autonomy for managers, which further alleviates tensions between them and shareholders.
Jensen and Meckling (1976) suggest that convertible debt can effectively discipline managers by reducing agency costs, as it allows debtholders to share in the firm's returns Firms with greater growth opportunities are more likely to overinvest, indicating a positive relationship between growth opportunities and convertible debt, while ordinary debt is negatively affected by growth potential Kensinger and Martin (1986) further argue that restructuring a firm into a limited partnership imposes restrictions on managers regarding dividend payments and investment decisions, thereby diminishing their decision-making power and reducing shareholder-manager agency costs.
The second agency problem identified by Jensen and Meckling (1976) highlights the conflict between debtholders and shareholders, arising from the use of debt to mitigate agency issues This conflict can lead shareholders to engage in risk-shifting behaviors, where managers, acting in shareholders' interests, make overly risky investments that prioritize shareholder value while jeopardizing debtholders’ interests As interest payments to debtholders are predetermined in contracts, successful risky projects can shift wealth from debtholders to shareholders, potentially altering cash flows However, such risk-taking can increase future borrowing costs and restrict access to debt financing, ultimately making the costs of debt outweigh its benefits This suggests that firms primarily use debt to reduce agency costs associated with ownership and control separation, rather than to exploit debt advantages over financial distress costs, as proposed by the trade-off theory.
The model of Jensen and Meckling (1976) shows that the impact of leverage level on agency costs is not monotonic This non-monotonic relationship is illustrated in the following figure
Figure 2.1: Total agency costs and the optimal capital structure
For firms with a specific size and total outside financing, low levels of debt can effectively mitigate shareholder-manager agency conflicts by curbing managers' opportunistic behaviors However, as debt levels rise, the risk of managers engaging in risk-shifting behavior increases, which can elevate the likelihood of bankruptcy and financial distress This escalation in debt may result in higher agency costs, ultimately negatively impacting the firm's overall efficiency.
According to Jensen and Meckling's agency theory (1976), firms aim to achieve an optimal debt level that minimizes agency costs and maximizes their value This optimal leverage represents a specific capital structure that varies among firms and over time, allowing each company within an industry to adjust its debt-to-equity ratio By doing so, firms can effectively reduce total agency costs and enhance their overall value.
The agency problem is more prevalent in developing economies compared to developed countries due to factors such as inadequate shareholder protection, weak enforcement of rules, high corruption levels, underdeveloped financial systems, inefficient capital markets, imperfect product markets, and poor corporate governance These institutional weaknesses lead to increased transaction costs for firms adjusting their financial leverage and foster opportunistic managerial behavior Consequently, higher transaction costs and managerial opportunism negatively impact firms' capital structures For instance, insufficient protection for outside investors can hinder access to external financing, compelling firms to rely on internal funds or bank loans (Myers, 2003).
The pecking-order theory
The pecking-order theory, developed by Myers and Majluf (1984), posits that firms prefer internal financing sources, such as retained earnings, over external options when seeking funds If external financing is necessary, companies opt for the least risky securities first, starting with debt, followed by hybrid securities like convertible debt, and finally equity Unlike the trade-off theory, the pecking-order theory does not establish a target leverage ratio, as retained earnings are prioritized over external equity, which ranks last in the financing hierarchy.
Internal financing is prioritized by firms to avoid issuing costs, with debt being the preferred external financing option due to its lower costs compared to equity However, Myers (1984) suggests that these issuing costs are minor when weighed against the costs and benefits of debt, as discussed in the trade-off theory He highlights the importance of asymmetric information between managers and external investors in shaping the pecking order of financing Managers, who act in the interests of existing shareholders, possess more knowledge about the firm's current asset values and growth prospects than outside investors By relying on internal finance, managers can keep this information private, avoiding the need to disclose the firm's investment opportunities and potential profitability Consequently, a firm's financing decisions serve as a reflection of its true value.
Let N is the amount of money that the firm needs to carry out its potentially profitable projects;
Net Present Value (NPV) represents the value of projects, while V denotes the firm's market value if the projects are not pursued If the firm opts to issue shares to raise capital, V1 reflects the new market value, and N1 represents the "true" value of the newly issued shares The difference between these values is expressed as ΔN = N1 - N.
Given the asymmetric information, the firm’s managers know the value of NVP, V, V 1 and
Investors may not fully understand the firm's management objectives, which focus on maximizing the market value of existing shareholders' shares Consequently, potential investors adjust their willingness to pay for the firm's stocks based on this assumption.
When the Net Present Value (NPV) is greater than or equal to the change in net worth (ΔN), managers opt to issue shares and invest in projects Conversely, if ΔN is negative, indicating that the market price of new shares is overvalued, the firm may still issue shares, even for projects with zero NPV, such as depositing the raised funds in banks If ΔN is positive, the firm is likely to pursue more favorable investment opportunities.
Managers of overvalued firms are typically more inclined to issue shares, while those of undervalued firms tend to avoid doing so This behavior can be interpreted as a negative signal to potential external investors, who may infer that the firm is only selling equity because its assets are overvalued (Frank & Goyal, 2007b).
In this scenario, while N remains constant, the number of shares fluctuates based on the stock price during issuance, making ΔN an endogenous variable influenced by V1 For example, when a firm issues new shares, the proportion of stock owned by new investors is represented by N/V1 The actual value of these new shares, as understood by the company's managers, is critical for assessing investment decisions.
With given N, V, and NPV, the higher the stock price is (i.e overpriced), the less “true” value of the new stocks belongs to the new investors, and the less N is
Myers (1984) highlights that beyond administrative and underwriting costs, asymmetric information creates an additional cost that can lead firms to forgo issuing new shares, especially when they are underpriced This results in the rejection of potentially profitable projects with a positive net present value (NPV) If a firm's free cash flow is sufficient to fund these projects, it can avoid this opportunity cost, demonstrating that internal funds are preferable to external financing sources.
When comparing debt and equity, Myers (1984, p 584) states that “issue safe securities before risky ones.” In other words, firms decide to employ debt first and then shares
In a scenario where a firm requires $100 for its projects, it may need to issue shares valued at $120 to secure that amount, illustrating an underpricing situation This results in a discrepancy in the net number of shares issued, denoted as ΔN.
The firm will proceed with projects only if their Net Present Value (NPV) is at least $20 If the NPV falls below this threshold, such as $13, the firm refrains from investing, resulting in a loss of $13 and a corresponding decrease in the firm's total value.
However, on the side of the existing shareholders, they tend to avoid a loss of $7 (if the firm issues shares and invests, the firm’s value increases by N + NPV = $100 + $13 = $113 but
$120 belong to the new equity investors Thus, the firm’s value that belongs to the existing shareholders reduces by $7) The managers can evade the problem of bypassing positive-
To enhance NPV investment opportunities, firms can reduce the change in net worth (ΔN) by issuing less risky securities For instance, if ΔN can be lowered to $13 or less, projects can proceed without diluting the existing shares' true value By focusing on securities that exhibit minimal future value fluctuations when internal information is revealed, firms can effectively manage risk while maintaining shareholder equity.
Because N depends on V 1 , it does not seem to be reasonable for the managers to control
When a firm issues debt, the absolute change in net worth, |ΔN d|, is typically lower than the change in net worth from issuing shares, |ΔN s|, under normal circumstances For example, if a firm can issue risk-free debt, ΔN becomes zero, allowing the firm to pursue all positive-NPV projects In cases involving risky debt, traditional option pricing models indicate that |ΔN d| remains less than |ΔN s| Therefore, utilizing debt is often a more advantageous option than issuing shares.
When a firm faces overpriced risky securities, it may opt to issue shares to capitalize on new investors According to Myers (1984, p 585), the guideline for issuing decisions is to "issue debt when investors undervalue the firm, and equity, or other risky securities when they overvalue it." Potential investors are aware that shares are issued primarily when they are overpriced, leading them to refrain from purchasing unless the firm has exhausted all other options.
“borrowing capacity.” Through this behavior, the outside investors drive the firm to follow a pecking order
Myers and Majluf (1984) highlight that potential outside investors often undervalue a firm's shares when managers opt for equity issuance over debt This undervaluation poses a significant risk for firms seeking to fund new projects, as new investors may capture more than the net present value (NPV) of these projects, resulting in a net loss for existing shareholders Consequently, managers may hesitate to invest, even when the NPV is positive To mitigate this issue, firms are encouraged to raise funds for new investments through securities that are not subject to undervaluation, such as internal funds or debt, which are preferred over new equity Typically, announcements of equity issuance lead to a decline in the value of existing shares, whereas financing through internal funds or riskless debt does not impact share prices.
The issue of underinvestment is closely linked to asymmetric information, with higher levels of this information imbalance leading to more frequent underinvestment occurrences Empirical studies, such as those by Korajczyk, Lucas, and McDonald (1991, 1992), demonstrate that the announcement of firms' business results through annual reports and financial statements significantly mitigates the underinvestment problem Additionally, the ratio of tangible fixed assets to total assets serves as a key indicator of asymmetric information; a lower ratio indicates a higher level of information asymmetry Consequently, Harris and Raviv (1991) suggest that firms with lower tangible asset ratios may experience an increase in debt over time.
EMPIRICAL EVIDENCE ON THE CAUSAL RELATIONSHIP
The impact of firms' leverage on performance remains a central issue in corporate finance, as the financing structure can influence a firm's value due to market imperfections Despite extensive theoretical and empirical research, the existence of an optimal financial leverage that maximizes a firm's value remains unresolved Discrepancies in corporate capital structure theories and empirical evidence lead to mixed results regarding the relationship between capital structure and performance, with some studies indicating a positive correlation, others showing a negative association, and several finding no relationship at all.
Several studies, including those by Krishnan and Moyer (1997) and others, have found no significant relationship between capital structure and firm performance Notably, Krishnan and Moyer's research indicates that while the country of origin affects both capital structure and firm performance, leverage, as measured by the total debt to total equity ratio, does not impact the return on equity (ROE) for large firms in Hong Kong, Korea, Malaysia, and Singapore These findings challenge the validity of capital structure theories in emerging market economies.
Similar results are revealed in the work of Alzharani, Che-Ahmad, and Aljaaidi (2012) These authors use a sample of 392 firms listed on the Saudi Stock Exchange from 2007 to
In a study conducted in 2010, researchers found no significant impact of debt levels on firm performance, as measured by Return on Assets (ROA) and Return on Equity (ROE) Similarly, Salameh, Al-Zubi, and Al-Zu'Bi (2012) analyzed data from 27 listed firms on the Saudi Stock Exchange between 2004 and 2009, confirming the absence of a relationship between debt ratios and ROE.
Zeitun (2014) investigates the impact of ownership structure and concentration on the performance of 203 companies across five GCC countries—Bahrain, Kuwait, Oman, Qatar, and Saudi Arabia—over the period from 2000 to 2010 The findings reveal that ownership structure significantly influences firm performance, with ownership concentration also having a positive effect In contrast, financial leverage does not appear to affect performance.
Chadha and Sharma (2015) conducted a study involving 422 Indian manufacturing firms listed on the Bombay Stock Exchange to examine the relationship between leverage and firm performance Their findings indicate that, within the Indian context, debt does not significantly impact Return on Assets (ROA) or Tobin’s Q, but it does negatively affect Return on Equity (ROE).
Numerous studies on capital structure reveal that financial leverage can enhance performance Schiantarelli and Srivastava (1997) examined the effect of debt maturity on the performance of Indian firms, particularly focusing on productivity Their findings indicate a positive correlation between longer debt maturity and both profitability and output growth Additionally, long-term debt contributes positively to firm-level productivity However, it is important to note that excessive leverage can adversely affect productivity.
Berger and Patti (2006) explore agency cost theory through efficiency as a measure of firm performance, specifically examining the influence of leverage on U.S bank performance Their research reveals that leverage positively affects profit efficiency across nearly the entire data set, with a 1% increase in debt ratio leading to a 6% increase in profit efficiency This relationship remains significant even at high leverage levels The authors argue that increased leverage can lower agency costs and align managerial behavior with shareholder interests, ultimately enhancing firm value.
Margaritis and Psillaki (2007) investigate the impact of capital structure on the performance of New Zealand firms using a non-parametric efficiency measure and quantile regression method Their findings indicate that both linear and quadratic leverage terms positively influence efficiency, aligning with agency theory that suggests increased debt enhances efficiency Additionally, the study reveals that industry concentration and intangible assets positively affect efficiency, while firm size and risk have negative effects The authors attribute the negative relationship between firm size and efficiency to the loss of control resulting from inefficient hierarchical management structures.
Margaritis and Psillaki (2010) examine the relationship between leverage, ownership, and performance in French manufacturing firms from 2002 to 2005, utilizing quantile regression and a quadratic functional form of debt ratio This approach effectively captures the non-monotonic relationship between leverage and profit efficiency Their findings support agency theory, indicating that a higher debt ratio generally enhances performance, as measured by X-efficiency However, they also note that in certain industries, the coefficient's sign shifts from positive to negative at elevated leverage levels.
Gill et al (2011) conducted a study involving 272 American firms from the service and manufacturing sectors listed on the New York Stock Exchange between 2005 and 2007 The results reveal that, in service industries, both short-term and total debt positively impact Return on Equity (ROE) Similarly, in manufacturing industries, long-term debt and total debt show a positive correlation with performance.
Fosu (2013) analyzes the influence of capital structure on the performance of 257 South African firms using panel data from 1998 to 2009 The study reveals a positive correlation between the debt ratio and firm performance, indicating that higher leverage can enhance performance Additionally, it finds that competition in product markets amplifies the effect of leverage on performance, suggesting that competitive environments further strengthen the relationship between debt and business success.
In a study conducted by Salehi and Moradi (2015) involving 100 listed firms on the Tehran Stock Exchange from 2008 to 2012, it was found that leverage positively impacts return on assets (ROA) Additionally, the research indicates that increased competition in product markets enhances the relationship between debt ratio and ROA, aligning with findings from Fosu (2013).
Numerous studies highlight the detrimental impact of leverage on firm performance For instance, research by Majumdar and Chhibber (1999) reveals an inverse relationship between total debt and profitability, specifically the profit-to-sales ratio, among Indian firms This negative correlation suggests that debt does not serve effectively as a control mechanism for shareholders to improve performance in the Indian context Consequently, substantial cash flows from borrowing may empower managers to exercise their discretion, ultimately harming the firm's performance.
Research by Gleason, Mathur, and Mathur (2000) indicates that higher debt levels negatively affect the performance of European retailers, as measured by ROA, sales growth, and pretax income Similarly, King and Santor (2008) analyzed 613 Canadian firms from 1998 to 2005 and found a negative correlation between financial leverage and Tobin’s Q, highlighting the impact of ownership on firm performance Additionally, Ghosh (2008) examined firm-level data from India's manufacturing sector between 1995 and 2004, revealing that increased debt levels are associated with decreased profitability and cash flows.
Asimakopoulos, Samitas, and Papadogonas (2009) analyze firm-specific factors impacting performance, highlighting that increased leverage negatively affects profitability Their study reveals that sales growth and larger firm size contribute positively to the profitability of companies listed on the Athens Stock Exchange from 1995 to 2003 They argue that firms with high debt levels must allocate a significant portion of their earnings to cover interest expenses.
That leads to fewer funds available to reinvest, thereby negatively affecting future growth opportunities of firms
EMPIRICAL EVIDENCE ON THE REVERSE CAUSALITY
Berger and Patti (2006) argue that neglecting the potential for reverse causality between leverage and firm performance in capital structure analysis can result in simultaneous equation bias They propose two key assumptions to address this issue.
“efficiency-risk hypothesis” and the “franchise-value hypothesis”) to explain how firms’ performance affect their leverage choices
The "efficiency-risk hypothesis" suggests that firms with superior performance utilize more debt due to reduced bankruptcy and financial distress costs This hypothesis indicates that more efficient firms, at any given capital structure, generate higher expected returns that shield them from financial difficulties, enabling greater debt utilization (Berger & Patti, 2006) Empirical evidence from Berger and Mester (1997) supports this positive correlation between profit efficiency and expected returns, particularly in their analysis of U.S banks from 1990 to 1995, where they found a strong link between profit efficiency and key performance metrics like ROE and ROA Consequently, higher returns can act as a substitute for equity, allowing more efficient firms to leverage debt more effectively.
The franchise-value hypothesis highlights how firms' profit efficiency influences their debt levels, suggesting that more efficient firms maintain a higher equity ratio to safeguard their economic rents from insolvency risks These firms are likely to generate economic rents that are expected to persist in the future, prompting them to retain additional equity capital to protect their franchise value (Berger & Patti, 2006) Research by Keeley (1990) indicates that the relaxation of chartering rules in the U.S banking sector during the early 1980s led to a decrease in equity capital among banks, as they had less franchise value to defend, aligning with the franchise-value hypothesis that emphasizes the importance of retaining equity to protect economic interests.
Faulkender, Thakor, and Milbourn (2006) assert that improved firm performance fosters greater alignment between managers and investors, leading to reduced leverage levels As firms excel, investor confidence in managerial decision-making grows, minimizing disagreements over investment choices This enhanced consensus lowers the costs associated with financial policy decisions, allowing managers to exercise more control over investments while diminishing the likelihood of investor opposition Ultimately, their findings indicate that firm performance significantly impacts capital structure.
Margaritis and Psillaki (2007) provide empirical evidence supporting the efficiency-risk and franchise-value hypothesis from Berger and Patti (2006) Their quantile regression analysis reveals that efficiency has a positive impact on debt levels at low to medium levels, while negatively affecting high debt levels Additionally, profitability is shown to positively influence financial leverage in firms with both low and high leverage quantiles.
The research by Margaritis and Psillaki (2010) investigates the relationship between leverage levels, equity ownership, and firm performance, while also considering reverse causality through the efficiency-risk and franchise-value hypotheses Utilizing a similar methodology from their 2007 study, they estimate the leverage model and find that profit efficiency positively influences capital structure, indicating that the efficiency-risk effect prevails over the franchise-value effect.
The study by Al-Sakran (2001) highlights a positive correlation between performance, indicated by profitability and ROA, and capital structure, suggesting support for the franchise-value hypothesis over the efficiency-risk hypothesis In contrast, Wiwattanakantang (1999) demonstrates a negative effect of ROA on leverage levels, while Al-Najjar and Taylor (2008) reveal that ROE adversely affects debt ratios Additionally, research by Biger et al (2007), Okuda and Nhung (2010), Nguyen et al (2012), and Balios et al (2016) consistently shows an inverse relationship between profitability and debt levels.
The impacts of performance on leverage, as predicted by the efficiency-risk and franchise-value hypotheses, present contrasting outcomes The efficiency-risk hypothesis suggests a positive relationship through its "substitute effect," while the franchise-value hypothesis indicates an inverse association via its "income effect." Margaritis and Psillaki (2010) argue that while researchers cannot distinctly separate these effects, they can determine which effect prevails Consequently, the findings are interpreted as the "net" effect of these two competing hypotheses.
OTHER DETERMINANTS OF CAPITAL STRUCTURE
Effect of firm-specific characteristics on capital structure
Taub (1975) found that volatility has a consistently inverse effect on capital structure, although this relationship is not always statistically significant Additionally, total assets, which serve as a proxy for firm size, and long-term interest rates positively influence the debt-to-equity ratio.
Marsh (1982) examines the debt and equity issuance of 748 UK firms from 1959 to 1970, finding that leverage decisions are significantly influenced by market conditions and past security prices The study highlights that financial leverage is affected by factors such as operating risk, firm size, and asset composition Specifically, firms with higher operating risk tend to use less debt, smaller firms favor short-term debt over long-term debt, and firms with a greater ratio of fixed assets are more likely to utilize long-term debt.
Bradley et al (1984) show that debt ratios are strongly associated with industry classification and earnings volatility, intensity of R&D, and advertising expenses negatively affect leverage level
Kim and Sorensen (1986) found that insider ownership has a positive impact on leverage Additionally, companies experiencing higher growth rates tend to utilize less debt, while those with greater operating risk tend to rely more on debt Interestingly, the size of a firm does not show a correlation with its debt levels.
A comparative study by Kester (1986) reveals that factors like growth, profitability, risk, firm size, and industry classification significantly affect the market value measure of leverage for both U.S and Japanese firms After accounting for these variables, no notable difference in leverage is observed between the two countries However, when examining the book value measure of leverage, Japanese firms exhibit significantly higher leverage levels compared to their U.S counterparts, particularly in mature, heavy industries, while this trend does not extend to other Japanese manufacturing sectors.
By comparing the benefits of debt with the costs of liquidation, Myers (1977), Williamson
In their studies, Shleifer and Vishny (1992) establish a connection between asset characteristics and the capital structure of firms, revealing that firms with liquid assets are better positioned to finance debt This is primarily because the financial distress associated with these firms is less costly, making liquid assets a strong indicator for debt financing.
5 See Taub (1975, p 412) for the definitions of the uncertainty variable
Easier liquidation of firm assets encourages the use of higher debt levels, as confirmed by Alderson and Betker (1995), aligning with previous empirical studies Their research highlights that liquidation costs significantly influence the choice of unsecured public debt and equity during corporate reorganization, while factors such as firm size and non-debt tax shields play a negligible role in determining debt levels in this context.
Titman and Wessels (1988) found that factors such as growth opportunities, non-debt tax shields, volatility, and asset collateral value do not influence convertible debt ratios; however, past profitability and transaction costs play a vital role in capital structure decisions Additionally, firm size and uniqueness have a negative relationship with short-term debt, indicating that smaller firms tend to rely more on short-term debt compared to their larger counterparts.
Harris and Raviv (1991) highlight that factors such as firm size, non-debt tax shields, fixed assets, and investment opportunities positively influence leverage Conversely, elements like business risk, advertising expenses, product uniqueness, profitability, and the likelihood of bankruptcy negatively impact a firm's leverage.
The influential study by Rajan and Zingales (1995) examines how tangible assets, market-to-book ratio, profitability, and firm size impact capital structure Firms with a high proportion of tangible assets can leverage these as collateral, making lenders more inclined to offer loans, which may result in higher debt ratios However, firms anticipating significant growth may prefer equity over debt due to the tendency of highly leveraged firms to underinvest (Myers, 1977) The relationship between firm size and leverage is complex; larger firms may benefit from diversification, potentially increasing leverage, yet they also face fewer asymmetric information issues, allowing them to issue equity more readily and possibly reducing debt usage The effect of profitability on leverage remains debated, with Myers and Majluf (1984) suggesting a negative link, while Jensen (1986) posits that the relationship depends on the effectiveness of the corporate control market, influencing lenders' willingness to extend credit based on a firm's free cash flow.
Research by Hovakimian, Hovakimian, and Tehranian (2004) indicates that return on assets (ROA), stock returns, and industry leverage have a significant positive impact on leverage, while firm size shows an insignificant effect in certain regressions In contrast, tangible assets, selling costs, and R&D expenses are negatively correlated with debt ratios.
Schmid (2013) highlights the influence of major shareholders' control and creditor monitoring on leverage levels, revealing that German family firms exhibit lower leverage compared to firms in other countries The study indicates that rigorous creditor monitoring significantly impacts the debt policies of these family-owned businesses, leading them to avoid incurring debt.
Wiwattanakantang's (1999) study is a pioneering analysis of firm-specific and country-specific factors influencing debt levels in developing countries, focusing on 270 listed firms on the Thailand Stock Exchange in 1996 The research reveals that both the market-to-book ratio and non-debt tax shield inversely affect debt ratios, while firm size and tangible assets positively correlate with leverage Interestingly, when analyzing book value leverage, business risk shows a positive coefficient, but this turns negative for market value leverage, although these results lack statistical significance Additionally, the study examines agency variables, finding that tangibility, business risk, and market-to-book ratio coefficients are not statistically significant, whereas family ownership positively influences both market and book leverage Other factors such as firm age, conglomerate status, government affiliation, foreign ownership, board size, and CEO characteristics show no significant impact, except for the director variable, which is positively correlated.
The study examines the influence of different major stockholder types—family, conglomerate, government, and foreign—on the leverage of single-family-owned firms It finds that managerial ownership, represented by the proportion of stocks held by directors and CEOs, positively affects leverage Additionally, ownership concentration, measured by the largest individual, corporate, and five-largest shareholders, negatively impacts debt ratios, while the effect of the largest financial institutions is also negative but statistically insignificant.
Al-Sakran (2001) shows that growth opportunities positively influence debt ratios, but firm size and state ownership are negatively correlated with the leverage level of firms in Saudi Arabi
Keister (2004) explores the capital structure of Chinese state-owned unlisted firms, highlighting that retained earnings play a crucial role These firms often leverage retained earnings as an indicator of their financial strength, which enhances their ability to secure bank loans.
Research by Chen (2004), Huang and Song (2006), Qian, Tian, and Wirjanto (2009), and Zou and Xiao (2006) highlights key factors influencing financing decisions of firms in China, including firm size, non-debt tax shields, profitability, tangible assets, growth opportunities, earnings volatility, and industry classification Additionally, Zou and Xiao (2006) found that ownership structure does not impact capital structure.
Li, Yue, and Zhao (2009) present empirical evidence that ownership and governance structure are the most important determinants of leverage level
Country-specific factors as determinants of capital structure
The corporate capital structure of firms is influenced by the varying legal institutions and economic environments in which they operate This highlights the importance of understanding how external factors affect firms' leverage Numerous studies have explored the impact of institutional and macroeconomic factors, as well as firm-specific characteristics, on financing decisions.
Rajan and Zingales (1995) conducted a groundbreaking study examining how institutional characteristics directly affect capital structure, using data from firms in the U.S and G7 countries Their research reveals that the factors influencing leverage decisions are largely consistent across these regions However, despite the thorough investigation, the theoretical basis for the observed correlations remains unresolved They emphasize the need to strengthen the connection between theoretical frameworks and empirical models to gain a deeper understanding of how institutional characteristics impact firms' leverage choices.
Demirgỹỗ-Kunt and Maksimovic (1996) investigate the impact of financial market development, macroeconomic factors, tax treatment of corporate debt and equity, and firm-level characteristics on leverage choices in thirty developed and developing economies from 1980 to 1991 Their findings indicate a significant positive relationship between banking sector development and firm leverage, while the link between stock market development and debt levels is insignificantly negative However, when analyzing subsamples, they discover that in developed stock markets, enhancements lead to a shift from debt to equity in firms' capital structures Conversely, in less developed stock markets, increased stock market development correlates with higher leverage for large firms, while small firms show no significant changes in capital structure due to stock market development.
Caprio and Demirguc-Kunt (1997) highlight the importance of financial market development and legal effectiveness in enabling firms in developing countries to access long-term loans, which in turn supports their growth Their findings indicate that institutional factors, along with the banking sector and capital market, significantly influence firms' leverage decisions Similarly, Hirota (1999) reinforces the notion that institutional and regulatory features are key drivers of leverage choices among Japanese firms.
Demirgỹỗ-Kunt and Maksimovic (1999) found that in countries with effective legal systems, large firms tend to have a higher long-term debt to assets ratio and lower short-term debt to assets ratio, resulting in longer debt maturities Conversely, the legal system's effectiveness does not impact the leverage levels of small firms While the size of stock markets does not influence the financing patterns of large firms, active stock markets encourage them to utilize more long-term debt with extended maturities In contrast, small firms' leverage remains unaffected by both the size and activity level of stock markets Additionally, the size of the banking industry does not impact the debt ratios of large firms but negatively influences the short-term debt of small firms, while inflation adversely affects long-term debt.
Booth et al (2001) reveal that while firms in developing countries face significant institutional differences compared to those in developed nations, their leverage decisions are similarly affected by firm-level variables However, the influence of country-level factors, such as inflation, economic growth, and capital market development, leads to distinct patterns in leverage choices between these two groups of countries.
Nejadmalayeri (2001) examines macroeconomic factors influencing firms' financing decisions, with a primary focus on the term structure of interest rates The study reveals that short-term rates, corporate bond yields, and yield curve volatility significantly affect financial leverage Additionally, factors such as inflation, cyclicality, collateral rates, and personal tax rates also play a crucial role in shaping firms' leverage choices Notably, a positive correlation exists between short-term rates and debt ratios, while long-term rates and inflation negatively impact debt levels.
Giannetti (2003) investigates how firm-specific factors, legal systems, and financial development influence the leverage decisions of 33,885 firms across eight European countries The study reveals that stronger creditor's rights protection can enhance financing opportunities for unlisted firms Notably, the author highlights that Italy's inadequate law enforcement contributes to the short debt maturity of its firms, while France's weak creditor's rights protection hinders firms from investing in intangible assets to secure debt financing.
Deesomsak, Paudyal, and Pescetto (2004) investigate the impact of the 1997 Asian financial crisis on the leverage decisions of publicly listed companies in Australia, Malaysia, Singapore, and Thailand Their findings indicate that the financial activity of stock markets negatively influences firms' debt levels, while interest rates show a positive but statistically insignificant relationship with leverage prior to the crisis However, post-crisis, this relationship becomes significant The study also highlights that creditor rights positively impact leverage in both the overall and post-crisis periods, contrasting with a negative effect observed before the crisis Additionally, ownership concentration is positively correlated with debt ratios during and after the crisis, whereas it had a significant negative association prior to the crisis Overall, the research confirms that the 1997 Asian financial crisis affected capital structure decisions at both firm-specific and national levels.
De Jong, Kabir, and Nguyen (2008) highlight that country-level variables impact capital structure through direct and indirect channels Directly, these variables, such as economic growth, creditor protection, and bond market development, significantly influence firm leverage Indirectly, country characteristics affect the relevance of firm-specific factors in financing decisions Their findings indicate that country-level variables are more powerful than firm-specific factors in explaining variations in financial leverage across countries Additionally, the authors suggest that country-level factors indirectly influence capital structure by affecting firm-specific determinants.
7 The ownership concentration in the study of Deesomsak et al (2004) is measured by the ownership of the three largest shareholders of the ten largest non-financial domestic firms
Psillaki and Daskalakis (2009) investigate the leverage determinants of SMEs in Greece, France, Italy, and Portugal, focusing on firm-level factors such as asset composition, profitability, firm size, business risk, and growth opportunities, as well as country-level variables Their findings align with Rajan and Zingales (1995), indicating that SMEs in these countries make similar leverage decisions Specifically, the study reveals that tangible assets and profitability negatively influence debt ratios, while firm size has a positive relationship with debt levels Notably, growth does not significantly impact leverage across the four nations Ultimately, the research concludes that firm characteristics are the primary determinants of SMEs' leverage decisions, overshadowing country-specific factors.
Bokpin (2009) examines how macroeconomic and firm characteristics influence the capital structure of firms across 34 emerging economies from 1990 to 2006 The study reveals that GDP per capita negatively impacts debt ratios, while inflation and the size of the banking sector positively influence the short-term debt to equity ratio, although the inflation effect is statistically insignificant Additionally, interest rates show a significant positive correlation with the short-term debt to equity ratio, but this significance diminishes with other financial leverage measures Furthermore, the development of the stock market, indicated by the ratio of stock market capitalization to GDP, does not have a statistically significant effect on firms' leverage decisions.
Vasiliou and Daskalakis (2009) found that variations in investor protection, enforcement of creditor rights, capital market development, and the role of financial intermediaries between Greece, the U.S., and other developed European nations do not significantly impact firms' leverage decisions.
A recent study by Jõeveer (2013) examines firms in Eastern European transition economies, including Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Slovakia The findings reveal that firm-level variables significantly influence financial leverage decisions for both listed and large unlisted firms, while small unlisted firms are more affected by country-level variables Approximately 50% of the variation in debt levels among small unlisted firms can be attributed to institutional and macroeconomic factors Jõeveer highlights the substantial impact of country-level factors on leverage choices, particularly for unlisted firms.
Belkhir, Maghyereh, and Awartani (2016) highlight the significance of institutional factors in determining firms' debt levels, revealing that leverage adjustment speeds vary across countries in the MENA region Their findings suggest that these variations stem from differing institutional characteristics, where more developed financial systems, robust law enforcement, and effective regulations contribute to increased firm leverage Additionally, a higher corruption index correlates with elevated debt ratios, indicating that the quality of a country's institutions significantly influences firms' capital structure decisions.
Some studies including those of Kim and Wu (1988), Cebenoyan, Fischer, and Papaioannou