A Comparison of Capital Structure. in Market-based and Bank-based Systems. Name: Zhao Liang. Field: Finance. Supervisor: S.R.G.

Transcription

1 Master Thesis A Comparison of Capital Structure in Market-based and Bank-based Systems Name: Zhao Liang Field: Finance Supervisor: S.R.G. Ongena L.Zhao_1@uvt.nl 1

2 Table of contents 1. Introduction Literature Review Theories Related to Capital Structure...8 Static Trade-off Theory Pecking Order Theory Asymmetric Information Theory Agency Costs Based Theory 2.2 Empirical Studies on the Determinants of Capital Structure...12 Firm-Specific Variables Country-Specific Variables Market-based vs. Bank-based System 3. Research Design and Data Selection Dependent and Independent Variables Dependent Variables Independent Variables Firm-specific variables Financial markets development variables 3.2 Data Description and Sample Selection Empirical Model and Results Model 1: Firm-specific Determinants of Capital Structure Regression Model Empirical Results of Model Summary of the differences on capital structure across systems 4.2 Model 2: Development of Financial markets as the Determinants of Capital Structure Regression Model Empirical Results of Model Country effects 5. Conclusions and Further Research...37 REFERENCE APPENDIX 2

3 APPENDIX Table 1: Theories and expected relationship between leverage and firm-specific variables Table 2: Level of economic and institutional development across countries Table3: Firm characteristics by country Table 4: Definition of the leverage and independent variables Table 5: Correlation matrix of dependent and firm-specific variables Table 6: Pooled OLS results of model 1 (firm-specific determinants) Table 7: Descriptive statistics of development of financial markets Table 8: Correlation matrix of independent variables (including all indicators measuring the development of financial markets) Table 9: Pooled OLS regression results of model 2 Table 10: Fixed-effects regression results of model 2 3

4 ABSTRACT In this thesis, I use firms from four market-based and six bank-based countries in Europe during the period to investigate how leverage ratios are related to firm-specific characteristics and how they differ across financial systems. Then I try to examine whether these differences can be explained by the development of financial markets. The pooled estimates results suggest that besides the firm-specific determinants, the development of financial markets (stock markets and banking sectors) also contributes to the explanation of the differences on financing choices across systems. 4

5 1. Introduction More than four decades ago modern theory of capital structure established, following the publication of the celebrated paper of Modigliani and Miller (1958), that in a perfect capital market the value of the firm is unaffected by its capital structure and hence that debt and equity are perfect substitutes for each other. However, once the assumption of the perfect capital market is relaxed, the choice of capital structure becomes an important value-determining factor. This paved the way for the development of alternative theories of capital structure and their empirical analysis. Most previous studies on this issue model firm-specific characteristics as the determinants of capital structure. For instance, Harris and Raviv (1991) summarize that leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size, and decreases with volatility, advertising expenditure, the probability of bankruptcy, profitability and uniqueness of the product. Later, Rajan and Zingales (1995) contribute to this issue by making a cross-country comparison instead of studying a single country. They investigate the leverage ratios and capital structure determinants in G-7 countries 1 by using four key independent variables: the tangibility of assets, market-to-book ratio, size and profitability. The results indicate that the factors identified by previous studies in US seem similarly related to the leverage choice in G-7 countries as well. However, such previous models only explore the firm-specific factors, which cannot capture the possible effects of market conditions on firms capital structure decisions. While these market (or country-specific) factors are also under the consideration of the managers when they make financing decisions. Unfortunately, little empirical studies are undertaken to investigate the effect of the institutional environment on firms financing choices. Notable exceptions are Demirguc and Maksimovic (1996), who empirically explore the effect of the legal and financial institutions on firms debt maturity in 30 developing countries during Gabrielle Wanzenried (2002) investigates the impact of different corporate governance systems on the capital 1 G-7 countries stand for 7 major industrialized countries: the United States, Canada, Japan, Germany, France, Italy and the UK. According to Mayer (1990), who uses aggregate flow of funds data to distinguish financial systems, United States, Canada and UK are classified into the market-based countries, and the other four are accepted as bank-based economies. 5

6 structure choices of UK and continental European firms from 1988 to In her study, she explores the impact of three sets of country-specific variables on debt ratio. They are: the development of financial markets, the legal system and the ownership structure. However, both of these two researches (Demirguc and Maksimovic (1996), Gabrielle Wanzenried (2002)) are somewhat questionable. For example, the measures they used are averaged over the whole sample period. This is problematic as many changes occur over time will be smoothed over and hence are ignored. Another problem is that the sample period is more than a decade ago, and thus it may not reflect the current situation. Finally, their proxies for financial markets are insufficient to measure the aggregate development of stock markets and banking sectors 2. Another notable study is made by Booth et al (2001), who investigate ten developing countries with different legal and ownership traditions. The limitation of his model is that they only explore the impact of firm characteristics on capital structure decisions, and use country dummies to investigate the differences of financing choices between the sample countries. Although they find persistent differences across countries and suggest that some country factors are at work, they do not point out which specific institutional factors contribute to these differences. In this paper, I will try to address these issues. Some literature in corporate finance suggest that financial markets play an important role when firms make their financing decisions, because equity and debt financing are in general not perfect substitutes. It is expected that a well-developed stock market favors equity financing over debt financing, while a well-developed banking sector results in the opposite effect. Moreover, stock markets and banking sectors play a different role in different financial systems. In market-based economies, there are large numbers of listed companies and the stock markets are highly active, banks sometimes act as the lenders as a last resort. While in bank-based systems, banks play a central role in the economy and stock markets are comparatively less developed. Therefore, it is interesting to compare the effect of financial markets development on firms financing choices across different financial systems. 2 In their studies, three indicators are used to measure the development of financial markets: 1) the size of stock markets, as measured by market capitalization ratio, 2) the activity of stock markets, as measured by turnover ratio, and 3) the size of banking sectors, as measured by bank assets ratio. 6

7 Specifically, in this paper I compare firms capital structure decisions between four market-based and six bank-based European countries during the period I first analyze the effects of firm-specific variables on financing choices, then I try to explore if the development of financial markets can add power in explaining the differences between capital structure choices across systems. This study attempts to answer two research questions: First, do capital structure decisions differ significantly between bank-based and market-based systems? If so, what are the differences in financing choices and the firm-level determinants? Second, can the differences between capital structure decisions across systems be explained by the level of development of financial markets? In this study, a two-step model is used to answer these two research questions. In the first step, I pool all the firms (across the whole sample countries and over the sample periods) in one OLS model and explore the effects of firm-specific variables on debt ratios. In this model I use a dummy variable (takes value 1 for firms in bank-based systems and 0 otherwise) to investigate if significant differences exist between firms financing choices in bank-based and market-based systems. In a second step, I expand the independent variables to include the indicators measuring the development of financial markets and try to answer the second research question. In this second model, firm-specific variables are used as control factors. In order to combine firm-specific variables with financial markets indicators into one model, I average the leverage ratios and all the firm-specific data in each country in each year. In this way, it also provides a sufficient number of observations 3 compared to the previous studies that average all the data across the whole sample period. The results from pooled OLS reveal that significant differences exist between firms capital structure decisions across financial systems. Firms in bank-based systems uniformly have higher debt ratios (both long-term and short-term) than firms in market-based economies. Further, I also find some evidence from the pooled OLS regression that the development of financial markets (stock markets and banking 3 As this paper explore data from 4 market-based and 6 bank-base economies from , it thus provides 40 observations in the second model. 7

8 sectors) also contributes to the explanation of the differences between firms financing choices across systems. The rest of the thesis is organized as follows: In section 2 I take a preliminary look at the literature related to capital structure theories and make a brief comparison of bankbased and market-based systems. Data and methodology are presented in section 3. Section 4 discusses the two empirical models and interprets their regression results. Finally, section 5 concludes the paper and suggests further research. 2. Literature Review of Capital Structure 2.1 Theories Related to Capital Structure Regarded as the starting of modern theory of capital structure, Modigliani and Miller (1958) illustrate that under certain key conditions, a firm s value is independent of its capital structure. Capital market is assumed to be perfect in this MM world, where insiders and outsiders have symmetric information; and there is no transaction costs, bankruptcy cost and no distortionary taxation exist; equity and debt choice becomes irrelevant and internal and external funds can be perfectly substituted for each other. While in a real world, where these key assumptions are released, capital structure may become relevant to the firm s value. Following the path that Modigliani and Miller mapped, great efforts have been made by many economists to relax these ideal assumptions and to describe the consequences. In this section, some important theories and empirical works related to the capital structure decisions will be presented. Static Trade-off Theory This theory builds around the concept of a target capital structure that balances between the costs and benefits of debt financing. Managers make financing decisions and gradually move towards this target debt ratio. Debt financing has two important advantages over equity financing: i) the interest firms pay is tax-deductible while equity income is subject to corporate tax. ii) debt financing may also reduce agency costs of managers. However, debt may also increase the financial risk and monitoring 8

9 costs, which makes debt-financing choice no cheaper than equity. Therefore, a valuemaximizing firm will pursue an optimal capital structure by considering the marginal costs and gains of each additional unit of financing. The Static Trade-off Theory is actually a sub-theory of Modigliani and Miller s general capital structure theory as it releases two assumptions in MM s perfect world: no bankruptcy cost and no tax incentive assumptions. Pecking Order Theory Myers (1984) develops an alternative theory known as the pecking order model of capital structure. Compared with the trade-off theory, this model assumes that managers do not attempt to maintain a particular optimal capital structure. In fact, there is a hierarchy when firms make their financing decisions: they prefer internal financing (retained earnings) to external financing, and if they have to finance externally they will prefer debt to equity. The reason they choose retained earnings first is that it involves few transaction costs and requires no additional disclosure of financial information about the firm s investment opportunities and potential profits. More specifically, when using external funds, the preference is to use the following order of financing sources: safe debt, risky debt, convertible securities, preferred stock, and common stock. Since only common stockholders hold the right in the management, this financing preference reflects manager s incentive to retain control of the firm and the willingness to avoid the negative market reaction to an announcement of a new equity issue. Narayanan (1988) and Heinkel and Zechner (1990) obtain similar results to Myers with the conclusions: i) firms should issue less risky securities over more risky ones; ii) debt should be used in preference to equity; iii) internal finance should be used in preference to external finance. However, the pecking order hypothesis cannot explain everything. Some economists cast doubt on this theory based on the evidence that there are plenty of examples of firms issuing stock when they could issue debt. Brennan and Kraus (1987), for instance, conclude that firms do not necessarily have a preference for issuing straight debt over equity. While looking at aggregates, managers heavy reliance on internal finance is clear. This can be understood as the result from the separation of ownership and control: managers try to avoid the reliance on external finance because it would subject them to the discipline of the capital market. 9

10 Asymmetric Information Theory Theories based on asymmetric information assume that firm managers and insiders possess private information about the firm s characteristics of return stream or investment opportunities that are rarely known by outside investors. Myers and Majluf (1984) state that if investors are less well-informed than current firm insiders about the value of the firm s assets, and if firms are required to finance a new project by issuing equity, an underpricing problem will occur. This problem may be so severe that new investors capture more than the NPV of the new project, resulting in a net loss to existing shareholders. Since theories under information asymmetry assume that managers act on the interests of existing shareholders, the managers may even forgo a positive-npv project if it would require the issue of new equity. This is because the new equity issue would give much of the project s value to new shareholders at the expense of the old. In this case, the underinvestment problem will occur. While it can be avoided if the firm can finance the new project by using a security that is not so severely undervalued by the market. Debt is such kind of security. Another framework under asymmetric information argues this issue from the perspective of signalling with debt. Ross (1977) regards debt level as a signal to the outside investors about the information of the insiders. In his model, the investment decision is given, managers benefit from a higher market value and are penalized in the case of bankruptcy. The expected bankruptcy costs of debt are higher for low quality firms as a default is more likely to happen when the debt ratio is increased. Therefore, high quality firms will signal their quality by issuing debt while low quality firms may not mimic this because of the expected bankruptcy costs. This literature then summarizes that debt ratio is positively related to the quality of firm. Agency Costs Based Theory A significant fraction of the research effort on capital structure over the last 10 years has been devoted to agency costs models. Research in this area was initiated by Jensen and Meckling (1976), who developed two well-known predictions. Firstly, leverage mitigates agency problems that arise from the conflicts between managerial behaviour and the interests of shareholders. Secondly, leverage aggravates the agency conflicts between bondholders and shareholders. 10

11 Shareholder manager conflicts These kind of conflicts stem from the separation of ownership and control, and it mainly takes two distinct forms: i) divergent from the shareholder s interest of firm value maximization. According to Jensen and Meckling (1976), managers have incentives to exert less effort and to have greater perquisite levels such as luxurious office and corporate jets. ii) overinvestment problem. Argued by Jensen (1986), managers prefer to increase firm s size to enjoy the benefit of control. They have incentives to accept the negative NPV projects and let their firm grow beyond the optimal size. These two kinds of conflicts between the shareholders and managers can be mitigated by increasing the debt level because debt increases the risk of bankruptcy and limits the free cash flow that managers can waste on the perquisites or on the negative NPV projects. Shareholder bondholder conflicts The typical phenomenon of these conflicts is that the shareholders make decisions that will transfer wealth from the bondholders to themselves. Three potential conflicts can be distinguished: direct wealth transfer, asset substitution, and underinvestment. In the case of direct wealth-transfer conflicts, argued by Smith and Warner (1979), shareholders can increase their wealth at the expense of bondholders interests by increasing the dividend payment. The asset substitution problem means that the firm have the incentive to substitute projects that have higher risk for current projects. The reason is that if it succeeds the return above the face value of debt will be owned by shareholders and in case of failure, the consequence will be mainly born by the bondholders because of shareholders limited liability (Jensen and Meckling (1976)). In terms of underinvestment problem, Myers (1977) states that the overhang of debt decreases the shareholders incentives to invest in new projects (even projects with high growth opportunities will be passed through) because the profits from these projects will be exhausted in debt repayment. One way to minimize these conflicts is that firms with high growth opportunities should have lower leverage than firms in more mature industries. The conflicts can also be mitigated by adjusting the properties of the debt contracts, for example, the involvement of covenants that have restrictions on the dividends payment or on the disposition of assets. Alternatively, debt can be 11

12 secured by collateralization of tangible assets in the debt contracts, as discussed by Stulz and Johnson (1985). 2.2 Empirical Evidence on the Determinants of Capital Structure Most of the empirical evidence on capital structure comes from studies of the determinants of corporate debt ratios and studies of issuing debt vs. equity financing choice. The early studies focus on the analysis of firm-specific variables as the determinants of capital structure, whereas recently some efforts are also made on the institutional or country-specific characteristics and try to explore if they have some explanatory power in the capital structure decisions across countries. In this subsection, I ll present some of the important empirical studies. Firm- Specific Variables Previous studies have shown that a number of firm characteristics, such as profitability, growth opportunities, size, tangibility, tax rate, non-debt tax shields, and volatility etc., affect firms capital structure choices. Under the trade-off theory, higher profitability implies more debt-serving capacity and lower expected financial distress costs, therefore a higher debt ratio will be anticipated. With regard to firm size, it predicts that large firms are likely to be more diversified and less prone to bankruptcy, and hence they are expected to employ a higher amount of debt than small firms. Trade-off theory regards growth opportunities as a proxy of financial distress, and hence firms with high growth opportunities should borrow less. Tangible assets can support debt claims because creditors can assert their rights over these assets in a default. Thus, a positive relationship between leverage and tangibility is expected. The tax effects on financing decisions are examined following the nondebt tax shields argument of DeAngelo and Masulis (1980). They argue that firms can use other non-debt tax items such as depreciation, tax credit and pension funds to substitute the interest deduction associated with debt. Therefore, firms with larger non-debt tax shield are expected to use less debt. These ideas have been developed in many papers, including DeAngelo and Masulis (1980), Bradley, Jarrell and Kim (1984) and more recently Barclay and Smith (1999). However, it has long been questioned empirically. For instance, Ferri and Jones (1979), Long and Malits (1985), 12

13 and Harris and Raviv (1991) support the view of the positive association between leverage and fixed assets, non-debt tax shields, growth opportunities, firm size, and the negative relationship between leverage and profitability, volatility, advertising and R&D expenditures, bankruptcy probability, and uniqueness of the product. Bowen et al (1982), and Kim and Soresen (1986) provide evidence on the negative relationship between the non-debt tax shields and leverage. According to the pecking order theory, the highly profitable firms might be able to finance their growth by using retained earnings, and thus should have low debt ratio. Most of the empirical studies prove that. In terms of growth opportunities, the pecking order theory concludes that growing firms with strong needs can only get short-term debt because of the information asymmetries. However, if these firms have a close relationship with banks, then the information asymmetries will be less severe, and those firms can also get long-term debt. Empirically, Michaelas et al (1999), and Bevan and Danbolt (2002) find short-term debt to be positively related to growth opportunities. Rajan and Zingales (1995) find a negative relationship between growth opportunities and leverage. With regard to the information asymmetry theory, Krishnaswami et al (1999) analyze the impact of information asymmetries on firms debt structure, confirming that firms operating under a greater degree of information asymmetry with favourable future profitability rely more on private debt. Petra (2002) examines how asymmetric information between corporate insiders and lenders influences debt maturity structure by using a sample of 457 US firms. His findings imply that firms with high asymmetric information rely significantly more on short-term debt. Another research on this issue is done by De Jong and Van Dijk (2002), who study how the information asymmetry determines capital structure choice of Dutch firms through private questionnaire information acquired from insiders. Agency costs theory suggests that growth opportunities aggravate the underinvestment problem and increase the bankruptcy costs. Therefore, this theory predicts a negative relationship between growth opportunities and leverage. Smith and Watts (1992) provide empirical evidence, using US data, that confirm this negative relationship. Titman and Wessels (1988) also estimate a negative association between leverage and R&D expenses, which are frequently regarded as a proxy for growth 13

14 opportunities. They also find that small firms with large intangible assets have low debt levels. Mao (2003) studies firms with high growth opportunities, and confirms there is a significant and positive relationship between leverage and marginal volatility of investment. Table 1 summarizes the firm-specific determinants and their theoretical predicted signs with leverage. Insert Table 1 here Country-Specific Variables In the previous paragraph, I present the empirical studies that investigate the effect of firm characteristics on their financing choices. Although these early studies differ in the sample countries or in the regression models, they share one thing in common: they only take the firm-specific variables, such as profitability, tangibility and size etc., as the determinants of capital structure decisions. As the results vary and sometimes even contradict across countries, following studies try to explore the impact of some country related factors. In other words, later empirical studies expand the explanatory variables to include country-specific factors, and try to find out if the institutional traditions have some power in explaining these differences of financing decisions across countries. In these studies, four categories of institutional traditions are generally investigated: i) Legal institutions: Common Law vs. Civil Law. ii) Financial systems: market-based vs. bank-based system. iii) Corporate governance systems: Anglo-American vs. relation-based system. iv) Macroeconomic factors: GDP per capita and inflation rate, etc. Next, I ll present several notable studies that make research on the association between leverage and country-specific variables. Demirguc and Maksimovic (1996) empirically analyze the relationship between firm capital structure decisions and the level of stock market development in 30 developing and developed countries for the period They find a significantly negative correlation between the level of stock market development and both of long-term and short-term debt to equity ratios. In developed markets, further development in stock markets will cause the substitution of equity for debt financing. While in developing markets, they argue that large firms become more leveraged as the stock market 14

15 develops, small firms by contrast appear not to be significantly affected by market development. Later, in Demirguc and Maksimovic (1998), they include the legal system in the analysis of the country-specific variables and investigate how differences in legal and financial systems affect firms use of external financing to fund growth. They show that in countries whose legal systems score highly on an efficiency index, a greater proportion of firms use long-term external financing. With regard to the development of financial markets, they conclude that a large banking sector and an active stock market (though not necessarily large) are associated with external financing to fund firm growth. In 1999, they wrote another paper (Demirguc and Maksimovic (1999)), but this time they focus on the examination of the effect of legal and financial systems on debt maturity instead of on internal vs. external financing decisions. After comparing the capital structure choices of large firms with small ones, they conclude that in countries with active stock markets, large firms use more long-term debt. In countries with a large banking sector, by contrast, the debt of small firms appears to have longer maturity. They also find other macroeconomic factors that play some roles when firms make their financing decisions. For example, government subsidies to industry are positively related and inflation is negatively related to the use of long-term debt. Booth et al (2001) use a sample of 10 developing countries to analyze whether capital structure theory is portable across countries with different institutional traditions. After comparing the different legal and ownership structures across the sample countries, they provide evidence that the capital structure decisions are affected by the same firm-specific factors as in developed countries. They also notice that although some of these variables have the expected signs, their overall impact is low and the signs sometimes vary across countries. Therefore, they assume these differences may indicate that some specific country factors are at work. In order to test their inference, in the next step they use country dummies as the sole independent variables to analyze the effects of country-specific determinants. They then conclude their paper with the findings that although some of the insights from the capital structure theory are portable across countries, much remains to be done to understand the impact of different institutional traditions. 15

16 Gabrielle Wanzenried (2002) compares the capital structure determinants in UK and Continental Europe from 1988 to 1998 based on the fact that they follow different corporate governance systems. His study differs from the earlier ones because it considers the issue within a dynamic framework. He analyzes the short-term and longterm adjustment processes and relates them to firm-specific and system-specific characteristics. The results suggest that the size and the liquidity of stock markets as well as the stability of the economic environment are important determinants of the adjustment financing behaviour over time. Rataporn et al (2004) contribute to the capital structure literature by investigating the determinants of capital structure of firms operating in four Asia Pacific countries with different legal, financial and institutional environments. Like Booth et al (2001), Rataporn et al also first test the firm-specific determinants and find some significant differences between the sample countries. These differences confirm that managerial decisions may be affected by country-specific considerations. This inference is supported by the findings following the introduction of country-specific variables. The results suggest that the capital structure decision is not only the product of the firm s own characteristics but also the result of the corporate governance, legal framework and institutional environment of the countries in which the firm operates. 2.3 Market-based vs. Bank-based System Major tasks of financial markets include mobilizing resources for investment, selecting investment projects to be funded, and providing incentives for the monitoring of the performance of the funded investments. A large body of theoretical and empirical research analyzes how these tasks are performed in a market-based system and in a system where banks and other financial intermediaries play a major role. As explored by Allen and Gale (1999), stock markets and banking sectors have comparative advantages in selecting different types of investment projects. In this subsection, I will compare the differences between these two financial systems and their possible influences on capital structure choices. In a market-based system, firms raise funds mainly in capital markets and banks play a less important role and sometimes act as the lenders as a last resort. However, the 16

17 impacts of a large stock market on capital structure are mixed. On one hand, large stock markets provide entrepreneurs with opportunities to diversify their portfolios. Thus, in countries with developed stock markets there may be an incentive for firms to substitute equity for long-term debt. In this case, a developed stock market is expected to be negatively associated with long-term debt ratio. This relation is confirmed by Rataporn et al (2004), who provide evidence that as stock market activity increases, firms preference for equity over debt increases as well. On the other hand, the existence of a developed stock market may increase the firms ability to obtain long-term credit. This can be explained from the point of view that stock markets also transmit useful information to the creditors. Grossman (1976), and Grossman and Stglitz (1980) demonstrate that prices quoted in stock markets at least partially reveal information that more informed investors possess. In this case, the revelation of information may make the lending to a publicly quoted firm less risky, and hence a positive correlation between the development of stock markets and firms debt capability is expected. Just now I stated that the development of stock markets could influence firm s debt ratios either in a positive or in a negative way. Demirguc and Maksimovic (1996) confirm both of the opposite effects in their analysis of developed and developing markets. Their results suggest that in developed markets there is a negative correlation between development of stock markets and long-term debt ratio, indicating that in economies with more developed stock markets, further stock market development leads to a substitution of equity for debt financing. While in countries with developing stock markets, they find a positive relationship that firms debt-equity ratios increase with an increase in stock market size and activity. In a bank-based financial system, banks play a leading role in allocating financial resources and providing most of the credit to the economy. Daimond (1984) argues that banks or other financial intermediaries have economics of scale in obtaining information. They may also have greater incentives to use the collected information to discipline the borrowers. Thus, the author suggests a developed banking sector will facilitate access to external financing, and larger financial intermediaries are expected to have a positive effect on firms leverage. According to Allen and Gale (1999), significant differences exist in outcomes between systems in which financial 17

18 intermediaries (like banks) play the dominant role and those where they do not. They argue that banks and stock markets can have a comparative advantage in selecting different types of investment projects. A developed banking sector leads to an increase in the availability of short-term financing, since this form of financing enables intermediaries to use their comparative advantage in monitoring. Demirguc and Maksimovic (1999) present different empirical results by studying firms with different sizes in 30 developing and developed countries. They find that in countries with large banking sectors, small firms have less short-term debt. When it turns to large firms, they fail to find a significant relationship between the size of banking sectors and debt ratio. 3. Research Design and Data Selection The sample consists of four market-based and six bank-based economies in Europe for the period The study period is chosen to be recent to gain an insight of current aspects of capital structure across the two financial systems. The countries are selected because they are all developed countries in the European area with similar levels of economic development while following different financial systems. To distinguish the sample countries, I use the criteria in Demirguc and Levine (1999), who construct a conglomerate index of financial structure based on the characteristics of the financial sectors and classify countries according to the relative development of stock markets to banking sectors. In their study, countries that have above the mean values of conglomerate structure index are regarded as market-based and countries that have below the mean values of structure are classified as bank-based. Following their classification, UK, Sweden, the Netherlands, and Switzerland belong to the market-based financial system, while Germany, France, Italy, Spain, Finland and Norway follow the bank-based system. Table 2 presents the level of economic and institutional development across these sample countries. Insert Table 2 here 18

19 In this empirical study, I first explain the firm s capital structure by a set of firm specific variables as outlined below. This procedure mainly reflects the standard approach in the previous literature. 4 In addition to the firm specific variables, I also consider country specific aspects with an attempt to capture the effects of the financial markets development on firms capital structure choices. 3.1 Dependent and Independent Variables Dependent Variables This thesis employs three measures of book value leverage: total debt to assets, longterm debt to assets, and short-term debt to assets. The choice for a book value measure of leverage above market value is mainly because market values are too volatile to be used as a measure. Many early studies also show that financial executives consider capital structure choice in book value rather than market value terms Independent Variables Firm-specific Variables Profitability Theoretical predictions yield no consistent conclusions for the correlation between profitability and leverage. Trade-off model argues that higher profitability implies lower expected costs of financial distress, therefore more profitable firms should use more debt. While the pecking order theory suggests an inverse relationship because firms are assumed to prefer internal financing to external financing, and hence they use retained earnings first. In this case, profitability is expected to have a negative relationship with debt ratio. Most of the empirical results are consistent with the pecking order theory. In this study, I use return on assets (defined as earnings before interests and tax over total assets) as a proxy for profitability. Size It is generally agreed that size is positively associated with leverage. According to the trade-off model, size may be an inverse proxy for the probability of bankruptcy 4 I exclude the Non-debt tax shields variable because of the insufficient data on most of the sample countries. 19

20 because large firms are usually more diversified and have a more stable cash flow. And because of the advantage of economies of scale and bargaining power with creditors, large firms bear lower costs in issuing debt compared with small firms. In asymmetric information theory, size is also regarded as an inverse proxy for information asymmetry between insiders and outsiders. Fama and Jensen (1983) argue that larger firms provide more information to the outside investors than smaller firms, and because of the lower information asymmetry, larger firms are expected to have easier access to the debt market and borrow at a lower cost. To capture the size effect on firm s leverage choice, I use the natural logarithm of sales as a proxy of size. Growth Opportunities Trade-off theory predicts that higher growth opportunities lead to higher costs of financial distress, and less debt is therefore used. Agency costs theory also assumes a negative relationship between growth opportunities and leverage. In an underinvestment situation, firms with high growth opportunities may forgo positive NPV projects because of the existing outstanding debt. They fear that the returns from such investments will be transferred to debtholders rather than shareholders. In case of overinvestment, debt limits the agency costs of managerial discretion so that firms with high growth opportunities may not ask for loans in the first place. The change rate of sales is adopted to measure growth opportunities. Tangibility Theories generally state that tangibility is positively related to debt ratio. According to the trade-off theory, since the tangible assets can be used as collateral in debt financing, the presence of a large fraction of tangible assets helps to get bank loans at a lower interest rate. Therefore, trade-off theory predicts that companies that have more tangible assets use more debt. On the other hand, tangible assets help to reduce the risk the lender suffers from the agency costs of debt. Jensen and Mecking (1976) point out that agency costs of debt exist as the firm may shift to riskier investment after the issuance, which is called the asset substitution problem. Since the debts can be secured by the collateralization of tangible assets, the firm s opportunity to engage in asset substitution is reduced by the presence of a large fraction of secured debts. 20

21 Hence, a positive relationship is expected. In this study, tangibility is defined as the book value of property, plants and equipment (PPENT) scaled by total assets. Tax Rate The effect of tax rate on leverage is rather mixed. On the one hand, as the interest on a loan is tax-deductible, firms with higher taxable income have an incentive to use more debt to benefit from tax-shield gain. In this case, a positive relationship between the tax rate and leverage ratio is expected. On the other hand, higher tax rate also reduces internal funds and increases the cost of capital. Therefore, a negative relationship is expected. The tax rate item can be derived directly from Compustat to use as a proxy. The averages for leverages and firm characteristics on a country level are reported in Table 3. Insert Table 3 here Indicators Measuring the Development of Financial Markets As this paper mainly tests the differences between firms financing choices in marketbased and bank-based systems, with regard to the country-specific factors, I focus on the influence of financial markets development instead of testing other institutional factors such as the legal and ownership traditions. In the absence of a theory on financial markets development, I use empirical indicators to measure the level of development of stock markets and banking sectors. Specifically, the development of financial markets can be measured by the size, activity and efficiency of stock markets and banking sectors. Market Capitalization Ratio Market capitalization ratio, which equals the value of domestic equities listed in domestic exchanges divided by GDP, is a measure of stock market size. The assumption behind this measure is that the overall size of a stock market is positively 21

22 correlated with its ability to allocate capital to investment projects and to provide significant opportunities for investors to diversify the risk on an economy-wide basis. Total Value Traded Ratio I use the total value traded ratio to measure the activity of stock markets. It equals the value of domestic equities traded in domestic exchanges divided by GDP. This ratio complements the market capitalization ratio in the way that although the stock markets might be large, there may be little trading, and thus the value traded ratio might be low. According to Demirguc and Maksimovic (1996), stock market development plays an important role in firms financing choices. As the activity increases, firms preference for equity over debt also increases. In this case, stock market activity is expected to be inversely related to leverage. Turnover Ratio The turnover ratio is used to measure the efficiency of the stock markets and is defined as the value of total shares traded divided by the market capitalization. To put it in another way, it measures the value of stock market transactions relative to the size of the market. Higher value of turnover indicates a higher level of liquidity and lower transaction costs, and thus increases the incentives for investors to become informed. Therefore, a high turnover ratio facilitates external monitoring of corporations. The turnover ratio complements the market capitalization ratio in that a large but inactive market will have a large market capitalization ratio but a small turnover ratio. It also complements the total value traded ratio. While the total value traded captures the trading relative to the size of the economy, turnover measures the trading relative to the size of stock markets. A small, liquid market will have a high turnover ratio but a small total value traded ratio. Bank Assets Ratio Bank assets ratio is calculated as the share of the total domestic assets of deposit money banks divided by GDP. This ratio provides a measure of the overall size of the banking sector in relation to the economy as a whole. Past studies have used this 22

23 indicator to examine the effect of financial sectors on the growth of the economy. (See, King and Levine, 1993). Bank Credit Ratio Bank credit ratio equals the value of deposit money bank credits to the private sector as a share of GDP. This ratio is a general indicator of the activity of banking sectors. Overhead costs Early studies provide two indicators measuring the efficiency of banking sectors. One is overhead costs, defined as the ratio of bank overhead costs to the total assets of the banks. A lower overhead cost is interpreted as a sign of greater efficiency, and excessive overhead expenditures may reflect waste and a lack of competition. The second measure of bank efficiency, bank net interest margin, equals the bank interest income minus interest expense over total assets. Tighter interest margins are frequently viewed as representing greater competition and efficiency. In this study, I choose to use the first indicator due to the easier access to the data on overhead costs. Table 4 summarizes the definitions of dependent and independent variables. Insert Table 4 here 3.2 Data Description and Sample Selection Data on firm characteristics are extracted from COMPUSTAT database over the years The data include total debt to total assets, long-term debt, short-term debt, total assets, total sales, book value of equity, property, plant and equipment (PPENT), earnings before interest, tax and depreciation. Financial firms such as banks and insurance companies are excluded from the sample, as their financial characteristics and use of leverage are substantially different from other companies. The original samples for bank-based and market-based countries consist of 1675 and 1406 firms respectively. After removing the firms with debt ratios exceeding 100 percent, the final data set contains 1443 firms from bank-based systems and 1152 firms from market-based systems. All data measuring the development of financial markets are derived from the World Development Indicators of World Bank and IMF. 23

24 4. Empirical Model and Results In this thesis, the firm-specific variables accomplish two objectives. On the one hand, they allow me to test if significant differences exist between firms financing choices across different financial systems. On the other hand, if significant differences do exist, then these firm characteristics work as control factors in a second model to investigate the impact of the development of financial markets. Accordingly, a twostep model is used to achieve these objectives. In the first step, all the firm-specific data of the whole sample countries are pooled into one OLS model to analyze their relationship with debt ratios. To capture the differences between capital structure decisions across systems, a dummy variable is used. By investigating the interaction effects, the dummy variable enables me to test if the impact of each firm-specific variable on leverage is different significantly across systems. If these differences are confirmed, it will be expected that some market factors may be at work. Therefore, in a second step I expand the independent variables to include indicators that measure the development of financial markets and try to find out if they add some power in explaining the significant differences. In order to combine firm-specific factors with financial markets variables in one model, I average the leverages and all the firmspecific variables in each country in each year. By doing so, it can also provide a sufficient number of observations compared to the previous studies that average all the data across the whole sample period. 4.1 Model 1: Firm-specific Determinants of Capital Structure Regression Model In this model, I use pooled OLS 5 regressions to analyze the statistical relationship between leverage and firm-specific variables. Here I use a system dummy variable to classify the firms from market-based systems with firms from bank-based economies. 5 Here I choose to use pooled OLS instead of fixed-effects estimates because I fail to get the regression results from the latter one. This may due to the large number of observations (2695 firms each across 4 years) or to the use of dummy variable in this model. 24

25 As the data are from four years, three year dummies are also used to control the year effects. The estimated regression model is specified in Equation (1): D i,c,t =α 0 + β X i,c, t +θdm+ ϕ X i,c, t DM + γ YearDM +ε i,c,t Equation (1) - D i,c,t represents three measures of dependent variables. They are total debt / total assets ratio, long-term debt / total assets ratio and short-term debt / total assets ratio. The sub-indexes i, c, t stand for firm, country, and time respectively. - β X i,c, t captures the main effect of firm-specific variables. They are: profitability, growth opportunity, tangibility, size and tax rate. k=1, 2, 3, 4, 5. - DM is a system dummy variable, and it takes the value 1 for all firms in bank-based economies and 0 otherwise. X i,c, t - ϕ DM stands for the interaction term and if the coefficient is significant, then I have confidence to say that the corresponding firm-specific variable has different effects on leverage across systems. - γyeardm effects. are three year dummies (2001, 2002 and 2003) to control the year - ε i,c,t is the random error term for firm i in country c at time t. More specifically, Equation (1) can be interpreted as: D i,c,t =β 0 +β 1 Profitability i,c,t +β 2 Growth opportunities i,c,t +β 3 Size i,c,t +β 4 Tangibility i,c,t +β 5 Tax rate,c,t +β 6 DM +β 7 Profitability i,c,t DM+β 8 Growth opportunities i,c,t DM +β 9 Size i,c,t DM+β 10 Tangibility i,c,t DM + β 11 Tax rate i,c,t DM +β 12 Year 03 DM+β 13 Year 02 DM+β 14Year 01 DM +ε i, c, t Equation (2) Based on the theoretical predicted signs of firm-specific determinants reported in Table 1, I establish 2 sub-hypotheses as follows: 25