The determinants for the capital structure choice of United States firms compared to United Kingdom firms

Transcription

1 The determinants for the capital structure choice of United States firms compared to United Kingdom firms Supervisor: P.H.M. Geiler Mphil MSc Second Supervisor: Drs. J. Grazell G.A. Hendriks (Gerben) Anr: Business Administration Bachelor Thesis 1 P a g e

2 1. Introduction On the first of May 2011, the president of the Dutch Central Bank and board member of the European Central Bank, Dr. A.H.E.M. Wellink, has spoken at Tilburg University. During this meeting Wellink gave his view on the problems for countries and financial institutions. After several financial institutions also some European countries had to be saved with government money last year. The countries and the financial firms had too much debt compared to equity and could therefore not fulfill their liabilities. In the interview Wellink stated that there is a change that some European countries could not pay their complete loans back in the future. This has several reasons but an important one, according to Wellink, are there difficulties in the future. This difficult prospect is not only for countries and financial firms but also for nonfinancial firms. In this paper, the focus lies on the non-financial firms and their capital structure. This raises questions like; why do companies have debt? How do they determine the level of debt? What are the factors that influence the amount of debt for a company? Beside these questions this paper also show a comparison between the factors which are used in the United States (US) and the United Kingdom (UK). The goal of this paper is to explain why an optimal capital structure is important for nonfinancial firms. Besides this aim, the paper also gives answers to the question of non-financial US firms make their decisions based on the same determinants as UK firms. When Modigliani and Miller (MM) in 1958 came with their celebrated paper The Cost of Capital, Corporation Finance and the Theory of Investment 1 they make a big step forward in the academic view of capital structure. MM stated which conditions capital structure has no influence on the value of a company. After this first proposition, MM follow with other propositions which explain why an optimal capital structure is important for the value of a company. Besides the MM propositions there are also other theories about capital structure of a company, the most important theories about capital structure are; The Trade-off Theory of Kraus and Litzenberg (1976), Agency Costs of Jensen and Meckling (1973), and the Pecking Order Theory of Myers (1984). All these theories explain the importance for a company to pay attention in order to their capital structure to maximize company value. The trade-off theory of Kraus and Litzenberg (1973) describes the trade-off a company has to make about the tax advantages of debt against the bankruptcy costs. The agency cost arises when there is a conflict of interest 1 Rajan and Zingales 1995 (pp. 1) 2 P a g e

3 (between the shareholders and stakeholders). This could lead to a capital structure different to the capital structure which maximizes the company value. The pecking order theory states that the amount of debt is not driven by the costs and benefits of debt but by the firm s net cash flow (cash earnings minus investment outlays). Following Rajan and Zingales (1995) and Bevan and Danbolt (2004), four key independent variables are adopted: the market-to-book ratio (as a proxy for growth opportunities), the natural logarithm of sales (as a proxy for company size), profitability, and tangibility (calculated by the ratio of fixed assets to total assets). 3 These variables are all significant for non-financial US firms and are tested for non-financial UK firms. The results of the tests are not fully clear about the influence of the factors on capital structure. The company size determinant is the only factor which is the same for US and UK firms. The other factors are not clear enough to make statements about it. This is in line with the academic research of the other three factors. Currently, the academic research is not fully clear about the influence of these factors on the capital structure choice of companies. More research for this part is called for. However, when the tests is not only done for a single year but for a longer time horizon, from 2002 until 2010, similarities between the US and the UK occur. The construction of the paper is as follows. Chapter two is a theoretical looking at capital structure and explains why capital structure is important for companies. In addition, a theoretical background of the tested factors is provided. Chapter three gives an explanation about the data and methodology. In chapter four the test results are evaluated. In the last chapter, the conclusion, limitations and recommendations for further research will be discussed. 3 Bevan and Danbolt 2004 (pp. 56) 3 P a g e

4 Chapter 2 Capital Structure 2.1 What is Capital Structure? There are several definitions about capital structure used in the academic world. The starting point is that capital structure is the ratio of debt and equity of the total company value. Nevertheless, there are several ways to calculate the capital structure of a company and these different calculations bring some nuance differences in the academic world. Aghion and Bolton (1992) have focused on the question whether a firm can fulfill his obligations. They calculated this as a means of transferring control when the firm is economically distressed, from shareholders to bondholders. This is not one of the best ways to calculate the capital structure, because the calculation looks at the fact if the firm can make his fixed payments instead of the ratio of debt to equity. According to Rajan and Zingales (1995) a better way of calculating the capital structure is using the ratio of total liabilities to total assets. This is also not the most optimal calculation, because it is not clear if the company is at risk in the near future. However, it is a good indication of the capital structure and for shareholders to see what is left in case of liquidation. Another way of calculating the capital structure is using the ratio of debt to total assets, but also this method has some disadvantages. This calculation pays no attention to the fact that there are some assets which are influenced by specific non debt liabilities. This paper will follow the same calculations as Rajan and Zingales (1995), which is probably the best proxy for capital structure. To calculate the capital structure is the ratio of total debt divided to capital, where capital is the sum of total debt plus equity. With this kind of calculations there are less influences of trade credit or factors that have nothing to do with finance. When the ratio of total debt to net assets is used, there is a possibility that there is some influence of factors which have nothing to do with finance. An example of this, are the pension liabilities which are held against the assets. 2.2 Capital Structure theories There are several theories about capital structure. The historic basic point of the capital structure surveys review is the Modigiliani and Miller paper (1958) with their capital structure irrelevance proposition. This was the first paper about capital structure which was generally accepted as a theory about capital structure. 4 MM start their paper with referring 4 Murray and Vidhan 2007 (pp. 5) 4 P a g e

5 to the market-value approach. One of the consequences of this approach, is that a firm acts rationally. There are two criteria of rational decision making to follow for a firm; (1) the maximization of profits and (2) the maximization of market value. Next to this approach, any investment project and its corresponding financial plan must pass only the following test: Will the project raise the market value of the firm s shares? If so, it is worth undertaking; if not, its return is less than the marginal cost of capital to the firm. 5 These academic results are not strong enough to convince MM, they were not completely satisfied with the marketvalue approach and they tried to make their own model. Before MM begin with explaining their model they make some assumptions about the world 1) No corporate or personal taxes, 2) no transactions costs, 3) symmetric information, 4) no cash margin requirement on short sales, 5) perfect capital markets, and 6) no bankruptcy possibilities. Through these assumptions MM proof that the capital structure of a company has no influence on the company value. So, it makes no difference for the company value if there is more debt or more equity. MM also formulate another proposition in their paper of 1958, called proposition 2. The equation of this proposition is: (1) Re= Ra+ (Ra- Rd)D/E This proposition explains why the costs of equity Re the expected rate of return demanded by equity investors increases with the market-value debt-equity ratio D/E. The rate of increase depends on the spread between the overall costs of capital Ra and the cost of debt Rd. 6 This explains that a company does not choose for cheaper debt instead of expensive equity, because this makes the remaining equity even more expensive. According to Stiglitz (1969) the MM theorem, proposition 1, holds under much more general conditions than those assumed in their original study. The validity of the theorem does not depend on the existence of risk classes, on the competitiveness of the capital market, or on the agreement of individuals about the probability distribution of outcomes. Stiglitz (1969) states that there are two assumptions important for the proof; (1) individuals can borrow at the same market rate of interest as firms and (2) there is no bankruptcy. Miller (1988) stated that; We first had to convince people (including ourselves!) that there could be any conditions, even in a frictionless world, where a firm would be indifferent between issuing securities as different in legal status, investor risk and apparent cost as debt and equity. Remember that interest rates on corporate debt were then in the 3 to 5 percent range, with 5 Modigliani and Miller 1958 (pp. 264) 6 Myers 2001 (pp. 85) 5 P a g e

6 equity earnings / price ratios - then the conventional measure of the cost of equity capital running from 15 to 20 percent. 7 Miller (1988) developed proposition 2, which showed that when proposition 1 (the irrelevance theorem) holds, the cost of equity capital is a linear increasing function of the debt/equity ratio. Several gains came from using more of what might seem to be cheaper at that moment; debt capital would thus be offset by the correspondingly higher cost of the now riskier equity capital. The MM propositions implied that the weighted average of these costs of capital to a firm would remain the same no matter what combination of financing sources the firm actually chose. The first criticism on the paper of MM (1958) came from David Durand (1959). Durand stated, though not proved, that investors might ignore the firm s then-existing capital structure and first price the whole firm by capitalizing its operating earnings before interest and taxes. Miller (1988) gave a reaction on this comment, namely that the value-invariance proposition 1 was in a sense only the application of the macroeconomic intuition on the microeconomic of corporate finance; the arbitrage proof they gave for proposition 1 was just the counterpart at the individual investor level of the consolidation of accounts, and the washing out of the debt/equity ratios at the sector level. In fact, at one side of our arbitrage proof are the investors which use arbitrage doing exactly the washing out of the debt/equity ratio at the sector level. Miller wants to make clear that what Modigliani and he did in 1958 created knowledge about macroeconomic use for the microeconomic in this particular case for corporate finance. Miller (1988) also proposed that if levered firms were undervalued relative to unlevered firms, our arbitrager was ask to undo the leverage by buying an appropriate portion of both the levered firm s debt and its shares. On a consolidated basis, the interest paid by the firms cancels out against the interest received and the arbitrager owns a pure equity stream. Unlevered corporate equity streams could in turn be re-levered by borrowing on an individual account if streams ever sell at a discount relative to levered corporate equity. This possibility of homemade leverage by individual investors provided the second and completing part of the arbitrage proof of value invariance. One of the most used criticism against proposition 1 is the question if investors could react quickly enough and complete enough to make the proposition useful (Miller, 1988). So, could the investors wash out the debt/equity ratios at sector level? There is no clear answer to this; MM stated that it was not their goal to show that companies do not have to look at their capital structure. At the individual firm level it is recommendable to look carefully at the capital 7 Miller 1988 (pp. 100) 6 P a g e

7 structure, because there have to be several things taken into account, like the costs of other financial alternatives. There are a lot of assumptions made about the world in the paper of MM 1958, for example taxes. The taxes did not exist in the world of proposition 1. In 1963 MM published a new paper, called; Corporate Income Taxes and the Cost of Capital: A Correction. This paper incorporated corporate taxes into the model and explain what the consequences are of the capital structure choice of companies. By allowing corporate tax in the model there is a possibility of an interest tax shield. This means that a company which pays an extra dollar of interest, gets a partially offsetting, the interest tax shield, in the form of lower tax paid. This interest tax shield can be very large for a company and therefore is very attractive. MM (1963) assumed that the debt is fixed and permanent with a corporate tax rate of 35 percent. So, for a loan of one million the NPV would be 0.35 million. A company could also use larger loans for the interest tax shield. This makes the NPV even higher. According to Myers (2001) these calculations are now referred to as remote upper limits. Myers thinks it is not always the case that a company has a positive NPV by corporate taxes for three reasons. First, the firm may not always be profitable, so the average effective future tax rate is less than the statutory rate. Second, debt is not permanent and fixed. Investors today cannot know the size and duration of future interest tax shields. Third, the corporate-level tax advantages of debt could be partly offset by the tax advantage of equity to individual investors, such as, the ability to defer capital gains and then to pay taxes at a lower capital gains rate. The tax rate on investors interest and dividend income is higher than the effective tax rate on equity income, which comes as a mixture of dividends and capital gains. 8 In 1973 Kraus and Litzenberger introduced the trade-off theory of capital structure. Kraus and Litzenberger allowed bankruptcy costs in the model of MM. As a consequence, a company has to make a trade-off between the tax advantages of debt and the bankruptcy penalties. The probability of bankruptcy is higher for companies that hold more debt on their balance sheet than for companies with less debt holdings. This statement also explained why banks want moderate debt ratios. According to Haugen and Senbet (1987) bankruptcy costs are not easily to predict. They stated that bankruptcy costs are not fixed or sure. This makes it difficult to use the trade-off theory, because one side of the trade is not predictable very precisely. Myers (1984) introduced the static tradeoff framework. This framework states that a firm sets a target debt-to-value ratio and then moves towards it. As mentioned before, the 8 Myers 2001 (pp. 87) 7 P a g e

8 interest tax shield is difficult to predict for the upcoming years, just like the bankruptcy costs are hard to predict. This makes it difficult to use the static tradeoff framework of Myers (1984). Myers and Maljuf (1984) and Myers (1984) formulated the pecking order theory. They assumed perfect financial markets, except for the fact that investors do not know the true value of either the existing assets or the new opportunity. Therefore, investors cannot precisely value the securities issued to finance the new investment. 9 Myers (2001) gives a good summary and guide for the pecking order theory which generally consists of four points: 1) Firms prefer internal to external finance. (Information asymmetries are assumed relevant only for external financing.) 2) Dividends are sticky, so that dividends cuts are not used to finance capital expenditure, and that changes in cash requirements are not soaked up in short-run dividends changes. In other words, changes in net cash shows up as changes in external financing. 3) If external funds are required for capital investment, firms will issue the safest security first, that is, debt before equity. If internally generated cash flow exceeds capital investment, the surplus is used to pay down debt rather than repurchasing and retiring equity. As the requirement for external financing increases, the firm will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. 4) Every firm s debt ratio therefore reflects its cumulative requirement for external financing. According to Myers and Maljuf (1984) managers will avoid external equity when they want to maximize the market value of their company. This is possible when they have better information than outside investors and these investors are rational. The pecking order theory also gives an explanation for the fact that more profitable firms borrow not as much as their less profitable colleague firms. This is because the more profitable firms have more internal funds available. A disadvantage of the pecking order theory is the underinvestment problem. This problem arises when companies reject some projects, which would have added value to the company, for the financing. Not all the researchers make use of the pecking order theory or trade-off theory for signaling debt-to-equity ratios. Brennan and Kraus (1987), Noe (1988) and Constantinides and Grundy (1989) make another conclusion than Myers and Maljuf (1984) Kraus and Litzenberg (1973) 9 Myers 2001 (pp. 91) 8 P a g e

9 and lot of others. They give companies more finance choices which leads to another conclusion. They conclude that firms do not necessarily have a preference for issuing straight debt over equity and that the underinvestment problem can be resolved through signaling with the richer set of financing options. 10 This means that when there are more financial options allowed in the model the underinvestment problem as described before will disappear. The agency costs have also influence on the capital structure choice of companies. These costs arise when there is a conflict of interest. For example; a company has shareholders and directors. The shareholders are the owners of the company and the directors or managers are the people who make the daily decisions. When these people are not the same it is for the directors tempting to spend money at things which are nice for the stature and lifestyle of themselves. For the owners of the company this is not in either case the most optimal investment. Because the shareholders want to control the directors of the company there are some controlling mechanism necessary. The costs that arise to ensure that the directors of the company only focus on maximizing the shareholder value are the agency costs. Jensen and Meckling (1976) identify two types of conflict which lead to agency costs for a company. The first type of conflict they identify is the fact that directors have less than 100% of the shares of the company. As a consequence, a manager does not get the entire gain of the company s profit but the manager does get the whole cost of the activities. In other words, his efforts are only partly paid off in terms of reward. This is why it is interesting for directors to invest in personal benefit locations instead of the company activities. According to Jensen (1986) it is important for the shareholders that there is not a lot of cash available for the managers to invest. When there is lots of cash available Jensen thinks that managers are eager to invest this money in projects that are not in the in best interest of the company. To reduce this problem it is allowed to have debt in the company. Debt ensures that the company spends its cash, thereby reducing the amount of free cash available to the managers. Grossman and Hart (1982) argue in their paper that there is another agency reason for allowing debt in the company, namely to ensure that managers work better in the interest of the company. Jensen and Meckling (1976) argue that there is a tradeoff between the costs of debt against the benefits of debt. Barnea (1985) and Brander and Poitevin (1989) argue in their papers that the agency costs can be eliminated or at least be reduced by the use of managerial inventive schemes and/or more complicated financial securities. An example of a 10 Harris and Raviv (pp. 309) 9 P a g e

10 complicated financial security is the convertible debt. This debt can change in shares, equity, for a price which is fixed and agreed before the convertible bond is issued. According to Harris and Raviv (1991) lenders are aware of the asset substitution effect when there is debt in the company. The consequence of this effect for lenders is that they lose their money in case of a bankruptcy. But when the risky project is profitable, the equity holders get most of the gain. The limited liability makes it more interesting for equity holders to invest in these projects, because most of the risk lies with the debt holders. According to Titman and Wessels (1988) and Harris and Raviv (1991) it is difficult to choose the explanatory variables in the analysis of capital structure. Rajan and Zingales (1995) and Bevan and Danbolt (2002) have chosen four independent variables, such as: the market-tobook ratio (as a proxy for growth opportunities), the natural logarithm of sales (as a proxy for company size), profitability, and tangibility (proxies by the ratio of fixed assets to total assets). The following section provides the theoretical evidence for the choice of these variables. Market-to-book (growth opportunities) Myers (1977) argues in his paper that the amount of debt in the company is related to the growth opportunities for the company. It is important for a company to have enough possibilities to invest in projects which add value to the company. When a company has too much debt it is possible that it has to pass on some interesting projects which would add value to the company. This is because the company has not enough cash or other financing possibilities to finance the project. Myers (1977) stated that lenders are not enthusiastic with providing financing to companies from which the company value is valued by the future investment opportunities instead of the assets in place. Titman and Wessels (1988), Chung (1993), Rajan and Zingales (1995), Barclay and Smith (1996) and Chen et al. (1997) all found a negative relation between the growth opportunities and the total debt. 11 The theory behind this correlation could be the fact that companies with higher market-to-book ratios have more costs of financial distress (bankruptcy costs and agency costs) according to Rajan and Zingales (1995). Fama and French (1992) stated that the shares of firms in financial distress, high levered, may be discounted at a higher rate, because distress risk is priced. Investors are not willing to pay the same price for companies who have a high level of leverage than for companies with a low level of leverage. The explanation of this is the fact that a company 11 Bevan and Danbolt 2004 (pp. 56) 10 P a g e

11 with a high level of leverage has a higher chance to go bankrupt which has as consequence that the investor lose their investment. That is why there is a difference in the price of a firm in financial distress compared with a firm without financial distress. Rajan and Zingales (1995) also have another theoretical explanation for the correlation between the market-to-book ratio and capital structure. Companies which issue their stock want to do this when their stock price is high relative to the earnings or book value. So, a high market-to-book ratio is a signal for companies to issuing equity. A temporary low leverage ratio is the result of the stocks issuing. From the theoretical consideration about the market-to-book ratio the following hypotheses arise: H1: The level of leverage is negatively related to the level of growth opportunities. Size (logarithm of sales) According to Rajan and Zingales (1995) the size of company is the inverse probability of default. They stated that a company which is larger has less chance of bankruptcy than a smaller company. Titman and Wessels (1988) stated that a large company has more diversification than a small company. Warner (1977) suggests that the bankruptcy costs of a larger firm are less than those of a small firm. All these arguments have to lead to a higher leverage ratio for larger companies. In countries were the costs of financial distress are low, the size should not be positively correlated with leverage. For this theoretical view is no empirical evidence. According to Rajan and Zingales (1995) are firms in Germany tend to be liquidated more easily than in other countries. With the assumption that liquidation is very costly it would be logic that large firms have higher leverage ratios than the smaller firms. But the opposite is the case; the large firms have substantially less debt than small firms in Germany. Another theoretical explanation is given by Smith and Warner (1979) and Michaels et al. (1999). They argued that it is harder for smaller firms to get long term loans from lenders. Ferri and Jones (1979) argue that larger firms have easier access to the capital market, and the large companies have the possibility to borrow at lower interest rates. The empirical evidence about the relationship between size and capital structure is not clear. Crutchley and Hanson (1989), Bennet and Donnely (1993), Rajan and Zingales (1995), Barclay and Smith (1996), and Bevan and Danbolt (2002) found a positive significant correlation. This means that a large company has a higher leverage ratio than a smaller company. At the other hand found Kester (1986) a negative correlation. Remmers et al (1974) did not found any 11 P a g e

12 correlation between the size and the capital structure of a company. This makes that it is not totally clear at the moment what the effect of size is on the capital structure. H2: The level of leverage is positively related to company size. Tangibility (fixed to total assets) Tangible assets are relative easy to collateralize, they reduce the agency costs of debt, is argued by Rajan and Zingales (1995). When this is true, there will be a positive correlation between tangibility and capital structure. Several researchers, like Scott (1977) and Stiglitz and Weiss (1981), think this is the case, because lenders want some certainty before they give a loan. There is also a lot of empirical evidence which found a positive correlation between tangibility and the leverage ratio, such as the research papers of; Bradley et al. (1984), Titman and Wessels (1988) and Rajan and Zingales (1995). H3: The level of leverage is positively related to the level of tangibility. Profitability According to the MM paper of 1963 there should be a positive correlation between profitability and leverage ratio. This is because they introduce the tax shield in this paper for their MM theorem. With this tax shield it is more profitable to have a large degree of leveraging by means of which a company can make full use of the interest tax shield when it is profitable. On the contrary, DeAngelo and Masulis (1980) argued that the interest tax shield is not that important. They stated that tax shields for depreciation are maybe more important and lucrative for companies. A low level of debt follows when a company is focusing on the depreciation tax shield. Bradley et al. (1984) have done some empirical research to the statement of DeAngelo and Masulis but did not found any empirical evidence for their opinion. Following the pecking-order theory, which has been mentioned before, there will be a negative correlation between profitability and the leverage ratio. This is in accordance with the theory that states that a company with large profits firstly finances itself with the free cash flows resulting from operating profits and with equity. This suspected negative correlation is also supported by some empirical evidence from researchers such as; Kester (1986), Titman and Wessels (1988), Bennet and Donnelly (1993), Rajan and Zingales (1995) and Bevan and Danbolt (2002). H4: The level of leverage is negatively related to the probability. 12 P a g e

13 Chapter 3- Determinants, data and Methodology 3.1 The used capital structure determinants for the capital structure choice According to Bradley, Jarrel and Kim (1984) there are several determinants which have an influence on the capital structure choice of a company. In their investigation on the existence of an optimal capital structure they have made several conclusions, such as the fact that when costs of financial distress are significant, optimal firm leverage is related inversely to the variability of firm earnings. This means that investors are searching for some kind of assurance when a company has a greater chance of bankruptcy. When a company has very small profitability chances, it is not interesting for an investor to give the company a loan. In their model they incorporate positive personal taxes on equity and on bond income, expected costs of financial distress, and a positive non-debt tax shield. Their research also proves that optimal firm leverage is related inversely to expected costs of financial distress and to the (exogenously set) amount of non-debt tax shields. According to Long and Malitz, (1985) moral hazard is an important factor for the capital structure choice and indicator of independency of financing decisions. They proof that advertising, research and development have less influence then expected by them on the capital structure choice. The moral hazard explanation is closely related to the basis of the agency costs. An employee of the company, like the manager, is not always handling in the interest of the company but sometimes for his own interest. These costs, agency costs, or the fact that some decisions are not made independently arise, because the moral hazard of people. The research of Titman and Wessels (1988) found that the level of debt is negatively related to the uniqueness of a firm s line of business. So, for companies in a market with less competitors the debt ratio is not very high. When companies are operating in a market which is very mature and where there is a lot of pressure then there is a positive relationship with the debt ratio. Since transaction costs are generally assumed to be small relative to other determinants of capital structure, their importance in this study suggests that the various leverage-related costs and benefits may not be particularly significant. Additional evidence relating to the importance of transaction costs is provided by the negative relation between measures of past profitability 13 P a g e

14 and current debt levels scaled by the market value of equity. This evidence also supports some of the implications of Myers and Majluf (1984) and Myers (1984). 12 The independent variables, which are tested in this paper, are the four independent variables which are mentioned before. These variables are tested with the following hypothesis: H1: The level of leverage is negatively related to the level of growth opportunities. H2: The level of leverage is positively related to company size. H3: The level of leverage is positively related to the level of tangibility. H4: The level of leverage is negatively related to the level of probability. The independent variables will be tested by the following regression: Leverage = α +β1 Tangibilityi +β2 Market-To-Book Ratioi +β3 Sizei + β4 Profitabilityi In the paper of Rajan and Zingales (1995) is the regression, which is mentioned above, tested for listed United States companies, without companies from the financial sector. All the four independent variables have a significant correlation with the dependent variable leverage at an one percent level. The four hypotheses which will be tested are also tested by Rajan and Zingales (1995). For non-financial companies from the United States are all the hypotheses true, according to Rajan and Zingales (1995). The data used in this paper also only allows for non-financial firms and does not include financial firms. This has several reasons; first, the leverage of a financial firm is strongly influenced by the investor insurance schemes, like deposit insurance. Second, the debt-like liabilities are not strictly comparable to the debt issued by non-financial firms. Finally, financial firms are subject to regulations which affect the capital structure directly, like the minimum capital requirement. Data is obtained by using Thomson Reuters Datastream. For most non-financial UK firms, necessary data is available. Because of outliers and non-availability in certain years, data is cleaned for this. To clean the data for the outliers the 2,5% level theory which is explained by Tuckey (1962) is used. The leverage regression which is mentioned earlier, will be tested with a linear regression analysis. Results and interpretation of the data are presented in the following chapter. Chapter 4- Empirical evidence Table 1 presents the results of the regressions which are taken from the data. For the years 2002 to 2010 regressions have been made to compare the United Kingdom with the United 12 Titman and Wessels 1988 (pp. 17) 14 P a g e

15 States and to perform a time-series regression. The following table gives a good indication of the differences between the several years in the UK. At the end of the table are also the results of regressions from the years What is really striking in Table 1 are the differences between the years. Hypothesis 1, was about the correlation between the growth opportunities and the leverage ratio. From the literature review a negative relation between the growth opportunities and the leverage ratio is expected but this seems only be the case in the years 2002, 2003, 2009, and In the other years was there a positive relationship between the leverage ratio and growth opportunities. Just hypothesis 2, which is about the relationship between company size and leverage ratio, is almost clear. Only the year 2010 gives a negative relationship between the two variables. The variables are not clear enough over the last 9 years when there is a look at the years separately. However, in regressions over the period the differences between the US and UK disappear. For the variables is a relation found which the same is for US and UK companies. Table 1 Years H1: The level of H2: The level of H3: The level of H4: The level of leverage is negatively leverage is leverage is positively leverage is negatively related to the level of growth opportunities. positively related to related to the level of tangibility. related to the level of probability. company size True True False False 2003 True True False False 2004 False True True False 2005 False True True True 2006 False True True False 2007 False True False False 2008 False True False True 2009 True True False False 2010 True False False False True True True True 15 P a g e

16 Table 2 presents the R-square of all the regressions. The R-square of regressions assumed which part of the dependent variable is explained by the independent variable. Only year 2005 is for a large part explained by the model. In the year 2006 hardly anything is explained by the model. This means that there are other variables which are not in the model, but have an influence on the leverage ratio of a company. Table 2 Year R-squared of the regressions ,57 % ,26 % ,2 % ,48 % ,83 % ,28 % ,69 % ,57 % ,47 % ,5 % Chapter 5 Conclusions and Recommendations Before the conclusions and recommendations will be discussed it is important to be aware of the limitations of this research. First of all, is it important to understand that the conclusions of this research neither is used for every company nor represent the economy of the UK as a whole. Secondly, this research only takes the four variables, market-to-book ratio, the natural logarithm of sales, profitability and tangibility, which does not explain, especially not every year, very much of the leverage ratio. There is an influence of the determinants on the leverage ratio of the non-financial UK firms but it does not explain the leverage ratio fully. So, it would be too premature to make statements about the leverage ratios, because the other determinants are not known. Also, the influences of the other determinants on the four tested determinants are unknown. The comparison in this paper with the research of Rajan and Zingales (1995) for the empirical part has some limitations. For example the investigated years, are not the same in both papers. However, after this said there are still some conclusions which can be made. To conclude the hypothesis from the period 2002 to 2010 there is not one separate year 16 P a g e

17 where the four determinants have the same influence as in the US. The year 2005 is the closest year with only the growth opportunities determinant different from the US. When there is a vertical look to table 1 it is clear to see that hypothesis 2 is the hypothesis which is most similar to the US. The firm size has almost every year a positive influence on the leverage of companies. With the time frame from 2002 till 2010 then is the UK for all the four variables the same as the US. Consequently, at the individual years it is hard to see a similarity between the US and UK but when we looked in a nine year time horizon then is there a lot of similarities. It is hard to make clear statements about the empirical part. Where the theoretical expectations not always are clear and obvious, the empirical part of this paper also not very clear at several points. Especially, the differences between the years are hard to explain, because there is not an obvious pattern to recognize, at first hand. A good research recommendation would be to watch carefully to the conduct of the variables and leverage ratios in several countries over the years. Maybe there is a pattern to recognize which could be combined with more macro-economic research. Also, it would be nice when the R-square of the model could be higher, such as 95%, to explain the leverage ratio. With more empirical evidence there could arise a more clear view in the academic world. It would also be nice to have more data of non-listed firms. These firms are a large part of the economy in many countries but unfortunately not much is known yet of this group. Maybe these companies make other decisions than the listed firms or they make their decisions based on other variables. To look at this part of the economy would be interesting to get a more complete view on the capital structure. 17 P a g e

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22 Appendix 1 Year Tangibility (P > t ) Profititability (P> t ) Size (P> t ) Growth Opportunitie s (P> t ) Numer of observ ations R- Squar e Adj. R- Squared (.000).1128 (.000).0003 (.055).0004 (.022) (.006) (.001).0005 (.017).0004 (.007) (.000).0006 (.981).0003 (.497).0001 (.681) (.000) (.000).0006 (.015).0006 (.012) (.598) (.279).0004 (.061).0001 (.172) (.000).0083 (.204).0003 (.069).0000 (.814) (.000) (.000).0000 (.653).0003 (.075) (.000).0113 (.520).0000 (.942) (.914) (.000).0448 (.066).0000 (.964) (.969) (.000) (.677).019 (.000) (.793) P a g e