DETERMINANTS OF THE CAPITAL STRUCTURE: EMPIRICAL STUDY FROM THE KOREAN MARKET

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1 DETERMINANTS OF THE CAPITAL STRUCTURE: EMPIRICAL STUDY FROM THE KOREAN MARKET Doug S. Choi Metropolitan State University of Denver INTRODUCTION This study intends to examine the important determinants of the capital structure of the Korean firms. In general, the existing empirical studies on the issue of capital structure decision have analyzed the role of firmspecific characteristics that represent taxation, bankruptcy costs, agency costs, and information asymmetries. However, the extant empirical studies in this area have been confined to the U.S. and a handful of other developed countries. Different studies (Mayer 1990; Kunt and Maksimovic 1994) have suggested that financial decisions in developing countries are somehow different from those of developed ones because of their institutional differences such as level of transparency and investor protection, besides the bankruptcy and tax laws. There have been many empirical studies in this area on U.S. domestic firms, but not on international firms. The important factors of the financial leverage studied for U.S. firms may, or may not, be relevant to those for international firms. In this regard, this study intends to highlight those different factors of the financial leverage, if any, for international firms. The results of this examination will reveal if the experiences of U.S. firms hold true in the Korean financial community. The capital structure studies incorporating recent developments in the Korean market are beneficial to U.S. as well as Korean firms since many U.S. firms have become heavily involved with many Asian firms through direct and indirect investment. The asymmetric information hypothesis, supporting Myers modified pecking order theory, can be tested by examining market reactions to the announcement of external financing decisions. RATIONALE FOR THE EXPLANATORY VARIABLES In order to examine the recent developments in Korean firms capital structure, the variables supporting Myers modified pecking order theory and the static trade-off variables with strong empirical validity were selected for this study. The variables considered in this study exhibit good theoretical foundations and empirical supports. A substantial amount of research has been carried out on the determinants of the capital structure. Most of these empirical studies employ models that involve the regression of the observed leverage ratio against a number of explanatory variables. Typically the explanatory variables include profitability, asset structure, size, earnings volatility, internal cash-generating abilities, nondebt tax shields, and growth opportunities. This study measures leverage as the total debt divided by total assets. In fact, various capital structure studies have not specified which leverage measure should be used (Rajan and Zingales 1995). However, the majority of the research on the issue of capital structure decision has employed this measure for leverage. Profitability Trade-off and pecking order theory have different views on the relationship between leverage and profitability. Modigliani and Miller (1963) maintain that firms generally prefer debt for tax consideration. More profitable firms would therefore employ more debt since increased leverage would increase the value of their tax shield. Besides the tax advantage of debt, agency and bankruptcy costs may encourage highly profitable firms to have more debt in their capital structure. This is because highly profitable firms are less likely to be subject to bankruptcy risk because of their increased ability to meet debt repayment obligations. However, the 116

2 pecking order theory of Myers and Majluf (1984) and Myers (1984) maintains the opposite view. The pecking order theory holds a negative association between leverage and profitability since highly profitable firms will be able to generate more cash flows through retained earnings and then have less leverage. This study uses the ratio of earnings before interest and taxes to the total assets as a measure of profitability. Tangibility of Assets The tangibility of assets represents the effect of the collateral values of assets on the firm s leverage level. The trade-off theory predicts a positive relationship between the financial leverage and the tangibility of assets. The underlying argument behind the use of tangible assets as collateral for debt is the higher liquidation value of these assets in the event of financial distress or bankruptcy (Rajan and Zingales 1995). The risk of lending to firms with more tangible assets is expected to be low and, hence, lenders will demand a low-risk premium. Furthermore, the firm s opportunities to engage in asset substitution can be reduced by issuing secured debt. Myers (1984) states that the market value of the assets does include intangibles and growth opportunities as well as tangibles. He proposes the firm s tangible assets as an important variable for leverage decisions by indicating that the level of borrowing is determined not just by the value of a firm s assets but also by the type of assets-in-place. Myers and Majluf (1984) conclude that issuing debt secured by property avoids the costs associated with issuing shares. This suggests that firms with more collateralized assets (fixed assets) will be able to issue more debt at an attractive rate as debt may be more readily available. This results in a positive association between leverage and tangibility. This study employs the ratio of fixed assets to the total assets as a measure of tangibility. Industry Type The relationship between industry class and financial leverage is not very conclusive in empirical studies. Ferri and Jones (1979) used two different measures of industry type: (a) the conventional four-digit SIC code, and (b) grouping firms with similar product lines and SIC codes. They found that industry class was linked to a firm s leverage but in a less pronounced and direct manner than had been previously suggested. Titman and Wessels (1988) used a dummy variable for industry classification and found insignificant association between industry and financial leverage. Stonehill et al. (1975) and Sekely and Collins (1988) also found minimal industry influences on the capital structure decisions with international data. On the other hand, Bradley, Jarrell, and Kim (1984) observed strong industry influences on firm leverage ratios. Their cross-sectional regressions on industry dummy variables explained 54 percent of variation in firm leverage ratios. Aggarwal (1981), using data for the largest five hundred European industrial firms, found that industry classifications were a significant determinant of capital structure. The current study used a dummy variable with a value of 1 for the manufacturing firms and a value of 0 for the nonmanufacturing firms. Firm Size Many studies of the static trade-off theory suggest a direct relationship between firm size and level of debt. The most obvious explanation relies on the bankruptcy costs, which are related to the firm size (Warner 1977). Warner maintains that there are scale economies regarding bankruptcy costs, such that these costs constitute a larger proportion of the firm s value as that value decreases. Titman and Wessels (1988) also maintain that larger firms are more diversified and less susceptible to bankruptcy than smaller ones. This suggests that firm size is inversely related to the bankruptcy risk and larger firms have higher debt capacity since they can borrow at more favorable rates than smaller firms. Myers (1984) emphasizes the importance of the asset type over the asset size of a firm to a firm s leverage decision. However, he does not eliminate the importance of the asset size to the leverage decision. According to Kadapakkam et al. (1998), size can be regarded as a proxy for information asymmetry between managers and outside investors. Large firms are subject to being more closely observed by the investors and less subject to information asymmetry than small firms. Thus they should be 117

3 more capable of issuing equity, which is more sensitive to information asymmetry, and have lower debt (Rajan and Zingales 1995). Pecking order theory suggests a negative association between leverage and firm size. In this study, the natural logarithm of the total assets was used as a proxy for size. Business Risk A firm s risk depends on a number of factors (e.g., earnings volatility and operating leverage). The traditional view of the static trade-off theory suggests that there exists an inverse relationship between a firm s risk and debt ratio because firms with high business risk tend to have low debt capacity. Firms with high earnings volatility face a risk of the earnings level dropping below their debt servicing commitments, thereby incurring a higher cost of financial distress (Bhaduri 2002). Accordingly, these firms should reduce their leverage level to avoid the risk of bankruptcy or to rearrange their funds at high cost. The pecking order theory, on the other hand, suggests a positive relationship between business risk and debt ratio since high operating variance may reduce the agency cost of debt in the presence of growth-induced agency problems. This study employed coefficients of variation in volatility of earnings over time as proxy for a firm s risk. Growth Opportunities Growth opportunities represent the expected growth of a firm s intangible assets that is created by managerial skills, goodwill, and competence. The trade-off theory suggests an inverse relationship between leverage and growth opportunities since these assets have no collateral value and decline rapidly in value if bankruptcy or financial distress occurs. This will lower the ability of firms to raise their debt financing and, consequently, result in more reliance on equity financing as tested by Titman and Wessels (1988) and Rajan and Zingales (1995). The pecking order theory, however, suggests that leverage and growth opportunities are positively related, since internal funds for growing firms may be insufficient to finance their positive investment opportunities and, hence, they are likely to be in need of external funds. According to Myers and Majluf (1984) and Myers (1984), if external funds are required, firms will prefer debt to equity because of lower information costs associated with debt issues. This results in a positive relationship between leverage and growth opportunities. We test the two conflicting predictions of the trade-off theory and pecking order theory by investigating the relationship between leverage and growth opportunities. The ratio of market-to-book value is used as a proxy for growth opportunities (Rajan and Zingales 1995; Bevan and Danbolt 2004). Tax Shield Substitutes The trade-off theory suggests that the main advantage of borrowing is the tax advantage of interest payments. Therefore firms that are subject to corporate tax will increase their leverage in order to reduce their tax bill (Modigliani and Miller 1963). However, firms with other tax shields, such as depreciation and investment tax credit deductions, will have less incentive to increase leverage for tax considerations since these deductions are independent from the firm s choice of financing its investments, whether it uses debt or not (Ozkan 2001). Firms with tax deductions for depreciation and investment tax credits, as a result, may consider these deductions as a substitute for the tax shield. Furthermore, the existence of nondebt tax shields makes leverage more expensive, because the marginal tax savings from an additional unit of debt decreases with increasing nondebt tax shields (DeAngelo and Masulis 1980), since the probability of bankruptcy may increase with financial leverage, which makes the marginal benefit low. Following Titman and Wessels (1988) and Ozkan (2001), we use the ratio of annual depreciation to total assets as a proxy for nondebt tax shields. The annual average of depreciation charges divided by the fixed assets is used as a proxy for the tax shield substitutes. 118

4 Corporate Taxes Since the works of Modigliani and Miller, the tax advantages of debt financing have been one of the most controversial areas in the capital structure theory. In this study, with corporate tax, any tax-paying firm gains by borrowing; the greater the marginal tax rate, the greater the gain. Miller (1977) proposes that personal income taxes on interest payments would exactly offset the corporate interest tax shield. Flath and Knoeber (1980) and Haugen and Senbet (1986) find a positive association between taxes and level of debt. The pecking order theory, however, doubts that the tax effects have been empirically supported. The firms with higher corporate tax rate, according to Myers (1984), should borrow more than the firms with lower corporate tax rate, if the tax side of the static trade-off theory is correct. Taub (1974) and Kim and Sorensen (1986) find that increases in the tax rate have a negative impact on the desired debt-equity ratio, a finding contrary to the traditional static trade-off theory. Williamson (1981) and Long and Malitz (1983) studied the tax effect on capital structure, and they did not find any significant association between taxes and level of debt. The ratio of taxes paid divided by earnings before taxes is used in this study as a proxy for taxes. HYPOTHESIS The hypothesis tests the variables that are expected to explain the financial leverage of the firms in the Korean market. The coefficients are tested to determine whether there is a significant relationship between the financial leverage decisions and the explanatory variables employed in this study. Hoj: bj = 0; there is no significant relationship between the financial leverage and the jth explanatory variable. (1) Haj: bj 0; there is a significant relationship between the financial leverage and the jth explanatory variable. (2) Where j is the respective explanatory variable employed in this study. DATA SOURCES AND METHODOLOGY In choosing the firms for the multiple regression analysis, the 50 firms providing balance sheet and financial statement information in the Moody s International Manual for five consecutive years from 2008 to 2012 are selected and tested. The explanatory variables that are expected to explain the financial leverage of the Korean firms in the regression model are profitability (PRFT), tangibility of assets (TANG), industry types (INTP), firm size (SIZE), business risk (RISK), growth opportunities (GROW), tax shield substitutes (TSUB), and corporate taxes (CTAX). DEBT = b0 + b1 PRFT + b2 TANG + b3 INTP + b4 SIZE + b5 RISK + b6 GROW + b7 TSUB + b8 CTAX (3) Table 1 summarizes the definitions of the variables employed in this study. 119

5 TABLE 1: DEFINITIONS OF THE EXPLANATORY VARIABLES EMPLOYED Variable PRFT TANG INTP SIZE RISK GROW TSUB CTAX Definition EBIT / total assets plant and equipment / total assets dummy variable natural logarithm of total assets coefficient of variation in EBIT market-to-book ratio depreciation charges / total assets taxes/ebit * The values of the variables are based on the five-year averages for the period 2008 to Table 2 summarizes the predictions of the trade-off theory and pecking order theory for the relationship between leverage and the variables that are suggested as determinants of optimal leverage. The trade-off and pecking order theories, as observed in this table, have no common predictions for most of the explanatory variables. TABLE 2: THE SUGGESTED SIGNS OF THE EXPLANATORY VARIABLES EMPLOYED Variable Trade-off Theory Pecking Theory Order Profitability Positive Negative Tangibility of Assets Positive Positive Industry Types Positive Negative Firm Size Positive Negative Business Risk Negative Negative Growth Opportunities Negative Positive Tax Shield Substitutes Negative - Corporate Taxes Positive - 120

6 RESULTS OF THE STUDY An analysis of variance is used to measure overall effectiveness of the multiple regression models. It is an arithmetic process for partitioning a total sum of squares into components associated with recognized sources of variation. The ANOVA results are presented in table 3, and the table shows an R-square of ; i.e., a relatively high portion (76.53 percent) of the total variation is associated with the eight explanatory variables of the multiple regression models. It is concluded that, to a large extent, the financial leverage is determined systematically by the variables included in the model. The variables tested here are profitability, tangibility of assets, industry types, firm size, business risk, growth opportunities, tax shield substitutes, and corporate taxes. The means and standard deviations for the above variables are presented in table 4. The model seems to explain the level of debt with a high value of R-square and five of eight explanatory variables in the model are statistically significant at the 10 percent level or better. The result presents that profitability, and tangibility of assets, and firm size are significantly positively related to the financial leverage, while growth opportunities and tax shield substitutes are significantly negatively related to the financial leverage. TABLE 3: TEST RESULTS OF ANALYSIS OF VARIANCE Source DF Sum of Squares Mean Square F-Value Prob>F Model Error Total R-square Adjusted R-square TABLE 4: TEST RESULTS OF PARAMETER ESTIMATES Explanatory Degree of Parameter Standard T-value Variables Freedom Estimates Deviation INTERCEPT PRFT TANG INTP SIZE RISK GROW TSUB TAX Contrary to the studies of the U.S. firms, profitability (PRFT) is found to be positively related to leverage and statistically significant with the t-value of This result supports the trade-off theory over the pecking order theory. This finding suggests that highly profitable Korean firms are less likely to experience bankruptcy costs, consequently enabling them to raise more debt at an attractive rate (Tong and Green 2005; Baskin 1989). 121

7 Korean banks, due to their conservative credit policies, usually offer debt to less risky firms at lower rates, and highly profitable Korean firms may increase their ability to reduce the costs of debt for higher financial leverage. The tangibility of assets (TANG) is found to be positively related to leverage and statistically significant. The TANG has a coefficient of and a t-value of 2.037, indicating a direct association that the debt ratio increases by approximately 0.15 percent when TANG increases by 1 percent. The findings support tradeoff and pecking order theories that the leverage decision is determined not only by the value and risk of the firm s assets, but also by the type of assets it holds. The importance of net fixed assets to the leverage decision is also realized by the static trade-off theory. The findings in the Korean firms may not support the view of Kunt and Maksimovic (1994) and Booth et al. (2001) that markets for long-term debt are not effectively functioning in developing countries. It may indicate that the financial leverage decisions regarding TANG among the Korean firms are showing the patterns of the developed countries. The INTP has a positive coefficient, but it is not statistically significant with a t-value of The results indicate that industry type may not have a strong association with the leverage decision among the Korean firms. The association between industry type and debt level is not very conclusive in past empirical studies with U.S. firms either. The two types of industries, manufacturing and nonmanufacturing, do not show substantial differences in the debt financing decisions. The firm size (SIZE) has a significantly positive coefficient of with the t-value of 1.852, indicating that as SIZE increases by 1 percent the debt ratio increases by approximately one-fifth of a percent. This result is consistent with the findings of Rajan and Zingales (1995) and Bevan and Danbolt (2002, 2004) with the U.S. firms. This finding supports the trade-off theory over the pecking order theory and suggests that borrowing capacity for Korean firms is significantly limited by their bankruptcy or financial distress risks. It also supports the view that larger firms may be more diversified and fail less often. As large Korean firms are diversified in many product markets, their risk to face financial distress is expected to be low, where the failure of one product market can be compensated by another. To the extent that this is the case, this finding implies that the cost of bankruptcy or financial distress is one of the main determinants of the leverage ratio for the Korean firms. The business risk (RISK) has an insignificantly positive coefficient of with the t-value of This result may refute the static trade-off theory that firms with higher risk have lower debt capacity. The result also tends to indicate that the leverage decision is not substantially affected by the volatility of the earnings in Korean firms. The market-to-book ratio, which is used as a proxy for a firm s growth opportunities (GROW), is negatively and significantly related to the financial leverage. GROW has a significantly negative coefficient of with the t-value of This finding supports the prediction of the trade-off theory and may refute the pecking order theory that firms with higher growth opportunities have higher debt capacity. A possible explanation for this finding is that increases in stock prices in recent years in the Korean market have reduced the cost of equity capital, encouraging Korean firms to go to the stock market for financing. This is because firms with higher market valuation can issue equity at lower costs of information asymmetries, saving their borrowing capacity for the future financing requirements (Kayham and Titman 2007). This supports the view of Baker and Wurgler (2002) that at a higher market-to-book ratio, the equity market is strongly favorable for increasing funds externally. 122

8 The TSUB, which measures the tax shield substitutes, exhibits a very significant negative association with financial leverage. The coefficient of the TSUB is with a t-value of The debt ratio decreases by approximately 1.14 percent when TSUB increases by 1 percent. Consistent with the prediction of the tradeoff theory, tax shield substitutes are found to be negatively related to the financial leverage. Similar evidence is presented by Ozkan (2001), Banerjee et al. (2000), and Flannery and Rangan (2006). The negative relationship may support the view that the existence of tax shield substitutes, such as depreciation, reduces the importance of the tax advantages of debt financing and consequently reduces the need to raise debt for tax consideration. This view seems to be relevant in the Korean market, where the tax laws prevent Korean firms from benefiting on excessive debt financing. It is therefore concluded that the level of depreciation is an important factor in leverage decisions for Korean firms. The tax advantage of debt financing has been a controversial topic since the original works of Modigliani and Miller. In this study, the variable corporate tax (TAX) exhibits an insignificant negative estimate of the coefficient. The coefficient of TAX is with a t-value of The low t-value for TAX tends to confirm Myers proposition that taxes are not an important factor for leverage decision making. The relatively lower corporate tax rate and relatively higher personal tax rate in Korean firms may explain the weak association between taxes and level of debt since lower corporate tax rates could discourage the use of debt for tax purposes. CONCLUSION A static model has been developed to explain how the optimal capital structure of Korean firms is determined. The estimated static model indicates that the financing decisions of the Korean firms can be explained by the determinants suggested by the typical corporate finance models. The model seems to well explain the level of debt with a high value of R-square and adjusted R-square, and five of eight explanatory variables in the model are statistically significant at the 10 percent level or better. The result presents that profitability, and tangibility of assets, and firm size are significantly positively related to the financial leverage, while growth opportunities and tax shield substitutes are significantly negatively related to the financial leverage. The most significant explanatory variable depreciation charges as a percent of total asset is unexpected. This relationship emphasizes the importance of tax shield substitutes for the firms in our sample. Furthermore, it would be valuable to conduct similar tests using different markets. This study may have reached different conclusions if the sample firms had been taken from different markets in Europe or other parts of Asia. Research covering different markets would enhance the quality of the study by providing more generalized information on the capital structure practices, which are not particular from one market to other markets. REFERENCES Aggarwal, Raj International Differences in Capital Structure Norms: An Empirical Study of Large European Companies. Management International Review: Baker, M., and J. Wurgler Market Timing and Capital Structure. Journal of Finance 57 (1): Banerjee, S., A. Heshmati, and C. Wihlborg The Dynamics of Capital Structure. SSE/EFI, Working Paper Series in Economics and Finance 333, Sweden. Baskin, J An Empirical Investigation of the Pecking Order Theory. Financial Management 18: Bevan, A., and J. Danbolt Capital Structure and Its Determinants in the UK: A Decomposition Analysis. Applied Financial Economics 12 (3): Testing for Inconsistencies in the Estimation of UK Capital Structure Determinants. Applied Financial Economics 14 (1):

9 Bhaduri, Saumitra Determinants of Corporate Borrowing: Some Evidence from the Indian Corporate Structure. Journal of Economics and Finance 26: Booth, L., V. Aivazian, A. Demirguc Kunt, and V. Maksimovic Capital Structures in Developing Countries. Journal of Finance 56 (1): Bradley, Michael, Gregg A. Jarrell, and E. Han Kim On the Existence of an Optimal Capital Structure: Theory and Evidence. Journal of Finance 39 (3): DeAngelo, H., and R. Masulis Optimal Capital Structure under Corporate and Personal Taxation. Journal of Financial Economics 8: Ferri, Michael G., and Wesley H. Jones Determinants of Financial Structure: A New Methodological Approach. Journal of Finance 34 (3): Flannery, M. J., and K. P. Rangan Partial Adjustment Target Capital Structures. Journal of Financial Economics 79: Flath, David, and Charles R. Knoeber Taxes, Failure Costs, and Optimal Industry Capital Structure: An Empirical Test. Journal of Finance 35 (1): Haugen, Robert A., and Lemma W. Senbet Corporate Finance and Taxes: A Review. Financial Management 15 (3): Kadapakkam, P., P. Kummar, and L. Riddick The Impact of Cash Flows and Firm Size on Investment: The International Evidence. Journal of Banking and Finance 22: Kayham, A., and S. Titman Firms Histories and Their Capital Structures. Journal of Financial Economics 83: Kim, W. S., and E. H. Sorensen Evidence on the Impact of the Agency Costs of Debt on Corporate Debt Policy. Journal of Financial and Quantitative Analysis 21 (2): Kunt, A., and V. Maksimovic Capital Structure in Developing Countries: Evidence from Ten Countries. Working Paper, The World Bank, Policy Research Paper Long, M. S., and E. B. Malitz Investment Patterns and Financial Leverage, Working Paper, National Bureau of Economic Research. Mayer, C Financial System, Corporate Finance, and Economic Development. In Asymmetric Information, Corporate Finance, and Investment, edited by R. G. Hubbard, Chicago: University of Chicago and NBER. Miller, M. H Debt and Taxes. Journal of Finance 32 (2): Modigliani, F., and M. Miller Corporate Income Taxes and the Cost of Capital: A Correction. American Economic Review 53: Moody s Investors Service, Moody s International Manual, Myers, S. C The Capital Structure Puzzle. Journal of Finance 39 (3): , and N. Majluf Corporate Finance and Investment Decisions When Firms Have Information That Investors Do Not Have. Journal of Financial Economics 13: Ozkan, A Determinants of Capital Structure and Adjustment to Long Run Target: Evidence from UK Company Panel Data. Journal of Business Finance and Accounting 28 (1 2): Rajan, R., and L. Zingales What Do We Know about Capital Structure? Some Evidence from International Data. Journal of Finance 50: Sekely, William S., and J. Markham Collins Cultural Influences on International Capital Structure. Journal of International Business Studies 19 (1): Stonehill, Arthur, et al Financial Goals and Debt Ratio Determinants: A Survey of Practice in Five Countries. Financial Management 4:

10 Taub, Allan J Determinants of the Firm s Capital Structure. Review of Economics and Statistics 57 (4): Titman, S., and R. Wessels The Determinants of Capital Structure Choice. Journal of Finance 43 (1): Tong, G. and C. J. Green Pecking Order or Trade off Hypothesis? Evidence on the Capital Structure of Chinese Companies. Applied Economics 37 (19): Warner, J Bankruptcy Costs: Some Evidence. Journal of Finance 32: Williamson, S The Moral Hazard Theory of Corporate Financial Structure: An Empirical Test. PhD diss., MIT. 125

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