Capital structure in the Chilean corporate sector: Revisiting the stylized facts

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1 Abstract: This paper uses panel data methodology to study potential drivers of debt-equity choice. This analysis is performed with a sample of 184 quoted Chilean firms for the period Our results show that leverage increases with firm size, the affiliation to economic groups, and with the availability of future growth opportunities; whilst it decreases with profitability, non-debt tax shields, and dividend pay-out. We find that highly leveraged capital structures and the affiliation to economic groups in Chilean firms are the answers to a financial system more oriented towards the banking with weak protection of both minority shareholders and creditors. Key words: Capital structure, panel data, Chilean firms 1. Introduction The main goal of this work is to empirically study capital structure decisions for the Chilean corporate sector based on the most important theories related to them trade off, pecking order, market timing, agency costs, and signaling theories. Specifically, the goal of this paper is to analyze if there is a significant correlation between capital structure and firm characteristics, e.g. firm size, profitability, asset tangibility, growth opportunities, non-debt tax shields, and firm market timing conditions; as well as between capital structure and corporate governance characteristic, e.g. ownership structure and pay-out policy. This paper contributes to the existing body of knowledge in several ways. First, we focus on a sample of firms from an emerging market which has its own particularities that so far have been somehow ignored in empirical studies. Examples of this are the financing through private/bank debt, highly concentrated ownership structures, and the affiliation of firms to economy groups or holdings. All these are key issues in the Chilean economy which justify its analysis because they differ from other researches done in other emerging markets. Our results confirm most of the theoretical relationships already tested in Anglo-Saxon economies (Frank & Goyal, 2009). We find a positive effect of firm size, profitability, ownership concentration, and the market timing condition, as well as the negative effect of the pay-out policy and non-debt tax shields, on firm leverage which verify the postulates of the main theories on capital structure decisions. Nevertheless, we observe some relations that are not in line with the current body of theory on capital structure. For instance, our results show a positive correlation between growth opportunities and level of debt that is due to agency problems derived from growth opportunities that would be solved by governance systems different than the ordinary ones, such as the debt level itself. Literature review Ever since Modigliani and Miller (1958) proposed that capital structure was irrelevant, several theories have been developed in order to reconcile the capital structure puzzle. Trade-off theory holds that managers try to balance the tax benefits of corporate debt; with the insolvency and bankruptcy costs of debt (Myers, 1984). The pecking order theory suggests that the existence of asymmetric information between managers and investors shareholders and creditors, leads to an undervaluation of the securities issued by firms. This increases the financing cost of external sources in comparison with internally generated funds and leads firms to follow a hierarchy, with a preference for internal over external finance, and for debt over equity (Myers, 1984; Myers & Majluf, 1984).

2 Agency considerations (Jensen, 1986; Jensen & Meckling, 1976; Myers, 1977), market timing theory (Baker & Wurgler, 2002), and signaling theory (Akerlof, 1970; Leland & Pyle, 1977; Ross, 1977) all add up to new potential drivers of capital structure decisions. More than half century of research on the influence of the capital structure on the firm value as well as on the determinant drivers of the financing decision has given as a result the model of the stylized facts. This model relates different measures of corporate debt with a number of outstanding variables basically due their statistical significance and theoretical consistency (Fama & French, 2002; Frank & Goyal, 2009; Harris & Raviv, 1991). Most of these variables have been widely tested in the Anglo American context. Despite of we use these variables in this study; we also included new ones which better fit with environment for the Chilean corporate sector. Firm size: Regarding the literature (Al-Najjar & Hussainey, 2011; Frank & Goyal, 2009; Gosh, 2007; Rajan & Zingales, 1995). we suggest there exists a positive relationship between the firms size and the corporate debt level. Profitability: According to current theoretical frameworks, there is no consensus on the relationship between profitability and debt level. On the one hand, the pecking order theory suggests that profitable firms are likely to have more retained earnings. Thus, a negative relation between debt and past earnings should be expected (Al-Najjar & Taylor, 2008). The higher the availability of internal funds, the lower will be the need for external funds (Booth, Aivazian, Demirgüç-Kunt, & Maksimovic, 2001; Harris & Raviv, 1991; Hovakimian, 2005; Rajan & Zingales, 1995; Shyam-Sunder & Myers, 1999; Titman & Wessels, 1988). On the other hand, trade-off theory posits that the relationship between profitability and leverage is positive. More profitable firms have more capacity to obtain external funds in order to take advantage of tax shields (Fama & French, 2002). Due this we can observe either a positive or negative relationship between profitability and the firm s debt level. Tangibility of assets: Tangible/fixed assets might be considered a real guarantee for creditors. According to the asymmetries of information theory, financing through debt might be more expensive for firms with a higher proportion of intangible assets (Myers, 1984; Myers & Majluf, 1984). Titman and Wessels (1988) then empirically test whether the tangibility of assets is positively related to the firm s leverage. Therefore, we suggest a positive relationship between asset tangibility and the firm s debt level. Growth opportunities: Myers (1977) predicts that debt level is negatively related to growth opportunities. Titman and Wessels (1988) find a negative correlation between the firms growth rate and its debt levels. Barclay et al. (2006) find that the debt capacity of growth opportunities is negative. The relationship between growth opportunities and leverage has been widely tested within the Anglo-Saxon context, basically for US firms. Nevertheless, the Chilean context is quite different from the Anglo-Saxon one and therefore the theoretical negative prediction between growth opportunities and debt must be rethought (Saona, 2011; Wald, 1999). In this respect, there are two arguments for that based on both the high concentration of ownership and the bank-based financial system in Chile, which address the financing of growth opportunities. First, in this respect we might say that firms with high ownership concentration and with available future growth opportunities will prefer debt over equity capital for financing 2

3 these investment opportunities. In doing so, current shareholders will avoid both ownership dilution, and the issuance of undervalued stocks (Azofra, Saona, & Vallelado, 2004). Wald (1999) finds a positive correlation between leverage and growth for firms in civil-law countries, while the same relation is negative for US firms. Second, most of the debt capital in Chile is issued through banks. Private creditors, relative to public bondholders, are more efficient in both obtaining information about future prospects for the firm e.g. growth opportunities, and in controlling the potential opportunistic behavior of managers e.g. suboptimal investment decisions, which are generated by growth opportunities (Jara, Moreno, & Saona, 2012; Saona, 2010). Therefore, shareholders will encourage managers to issue private/bank debt to solve agency problems related to growth opportunities. Thus, once we reconsider how the institutional setting determines financial decisions for the Chilean firms, the traditional negative relationship between growth opportunities and debt observed in the Anglo-Saxon context reverts to a positive relation for the Chilean corporate sector. Non-debt tax shields: Fama and French (2002) have shown that, in the presence of both corporate taxes and bankruptcy costs, firms should issue debt until the marginal corporate interest tax shield gains are exactly offset by the marginal expected bankruptcy costs. Additionally, the trade-off theory of capital structure predicts that firms with high levels of tax shields different than debt will accordingly issue less debt because both of them are substitute ways to obtain financing funds (Myers, 1984). Therefore, we should predict a negative empirical association between the non-debt tax shields and the debt ratios. Market timing: Market timing theory posits that corporate executives issue securities depending on the time-varying relative costs of equity and debt (Baker & Wurgler, 2002). This means that firms adjust their levels of leverage to time the market valuation by taking advantage of windows of opportunity (Graham & Harvey, 2001). Using a signaling model in a sample of seven developed countries, Saona and Vallelado (2012) test the market timing hypothesis and find that firms with higher asymmetries of information (e.g. firms which are not members of the index of the most traded quoted firms) take advantage of market conditions when prices go up to increase their leverage whereas they are financially constrained in bearish markets. Nevertheless, this timing effect might be constrained somehow due institutional issues. For instance, in the case of the Chilean corporate sector even though the stock repurchase is allowed, there are many legal restrictions to make it take place. As a result, we suggest that there is a negative relation between firms level of debt and the market timing condition firm market value. Ownership structure: Ownership structure plays a crucial role as a control mechanism of managers interests (Yafeh & Yosha, 2003). Thus, the higher the number of shares in the hands of the same shareholder, the higher will be his or her incentives to control managers. This eventually reduces agency problems by aligning the interests of managers and internal shareholders (La Porta, Lopez-de-Silanes, & Shleifer, 1999). One of the most important characteristics of Chilean ownership structures is the widespread use of pyramids as an effective way to exercise control over a wide variety of productive assets (Lefort & Walker, 2007a). Even more, economic groups could be an efficient way for firms to deal with imperfect markets in Chile, establishing for instance, internal capital markets that compensate for the lack of more developed formal markets (Azofra, et al., 2004; Maquieira, et al., 2012). Consequently, we hypothesize a positive relationship between ownership structure as a governance device and the firm s leverage. 3

4 Dividends: The most classical literature points out that firms pay dividends to signal inside information to the market or to meet the demand for pay-out from some dividend clienteles. In that sense, the dividend pay-out might be used as a reliable signal about the financial position of a firm, and therefore it implies a higher debt capacity. Thus, if dividend payments represent a signal of sound financial health, and hence of higher debt-issuing capacity, one would expect a positive relationship between dividend payments and debt level. Nevertheless, agency problems also seem to be one of the most important drivers of dividends worldwide (La Porta, Lopezde-Silanes, Shleifer, & Vishny, 2000). In fact, La Porta et al. (2000), find that strong shareholder rights enable minority shareholders to obtain relatively high dividend pay-outs from reluctant managers and controlling shareholders. In a parallel manner, La Porta et al. (1998) argue that mandatory dividends are used only in the French-civil law countries like in Chile 1. Additionally, Jensen (1986) argue that is needed to reduce the free cash flow available for discretional use in order to prevent agency problems. In this context, the dividend policy should behave as a substitute mechanism to the debt usage to reduce the free cash flow. We believe that for the Chilean corporate sector it seems more plausible that the negative relationship between dividends and debt suggested by agency theory is due to the weak protection of creditors rights provided by the legal system, on the one hand. And, on the other hand, recent studies have also cast doubt on the signaling effect of dividends (DeAngelo, DeAngelo, & Skinner, 2004; Denis & Osobov, 2008; He, 2012). 2. Sample, Variables, and Methodology The data base used in our empirical analysis is made up of 184 non-financial firms quoted in the Bolsa de Santiago de Chile (The Stock Exchange of Santiago of Chile) for the period from 2002 to The conjunction of these 184 individuals and the 9 cross sectional periods allows us to set up an unbalanced data panel with 1,392 non financial firm-year observations obtained from the audited financial statements and stock quotations at the end of each fiscal year gathered into the Economatica Data Base. Due to the panel structure of our data, which is a combination of cross sectional and time series information, we have estimated the model using the generalized method of moments (GMM). The panel data methodology allows us to control for two basic problems in this kind of studies: the unobservable heterogeneity and the endogeneity problems (Arellano, 2002). 3. Results Descriptive statistics From table 1 we can derive the following observations. First, the high level of debt (Tdta) corresponds to 41.0% of total assets; whilst the leverage ratio (Lev) says that the total corporate debt for a typical Chilean firm is about 1.1 times the total common equity. These average ratios are comparable with previous studies of the Chilean corporate sector (Espinosa & Maquieira, 2010; Saona, 2007, 2010, 2011). The explanation which supports such high debt ratios is rooted in the institutional context where firms operate. Specifically, the bank-based orientation of the financial system fosters high 1 In Chile there is a mandatory dividend pay-out of at least 30% of annual earnings 4

5 leverage, principally through the use of private debt (Demirgüç-Kunt & Levine, 2001; Demirgüç-Kunt & Maksimovic, 2002; La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1997; La Porta, et al., 1998) rather than through capital markets, as this is not quite developed yet in Chile (Lefort & Walker, 2002, 2007b). Second, the pay-out ratio (Div) is also high (87%). According to the law in Chile it is mandatory to pay-out at least 30% of net income as cash dividends in order to protect the claims of minority shareholders. This legal requirement pushes up the average pay-out ratio. Third, we observe that a typical firm has an approximate 6.5% rate of return on total assets (Prof). This rate is in line with the market-to-book value (Q2) which is higher than one (1.13 times), which means that the market value of the firm is higher than its book value. In other words, the market perceives as positive the performance of an average firm. Four, concerning ownership structure, on average, 48.3% of outstanding shares are in the hands of the majority shareholder, something that is far higher than what is needed to exercise control. Moreover, about 61.5% of Chilean firms are affiliated with some business groups/conglomerates. Highly concentrated ownership structures are the outcome of weak institutional protection of shareholders rights (Demsetz, 1983; La Porta, et al., 1999; F. López, 2005). It is not surprising, then, that there is such high concentration of ownership in Chilean firms. Finally, we also observe that the measure for the market timing condition (Mktt) is higher than one (1.4 times) which means that on average, the market value of a firm in the current year is usually higher than in the previous year. Table 1. Descriptive Statistics Multivariate analysis Variable Mean Std. Dev. Min Max Lev Tdta Size Prof Tang Q Q Ndts Mktt Own Econgroup Div The coefficients are estimated using the two step system estimator with adjusted standard errors. Our results show that the bankruptcy risk of larger firms is lower than the risk observed in smaller firms. Additionally, there are both the reputation and the visibility effects of a larger dimension of the firm which reduces the cost of debt and therefore increases leverage. These arguments support our empirical findings which observe a positive relationship between the firm size (Size) and the debt level. Concerning profitability (Prof), our empirical findings support the pecking order theory. In that sense, more profitable firms, by default, have a higher availability of resources internally generated The collateral guarantee measured as the tangibility of assets (Tang) does not support our hypothesis which indicated a positive relationship between the tangibility of assets and the debt level. Our findings indicate a negative and statistically 5

6 significant relation between these two variables. The explanation for this positive relationship is consistent with theories based on information asymmetries (Denis & Mihov, 2003; Holmström & Tirole, 1997). There is a positive and statistically significant relationship between growth opportunities, and leverage (Lev). Firms that account for future growth opportunities will follow a hierarchical order financing these investment opportunities as posited in our hypothesis. This relationship is reinforced in environments where firms have high ownership concentration, as the Chilean corporate sector is. In this case, shareholders will prefer to issue debt capital instead of equity capital for financing these growth opportunities because in doing so they will avoid capital dilution, loss of control. The negative agency problems caused by growth opportunities such as underinvestment and asset substitution might also be overcome by debt agreements, fostering a positive relationship between debt and growth options. Recall that most of the debt issued by Chilean firms is private debt. This kind of debt is far more efficient than public debt in controlling the performance of managers, reducing the potential agency problems between them and shareholders. This finding was also observed by Azofra et al. (2004) regarding a sample of quoted Chilean firms during the 90s. The typical characteristics of the ownership structure in Chile addressed by a high concentration and the active participation of a few number of controlling shareholders, as well as the affiliation of the firm to economic groups, allows companies to efficiently reduce the agency problems between managers and shareholders. Our empirical results support this idea. For the Chilean corporate sector, the more concentrated the ownership structure (Own) is, the higher the leverage is; basically because reduced agency problems allow firms to issue debt in more favorable conditions. The affiliation of the firm to a certain economic group/conglomerate (Econgroup) is also positively related with leverage. In this case, firms take advantage not only of the intragroup capital markets but also of the higher reputation which is gained by belonging to a certain group. This finding is consistent with previous empirical literature on Chile (Saona & Vallelado, 2005). The pay-out ratio (Div) seems to be negatively correlated with the debt level according to our results. This finding permits accepting our hypothesis as it is supported by both the arguments of the agency problems and the intrinsic characteristics of the regulatory Chilean system with regards to the protection of creditors rights. In this case, low dividend pay-out ratios serve as a substitute mechanism for weak creditors rights protection. Conclusions According to different theories, the potential drivers of capital structure decisions are still a black box. With this work we attempt to shed some light on the determinants of capital structure for firms in an institutional context that have somehow been forgotten from empirical analyses, such as the Chilean corporate sector. Our results are consistent with previous evidence, but there are some significant differences, however. We conclude that: First, the positive effect of firm size, profitability, ownership concentration, and the market timing condition, as well as the negative effect of the pay-out policy and non-debt tax shields, on firm leverage, verify the postulates of the main theories on capital structure decisions. Second, we observe some relations that are not in line with the current body of theory on capital structure. For instance, our results show a positive correlation between growth opportunities and level of debt that is due to agency problems derived 6

7 from growth opportunities that would be solved by governance systems different than the ordinary ones, such as the debt level itself. The negative relationship between the tangibility of assets and the level of debt is justified by the existence of asymmetries of information, which impels firms with more (less) asymmetries of information will issue more (less) debt. These empirical differences with theory confirm that financial decisions are also driven by the specific characteristics of a country; and that the debt/equity choice is not only determined by firm characteristics, but also by the outcomes of corporate governance and the institutional and legal environment of the country where the firm operates. Finally, our work contributes to the academic discussion about the capital structure puzzle, on the one hand; and also to the strategic decisions made by both practitioners and policy-makers, on the other hand. Concerning the practitioner, this work allows them to compare managerial performance with the average characteristics that more strongly impact the firms value creation under the current Chilean context. Regarding decisions by policy-makers, that current institutional context evidences the need for better legislation on corporate governance, to then foster the protection of rights of both minority shareholders and firms creditors. References Akerlof, G. (1970). The market for lemons : Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 84, Al-Najjar, B., & Hussainey, K. (2011). Revisiting the Capital-structure Puzzle: UK Evidence. The Journal of Risk Finance, 12(4), Al-Najjar, B., & Taylor, P. (2008). The Relationship Between Capital Structure and Ownership Structure: New Evidence from Jordanian Panel Data. Managerial Finance, 34(12), Azofra, V., Saona, P., & Vallelado, E. (2004). Estructura de propiedad y oportunidades de crecimiento como determinantes del endeudamiento de las empresas chilenas. Revista ABANTE, 7(2), Baker, M., & Wurgler, J. (2002). Market timing and capital structure. The Journal of Finance, 57(1), Barclay, M. J., Smith Jr, C. W., & Morellec, E. (2006). On the Debt Capacity of Growth Options. Journal of Business, 79(1), Booth, L., Aivazian, V., Demirgüç-Kunt, A., & Maksimovic, V. (2001). Capital structures in developing countries. The Journal of Finance, 56(1), DeAngelo, H., DeAngelo, L., & Skinner, D. J. (2004). Are dividends disappearing? Dividend concentration and the consolidation of earnings. Journal of Financial Economics, 72(3), Demirgüç-Kunt, A., & Levine, R. (2001). Financial structure and economic growth: a cross-country comparison of banks, markets, and development (1st. ed.). Massachusetts: Massachusetts Institute of Technology. Demirgüç-Kunt, A., & Maksimovic, V. (2002). Funding growth in bank-based and market-based financial systems: evidence from firm-level data. Journal of Financial Economics, 65, Demsetz, H. (1983). The Structure of Ownership and the Theory of the Firm. Journal of Law and Economics, 26(2), Denis, D., & Mihov, V. (2003). The choice among bank debt, non-bank private debt and public debt: Evidence from new corporate borrowings. Journal of Financial Economics, 70, Denis, D., & Osobov, I. (2008). Why do firms pay dividends? International evidence on the determinants of dividend policy. Journal of Financial Economics, 89(1), Fama, E., & French, K. (2002). Testing trade-off and pecking order predictions about dividend and debt. The Review of Financial Studies, 15(1), Frank, M., & Goyal, V. (2009). Capital Structure Decisions: Which Factors Are Reliably Important? Financial Management, 38(1), Ghosh, S. (2007). Bank Debt Use and Firm Size: Indian Evidence. Small Business Economics, 29(1), Graham, J., & Harvey, C. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60, Harris, M., & Raviv, A. (1991). The theory of capital structure. The Journal of Finance, 46(1), He, W. (2012). Agency problems, product market competition and dividend policies in Japan. Accounting & Finance, 52(3),

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