An Empirical Study on Capital Structure and Financing Decision- Evidences from East Asian Tigers

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1 An Empirical Sudy on Capial Srucure and Financing Decision- Evidences from Eas Asian Tigers Dr. Jung-Lieh Hsiao and Ching-Yu Hsu, Naional Taipei Universiy, Taiwan Dr. Kuang-Hua Hsu, Chaoyang Universiy of Technology, Taiwan ABSTRACT In general, managers make financial decisions of corporaions by wo ways which includes inernal financing and exernal financing. The inernal financing is he using of reained earnings. The exernal financing is he usage of equiy, deb, hybrid securiies. Based on hese wo kinds of financial behaviors, he capial srucures of companies could be shaped differenly. As a consequence, i is an imporan issue for managers how o minimize financial coss and maximize shareholders equiy. According o menion above, several heories explaining financing behaviors have been developed. There are he Modigliani-Miller heorem, he rade-off heory, he pecking order heory and he marke iming heory. In he presen sudy, we re-examine he model developed by Kayhan and Timan (27) o provide evidences abou he broad paerns of financing aciviy in Asian emerging markes, including Hong Kong, Korea, Singapore and Taiwan. The empirical resuls show ha he companies from all counries rebalance heir leverage following equiy issuances, resuls are more in line wih he dynamic rade-off heory raher han he equiy marke iming or pecking order hypohesis of capial srucure. Key Words: Capial srucure, Marke iming, Pecking order heory, Trade-off heory. INTRODUCTION The capial srucure refers o he way ha a corporaion finances is asses hrough some combinaion of financing sources. The firs choice is inernal financing which is he using of reained earnings. The second choice is exernal financing which is he usage of equiy, deb, hybrid securiies. Based on differen kinds of financial decisions, he companies could shape differen capial srucures. Evenually, i is an imporan issue for managers how o minimize financial coss and maximize shareholders equiy by financial decision and he seing of capial srucure. The Modigliani-Miller heorem (Modigliani and Miller, 1958), he firs relevan heory of capial srucure, saes ha he value of a firm is irrelevan o how ha firm is financed in a perfec marke. However, he real world reflecs he firm s value is relevan wih is bankrupcy coss, agency coss, axes, informaion asymmery and so on. Tha is why a company s value is affeced by he capial srucure i employs. Therefore, since Modigliani and Miller s irrelevance proposiion, researchers have invesigaed firms decisions abou how o finance heir operaions. According o he Modigliani-Miller heorem, wo radiional heories of capial srucure, he Trade-off Theory and he Pecking Order Theory, are developed. These heories guide mos of he capial srucure sudies. The Trade-off Theory considers firms have a arge capial srucure ha is deermined by he marginal benefis of deb (ax advanage of deb) and coss associaed wih deb (bankrupcy coss and agency coss) (Jensen and Meckling, 1976; Myers, 1977). In oher words, Trade-off Theory implies ha firms adjus heir capial srucure in response o he emporary shocks ha cause heir leverage o deviae from he arge. The Pecking Order Theory, due o asymmeric informaion (Myers and Majluf, 1984; Myers, 1984), when a manager finance by exernal funds, invesors would see his behavior as he firm is overvalued. Therefore, inverors end o sell heir socks and he value of he firm will fall. For his reason, firms follow a financing hierarchy; descends from inernal funds, o deb, o exernal equiy. Recenly, a new heory, he marke iming heory of capial srucure which was firs inroduced by Baker and Wurgler (22), develops a differen kind of view abou capial srucure. The Marke Timing Theory suggess ha managers are able o idenify cerain ime periods during which equiy issuance is less cosly due o he high valuaion of company s sock. In oher words, firms are more likely o issue equiy when heir marke values are high, relaive o book and pos marke values, and o repurchase equiy when heir marke values are low. As a consequence, curren capial srucure is srongly relaed o hisorical marke values. This resul provides he heory ha capial srucure is he cumulaive oucome of pas aemps o ime he equiy marke. The Business Review, Cambridge * Vol. 13 * Num. 1 * Summer *

2 However, Hovakimian (25), Flannery and Rangan (26), Ali (26), Kayhan and Timan (27) disagree wih Baker and Wurgler on he persisence of he effec on capial srucure because he imporance of hisorical average marke-o-book raios in leverage regressions is no influence he pas equiy marke iming. Kayhan and Timan (27) make he poin ha he significance of he hisorical marke-o-book series in leverage regressions may be due o he noise in he curren marke-o-book raio. Specifically, Kayhan and Timan decompose he exernal finance weighed average marke-o-book raio ino he mean marke-o-book raio, he covariance beween he marke-o-book raio, and he financing defici. They show ha he persisence resul of Baker and Wurgler is mainly driven by he persisence of he average marke-o-book raio raher han he covariance beween he marke-o-book raio and he financing defici. Kayhan and Timan (27) is one of he newly research for he comprehensively sudy how cash flows, invesmen expendiures, and sock price, hisories affec company s deb raios. Bu ha research only focus on he Unied Saes. I is curious abou wheher he Easern counries follow heir findings; herefore, his research reexamines he models of Kayhan and Timan (27) o provide evidences abou he broad paerns of financing aciviy in his case. In order o examine financing decision in Asian counries, we selec he samples including Japan, Singapore, Korea, Taiwan, and Hong Kong. The erm Four Asian Tigers or Eas Asian Tigers refers o he economies of Hong Kong, Korea, Singapore, and Taiwan. These regions were noed for mainaining high growh raes and rapid indusrializaion beween 196s and 199s. In he early 21s cenury, he original four Tigers are a fully developed saus. In addiional, Japan emerged as he mos developed naion in Asia. Due o heir economical levels and developmens are similar, we draw hese five counries in Asia. According o already menioned, we will check hree purposes of our sudy: (1) Wha drives capial srucure developmens? Which kinds of heories will he shor-erm capial srucure be fied o? (2) Are he effecs persisen? Does he capial srucure have long-lasing effecs? (3) Does he capial srucure revise? We end o esimae wheher he effec of rade-off, pecking order and iming variables on he deb raio is laer reversed. METHODOLOGY Daa Our sample is drawn from he daabase of Sandard & Poor s Compusa Global (Global Vanage) files in four counries in Asia, including Japan, Singapore, Korea, and Hong Kong. The observed period is from 1993 o 27. For comparabiliy of resuls for each counry, we ranslae sales figures in local currencies o US dollars, using respecive yearly average exchange raes.we resric he sample o exclude financial firms (SIC ) and regulaed firms (SIC ) since heir accouning and reporing environmens differ from hose in oher indusries. Besides, following Baker and Wurgler (22), we eliminae firms wih book value of asses less han $1 million. Our sample is furher resriced o include firms ha have a leas four years of daa due o our long-horizon analysis. Book leverage is defined as he raio of book deb o oal asses, where book deb is defined as oal asses minus book equiy, and book equiy is equal o oal asses less oal liabiliies and preferred sock plus deferred axes. Even hough, Baker and Wurgler (22) reclassify converible deb as equiy. However, global Vanage does no provide deailed daa on converible deb. Following recen capial srucure sudies, i.e. Ali (26), converible deb is included in deb in our sudy. In addiion, we drop observaions where his raio is greaer han one for individual firm-year observaions. Marke leverage is he raio of he book value of deb o he sum of he book value of deb and he marke value of equiy. Ne deb and ne equiy issues ha are used boh in marke iming and financial defici variables are calculaed using balance shee iems. We define ne equiy issues as he change in he book value of equiy minus he change in reained earnings; Baker and Wurgler (22) also use his approach. Ne deb issues are hen defined as he change in oal asses ne of he change in reained earnings and ne equiy issues. The Model 1. Wha drives capial srucure developmens? Which kind of heories will he shor-erm capial srucure be fied o? Sage 1: Predic he arge leverage: The Business Review, Cambridge * Vol. 13 * Num. 1 * Summer *

3 (1) Leverage defici = L L 4 T 4 4 (2) Change in arge arg e = L T T T 4 L 4 L = α Sage 2: Esimae he regression model L L = α β1m / B + β2ppe + β3ebitd + β4r & D + β5( R & Ddummy) + β SE 6 β FDd 1 + β SIZE + β EBITD β FD [, 4] 2 [, 4] 3 [, 4] 4 [, 4] 5 [, 4] + β + β YT + β LT + β T arg e [, 4] β r (1) (2) In his sudy, we selec wo-sage regression. The firs-sage regression is esimaed using a Tobi specificaion where he prediced value of he leverage raio is resriced o be beween zero and 1. In he secondsage regression we esimae he coefficiens wih sandard OLS regressions. Because of he overlapping inervals, we use a boosrapping echnique o deermine he saisical significance of he esimaed coefficiens. Tha is o say, since he sandard errors violae he assumpion ha he errors are independenly and idenically disribued, sandard regression models are no appropriae o deermine he significance of he parameer esimaes. Therefore, we use boosrapping o esimae sandard errors ha are robus o heeroskedasiciy, correlaion ha arises as a resul of muliple observaions for each firm, and auocorrelaion ha we induce by including observaions in overlapping periods. 2. Are he effecs persisen? The capial srucure has long-lasing effecs? L L 8 = α + β1fdd[ 4, 2FD[ 4, 3YT[ 4, 4LT[ 4, 5r[ 4, 8] + β 6EBITD[ 4, 7FDd[, 4] + β8fd[, 4] + β 9YT[, 4] + β1lt[, 4] + β11r[, 4] + β12ebitd[, 4] + β β14dt arg e 8 (3) The equaion is specified for he change in leverage from -8 o, and his is wice as long as equaion (1). We end o check wheher he proxy variables over a four year period -8 o -4 sill affec he change in leverage over a eigh year period running from -8 o. In he oher words, if he capial srucure has long-lasing effecs, we call his he es for persisence. 3. Does he capial srucure revise? L L 4 = α + β1fdd[ 4, 2FD[ 4, 3YT[ 4, 4LT[ 4, 5r[ 4, 8] + β 6EBITD[ 4, 7 FDd[, 4] + β8fd[, 4] + β 9YT[, 4] + β1lt[, 4] + β11r[, 4] + β12ebitd[, 4] + β β14dt arg e 8 (4) We have a endency o es wheher he direcion of he effecs swiches sign from equaion (2) o (4). Tha would indicae wheher he effec of pecking order and iming variables on he deb raio is laer reversed. I is a mehod o check non-persisence of he capial srucure. We selec wo-sage regression, Tobi model and OLS mode in his sudy. We also employ boosrapping echnique o deermine he saisical significance of he esimaed coefficiens. EMPIRICAL RESULTS The Table 1 shows he summary saisics for leverage, ne equiy issues, deb issues and changes in reained earnings for each counry for he overall period from 1988 o 27. Firs, we observe he mean of book leverage is higher han he mean of marke leverage in Singapore and Taiwan and he mean of book leverage is lower han he mean of marke leverage in Hong Kong and Korea. Second, he average of ne equiy issues, deb issues and changes in reained earnings are posiive in all counries. Besides, unlike oher counries, he mean of ne equiy issues is lower han he mean of ne deb issues for Singapore. The Business Review, Cambridge * Vol. 13 * Num. 1 * Summer * 29 25

4 Table 2 repors he regression resuls of book leverage change in book and marke leverage beween year and -3 on YT and LT. Table 3 repors he regression resuls of book leverage change in book and marke leverage beween year and -3 on EQUALWMB. The resuls of he esimaion appear o be similar for he whole sample of firms. Therefore we discuss hem ogeher. We observe ha a significanly posiive coefficien of FDd. In addiion, he proxy variables of pecking order, FD and EBITD, are no significan oally. This is o say, companies jus follow pecking order heory parly when hey finance. Besides, we find a significanly negaive coefficien for he sock reurn in all counries. This relaionship is in accordance wih marke iming, which indicaes ha firms use relaively more equiy afer periods of a sock price increase. This oucome would also be consisen wih he empirical evidence of KT for he US and evidence of Bie and Haan(27) for he Neherlands. However, he marke-o-book based iming measures YT and LT are no found o be significan in all counries. This implies ha he marke iming behavior of firms addresses changes raher han levels of sock marke valuaion in Eas Asian igers. Finally, a significanly negaive coefficien of and a significanly posiive coefficien of ΔTarge, which implies financial decisions are all followed wih rade-off heory in Eas Asian igers. Table 3 repors he regression resuls of change in book and marke leverage beween year and -6 on YT and LT. Since he pages consrain, we reserve he repors for he regression resuls of change in book and marke leverage beween year and -6 on EQUALWMB. Unlike proxy variables of pecking order and marke iming, a significanly negaive coefficien of and a significanly posiive coefficien of Targe, which implies financial decisions are all followed wih rade-off heory in Eas Asian igers. As a consequence, he capial srucures of hese four counries do no have long-lasing effecs. The empirical resuls show ha unlike proxy variables of pecking order and marke iming, a significanly negaive coefficien of and a significanly posiive coefficien of Targe, which implies he financial decisions are all followed wih rade-off heory in Eas Asian igers. As a consequence, he effecs of hisory do no reverse in hese four counries. CONCLUSIONS In finance, capial srucure refers o he way a corporaion finances is asses hrough some combinaion of sources. Based on many kinds of financial decisions, firms could shape differen capial srucures. According our findings above, firms from all counries rebalance heir leverage following equiy issuances, resuls are more in line wih he dynamic rade-off heory raher han he equiy marke iming or pecking order hypohesis of capial srucure. In oher words, firms have a arge capial srucure, deermined by he marginal benefis of deb and coss associaed wih deb. Thus, his implies ha firms adjus heir capial srucure in response o he emporary shocks ha cause heir leverage o deviae from he arge in Eas Asian Tigers, which are highly developed counries in Asia. This oucome would be consisen wih he previous empirical evidence of he US, he Neherlands and G7. REFERENCES Ali, A. (26). How persisen is he impac of marke iming on capial srucure? Journal of Finance, 61, Baker, M., and Wurgler J. (22). Marke iming and capial srucure, Journal of Finance, 57, Bie, T., Haan, L. (24). Does marke iming drive capial srucures? A panel daa sudy of Duch firms, Working Paper, De Nederlandsche Bank, Neherlands. Chen, L., Zhao, X. (24). Undersanding he role of he marke-o-book raio in corporae financing decisions. Working Paper. Michigan Sae Universiy, Eas Lansing. Flannery, M.J., and Rangan, K.P. (26). Parial adjusmen and arge capial srucures, Journal of Financial Economics, 79, Frank, M., and Goyal, V. (23). Tesing he pecking order heory of capial srucure, Journal of Financial Economics, 67, Greene, W. H. (28). Economeric analysis, 6h Ediion, Prenice Hall. Hovakimian, A. (25). Are observed capial srucures deermined by equiy marke iming? Journal of Financial and Quaniaive Analysis, 41. Huang, R., and Rier J.R. (26). Tesing he marke iming heory of capial srucure, Working paper. Kayhan, A., and Timan S. (27). Firms' hisories and heir capial srucure, Journal of Financial Economics, 83, Korajczyk, R.A., and Levy A. (23). Capial srucure choice: Macroeconomic condiions and financial consrains, Journal of Financial Economics, 68, Mahajan, A., and Tararoglu, S. (28). Equiy marke iming and capial srucure: Inernaional evidence, Journal of Banking and Finance, 32, Rajan, R.G., and Zingales L. (1995). Wha do we know abou capial srucure? Some evidence from inernaional daa, Journal of Finance, 5, Welch, I., (24), Capial srucure and sock reurns, Journal of Poliical Economy, 112, The Business Review, Cambridge * Vol. 13 * Num. 1 * Summer *

5 Table 1 Summary saisics for leverage, ne equiy issues, deb issues and changes in reained earnings Hong Kong Korea Singapore Taiwan Number of firms Book leverage Mean SD Marke leverage Mean SD Ne equiy issues Mean SD Ne deb issues Mean SD Newly reained Mean earnings SD Table 2 The regression of change in book and marke leverage beween year and -3 on YT and LT Hong Kong Korea Singapore Taiwan Panel A. Book Leverage Coefficien/SD.5***/.2.3***/.1.5***/.1.6***/.2 FD Coefficien/SD.6***/.3 -.2*/.2.5***/.2 -.3***/.6 YT Coefficien/SD.1/.24.19***/.6 -.3//.8 -.5/.11 LT Coefficien/SD.3/ */ /.3.1***/.4 r Coefficien/SD -.1**/.1 -.1***/.1 -.1***/.1 -.1***/.1 EBITD Coefficien/SD.6**/.4 -.5***/ ***/.4 -.8***/.2 3 T arge 3 Coefficien/SD -.6***/ ***/ ***/. -.82***/.3 Coefficien/SD.35***/.9.38***/.7.55***/.13.82***/.3 observaions clusers Panel B. Marke Leverage Coefficien/SD.3*/.2.2**/.1.5***/.1.5***/.2 FD Coefficien/SD.9***/.2 -.1***/.4.8***/.2 -.4***/.6 YT Coefficien/SD -.1/.13.41***/.12.1/.8.9*/.14 LT Coefficien/SD.14***/.6 -.5/ **/.5.15***/.4 r Coefficien/SD -.4***/.1 -.4***/.1 -.8***/.1 -.7***/.1 EBITD Coefficien/SD.13***/.6.3/.5.2/.3.7***/.3 3 T arge 3 Coefficien/SD -.67***/ ***/ ***/ ***/.3 Coefficien/SD.44***/.6.58***/.6.4***/.4.69***/.3 observaions clusers The Business Review, Cambridge * Vol. 13 * Num. 1 * Summer *

6 Table 3 Do he effecs of hisory persis? Regression of change in book and marke leverage beween year and -6 on YT and LT Hong Kong Korea Singapore Taiwan Panel A. Book Leverage Coefficien/SD.2/.2.3***/.1.2*/.1 -.2**/.1 FD Coefficien/SD -.4**/.3 -.3*/.3 -.1/.4.6**/.5 YT Coefficien/SD -.7/.2.1*/.11.5/ /.18 LT Coefficien/SD -.7/ **/.21.3/ ***/.7 r Coefficien/SD.1/.1 -.7***/.1 -.1*/.1.1/.1 Coefficien/SD EBITD -.8/.1 -.6*/.6.1/.6.3/.6 FDd Coefficien/SD.4**/.2.2***/.1.3**/.1 -.1/.1 FD Coefficien/SD.13***/.4 -.3/.3.7***/.4.15***/.5 YT Coefficien/SD.36***/.35.18***/.9 -.3/ ***/.21 LT Coefficien/SD.15***/ / */.1.2/.9 r Coefficien/SD -.1/.1 -.1***/ ***/.1 -.1**/.1 EBITD Coefficien/SD.25***/.11.4/.6 -.9***/ ***/.7 6 Coefficien/SD -.92***/ ***/.3-1.9***/ ***/.6 T arge 6 Coefficien/SD.67***/.1.67***/.7.63***/.1.96***/.6 observaions clusers Panel B. Marke Leverage Coefficien/SD.1/.2.2**/.1.2/.2 -.3***/.1 FD Coefficien/SD -.2/.3.1***/.6.6***/.5.6/.6 YT Coefficien/SD.25**/ ***/.2.1/ /.27 LT Coefficien/SD -.6/.11.39***/ ***/ ***/.1 r Coefficien/SD.1/.1.1***/.1.1/.1.2***/.1 Coefficien/SD EBITD.1/.11.1/.9.4/.5.6/.9 FDd Coefficien/SD.2/.2.1/.1.3**/.1 -.2/.1 FD Coefficien/SD.14***/.4 -.7***/.5.4/.4.4/.7 YT Coefficien/SD.13/.27.29***/.18.1/.21.1/.32 LT Coefficien/SD.22***/ /.23.3/.11.1***/.11 r Coefficien/SD -.5***/.1 -.7***/.1 -.5***/.1 -.8***/.1 EBITD Coefficien/SD.37***/.12.15***/.9 -.5/.7 -.3/.7 Coefficien/SD -.84***/ ***/.2-1.3***/.3-1.1***/.3 6 T arge 6 Coefficien/SD.78***/.6.74***/.6.78***/.5.99***/.4 observaions clusers The Business Review, Cambridge * Vol. 13 * Num. 1 * Summer *

7 Reproduced wih permission of he copyrigh owner. Furher reproducion prohibied wihou permission.

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