MSc in Finance & International Business. Capital Structure Determination of Small and Medium Sized Enterprises in Eastern and Western Europe

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1 MSc in Finance & International Business Authors: Anna Kaja Chudzinska Stefan Lukas van der Bijl AC70317 SV70600 Academic Advisor: Jan Bartholdy, PhD Capital Structure Determination of Small and Medium Sized Enterprises in Eastern and Western Europe -- An investigation based on the target adjustment model -- Aarhus School of Business September 2007

2 Abstract This research paper investigates the differences in capital structures and their determinants between Eastern and Western European Small and Medium sized Enterprises. The Tradeoff Theory is the underlying theoretical framework which is applied, therefore the research is based on a detailed analysis of differences in institutional factors that fit to different aspects of the Tradeoff Theory: credit availability, corporate taxes, bankruptcy costs and agency costs. The model tested is the target adjustment model. Data from firms of six countries is used to study the differences in capital structures between Eastern and Western European firms. The findings support the hypotheses that differences exist between the two regions, and confirm that firms do have different financing patterns. Eastern European firms have considerably lower amounts of debt in their capital structures. These lower leverage ratios in Eastern Europe are found to be the result of lower corporate taxes and higher bankruptcy costs. This indicates that the role of shielding taxes is stronger in Western Europe. Besides, although bankruptcy costs are found to be crucial in capital structure determination in both regions, they are higher in Eastern Europe, and have a more negative influence on leverage ratios. The research also confirms that agency costs do not have an important effect on capital structures in Small and Medium sized Enterprises. The Tradeoff Theory is proven to explain capital structure determination well on Small and Medium Sized Enterprises in both Eastern and Western Europe. Besides, the research shows the relevance of improvements in the financial systems and institutional factors of Eastern European countries. An obligatory note to the reader: We hereby declare that this MSc Thesis has been produced with the full input of both authors. From the initial stages of finding a research subject to the analysis and writing of the research findings, we have cooperated on every single part. No division in workload has been made, since the full research has been conducted in the presence of both of us. Sincerely, Anna Kaja Chudzinska Stefan Lukas van der Bijl MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl

3 Table of Contents Introduction 1 Chapter 1 Literature Review Capital Structure Theories 4 Tradeoff Theory 6 Pecking Order Theory Capital Structure internationally Eastern and Western Europe Small and Medium Sized Enterprises in Europe 21 Small and Medium sized Enterprises (SMEs) versus Large Enterprises (LEs) 22 SMEs in Eastern and Western Europe 24 Empirical findings on SME capital structure in Europe 26 Chapter 2 Research Question & Hypotheses 29 Chapter 3 Methodology Model Variables Data Two Stage Least Squares Regression Method 52 Chapter 4 Regression Results of Eastern Europe vs. Western Europe Regression Results of the Target Adjustment Model Difference in Leverage between Eastern Europe and Western Europe Differences in Proxies for Taxes between Eastern Europe and Western Europe Differences in Proxies for Bankruptcy and Agency Costs between Eastern Europe and Western Europe Conclusions of the Results in Eastern Europe and Western Europe Robustness Check 85 Conclusions 89 Limitations of the research 94 Recommendations for further research 96 Bibliography 97 Appendices Table of Contents 103 MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl

4 Introduction The determination of capital structures has been an ongoing area of research in the field of corporate finance for more than fifty years. Indeed, Capital structure theory forms the basic underlying fundamental on which financial theories and financial management are founded. The underlying question of such research is how and why companies come to the debt-equity ratios in their capital structures. For a long time it has been believed that an optimal debt-equity choice exists for any firm, and that this optimal capital structure is a tradeoff between the advantages of debt financing and the disadvantages of bankruptcy risks. From a firm s perspective, debt is ofen a cheaper source of finance than equity because of tax advantages to be gained. Debt is preferred over equity, especially where the firm does not face financial distress. Therefore, a tradeoff exists between the benefits of debt financing and the risks of debt financing. Since Modigliani and Miller (1958), many different insights into firm financing have been examined. Modigliani and Miller (1958) stated their famous irrelevance theory, where under perfect conditions, the choice of debt or equity is irrelevant. Other researchers, such as Myers and Majluf (1984) saw information asymmetry, which is a result of agency costs, as the underlying theory of how a firm comes to its debt-equity distribution. Many other theories have been proposed and tested, but the Tradeoff Theory, including agency costs as part of the tradeoff, is still often applied and discussed in literature. It seems that no perfect theory exists, and many theories explain only a part of the story. Perhaps one cannot hope to expect only one theory to hold true for every firm s capital structure determination (Myers, 2000). Initially, the different financial theories of capital structure have been principally developed and tested on large public firms from the Unites States. Evidence of capital structure research studies is still limited in Europe, and other continents outside of North America. One of the intentions of this research paper is to broaden the insights of capital structure determination in Europe by studying the Tradeoff Theory. Europe, in contrast to the United States, does not consist of one large economy, but rather of many small, country-specific, economies which are often interlinked with each other. Moreover, Europe contains both developed and developing economies, which in this research paper, are broadly categorized as Western Europe and Eastern Europe, respectively, due to their historic economical similarities. The majority of previous MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 1

5 research papers that study capital structures of firms from different countries, concentrated on developed economies, e.g. Rajan and Zingales (1995). In developed economies, market conditions are rather similar. However, there are reasons to believe that capital structure theory and its determinants work differently in developing economies. Another intention of this research paper is to investigate to what extent the state of economic development contributes to differences in capital structure. What is more, all current or previously developed theories have been aimed and tested almost solely on public firms, even though the majority of firms in every country are considerd to be Small and Medium sized Enterprises (SMEs). Consequently, this research will focus on private SMEs in order to test whether capital structure theory has application to smaller and private firms. The Research Question of this study is: To what extent do capital structures and their determinants differ between Small and Medium sized Enterprises from Eastern and Western Europe, in light of the Tradeoff Theory? Since most accepted research findings on capital structures have been based on data from public firms in the United States, it is essential for European financial management to further expand its knowledge in this field, based on European firms. The purpose of this study is to find an answer, which might help to explain whether firms in developing countries in Eastern Europe have different financing patterns from firms in the developed countries of Western Europe. This study will also help to shed light on the question whether the Tradeoff Theory is a valid theory for testing capital structures of Small and Medium sized Enterprises across different countries in two distinct geographic regions. Moreover, this study will help to identify aspects which Eastern European countries (and maybe some Western European countries) need to improve in order to create a strong financial climate. As it is outside the scope of this study to focus on the whole European continent, this research will be based on a comparitive study of three countries from Western Europe, Belgium, Ireland and the Netherlands, and three countries from Eastern Europe, Hungary, Poland and Ukraine. The choice of the countries was based on a MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 2

6 detailed analysis of some institutional factors that are crucial for a country s financial climate, and fit into the different aspects of the Tradeoff Theory, i.e., credit availability, corporate taxes, bankruptcy costs and agency costs. The research itself was conducted with the use of the target adjustment model which was tested with multiple Two Stage Least Squares regressions. The input for this model was based on constructed variables from data from private Small and Medium sized Enterprises from the six previously identified countries. The most important variable in light of the Tradeoff Theory is the Leverage ratio. Thus, four possible measures of Leverage were computed and studied. Other constructed variables, which were included in the target adjustment model, are three measures for the tax effect, KINK, STANDARDIZED KINK and EFFECTIVE TAX RATE, and several measures for the bankruptcy costs and agency costs effects, TANGIBILITY, SIZE, Z-SCORE, OPERATING RISK, PROFITABILITY, GROWTH and LAGGED LEVERAGE. The remainder of this research paper is organized as follows: Chapter One serves as a literature review. Here, some theoretical frameworks on capital structure are introduced, with a focus on the Tradeoff Theory. Also the literature about international capital structure, Europe and Small and Medium sized Enterprises is presented. Chapter Two introduces the reader to the main Research Question which is linked to the literature presented in Chapter One. Further, also based on the literature, the hypotheses on the research question and on the relationship between leverage ratios and the determinants of leverage are presented. Chapter Three introduces the reader to the research methodology. Namely, this chapter describes the model, variables, data and regression method used in this study. Chapter Four presents the analysis of the results. Based on this analysis, the hypotheses are controlled for. A robustness check is introduced, which serves to control the the research approach applied in the study. Chapter Five concludes this research paper and provides the implications of the research findings. Finally, a presentation is given of limitations in this study and suggestions for further future research on this important topic. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 3

7 Chapter 1 Literature Review The study of capital structure determination has been an important area of research within the field of finance. Many theories have been developed, which try to explain how a firm s capital structure develops over time, that is, for which reasons some firms are heavily debt-financed while other firms rely more on owners equity in their capital structure. The first section of this chapter introduces literature that has been written on this matter, and concentrates on the two most famous explanatory theories of capital structure: the Tradeoff Theory and the Pecking Order Theory. Multiple scholars compared capital structures of firms throughout different countries and regions. Some major similarities were found, as well as differences among such countries / regions. The second section of this chapter describes factors found in existing literature, which have been related to country and regional differences in the matter of capital structure determination. The third section concentrates on country differences and regional differences, based on literature and public data. It presents a study on differences between Eastern Europe and Western Europe, in respect to institutional factors. Based on literature, such differences have an impact on capital structure of firms in both regions. Hence, the implications of these differences on leverage are discussed. In the fourth section of this chapter, it will be explained to what extent such institutional factors play a role on Small and Medium sized Enterprises (SMEs). Based on literature, private SMEs are compared to large public companies and the differences between Eastern and Western European SMEs are discussed. Last, a short discussion of SMEs capital structures is presented. 1.1 Capital Structure Theories The research on capital structure attempts to explain how and in which proportions companies use debt and equity to finance their investments. The traditional capital structure theory assumes that there is an optimal capital structure and that companies can increase total value by the proper use of leverage. In short, debt is cheaper than MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 4

8 equity, from the costs of capital perspective. The use of debt also brings tax advantage; therefore, companies are able to increase their required rate of return. The study of capital structure determination is a relatively young discipline that started less than fifty years ago. At present, there is no one universal capital structure theory that is applicable in most companies around the world. Nevertheless, there are several useful conditional theories (Myers, 2001), which are discussed below. Modigliani and Miller (1958) introduced a concept of capital structure which, in contrast to the traditional capital structure theory, argued that financing does not matter in a perfect market. According to Modigliani and Miller (1958) the markets are perfectly competitive when the information is costless and available to all market agents, when there are no transaction costs or taxes in the issuance or trading of securities and when the securities are infinitely divisible. The authors also assume that all market agents are price takers and investors always act rationally. What is more, Modigliani and Miller (1958) assume that average expected returns stay equal over future periods, which means that expected earnings will always be the same as they are today. Therefore, the authors state that financial leverage is irrelevant. Taking into account all introduced assumptions and assuming that a firm s total cash flows to its debt and equity holders are not affected by financing, then the total market value of the firm is not affected by financing. The total value of the firm is equal to the sum of the market values of the items on the right-hand side of the balance sheet (i.e. debt and equity). To illustrate this theory, one can imagine two firms that differ only in respect to their capital structure. Firms can borrow at the risk free rate of return which, by the above assumptions, implies that the investors can also borrow at a risk free rate of return. The investors can employ two alternative strategies to obtain the same return structure: hold a certain percentage of the leveraged firms stock or hold a certain percentage of unleveraged firms stock and at the same time borrow on personal account. Since the return stream for both companies is the same in both strategies, the value of these two strategies is the same by a law of one price, thus the net investment has to be the same. Therefore, the value of the leveraged firm is equal to the value of the unleveraged firm. The driving force in this reasoning is the assumption that both firms and investors can borrow and lend at the same rate of interest and that the two cash flows are the same. In a perfect market, there is no MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 5

9 optimal capital structure. As Myers (2001) put it: In a perfect-market supermarket, the value of a pizza does not depend on how it is sliced. This theory is widely accepted; however, it is not really applicable. In the world as we know it, there is no perfect market, there are taxes and information is not evenly distributed. In a world with corporate taxes, leverage opportunities become valuable (Modigliani and Miller, 1963). Since taxes have to be paid only on corporate income and interest expenses are tax-deductible, an extra dollar in debt will decrease the tax payments. If there were no offsetting costs, companies would attempt to shield as much taxable income as possible and no company would pay taxes. However, costs of financial distress exist and might influence capital structure decisions. Tradeoff Theory The Static Tradeoff Theory is a single period model in which a company is viewed as setting a target debt-to-value ratio and then gradually moving towards it. According to Myers (2001) firms will borrow up to the point where the marginal value of tax shields on additional debt is just offset by the increase in the present value of possible costs of financial distress. In this view, costs of capital for equity are higher than the costs of capital for debt, due to two factors. First, since debt lenders are assured of their income payments, they will generally receive lower returns for their investment than equity investors. Secondly, interest on debt is deductible from taxes when a company has high levels of debt it can avoid paying corporate taxes due to tax deductibility from the interest payments. This works as an extra benefit for organizations to finance their operations and investments with debt. However, the higher the levels of debt, the higher the probability of financial distress, hence bankruptcy costs increase. A corporation finds itself in a situation of financial distress, when it is unable to pay its obligations or when it is illiquid or insolvent (a corporation is insolvent when its liabilities exceed its assets). Therefore, in order to avoid financial distress, it is crucial to find the optimum between tax shields and bankruptcy risks. The static Tradeoff Theory explains this optimum tradeoff between the benefits and the risks of debt financing and the influence on the market value of the firm. This is depicted in the graph below. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 6

10 Figure 1. The Static Tradeoff Theory of capital structure Source: Myers (1984). A slight deviation of the static Tradeoff Theory is a dynamic Tradeoff Theory, which recognizes the role of time and concentrates on aspects that are usually ignored in the single period model (Frank and Goyal, 2005). In a dynamic model, the financing decisions depend on the future financing margins that the firm anticipates. Some firms are planning to raise funds (equity or debt) while others plan to pay out funds. Fisher et. al. (1989) and Leland (1994) introduced dynamic models in which the firms allow their leverage ratio to fluctuate over time. This reflects accumulated profits and losses, and leverage does not adjust towards the target ratio as long as the adjustment costs exceed losses of suboptimal capital structure. Nevertheless, the static as well as the dynamic forms of the Tradeoff Theory try to explain the existence of an optimum in leverage whether it is constant or dynamic through time. According to Myers (1984) firms cannot immediately offset the random events that bumped them away from their optimum. Therefore, a difference among firms of actual debt ratios should exist across firms with the same target ratio. Adjustment costs, especially large ones, might possibly explain the wide variation in actual debt ratios among firms, since firms would be forced into long excursions away from their target ratios. Besides, the size of adjustment costs might influence the speed with MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 7

11 which firms adjust to their targets. In most tradeoff literature, adjustment costs are rarely mentioned. However, adjustment costs might have a profound impact on firms capital structures. The importance of bankruptcy costs is very crucial because it can erode the firm value even if formal default is avoided. Bankruptcy costs are the costs directly incurred when the perceived probability that the firm will default on financing is greater then zero. According to Cassar and Holmes (2003) a subset of bankruptcy costs are liquidation costs, which represent the loss of value as a result of liquidating the net assets of the firm. The liquidation costs reduce the proceeds to the lender and the firm can default on finance payments. Therefore, the firms can incur higher finance costs due to the potential of liquidation costs. Firms can incur these costs, even if non-lending stakeholders believe that the business is perceived to be close to bankruptcy (e.g. customers not willing to buy products due to the risk of not receiving the promised guarantee). Consequently, firms that have high distress costs should decrease debt financing to lower these costs. Miller (1977) sheds new light on the relation between taxes, bankruptcy costs and leverage. He found that bankruptcy costs do exist, but that they are lower than commonly assumed. For large public firms, bankruptcy costs are only between 1.7 and 5.3 percent of the value of the firm. For small firms, however, bankruptcy costs are higher, equaling 20 percent. Miller (1977) points out that the costs for large public firms are extremely small in relation to the tax savings that companies are able to receive. Besides, the author also questioned that if the optimal capital structure was only a matter of a tradeoff between tax advantages and bankruptcy costs, why then does capital structures show so little change over time. Miller (1977) noticed that in spite of rising tax rates, leverage ratios were found to remain almost the same. Minor variations in the ratios were rather caused by cyclical movements of the economy. Thus, the author concluded that the tax advantages of debt financing must be substantially less then the conventional wisdom suggests (Miller, 1977 pp. 266). Clearly, the tradeoff between tax advantages and bankruptcy costs is not the only matter in obtaining the optimal capital structure. Similarly, Jensen and Meckling (1976) found that leverage ratios were low in spite of large tax advantages enjoyed by debt. They came to an alternative explanation in which they add agency costs to the tradeoff function in order to explain these low MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 8

12 observed leverage ratios. The authors argue that a perfect market as described by Modigliani and Miller (1958) is not realistic, and therefore besides taxes and bankruptcy costs, agency costs should be taken into account. Agency costs are the costs that arise as a result of two types of conflicts (Harris and Raviv, 1990). The first conflict is between shareholders and managers and the second conflict arises between shareholders and creditors. The existing literature concerning these conflicts differs in respect to the way in which the conflicts arise. According to Stulz (1990) a conflict develops between managers and investors when managers tend to invest all available funds even if paying out cash would be in the interest of investors. This is the so-called problem of overinvestment. As pointed out by Jensen (1986) and Stulz (1990), in order to overcome this problem the company can issue debt and the required interest payments will reduce free cash flows. This reduces the conflict between management and shareholders and contributes to the benefit of debt financing. However, debt serves also as an agency cost. Stulz s model indicated this cost is the possibility of using too much cash flows on required debt payments and at the same time giving up profitable investments, hence the problem of underinvestment. Harris and Raviv (1990) stated that managers always want to continue investing in current projects, even though liquidation would be preferred by the investors. In this view, outstanding debt reduces the conflict between investors and management by shifting the controlling power to debt holders. Debt holders have the option to pursue liquidation if the cash flow from the project is lower than expected. Harris and Raviv (1990) pointed out the costs of debt from the creditors perspective, the costs of information gathering. They predicted that firms with high tangible assets and low information costs, i.e., firms with higher liquidation value, can issue more debt, and still, have higher market values in comparison to the firms with lower liquidation costs. The second type of conflict, which might occur between shareholders and creditors, arises because the debt contract gives an incentive to the shareholder to invest in risky projects (Harris and Raviv, 1990). If the project happens to be successful and yields high returns that are higher than face value of the debt, the shareholders will receive most of the gain. In the event when the project fails, only debt holders will bear the consequences, and as a result the value of debt will decrease. Because of asset MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 9

13 substitution problems, i.e. a situation when a firm invests in assets that are riskier than those that the debt holders expected, debt holders need to restrict and monitor the firm s behaviour. The lenders can only observe the firm s default history and it is possible for firms to build up a reputation of having only safe projects. However, the investors can never be sure in what kind of project the firm invests. Therefore, costly monitoring devices are incorporated into debt contracts in order to protect debt holders from possible asset substitution problems. Under the Tradeoff Theory, companies set an optimal target debt-to-value ratio. This target is set on the level when firms borrow up to the amount when the value of tax shields is offset by bankruptcy costs and agency costs. As argued by Myers (1984) adjustment costs are an important factor in setting this optimal target ratio. Nevertheless, according to Marsh (1982) and Shyam-Sunder and Myers (1999) the target ratio is unobservable and, therefore, difficult to test. Possible proxies used for testing the target debt level are the average historic debt level or a moving average of debt over time (Jalilvand and Harris, 1984). To better capture changes in target debt levels, Taggart (1977) and Jalilvand and Harris (1984) estimated target adjustment models. They did not test the optimal target debt level itself, but indirectly tested the adjustment towards a target level. In their research an adjustment coefficient was tested and if this coefficient was higher than zero, the Tradeoff Theory held. Pecking Order Theory A second theory on capital structure determination which has received much attention in the last twenty years is the Pecking Order Theory. This theory was introduced by Myers and Majluf (1984) and Myers (1984) and was developed from an agency cost perspective. The underlying assumption is asymmetric information, under which management has information about the firm that investors do not have. Management is expected to act merely in the benefit of existing shareholders. Asymmetric information means that only management knows the true value of the firm and its growth opportunities, while the market (possible new shareholders) can only infer these values by observing management s actions. Accordingly, the financing actions of management are used by the market as a signal of the firm s true value. Management will only issue equity when it knows that investments will benefit MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 10

14 existing shareholders more than new shareholders. This happens if the net present value of the investment is more than the over- or undervaluation of shares in the market. If management issues equity, it signals to investors that their funds should be worth less. Hence, new shareholders are only willing to invest when they are compensated for this risk. This increases the costs of attracting funds for the firm. Thus, the adverse selection costs make equity issues more expensive for the firm. Because of these added costs, equity might not be issued and management might pass on profitable net present value (NPV) projects. This is not the case when internally generated funds are used, since internal funds do not bear these costs. External investors, therefore, effectively force firms to follow a pecking order, in which internal funds are always preferred over external funds. Besides, under this pecking order, the use of debt is preferred over equity. From the investor s perspective, debt contracts are less risky than equity contracts, since debt covenants secure the face value of debt on the firm s assets (Frank and Goyal, 2005). Hence, the future value of debt is less volatile than the future value of equity, after managements inside information is revealed. Asymmetric information costs are lower for debt than for equity. In essence, risk-free debt would work similarly to internal funds. Therefore, according to the Pecking Order Theory, firms will always work down the pecking order starting from internal funds to several types of debt. Thus internal sources are followed by riskier debt, such as convertible securities, preferred stocks, and finally equity as a last resort when all debt capacity is exhausted. Clearly, under the Pecking Order Theory, an optimal capital structure does not exist. Rather, the capital structure is nothing more than an explanation of the firms past requirement for external financing over time. This theory predicts that more profitable firms borrow less because they have more internal financing available. Less profitable firms require external financing, and consequently accumulate more or heavier debt. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 11

15 1.2 Capital Structure internationally The focus of this section is to identify major country specific factors that are found to be related to capital structures of firms. Most researchers limited their investigations to public American firms. Later on, some focus was put on capital structure of firms from Western European countries. In general, most authors found similarities in capital structures and their determinants across borders. Rajan and Zingales (1995) investigated determinants of capital structure in the G7 countries. The authors found that leverage ratios were fairly similar in these countries, even though institutional settings were very different. The same conclusion was drawn by Antoniou, Guney and Paudyal (2002) who focused on differences in optimal capital structure decisions in companies from France, Germany and the United Kingdom. Bancel and Mittoo (2002) studied sixteen different European countries and found that European managers used similar factors in financing decisions as United States managers. Similarly, Booth et al. (2001) studied ten developing economies and found the same factors to be related to leverage ratios in developing economies, as in developed economies. These different sources of literature indicate that capital structure determination seems to have some general similarities across countries. This, while capital structures themselves are quite different among countries. Hence, one can conclude that country differences do exist. Knowing a firm s nationality explains as much of the firm s capital structure as knowing the size of the independent variables that determine capital structure under different theories (Booth et.al., 2001, pp.119). The focus in this section concentrates specifically on identifying how certain country specific differences can play a role on capital structure. The focus lies in differences in the legal systems, financial systems, taxes, bankruptcy laws and corporate governance. Even though most literature concentrates on Western developed economies, these institutional factors are expected to be even more important in emerging economies. They determine the status of the capital market to a great extent, and hence, the availability of finance (Demirguc-Kunt and Maksimovic, 1998). This in turn, is important for firms financing policies, and thus, capital structures. The theoretical analysis in this section serves as the basis for comparison of differences between Western and Eastern European countries, which will be presented in the next section. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 12

16 Legal and Financial System LaPorta et al. (1998) stated that the legal system is a fundamentally important corporate governance mechanism. Besides, bankruptcy procedures are only effective under a proper legal system (Demirguc-Kunt and Maksimovic, 1998). In particular, La Porta et al. argue that the extent to which a country s laws protect investor rights and the extent to which those laws are enforced are the most basic determinants of the ways in which corporate finance and corporate governance evolve in that country. LaPorta et al. (1997) and Gonzalez (2002) stated that better legal protection leads to investors demanding lower rates of return and companies using more external finance. Two aspects of the legal system are discussed in the following paragraphs. The first aspect is bankruptcy law and the second one is the legal investor protection. The effective enforcement of certain legal systems is highly correlated to effective bankruptcy proceedings and corporate governance. That is, the law is a necessary factor for investors to enforce their legal rights when dealing on issues with management. Bancel and Mittoo (2002) found that differences in legal systems were more relevant to factors related to debt than to factors related to equity, thus confirming the fact that external financing in different countries is influenced to a high extend by its legal environment. Hence, different legal systems lead to various financial systems. Rajan and Zingales (1995) and Peltoniemi (2004) observed two major types of financial systems. They classified countries based on the size, or power of the banking sector versus the market sector, hence the term bank oriented (e.g. Germany, France, Italy and Japan) and market oriented (e.g. the United States, the United Kingdom and Canada). This classification can explain the way in which the firms capitalize their investments. Banking (market) oriented economies are associated with a small (high) proportion of quoted companies, a high (low) concentration of ownership, and longterm (short-term) relations between banks and industry (Mayer 1994). In a marketoriented system, the financial securities market is well developed with a high level of competition, and institutional investors play an important role. In addition, direct financing dominates, and the monitoring of firms is organized by the central exchange (e.g. London Stock Exchange). In a bank-oriented system, bank lending dominates and monitoring is arranged by banks through client-specific relationships. Banks are MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 13

17 the most important sources of external credit for firms and, simultaneously, the main channels for financial intermediaries in financing different investment projects (Mayer, 1994). However, the difference between these two types of systems is rather the choice between private and public financing and not the amount of leverage (Rajan and Zingales, 1995). It can be further observed that market-oriented countries typically have a common law tradition, while bank oriented countries have civil law codes. Taxes Another institutional difference is the tax code of the country under consideration. As explained, taxes are a major determinant of leverage under the Tradeoff Theory, and, therefore, fiscal deductibility of debt and tax levies on dividends can have a serious influence on a firm s leverage ratio. For instance, tax advantages are stronger in Germany than in the United States (Rajan and Zingales, 1995). Moreover, corporate taxes are used as a mechanism by countries for attracting investors (Kennedy, 2007). Bankruptcy Law Bankruptcy law has the following effects: strict enforcement of creditor rights enhances credibility; it commits creditors to punishing management if the firm gets into financial distress and it reduces costly negotiating between claimholders. Strong bankruptcy laws therefore reduce bankruptcy costs for investors. Rajan and Zingales (1995) found that the G7 countries differ in their bankruptcy procedures; bankruptcy law in the United States is more management friendly while in Germany the law is more creditor friendly. Corporate Governance Corporate governance essentially deals with the problem of agency costs identified earlier. It is a broad phenomenon and goes beyond legal issues. The meaning of corporate governance has been stated in different ways. Corporate governance involves relations and controls among the stcockholders, boards of directors and the firm s senior management. It is most commonly found in corporate charters, firm s by-laws, governmental regulations and in legal decisions. The primary objective of such corporate governance is to ensure that the interests of senior management are aligned with the interests of the firm s shareholders. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 14

18 Where ownership and management are dispersed agency costs arise and corporate governance is the tool of reducing these agency costs. However, in the previous section it was identified that agency costs do not only exist between owners and management, but also between creditors and management. According to Shleifer and Vishny (1997), corporate governance should be seen as the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. They stated that corporate governance deals with three issues: the separation of ownership and control (which causes agency costs), management discretion and incentive contracts. The first two issues of corporate governance are especially important in the light of this research. In general terms, the investors and the managers sign a contract that specifies what the manager does with the funds, and how the returns are divided between him and the investors. However, since not all possible scenarios can be foreseen in the contract, the manager and the investor have to allocate residual control rights, i.e. the rights to make decisions in circumstances not fully foreseen by the contract. Since investors are not as familiar with the business as the managers, they are mostly not as well informed to decide what to do. As a consequence, the managers end up with most of the residual control rights. Corporate governance deals with the cases in which managers use their control rights, but are not in line with the investors wishes (Shleifer and Vishny, 1997). The second issue handles the question how managers can allocate the investors funds. They can expropriate them in several ways. Extreme forms of expropriation are: the construction of pyramid structures, in which funds are transferred to separate units that are outside the legal reach of investors, or by using transfer pricing techniques at below market prices to subsidiary firms that are not owned by the investors. Bancel and Mittoo (2002) found that agency costs of debt were usually higher in countries with a lower quality legal system. Taxonomy of Corporate Governance Systems and Legal Systems in Western countries Based on Rajan and Zingales (1995), Shleifer and Vishny (1997), LaPorta et al (1997, 1998, 1999) and Weimer and Pape (1999) a taxonomy is constructed of different legal and corporate governance systems which are observed in Western European countries. An overview of this taxonomy is depicted in Appendix I. According to Shleifer and Vishny (1997) the corporate governance systems observed in the US and Germany belong to the most effective systems in the world. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 15

19 The general characteristics of the systems are as follows: - The Anglo-Saxon system is a market oriented system. It has a common law tradition and is shareholder oriented, and thus shareholder protection is strong. Public companies have a one tier board system. There is an active external market for corporate control, e.g. the role of credit rating agencies is important. The relationship between stakeholders and management is generally short term. Besides, there is low ownership concentration. - The Germanic system has large oligarchic groups of stakeholders, of which the most important are industrial banks and employees (unions). Public firms generally have a two tier board system with an executive and a supervisory board. There is no external market for corporate control, and stakeholders and investors have to solve the corporate governance issues on their own and in different ways then under the Anglo-Saxon system. There is a moderate to high ownership concentration. Relationships between investors and management are generally long term. - Under the Latin system family control is relatively important. In general, public firms have a one tier board system. The major stakeholders are often: families, financial institutions and the government. There is no external market for corporate control. Under this system, there is high ownership concentration. Relationships between investors and management are generally long term. MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 16

20 1.3 Eastern and Western Europe In the previous section, a review of literature was presented that described factors of international differences in capital structure. It can be observed that most studies on such differences limit themselves to firms from the United States and Western Europe. This, since data is more available on these countries. Even though differences are observed between the United States and Western Europe, these countries have many things in common, most importantly, they all have well-developed economies. For several reasons, which will be mentioned, this section will investigate differences between Eastern and Western Europe that might have an impact on capital structures of firms from both regions. It will be identified which countries fit into Eastern and Western Europe. Subsequently, a summary of the differences between institutional factors of Eastern and Western Europe will be presented, as well as the implications of these differences. For a detailed analysis of these differences, based on numerical country scores, one is referred to Appendix II. There are several reasons for comparing Eastern and Western European countries in regards to capital structure. First of all, literature on capital structures in developing economies of Eastern Europe is relatively scarce and mostly country specific. Therefore, a comparative cross-country analysis between transition economies of Eastern Europe and the developed economies of Western Europe might shed new light on capital structure determination in Europe. Secondly, by comparing different countries, the findings might indicate whether the Tradeoff Theory is a valid theory of capital structure across Europe. Thirdly, it might become visible to what extent the development of the economy is related to financing decisions of firms. Information on the relationship between the development of an economy and financing conditions for firms might help in deciding whether financial theories, such as the Tradeoff Theory, are indeed as transportable across borders, as initially thought. What Constitutes Eastern Europe and Western Europe? It should be noted that no clear definition is found in literature on which countries belong to Eastern Europe and which to Western Europe. In this research, a typical Western European view on Eastern Europe is applied, in which Eastern Europe is defined as the former Warsaw Pact region (Svejnar, 2002). This is the region of MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 17

21 countries that were under Soviet control since the Second World War and had communist governments with planned economies, roughly until This definition also contains numerous countries that geographically and historically might be called Central Europe. Countries that fall under the applied definition of Eastern Europe, but may be labeled Central Europe under different definitions, include: Poland, Hungary, Czech Republic, Slovak Republic and Slovenia. With the exception of Slovenia, these countries are also labeled as the Visegrád group. The historical view on Central Europe also includes Germany, Switzerland and Austria. This view is based on a combination of historical, cultural, geographic and religious factors. According to Rupnik (2000) even Belgium and the Netherlands make up part of Central Europe. Starting with the Second World War and Cold War, most of Central Europe became Eastern Europe in the perception of many Western Europeans. The generalized perception of Eastern Europe is still widely applied and might have even become stronger with the original formation of the European Union, in which only Western European countries participated. Today, with the accession of new member states from Eastern Europe to the European Union, the concept of Central Europe as a separate numerator of a block of countries becomes more widely accepted again (Rupnik 2000). Because the focus in this research mainly lies on the development of a country s economy and capital market, the definition of Eastern Europe as the ex-warsaw Pact countries (Soviet Union, Albania, Bulgaria, Czechoslovakia, East Germany, Hungary, Poland, and Romania) is believed to be useful. Since all Warsaw Pact countries have experienced a period of transition beginning in the early 1990s, they are more or less in a similar state of development and provide an excellent study group for the research of capital structure theories. Western European countries are considered to be the original European Union member states (Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and United Kingdom) plus Switzerland and Norway. Differences between Eastern Europe and Western Europe on Institutional factors In Appendix II a thorough comparison is made on the previously identified institutional factors. These comparisons are based on numerical scores from the World Bank and various other (acknowledged) resources. First, several countries are MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 18

22 taken from the identified Eastern Europe and Western Europe and based on country scores, Eastern European and Western European scores are calculated in order to make inferences about differences between Eastern Europe and Western Europe. The conclusions and implications of this comparison are presented here. Access to Credit Access to credit is weaker for firms in Eastern Europe than for firms in Western Europe. The availability of commercial credits is lower. This is due to several factors. In Eastern Europe, legal systems are weaker than in Western Europe, and creditors therefore demand larger monitoring power over firms. Besides, in Eastern Europe, banks have less credit information available about firms. This is because companies in transition economies usually have short credit histories. Such short (and often less qualitative) credit histories make banks and other creditors more reluctant to extend credit. This leads to banks in Eastern Europe giving smaller loans and demanding higher compensation, i.e., higher interest rates. Moreover, higher interest rates lead to lower demand for loans. Lower access to credit in Eastern Europe might lead to different capital structures than in Western Europe, since availability of credits is lower and thus, on average, leverage ratios might be lower too. Corporate Taxes Both Eastern and Western Europe have been following a similar trend of decreasing corporate tax rates during years However, Eastern Europe indicates much lower average tax rates than Western Europe. This is due to the fact that emerging economies in the Eastern European region literally compete against eachother (and against Western European countries) with their tax rates, in order to attract foreign investors. Besides, the heavy tax cuts should be seen as an incentive for firms to invest, in order to offset the higher risks in these emerging economies, and the higher costs of short-term bank borrowing at high interest rates. It can be expected that the role of taxes in setting capital structures, is declining in both the Western and Eastern European regions. Since the corporate tax rates are lower than in previous years, the relative amounts of tax shields are also lower and thus, in light of the Tradeoff Theory, it might be expected that in both regions leverage ratios are lower today than they were a decade ago. Besides, the importance MSc Thesis in Finance & International Business A.K. Chudzinska & S.L.van der Bijl 19

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