Capital Structure in European SMEs

Transcription

1 MSc. Finance & International Business Authors: Niels Stoustrup Jensen (270404) Fabian Thomas Uhl (280905) Academic advisor: Jan Bartholdy, PhD Capital Structure in European SMEs An analysis of firm- and country specific variables in determining leverage Aarhus School of Business University of Aarhus Aug. 2008

2 ABSTRACT This study investigates how country specific factors related to macroeconomic development, corporate governance, legal- and financial environment affect the capital structure of European small and medium sized enterprises. Using regression analysis on a data panel consisting of nearly 500,000 observations from a total of 24 countries, the study shows significant relationships between proxies for different institutional factors and leverage. This suggests that policy makers can affect the environment for SMEs to operate in, by improving certain country characteristics. By distinguishing between Eastern and Western Europe using a dummy variable, the study further shows that there are differences in the impact of firm as well as country specific variables on leverage, depending on the region a company is incorporated in. More specifically, the study finds evidence that leverage is in general lower in Eastern Europe. This does to some extend support the findings of the OECD, that there exist an SME financing gap in transition countries which is argued to be due to a lack of institutional development, affecting the credit availability of SMEs. The expectation that corporate governance, legal- and financial environment are positively related to leverage, is only partly supported since a few surprising results are obtained regarding certain variables. Contrary, there is clear evidence that bank concentration is negatively correlated to leverage. Further, more profitable banks enhance the level of debt in the capital structure of SMEs. The study thereby questions the ability of the traditional ground pillars of capital structure theory, namely the static trade-off- and pecking order theory, to fully explain leverage, since they are argued to not sufficiently take into account the supply side of the financing decision. Obligatory note to the reader We hereby declare that this paper has been produced in full cooperation by the two authors. No division has been done in terms of workload, and each of us is therefore responsible for the entire paper. Best regards, Fabian Thomas Uhl Niels Stoustrup Jensen

3 Table of Contents 1. Introduction Outline of the paper Literature review Theories of capital structure Miller and Modigliani s irrelevance proposition The static Trade-off theory Pecking order theory SME financing gap Capital structure in East vs. West Market power Research question and hypotheses Methodology Fixed effects vs. random effects model Dummy variables Data collection Firm specific data Country specific data The final dataset Proxies Dependent variables Independent variables... 41

4 7. Analysis Descriptive statistics Regression output Interpretation of results Hypothesis 1 Leverage in Eastern and Western Europe Hypothesis 2 Corporate governance Hypothesis 3 Legal environment Hypothesis 4 Financial development Hypothesis 5 Bank concentration Hypothesis 6 Bank profitability Hypothesis 7 Eastern and Western Europe respond differently Conclusion Critical assessment and suggestions for further research Bibliography Appendices Table of contents

5 1. Introduction Ever since Miller and Modigliani in 1958 stated their famous irrelevance proposition, capital structure theory has been of great interest to many scholars around the world. Out of the wide body of research that has evolved over the last fifty years, the static trade-off and pecking order theories are standing as the ground pillars of capital structure theory. Lots of empirical work has so far been conducted in order to test the two theories, and some has tried to favor one over the other. But today, there is still no clear cut answer to what theory fits reality the best. Instead it seems like both theories has its drawbacks and are only partly able to explain capital structure of companies. The vast majority of the empirical work on capital structure has in the past been carried out on large listed companies in the US due to data availability. This research paper will instead focus on the capital structure of small and medium sized enterprises (SMEs) in Europe. According to the OECD, SMEs in OECD countries stand for percent of net job creation and contribute innovation and general dynamism to the economy. This gives an idea of the immense importance of SMEs in all economies. Acknowledging this fact, policy makers around the world should be concerned about fostering a fruitful environment for SMEs in order to promote growth. Different scholars have concluded that institutional factors are able to explain parts of the deviation in capital structure in cross country studies. This has lead to the primary motivation behind this research paper, which is to identify some of these country specific factors, and to determine their impact on capital structure. This rests on a belief that some SMEs, especially in transition countries, find it hard to acquire appropriate external financing in order to pursue their growth opportunities. This is supported by the OECD, who is specifically talking about an SME Financing GAP, which is determined by a country s macroeconomic, legal, regulatory and financial development (OECD 2006). This study is based on an analysis of the capital structure of companies from 24 Eastern and Western European countries. The goal of the analysis is to identify significant relations between firm specific as well as country specific factors, and leverage. The study then goes one step further by testing whether there are differences between Eastern and Western Europe in the use of leverage, and more importantly, whether the impact of different variables on leverage is different between the two samples. This can generally be summed up to the following central research question: 1

6 Central research question: To what extend do country specific variables concerning macroeconomic development, corporate governance, legal and financial environment help in explaining leverage in small and medium sized enterprises in Eastern and Western Europe Besides, hopefully contributing valuable information to policy makers on which factors affect SMEs access to finance, it can potentially add explanatory power in terms of better predicting the capital structure of companies. It is suggested that the traditional capital structure theories do not, to a sufficient extend, take into account country specific factors that influence SMEs access to external financing, and therefore only present an incomplete picture. Specifically, the supply side of external finance is not sufficiently reflected in the traditional theories of capital structure. The authors of this study suggest that especially for SMEs, that usually do not have access to international capital markets, the potential lack in supply of external finance is an important determinant of capital structure that cannot be ignored Outline of the paper The paper will continue as follows. Section 2 will consist of a literature review going over the two main theories of capital structure along with relevant empirical evidence. The literature review will also cover previous work on differences in capital structure between Eastern and Western Europe, along with a discussion of what institutional factors can potentially be responsible for this. Section 3 will state the research question and formulate the hypotheses that are going to be investigated in the paper. Section 4 will carry forward by describing the adopted methodology to test the hypotheses. Section 5 will describe the data collection including the different data sources and discuss the processing of the data in terms of eliminating outliers, observations with missing data etc. The adopted methodology implies the use of different proxies, which will be presented and discussed in section 6, together with expectations regarding their individual impact on leverage. Section 7 will present the results from the statistical analysis while these will be interpreted in section 8. The final conclusion of the paper will be presented in section 9. 2

7 2. Literature review 2.1. Theories of capital structure Trying to understand how firms choose their capital structure has been of great interest to scholars around the world for a very long time. Most effort has been done trying to explain the proportion of debt relative to equity, instead of the exact combination of different kinds of securities, such as long-term vs. short-term debt etc. During the last 50 years, several different theories have emerged. The next section will give a short review of Miller and Modigliani s theory of the irrelevance of the financing decision which started the era on capital structure research. After that, a review of today s most popular theories on capital structure, namely the trade-off and pecking order theories will be performed. According to (Frank, Goyal 2007), both of these theories are so called point of view theories. A point of view theory is characterized by offering a framework or guidelines, in which explicit models can be developed. It formulates some basic underlying principles and ideas that should serve as guidelines, whereas e.g. the well known Capital Asset Pricing Model (CAPM) is explicitly expressed in mathematical terms. Therefore when testing the pecking order or trade-off theory, it is necessary to formulate a specific model, which requires different assumptions to be made (Frank, Goyal 2007) Miller and Modigliani s irrelevance proposition The extensive number of research papers within the field of capital structure accelerated after 1958, where the later Nobel Prize awarded, Merton Miller and his colleague Franco Modigliani published their seminal paper on capital structure (Modigliani, Merton H. Miller 1958). In this paper they presented what is nowadays often referred to as M&M s proposition I, also known as The Irrelevance Proposition, which is considered to be the first real theory on capital structure, even though a similar idea was presented by (Williams 1938) 20 years before. As a matter of fact, (Weston 1955) argued that several teachers of business finance at that time actually doubted whether it was possible at all to develop theories of capital structure. Therefore it most likely came as a surprise when M&M in their paper stated that financing is irrelevant. Explicitly M&M stated the following (Modigliani, Merton H. Miller 1958, p. 268): 3

8 The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate ρ k appropriate to its class. Mathematically, this is expressed by the simple equation below, similar to saying that the value of a levered firm is equal to the value of an unlevered firm. V L = V U The underlying logic behind M&M s proposition was that the value of a pizza does not depend on how it is sliced (Myers 2001). Applying this intuitive point of view to a company basically means that depending on the composition of assets on the left hand side of the balance sheet, a company will receive a given expected stream of cash flows. Finding the value of the company is then done by capitalizing these cash flows at the appropriate discount rate, depending on the operating risk of the company. According to the irrelevance theory, the amount of debt relative to equity only serves to determine the successive split of cash flows between debt holders and equity holders, and does not affect the aggregate value of the company. M&M proved that under their assumptions, investors can create home-made leverage, by borrowing at the risk-free rate and buying stocks in an unlevered company. The other way around, shareholders can also undo unwanted leverage in a company by buying fewer stocks and lend money at the risk-free rate. Because investors can easily create or undo leverage on there own, the rationale is that they should not be willing to pay a premium for companies with a specific capital structure, due to possible arbitrage. Hence the value of two differently levered, but otherwise identical companies should be equal. However, no matter how appealing this simple statement sounds, it only holds in the synthetic world of M&M, where capital markets are perfect, i.e. no taxes, no business disruption costs etc. But even though the theory today does not make much sense because of the many strict and unrealistic assumptions, it brought about something else very valuable, namely focus on capital structure theory. The Irrelevance Proposition triggered a wave of research trying to develop evidence against M&M, i.e. that financing actually matters. Referring to the pizza again, (Myers 2001) argues that the value of a pizza actually depends on how it is sliced, since consumers gladly pay more for the many slices, than for a whole pizza. 4

9 2.3. The static Trade-off theory Probably due to the many critics of the unrealistic assumptions behind their proposition 1, M&M added taxes to their, still hypothetical world, in a later paper (Modigliani, Merton H. Miller 1963). By taking into account that interests were (and in most countries to some extend still are) tax deductable and therefore decreased the amount of taxes to be paid, their model introduced an interest tax shield. When debt is assumed to be risk-free, and there is no counterweight in the form of increasing costs due to high leverage, this resulted in an optimum capital structure consisting of 100% debt. This theoretical optimum fits very badly with the empirical observations, and that was probably one of the things that helped the trade-off theory to quickly become so popular. The trade-off theory suggests namely that the optimal capital structure is based on a trade-off between the value of the interest tax shield and the costs associated with leverage. The optimal capital structure is at the point where the marginal increase in the costs associated with additional leverage exactly offsets the marginal benefit of the increase in the interest tax shield from additional leverage. Traditionally when referring to the costs associated with leverage, one explicitly meant direct costs of bankruptcy i.e. lawyers fees, administration expenses etc. However a study (Warner 1977) showed that the direct costs of bankruptcy are negligible, and therefore do not alone rationalize the observed moderate borrowing among most firms. In a study among others (Altman 1984), evidence was found, indicating that indirect costs are way more important than direct costs, which is one of the reasons why we today refer to the costs associated with high leverage as business disruption or financial distress costs. Examples of indirect costs of bankruptcy that are incurred because of being highly levered, could be lost business or lost investment opportunities (Copeland 2005). Below a graphical presentation of the trade-off theory is shown. It can be seen that after some point (the optimum), the marginal financial distress costs are bigger than the marginal benefits from the interest tax shield, resulting in a decrease in the market value of the company. 5

10 Figure 1 Source: (Myers 1984) Agency costs and the trade-off theory (Myers 2001) argues that agency costs are also a part of financial distress costs, and an important contribution to the trade-off theory because it adds further counterweight to the interest tax shield, helping to justify the moderate borrowing that is usually observed in empirical findings. (Jensen, Meckling 1976) is probably one of the most well known articles describing different principle-agent conflicts and the agency costs in connection with these. Specifically relevant to the trade-off theory, the paper describes the agency costs associated with debt. One of the things described, is what the authors call The Incentive Effects Associated with Debt. This concerns the fact that there is an asymmetric payoff scheme between debt and equity holders. Equity holders have a residual claim on the company, whereas debt holders (if we assume non-convertible debt and other forms of equity-like securities) have a fixed promised payoff. If the manager acts 100% in the interest of shareholders, he would have an incentive to transfer wealth from debt holders to equity holders. This is possible through risk shifting, where after receiving debt financing conditional on a certain project, the company undertakes a different project with higher volatility. Even though the expected value of the project as a whole might be the same, equity holders will increase their expected payoff because they have an upside chance, while debt holders will see the value of their claim diminishing. The explanation for this 6

11 is that debt holders in a good scenario still only get their promised pay off due to the way a usual debt contract is constructed, while equity holders get the rest of the value. In a bad scenario where the company becomes worthless, debt holders get nothing exactly as equity holders. The incentive behind risk shifting can be illustrated very easy by considering the two scenarios as the only possible outcomes. Since equity holders never get anything in the bad scenario but get more in the good scenario depending on volatility, there is an incentive to increase the risk, in order to get the highest expected value from their perspective. For a numerical example of risk shifting see Appendix 1. Debt holders are of cause aware of this incentive, and will therefore demand debt covenants or monitoring devices in order to avoid such behavior of the stockholders who have the ultimate control over the company. Since the costs associated with debt covenants and especially monitoring devices are material, it will directly result in more expensive borrowing in order to compensate for the additional costs. Therefore the potential incentive among some borrowers to cheat the lenders, will effectively mean that all borrowers (with good or bad intentions), will end up paying more for their loans than if such an agency conflict did not exist between the two groups of capital providers. Another consequence of debt covenants could be that managers are constraint in their ability to distribute company profits to the stockholders, because the covenant could restrict doing so if not certain economic key ratios are reached. Furthermore it could be specified that additional borrowing is only possible under certain conditions or that further borrowing is even prohibited. If covenants are violated, it could result in the entire loan to fall due, and therefore the threat of financial distress could mean that the company has to pass up profitable investment opportunities. This is not a direct financial cost, but certainly a serious cost in terms of lost flexibility in that managers are restricted to take certain actions because of the covenants. To sum up, agency costs makes the use of debt less attractive because of financial as well as non-financial costs associated with it Dynamic trade-off theory One major drawback of the static trade-off model is that it is a static one-period model. The model solves for the best possible capital structure given the factors discussed above (interest tax shield, distress costs etc.) and implicitly assumes that all companies should at all time be at the optimal capital structure (Frank, Goyal 2007). However it is not realistic to expect companies to plan the financial structure only one 7

12 period ahead. This fact resulted in several scholars turning away from the underlying ideas of the trade-off theory (taxation and bankruptcy costs) and instead focusing on other theories trying to explain capital structure (Frank, Goyal 2007). In the later years, interest for a model based on the traditional trade-off ideas, but incorporating the fact that capital structure planning is not a 1 period problem, has increased leading to the formulation of a dynamic trade-off theory. By emphasizing for instance transaction costs, several dynamic models have emerged in the literature, leading to somewhat different conclusions. The underlying idea of all dynamic trade-off models is however that the optimal capital structure in period t+1 depends on the optimal capital structure in period t+2 which depend on t+3 and so on. One interesting thing about dynamic trade-off models is that they essentially allow companies to be at suboptimal levels of leverage. By introducing transactions costs it is not efficient to make constant rebalancing of the capital structure, which will from time to time drive companies away from their optimal capital structure. (Fischer, Heinkel & Zechner 1989, p. 19) finds that: even small recapitalizing costs leads to wide swings in a firm s debt ratio over time. The authors thereby state that recapitalizing costs or transaction costs are responsible for the observed deviations in capital structure for companies that are essential similar. At the same time they argue that all else equal, similar companies should have the exact same recapitalizing criteria s. Interestingly they find that smaller companies display larger swings in their capital structure which could be interpreted as a sign of higher transaction costs for SMEs Empirical findings concerning the trade-off theory A major weakness of the trade-off model is that it is very difficult to test. Nevertheless, several studies have tried to test the theory in different ways, and some of them will be highlighted in the following. One study (MacKie-Mason 1990) finds evidence that the amount of tax loss carry-forwards is negatively correlated to the amount of new debt issues. This is in line with the trade-off theory, since large tax loss carry-forwards would make the interest tax shield created through the use of debt redundant if the company does not earn enough taxable income to benefit from both. (Bradley, Jarrell & Kim 1984) also interprets their study as supporting a theory of optimal capital structure i.e. trade-off theory. The support is based on results showing that volatility of earnings has an impact on leverage together with strong industry 8

13 effects. The intuition according to the trade of theory is that when considering a given level of costs associated with actual bankruptcy proceedings, the volatility of earnings has an impact on the expected bankruptcy costs by simply affecting the probability of default. Therefore companies in risky businesses where earnings are highly volatile will incur higher levels of expected bankruptcy costs, and should therefore lever to a smaller degree. The strong industry effects are interpreted as being in favor of an optimal capital structure which is the trademark of the static trade-off theory. This is because factors like the magnitude of financial distress costs, non-debt tax shield and the variability of firm value, are expected to exhibit similarities within different industry classes. This expectation does not seem very far fetched, since obvious determinants of bankruptcy costs like e.g. the amount of tangible assets is highly industry specific. Other studies have used a target adjustment model for testing whether companies over time adjust towards an optimal capital structure. See for example (Auerbach 1985) or (Jalilvand, Harris 1984). They find significant adjustment coefficients, and interpret it as support for target adjustment behavior, hence also as support for the trade-off theory. But before one gets too excited about these findings it should be noted that the statistical power when testing the target adjustment model is essentially non-existing according to (Shyam-Sunder, Myers 1999). In their paper, Shyam-Sunder and Myers test the statistical power of the target adjustment model by applying it to a hypothetical dataset generated by following the pecking order model. Interestingly they find the target adjustment model to be accepted even though the observations in the simulated dataset were created, strictly based on pecking order behavior. They also did the experiment the other way around, by testing the pecking order theory based on a dataset generated based on an alternative capital structure theory, and here the pecking order hypothesis was correctly rejected. According to this evidence, one should be careful when interpreting tests of the trade-off theory. (Myers 2001, p. 94) explains it in the following way: such results might support the theory if it were the only game in town. The point here is that several ideas about capital structure exist, so one cannot test whether one is correct over the others if you are not aware of the expectations about the other theories. Otherwise one implicitly applies the logic of Erasmus Montanus 1 when he tells his mother that because a stone does not fly, and she does not fly, she must be a stone. 1 Erasmus Montanus is the name of a play written by Ludvig Holberg in

14 Naturally there are also studies that fail to find support of the trade-off theory or where there is only partly evidence in favor of it because some puzzling results show up at the same time. And finally some argues that there is no reason to believe that the static trade-off theory has any explanatory power in terms of the amount of leverage that companies take on. Critics point out that it is very hard for the trade-off theory to explain why quite some profitable firms for years have been running at only moderate levels of debt (Myers 2001). (Graham 2000) concludes that the average company in a subsample consisting of half the companies in his survey could add a non-trivial amount, equal to approximately 7.5 % to its value by increasing leverage. In the end, one must conclude that the opinions about the validity of the trade-off theory are split SMEs and the trade-off theory Traditionally, most research on capital structure including the trade-off theory has been performed on samples consisting of large listed US firms, due to the better availability of data. The scope of this paper is concerned with SMEs and therefore it is felt necessary to elaborate on whether one can expect SMEs to behave similar to large listed companies in terms of the trade-off theory. Some scholars argue that the actions taken by managers of SMEs regarding financial decisions can be explained by the same theories that are usually applied to large listed companies i.e. trade-off and pecking order (Sogorb-Mira 2005). In the framework of the trade-off theory it is hard to argue that SMEs would not face the same trade-off between interest tax shield and distress costs. However it is possible that SMEs might put more emphasis on certain issues or face problems that large listed companies do not face to the same degree. Here some of these issues and the possible implications for the capital structure of SMEs will briefly be discussed. One possible reason that could explain why SMEs might not follow the trade-off theory is simple lack of knowledge among managers. If the financing decision should be made according to the trade-off theory, it is naturally a necessity that managers are aware of the advantages of an interest tax shield. Within the SME segment, one could expect that many companies are led by entrepreneurs with their expert skills lying within a field different from finance, and therefore might not possess the knowledge or for some other reason, be ignorant of the interest tax shield and therefore do not take advantage of it (OECD 2006). If managers are not aware of the benefits of leverage, they might tend to operate at lower debt levels all else equal. 10

15 Another interesting factor is the potential financial constraint of SMEs. If some SMEs are in fact financially constrained it would mean that independently of whether managers are aware of the trade-off theory and recognize the advantage of debt, they might not be able to lever up to their optimal capital structure. This is by the authors suggested to be an important issue, since that would imply that it is for external reasons that SMEs might not have sufficient debt according to the trade-off theory. From an isolated perspective, it does not seem like a big issue if companies have less debt compared to what is suggested by the theory. But one can imagine serious consequences if the lack of debt financing results in the company having to pass up profitable investment opportunities and thereby restricting growth. Lack of debt-financing does not necessarily mean that no financing is available at all. It can also mean that the price of the available finance is prohibitive. Section 2.5 will elaborate on this issue. Finally, one reason why SMEs could have a different capital structure than their large listed counterparts could be that their experienced bankruptcy costs are higher due to a lot of them being family owned. Besides the expected financial distress costs and the economic loss due to bankruptcy, a family owned company most likely also represents a great amount of sentimental value to the owners. Therefore one can argue that this dimension of distress costs will increase the expected costs of debt, and therefore lower the optimal capital structure of family owned companies. A convenient thing about this is that it explains within the framework of the trade-off theory, why the capital structure of SMEs might deviate from the one of large listed companies Pecking order theory In 1984, Myers proposed an alternative approach to capital structure theory by introducing the pecking order theory. This theory states that firms prefer internal financing to external financing, and if external financing has to be used, the cheapest possible security is chosen first. Corporations will, when using external finance, first use debt, then hybrid instruments, and as a last resort, issue equity. In this framework there is no optimal debt ratio and companies do not try to maintain a target debt-ratio. Instead, the debt-equity mix of a company is determined by their need for external finance (Myers 1984). The basic assumption underlying the pecking order theory is that managers act in the interest of existing shareholders, and do have better information about the future 11

16 prospects of the company than potential outside investors. A planned stock-issue is perceived as a bad signal by prospective investors, because they assume that the goal of the management is to maximize the value of the existing shareholders. The rational supposition of outside investors is that a company issues shares because management thinks that the shares of the company are overvalued. Hence, this perceived information only makes an equity issue possible at a marked-down price. Therefore managers who are in need of external funds to finance a positive NPV-project, assuming issuance of debt is not possible, will only consider issuing undervalued shares, if the NPV of the project is higher than the cost incurred through the undervaluation in the stock-issue. This means that even when a company has significant growth opportunities, it will not realize these growth opportunities by means of a stock issue, if the undervaluation due to the signaling effect, exceeds the potential gains from the projects. Several studies have confirmed the signaling effect, in that the announcement of a stock issue has a subsequent negative impact on the stock-price. In a study of large listed companies by (Asquith, Mullins 1986), the announcement of a stock issue caused an average fall in the stock-price of about three percent. Furthermore it has been shown that the magnitude of the price drop is related to how strong the information asymmetry between inside management and outside investors is. Even if a company has good prospects for the future, the perceived signaling effect has a negative impact on the value of the firm in the short-run, i.e. the bad news of a stock issue outweigh the news of good investment opportunities of the company. When comparing debt to equity, debt has a senior claim on assets and earnings of the company. This implies that creditors face less risk compared to equity holders. Only if the risk of bankruptcy is high, the impact of the announcement of a debt issue will affect the share-price. Taking this into consideration it can be assumed that only pessimistic managers will make an equity issue if debt is available at a fair price. The key predictions of the pecking order theory are therefore as follows: 1) Internal financing is preferred to external financing if available, since asymmetric information is only relevant for external financing 12

17 2) Changes in the net cash-flow of a listed company will usually be accompanied by changes in external financing since dividends are in general rather sticky, and cannot be changed in the short-run to finance capital expenditures 3) If external financing is necessary, i.e. the internally generated cash-flow is not sufficient to cover capital expenditures, debt, which is the safest security, will be issued first followed by hybrid instruments and then equity. 4) The need for external financing of a company is reflected in its debt ratio The pecking order theory is therefore, contrary to the trade-off theory, able to explain why profitable firms have less debt compared to less profitable companies. The reason is not that they have a low target debt ratio, but that they to a higher degree are able to generate sufficient internal funds to finance necessary investments (Myers 2001) Empirical findings concerning the pecking order theory Like the trade-off theory, contradicting evidence is also observed when turning to the empirical literature concerning the pecking order theory. However it seems like the majority of research papers are not able to find convincing overall support of the theory. A paper that does find evidence for a pecking order is (Shyam-Sunder, Myers 1999). In the paper, both the static trade-off model as well as the pecking order model is tested. The paper finds that the pecking order model has more explanatory power than the trade-off theory, and is a much better first-cut explanation of debt-equity choice. Partly evidence in favor of the pecking order is found by (Frank, Goyal 2003). These authors show that large firms show some aspects of pecking order behavior, but do not consider the results robust enough. A common interpretation in favor of pecking order behavior is when researchers find a negative correlation between profits and debt. This is also the argument in (Fama, French 2002), (Titman, Wessels 1988), (Rajan, Zingales 1995) and others, who find that more profitable firms have less debt. In a later paper, Eugene Fama and Kenneth French however look critical at the pecking order (Fama, French 2005). In this article the authors study when, and how often, firms issue equity. They find that more than half of the companies in their sample violate the pecking order predictions. This is interpreted from their results showing that between 54% and 72% of their sample depending on the period, makes net equity issues each 13

18 year. Far from all of these companies are under distress, so the pecking order is not able to explain the behavior of these firms. (Galpin 2004) argues that the fundamental assumption of the pecking order, that equity is used as a last resort due to the high issue costs, is not valid. In his study he concludes that the costs of debt issues often exceed the cost of issuing equity. Galpin shows that issuance costs have evolved over time. In 1973 debt costs amounted to 50% of equity costs, increasing to 140% in This might suggest that the pecking order was valid at the time it was invented, but that times have changed and it might not hold anymore. It has to be said that the study was performed on large listed companies and that the cost-structure could very well be different for SMEs SMEs and the pecking order theory The development of the pecking order theory is largely based on observations from large listed companies in the US. The structure of SMEs as well as their access to capital markets is very different to that of large listed companies. Therefore it is interesting to see if it is possible to verify the validity of the theory for this kind of companies, similar to what was done regarding the static trade-off theory. Furthermore, when testing the static trade-off theory or the pecking order theory for SMEs, it is important to question the reason why SMEs behave according to one theory or another, since the reason can be very different compared to large listed companies. It turns out that there are very compelling reasons why the pecking order theory should be able to explain the behavior of SMEs regarding capital structure. One reason is that small firms are often owned by only one shareholder who is at the same time the director of the company. An issue of new equity would dilute the shareholding of the owner-manager, and can therefore lead to a loss of control in the company. To avoid this, the natural response would be to turn to debt instead of equity for financing (Lopez-Gracia, Sogorb-Mira 2008). Another argument against the use of equity by SMEs is that the cost of external equity is even higher to them compared to large listed companies. An initial public offering is not only expensive to organize, but also subject to under pricing which has been shown to be particularly severe for small companies (Chittenden, Hall & Hutchinson 1996). Another source of equity finance stems from private placements with private equity companies or business angels. Apart from the potential loss of control in the company, 14

19 this source of finance also has significant transaction costs due to the complexity of the contracts that have to be negotiated (Ou, Haynes 2006). The size of a company also has an impact on the availability of debt-financing. This is reflected in the fact that smaller companies rely more strongly on short-term financing than larger companies, since financial constraints are mainly present when attempting to acquire long-term finance. Therefore the pecking order for SMEs is expanded in the sense that there is a propensity towards short-term financing over long-term financing (Lopez-Gracia, Sogorb-Mira 2008). The circumstance that SMEs may be confronted with constraints in acquiring debt-financing will be discussed in greater detail in the next section, since it can have a potentially large effect on the capital-structure of SMEs SME financing gap An issue that has a possible impact on the capital-structure of SMEs is the so-called SME Financing Gap. In a survey performed by the OECD SME Task Force, most OECD member countries agreed that a lack of appropriate financing does have a negative impact on the growth of innovative SMEs. The SME Financing Gap is commonly defined as the situation where a significant share of SMEs cannot fulfill the financing needs which exceed their internal financing capacities, through banks, capital markets or other suppliers of finance. There are different reasons why the financial constraint of SMEs is larger than that of large companies. One reason is that the problem of asymmetric information is more severe in SMEs (OECD 2006). This is partly due to the fact that in many cases the company is very much tied to the entrepreneur. This leads to a situation where the entrepreneur has considerably superior information on the situation of the company. Related to this is also the problem that a manager in an SME is more likely to have insufficient management skills compared to the managers in large companies. Therefore potential investors have a more difficult time to assess whether an SME manager is making bad management decisions which could potentially threaten the well-being of the company. Morale hazard considerations also play a significant role for the availability of credit to SMEs. The lending bank is mainly interested in a firm s capability to repay its loan, while the company might prefer a high risk and high return strategy, which could lead to risk shifting (see section 2.3.1). Even though risk shifting is a potential problem with any kind of debt financing, it is usually more severe when lending to SMEs because, as mentioned, the asymmetric 15

20 information present when dealing with SMEs is higher compared to large listed firms (OECD 2006). The empirical evidence whether an SME Financing Gap exists in reality is rather mixed depending on region. Most empirical studies have problems with data availability. Nevertheless there is a general tendency in the empirical studies performed by the OECD. It has been shown that the financing gap is more severe in OECD countries that are considered transition countries compared to developed OECD countries, while it is most significant in non-oecd countries. The research regarding SME financing has shown that there are different types of financing gaps. For instance in some emerging countries, the financial system is very much geared towards large firms, making it much more difficult for SMEs to obtain bank-credit. This leads to a situation where the growth potential of SMEs is constrained, and the ability of SMEs to be the innovators of the economy, which is a role they often play, is thereby limited. Another issue which is particularly widespread in the bank-dominated countries in central Europe is the rather decent access to debt-financing but a lack of equityfinancing. It is argued that a crucial component for SME financing is a solid legal, institutional and regulatory environment. In the case of debt-financing, it is important for lenders to get reliable financial information about prospective borrowers. In this context, weak accounting standards are argued to be a problem. A related issue that can complicate the access to debt-financing is weak creditor-rights. Weak creditor-rights could be expressed through for instance a weak bankruptcy code, where bankruptcy procedures take a very long time and the access to collateral is difficult (OECD 2006). Several studies have been performed, looking at financial development and access to finance in Eastern Europe, and more specifically on the possibility of an SME Financing Gap in that region. Some of the empirical evidence is presented here. (Cornelli, Portes & Schaffer 1996), (Chaves et al. 2001) and (Egerer 1995) all find indication that leverage in Eastern Europe is low and the access to external finance is insufficient, either in terms of the associated cost or the availability. All studies attribute this problem to some sort of institutional factors. A more detailed description on these studies will be presented in section More evidence for a SME finance gap has been presented by (Bratkowski, Grosfeld & Rostowski 1998). In this study the authors state that banks in transition countries are 16

21 more reluctant to provide debt-financing to SMEs than in developed countries. Another explanation for the lower debt-levels in Eastern Europe compared to Western Europe has been presented by (Jõeveer 2005). In her study of nine Eastern European countries, she points out that domestic credit provided by the banking sector compared to GDP, is around 40 percent in the observed region of Eastern Europe, and more than 100 percent in Western Europe. This view is to some extend also supported by a survey that was commissioned by the European Union, which was supposed to investigate the access to finance of SMEs in Eastern and Western Europe. In this survey, less than two third of the interviewed SMEs in Eastern Europe said that they had sufficient financing to see their projects through (EOS Gallup Europe 2006). On the contrary more than three quarters of the interviewed SMEs from Western Europe said that they had sufficient financing opportunities for their projects. In this context it is also interesting to note that 59 percent of the interviewed companies in Eastern Europe believe that banks are not willing to take on the risk associated with lending to SMEs. It has to be mentioned that the availability of external-finance is of cause also highly dependent on the type of SME. For instance, innovative SMEs that are for example developing a new product and have at present, negative cash-flows and high uncertain growth opportunities might not be able to acquire debt-financing independent of location. The risk-premium associated with a loan for such a company could potentially drive up the cost to prohibitive heights. It has to be pointed out that for example the type of SMEs in the respective sample, as mentioned above, also has to be considered when drawing conclusions about a potential financing gap. Nevertheless, to sum up the empirical evidence, it is supported that companies in Eastern Europe rely to a smaller degree on debt-financing and it has also been put forward that this is due to short-comings in the institutional environment Capital structure in East vs. West Since this study is dealing with capital structure in Western as well as Eastern Europe, it is necessary to look at some previous work, concerning differences in capital structure from a geographical point of view. Thereby the research questions and expectations about the findings in this study can be formulated based on a review of other people s experience, and hopefully shed light on new unexplored issues. 17

22 As previously mentioned, most research on capital structure has been performed on datasets consisting of large listed companies mainly located in the US. Even though an increasing body of literature has lately focused on SMEs, the research has primarily been based on US or Western European firms (Klapper, Sarria-Allende & Sulla 2002). Some of the studies that highlight the general importance of country specific factors are e.g. (Porta et al. 1998), (Booth et al. 2001), (Giannetti 2000), (Jõeveer 2005) and several others. After reviewing these studies there is no doubt as to the importance of country specific factors in general. An important statement in this connection is that of (Jõeveer 2006). She argues that country specific factors have a larger impact on the capital structure of small unlisted companies, while firm specific factors explain a relatively larger portion of the capital structure of listed and large unlisted companies. Her study highlights the importance of country specific variables in the context of this study since it exclusively deals with unlisted SMEs. This might suggests that when a company reaches a certain size, the importance of country specific factors are reduced because the company for instance has access to international capital markets. A brief discussion of differences in institutional factors in Eastern and Western Europe can be found in appendix Empirical findings In the following, some empirical work specific to the capital structure of Eastern European countries, and how it may deviate from their Western counterparts, will be highlighted. According to (Klapper, Sarria-Allende & Sulla 2002), Eastern Europe offers an interesting study base, because of the unique state of financial development and market characteristics, and therefore one can expect that SMEs incorporated in these countries will exhibit a different financing behavior, compared to Western companies. The expected difference in the environment for SMEs is also what makes it ideal in terms of this study, where the variability is a necessity for making inference about the relationship between leverage and the different country specific factors. One of the later studies (Nivorozhkin 2005) looks at leverage in five countries (Bulgaria, the Czech Republic, Poland, Romania and Estonia) from Eastern Europe. The paper observes that on average, the companies in transition countries operate at lower debt levels than comparable Western European firms. Trying to explain the leverage ratio, a panel data regression is being performed with leverage as the dependent variable 18

23 and different country characteristics as the independent variable. Among other things, they find that leverage is positively correlated with variables that proxy for financial development like domestic credit to private sector as a proportion of GDP. The results of the macroeconomic variables showed that inflation is negatively related, while growth in GDP is positively related to leverage. In the study the authors distinguish between advanced transition countries and less advanced transition countries. Their results show that the more advanced countries are more similar to the Western countries on some aspects while the less advanced countries are more different. This intuitively makes good sense when taking the importance of the country specific factors into consideration, since one would also expect these factors to be more like the West in the advanced transition countries (e.g. Poland and Czech Republic). Lower leverage in Eastern Europe (Poland and Hungary) is also found by (Cornelli, Portes & Schaffer 1996). Here the authors conclude that the reason for the lower leverage in East is a supply side phenomenon. By this it is meant that sufficient finance is not available to the firms who are actually willing to take on more debt. The lack of financial supply is interpreted as being a consequence of country specific factors like underdeveloped financial markets and legal environment etc. Similarly, a country specific study of Romanian firms, performed by (Chaves et al. 2001), shows that companies in this region suffer from insufficient finance. It further suggests that the reason for the insufficient finance is high inflation and a weak legal system, which makes it very difficult for firms to obtain long-term financing. Finally a similar conclusion is drawn in another country specific study (Egerer 1995). Here it is found that firms in the Czech Republic also have insufficient access to finance due to country specific factors. The author argues that the financing difficulties arise from weak creditor rights and collateral laws. So to some degree, similar factors as in Romania are responsible for the observed financing gap How do country specific factors fit with traditional capital structure theory The observed differences in institutional factors and their implications for capital structure will here briefly be discussed, within the framework of the two main capital structure theories, as described in section 2.3 and 2.4. According to the trade-off theory, the benefit of a tax shield is affected by the statutory tax rate, which is highly individual from country to country. A higher tax rate should all else equal increase the potential gain from a tax shield, and will therefore make the use 19