THE INVESTMENT OPPORTUNITY SET AND THE LONG-TERM DEBT DECISION OF U.S. LODGING FIRMS

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1 / JOURNAL Dalbor, Upneja OF HOSPITALITY / U.S. LODGING & TOURISM INVESTMENT RESEARCH AND DEBT ARTICLE THE INVESTMENT OPPORTUNITY SET AND THE LONG-TERM DEBT DECISION OF U.S. LODGING FIRMS Michael C. Dalbor University of Nevada, Las Vegas Arun Upneja The Pennsylvania State University This article investigates, in further detail, a previously researched positive relationship between long-term debt and growth opportunities in the U.S. lodging industry. In addition to utilizing variables related to the three major theories of capital structure, the authors use alternative growth opportunity measures in an attempt to confirm previous findings in the hospitality literature. The results indicate that certain growth opportunity proxies do a better job of explaining the long-term debt choice for U.S. lodging firms. This research could be used to reexamine the long-term debt decision and growth opportunities in other sectors of the hospitality industry. KEYWORDS: hotel financing; hotel capital structure Financial researchers have investigated the capital structure decision made by firms for some time. However, although much research has been completed across a wide variety of industries, some research has focused on the capital structure of specific components of the hospitality industry, beginning with the restaurant sector (Upneja & Dalbor, 2001a). Furthermore, other research has investigated not only the factors affecting total debt, but specifically the long-term debt decisions of both restaurants and hotels (Dalbor & Upneja, 2002; Upneja & Dalbor, 2001b). It is a finding in this most recent article regarding the long-term debt decisions of hotel firms that we believe warrants further investigation. Upneja and Dalbor (2001b) examined the long-term debt decision of hotel firms under three hypotheses as tested by Barclay and Smith (1995): pecking order, trade-off (tax effects), and free cash flow. Based upon Myers (1977) theory regarding capital structure (which will be described in greater detail later in this article), a firm with more growth opportunities will use less debt to reduce agency problems with lenders. Controlling for firm size, industry regulation, firm quality, and tax effects, Barclay and Smith (1995) find a significantly negative relationship between growth opportunities and long-term debt. This is not only consistent Journal of Hospitality & Tourism Research, Vol. 28, No. 3, August 2004, DOI: / International Council on Hotel, Restaurant and Institutional Education 346

2 Dalbor, Upneja / U.S. LODGING INVESTMENT AND DEBT 347 with Myers hypothesis, but also with other research by Smith and Watts (1992) and Gaver and Gaver (1993). On the other hand, Upneja and Dalbor s (2001b) research regarding the capital structure of hotel firms found a significantly positive relationship between growth opportunities and long-term debt. Therefore, we believe that this model may have been misspecified regarding the growth opportunities variable. The direction of the relationship between the two variables may be attributable to factors related to the data sample analyzed. For example, it is important to note that data analyzed by Barclay and Smith (1995) involved firms with SIC codes between 2000 and 5999 that excludes hotels. In addition, Wald (1999) finds a negative relationship between long-term debt and growth opportunities for U.S. firms, but a positive debt/growth opportunity relationship for firms in Japan, the United Kingdom, Germany, and France. This conflicting evidence has motivated us to further investigate the validity of the previous models used in the hospitality literature. In particular, one reason for the negative relationship is that the growth proxy used by previous researchers may not capture the actual growth potential of hospitality firms. Therefore, we investigate other variables that have been used by accounting researchers to surrogate for the growth potential of firms. We find the five most commonly used variables and use each of those in our article. We hope to shed more light on the controversial positive relationship identified by Upneja and Dalbor (2001b) between the presence of growth opportunities and long-term debt usage of lodging firms. Furthermore, this research may help understand the unique and important relationship between hotel firms and the institutions that lend to them. The remainder of the article is organized in the following manner. We discuss the relevant literature in section two. section three discusses the data and methodology employed whereas section four presents the results. Finally, section five presents our conclusions and recommendations for further research. LITERATURE REVIEW Myers s (2001) most recent article on capital structure delineates capital structure research into three major theories: trade-off (tax), pecking order, and free cash flow as discussed by Jensen (1986). The trade-off theory states that a firm will use debt to take advantage of interest tax shields available to them. The firm will use debt to the point where the benefits of the interest tax shields will be equal to the costs of potential financial distress. A study by MacKie-Mason (1990) showed companies with low marginal tax rates issued more equity than debt. However, the research does not explain why profitable companies with high tax rates do not issue debt. Therefore, the trade-off theory is currently thought to be able to only explain a portion of the capital structure story. The pecking-order theory as first proposed by Myers (1977) is simply that the financing decision is a kind of path of least resistance story. The easiest type of financing is from retained earnings, referred to as internal equity. The next logical choice is debt, because of the tax deductibility of interest payments and the relative ease of borrowing funds. The last choice is new external equity (common

3 348 JOURNAL OF HOSPITALITY & TOURISM RESEARCH stock) because of the difficulty in its issuance along with the inability to deduct dividend payments. The assets of firms can be placed into two categories: assets in place and growth opportunities. A classic example of a firm with significant growth opportunities is a pharmaceutical firm. In this case, the pecking order may change and external equity would be preferred because of bond indenture restrictions on potential investments and borrowing, dividend payments and the potential to call the bonds due if there are conditions that have been violated. Jensen s (1986) free cash flow theory is in line with the pecking-order theory. This theory is based upon the idea that as firms grow, there are more assets and subsequently more disposable cash flow available under management s control. Accordingly, firm managers may engage in consumption of perquisites or some form of empire building. Therefore, because interest payments on debt are restrictive on managers actions, much like dividend payments, shareholders are willing to hold more debt to control the associated agency problem. A positive relationship between firm size and debt has been found by other researchers such as Barclay and Smith (1995) and will be discussed more in the methodology section of this article. Our research for this article focuses largely on the pecking-order theory discussed by Myers (1977). In addition to the order of preference, he suggests that the amount and maturity of debt used by firms is based largely upon agency problems between bondholders and owners. Firms that have growth opportunities essentially own options that have value. It is possible for the benefits of future projects to accrue to the bondholders and not provide the stockholders with an adequate return. Accordingly, the more growth options held by the firm, the greater the conflict between bondholders and shareholders. Therefore, Myers suggests that firms with a lot of growth opportunities can minimize these conflicts by using less debt or debt of shorter maturity giving more of the potential benefits to the shareholders. However, as discussed by Gaver and Gaver (1993), growth opportunities are not homogeneous. Classic examples of these opportunities include firms exploring for mineral deposits or pharmaceutical manufacturers incurring research and development expenditures. However, almost all future discretionary investments can be considered growth opportunities. These can include items such as expansion projects, replacement of existing assets or acquisition of other firms. Any of these expenditures would certainly apply to the lodging industry and could be considered to be quite different from items such as pure research and development expenditures by pharmaceutical firms. Herein lies the potential conflict in assessing the relationship between growth opportunities and long-term debt for lodging firms. Growth opportunities for lodging firms will usually involve expansion, renovation, or acquisition of fixed assets. Barclay and Smith (1995) argue that Myers analysis implies that firms face a reinvestment decision at the end of an asset s life. Accordingly, the issuance of debt of the appropriate maturity helps to establish appropriate investment incentives at the time a new investment is made. Accordingly, this would imply that firms should match the maturity of their debt with the life of the assets. For

4 Dalbor, Upneja / U.S. LODGING INVESTMENT AND DEBT 349 lodging firms that typically have a significant amount of long-lived fixed assets, this would imply more long-term debt. It may be the case that if the growth opportunities for lodging firms involve fixed assets, then a positive relationship between long-term debt and a growth opportunity variable may be hypothesized. Nevertheless, finding one appropriate proxy for growth opportunities has been a challenge to previous researchers as discussed by Gaver and Gaver (1993). Smith and Watts (1992) use the ratio of book value of assets to firm value, with book value of assets as a proxy for assets in place (the higher the ratio, the fewer number of growth opportunities). Although this variable is significant in their findings, they conduct a sensitivity analysis and examine alternative investment opportunity set measures, including the ratio of depreciation to firm value, the ratio of capital expenditures to firm value, and the earnings to price ratio. Gaver and Gaver (1993) build upon the work of Smith and Watts (1992) to examine the relationship between corporate financing policy and investment opportunities. The authors construct an index of investment opportunities based on variables used in earlier research. The variables they use include the ratio of market value of the firm to the book value of assets, the ratio of the market value of equity to the book value of equity, and the ratio of research and development expenditures to book value of assets. Generally, the variables used in previous research to measure the investment opportunity set compare book values to market values or else utilize the research and development expenditures made by firms. However, as discussed by Gaver and Gaver (1993), research and development expenses may not apply to industries that often have other types of discretionary investments such as adding to or renovating the physical plant in the lodging industry. A significantly positive relationship between long-term debt and property plant and equipment (PP&E) was found by Upneja and Dalbor (2001b). A similar finding was published by Wald (1999) for a wide variety of international firms. Wald (1999) argues that the positive relationship exists between long-term debt and PP&E because lenders are more comfortable knowing that funds are being used for assets in place. Assets secured with real estate provide collateral, giving lenders extra security. In addition, PP&E are fixed assets with longer lives and according to Myers (1977), owners will set up the appropriate incentives by issuing debt that matches the life of the assets of the firm. In addition to growth opportunities available to firms, the quality of the firm has also been linked to the use of debt. Research involving restaurants (Dalbor & Upneja, 2002) and hotels (Upneja & Dalbor, 2001b) finds that firms with a greater likelihood of bankruptcy use more long-term debt. Although some may believe this to be a reverse causation problem, previous research has used lagged bankruptcy prediction variables and still found a positive relationship between the probability of bankruptcy and the use of debt. Moreover, Wald (1999) found this relationship for firms in the United Kingdom and Japan. These findings may be congruent with the idea that long-term debt for hotels is most typically used for assets in place, and is often secured by real estate or property. Lenders may be confident that they will maintain a very good chance of recovery even if a bankruptcy occurs. In addition, this is also consistent with

5 350 JOURNAL OF HOSPITALITY & TOURISM RESEARCH Myers (1984) pecking-order theory, where firms prefer retained earnings, then debt, and finally new external equity. However, firms that have greater chance of bankruptcy can typically be expected to have fewer retained earnings and therefore debt remains the financing method of choice, assuming the firm can handle the fixed costs associated with a long-term debt issue. A major tax savings for hotel properties related to PP&E is depreciation. Depreciation represents the other side of the tradeoff argument. Both interest expense and depreciation expense are tax deductible. However, depreciation does not involve the use of cash. Therefore, firms may prefer a depreciation expense tax shield rather than the tax shield from interest expense. Previous research by Mackie-Mason (1990) finds a negative relationship between depreciation tax shields and the use of debt. In terms of long-term debt, Wald (1999) also finds a negative relationship between the use of debt and depreciation tax shields. Upneja and Dalbor (2001b) also found this for the lodging industry. Accordingly, it appears that firms with significant depreciation expenses (usually those that had made discretionary investments in PP&E recently) will not want or need to issue debt because they are already receiving tax benefits from depreciation. Given the inability of the trade-off theory to adequately explain the capital structure decision and the unique nature of the lodging industry, we have focused on the pecking-order and free cash flow theories to provide an explanation of the financing decision. Growth opportunities for lodging firms may involve fixed assets, and therefore, be associated with more long-term debt. In the next section, we will try to assess this relationship. DATA AND METHOD Data Sample The sample of lodging firms used in this study was extracted from the COMPUSTAT database for the years 1981 through 2000 and restricted to DNUM We deleted the firm-year observation from our sample if any variable could not be calculated for that particular firm-year. Observations were treated as outliers if they were above the size adjusted cutoff for both Cook s D and Covratio. After deleting the outliers, between 71 and 171 observations were used, depending on the regression model used. Summary statistics of the data are provided in Table 1. Method We use the pooled regression approach that is used in the bulk of research in this area. The independent variables used in this article are related to the three major theories of capital structure: pecking order, Jensen s (1986) free cash flow, and tradeoff (tax effects). The pecking order variables include growth opportunities, Physical Plant Assets (PPA), and estimated probability of bankruptcy using Ohlson s O Score (EOO), as described by Begley, Ming, and Watts (1997). As shown in the extant literature, nonhospitality firms with significant growth opportunities prefer to use retained earnings as a means for funding future growth, and

6 Dalbor, Upneja / U.S. LODGING INVESTMENT AND DEBT 351 Table 1 Descriptive Statistics for Sample Variable n Mean Standard Deviation LTDR Firm size PPA Depreciation EOO MVA/BVA Earnings/price MVE/BE Cap. exp./sales Cap. exp./assets Note: LTDR is the ratio of long-term debt to total assets. Firm size is the natural log of stockholder equity, adjusted for inflation. PPE is the ratio of property, plant, and equipment to total assets. Depreciation is the ratio of annual depreciation expense to total assets. EOO is Ohlson s Estimated O Score, measuring the probability of bankruptcy. MVA/BVA is a growth opportunity variable, measuring the market value of assets to the book value of assets. Earnings/Price is a growth opportunity variable, measured by net income divided by annual closing stock price. MVE/BE is a growth opportunity variable, measured by the ratio of the market value of equity to book value of equity. Cap. Exp./Sales and Cap. Exp./Assets are both growth opportunity variables, utilizing the ratios of annual capital expenditures to total sales and total assets, respectively. thus, use less debt. Firms with more PP&E have more tangible assets in place, allowing the use of more debt. Finally, risky firms may not have enough retained earnings, thereby making debt the logical financing choice. The free cash flow theory variable is measured by firm size. As discussed previously, larger firms have more assets under management control and could be subject to empire building. Therefore, larger firms will use more debt as a control mechanism. Finally, the trade-off (tax) theory is represented by the ratio of depreciation expense to total assets, measuring the nondebt tax shield. Firms with a significant amount of depreciation will not need to use as much debt because of the availability of the depreciation tax shield. As discussed previously, the growth (GROWTH) variable is measured in a variety of ways as described in more detail in Table 2. The variables were identified from Smith and Watts (1992) and Gaver and Gaver (1993). As discussed by Gaver and Gaver (1993), there is as of yet no consensus in the literature regarding the most appropriate variable to measure growth opportunities. This is one of the main reasons why a number of variables should be employed. The dependent variable is the long-term debt ratio, which is calculated as debt that has maturity of more than 3 years, divided by total assets. This ratio is consistent with both Barclay and Smith (1995), and Upneja and Dalbor (2001). The model is as follows: LTDR = α 0 + α 1 GROWTH + α 2 SIZE + α 3 PPE + α 4 DEP + α 5 EOO + σ i

7 352 JOURNAL OF HOSPITALITY & TOURISM RESEARCH Table 2 Growth Opportunity Variables Used in Regression Models Variable MVA/BVA E/P MVE/BVE CAP EX/SALES CAP EX/ASSETS Calculation Market value of assets/book value of assets Earnings/closing stock price Market value of equity/book value of equity Capital expenditures/total sales Capital expenditures/total assets The models were checked for potential multicollinearity by examining variance inflation factors for the variables. A variance inflation factor of 10 or more is considered to be serious; most of the variance inflation factors in our models were less then two. An additional check was made for potential serial correlation using the Durbin-Watson statistic. No problems were detected. Results The results of our regression models are shown in Table 3. The results show the size variable to be positive and significant in each of the regression models. The PPA variable is positive and significant in most of the models, which was also expected. The probability of bankruptcy variable, EOO, shows that firms that exhibit greater risk also use more long-term debt, as expected. On the other hand, the depreciation expense variable is not significant in any of the models. This indicates that the nondebt tax shield may not play a large role in the long-term debt decision of the hotel firm when considering growth opportunities. Moreover, as discussed by Myers (2001), there has been no conclusive study to date documenting the static trade-off theory of capital structure. In terms of the growth opportunity variables, the MVA/BVA (growth opportunity variable, measuring the market value of assets to the book value of assets) variable is positive and significant, as found by Upneja and Dalbor (2001b). This was not the case for the Earnings/Price (E/P) or MVE/BE (growth opportunity variable, measured by the ratio of the market value of equity to book value of equity) ratios. Although the CAPEX/SALES (growth opportunity variable, utilizing the ratio of annual capital expenditures to total sales) ratio was not significant, the CAPEX/ASSETS (growth opportunity variable, utilizing the ratios of annual capital expenditures to total assets) ratio was positive and significant as expected. Overall, the growth opportunity results are somewhat mixed, as only two of the five chosen proxies were significant. However, two of the variables were significant and had the expected signs. Moreover, the adjusted r-squared statistics indicate the relatively high explanatory power of the models. Overall, the results lend support to the notion of the lodging industry being different from other industries used in general financial research. The MVA/BVA variable has been used successfully in previous research (Barclay & Smith, 1995) and it is significant here. In addition, the ratio of capital expenditures to assets was also positive and significant. The lodging industry has been considered unique because of its seasonality and fixed asset intensiveness. Because these features

8 Table 3 Ordinary Least Squares Regression Results MVA/ MVE/ CAP EXP/ CAP EXP/ Adj. R 2 Sample Size Intercept SIZE PPE DEP EOO BVA E/P BVE SALES ASSETS (%) ( 5.36)** (3.43)** (4.22)** ( 1.73) (9.37)** (4.06)** ( 2.77)** (5.44)** (1.79) ( 0.99) (9.01)** ( 0.69) ( 3.32)** (4.06)** (4.15)** ( 1.42) (7.94)** (1.17) ( 3.38)** (5.71)** (2.67)** (0.12) (8.85)** (2.71)** ( 3.15)** (6.37)** (2.58)* ( 0.41) (8.79)** (1.13) 41.7 *Significant at 10%. **Significant at 5%. 353

9 354 JOURNAL OF HOSPITALITY & TOURISM RESEARCH tend to set the industry apart from others, the growth opportunities and the financing of those opportunities seem to be different as well. Growth opportunities for the lodging industry appear not to be intangible research and development-type expenses, but rather renovations, additions, and other capital investments that can be made to attract more guests at a higher rate. Moreover, it may be the case that the use of debt may have a lower cost of capital than internal equity alone which would confirm a pecking-order theory of capital structure. CONCLUSIONS AND IMPLICATIONS FOR FURTHER RESEARCH The findings of this article largely support the unexpected positive relationship between long-term debt and growth opportunities documented in previous research (Upneja & Dalbor, 2001b). Although this is different from the literature that examines other types of firms, it may be such that the type of investments made by hotel firms are better financed with long-term debt because lenders are more comfortable with real estate type investments and debt capital works better to control any associated agency problems. Other capital-intensive industries could also have a similar relationship. As noted by Myers (2001), capital structure theory is not intended to be broadly applied to a diverse group of industries. As shown in this article, an examination of an individual industry may reveal results that are different from the existing literature that groups a wide variety of industries together. Nevertheless, the lack of significance of the other growth opportunity variables used in the regression models in this article tends to support the notion that growth opportunities are inherently unobservable. This reveals the need to further research other variables that serve as better proxies for these opportunities. There is currently no consensus in the literature as to what constitutes growth. It could be anything from growth in profit, sales, or growth in sales from new or existing customers. Therefore, it is not surprising that the literature uses multiple proxies to surrogate for growth. Furthermore, the relationship between long-term debt and growth opportunities can be explored in other segments of the hospitality industry such as restaurants and casinos. REFERENCES Barclay, M., & Smith, C., Jr. (1995). The maturity structure of corporate debt. Journal of Finance, 50, Begley, J., Ming, J., & Watts, S. (1997). Bankruptcy classification errors in the 1980 s: An empirical analysis of Altman s and Ohlson s models. Review of Accounting Studies, 1, Dalbor, M., & Upneja, A. (2002). Factors affecting the long-term debt decision of restaurant firms. Journal of Hospitality and Tourism Research, 26(4), Gaver, J., & Gaver, K. (1993). Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Accounting and Economics, 16,

10 Dalbor, Upneja / U.S. LODGING INVESTMENT AND DEBT 355 Jensen, M. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76, MacKie-Mason, J. (1990). Do taxes affect corporate financing decisions? Journal of Finance, 45, Myers, S. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5, Myers, S. (1984). The capital structure puzzle. Journal of Finance, 39, Myers, S. (2001). Capital structure. Journal of Economic Perspectives, 15, Smith, C., Jr., & Watts, R. (1992). The investment opportunity set and corporate financing, dividend, and compensation policies. Journal of Financial Economics, 32, Upneja, A., & Dalbor, M. (2001a). An examination of capital structure in the restaurant industry. International Journal of Contemporary Hospitality Management, 13, Upneja, A., & Dalbor, M. (2001b). The choice of long-term debt in the U.S. lodging industry. Journal of HTL Science, 1. Retrieved from: Wald, J. (1999). How firm characteristics affect capital structure: An international comparison. Journal of Financial Research, 22(2), Submitted July 17, 2003 Final Revision Submitted December 4, 2003 Accepted February 9, 2004 Refereed Anonymously Michael C. Dalbor ( michael.dalbor@ccmail.nevada.edu), Ph.D., is an assistant professor in the William F. Harrah College of Hotel Administration, at the University of Nevada Las Vegas. Arun Upneja ( aupneja@psu.edu), Ph.D., is an associate professor in the School of Hotel, Restaurant and Recreation Management, at the Pennsylvania State University.