CAPITAL STRUCTURE AND DIVIDEND POLICY IN A PERSONAL TAX FREE ENVIRONMENT: THE CASE

Transcription

1 CAPITAL STRUCTURE AND DIVIDEND POLICY IN A PERSONAL TAX FREE ENVIRONMENT: THE CASE OF OMAN Khamis Al Yahyaee SCHOOL OF BANKING AND FINANCE THE UNIVERSITY OF NEW SOUTH WALES A dissertation submitted to the University of New South Wales in fulfillment of the requirements for the degree of Doctor of Philosophy. 2006

2 CERTIFICATION I hereby declare that this submission is my own work and to the best of my knowledge it contains no materials previously published or written by another person, or substantial proportions of material which have been accepted for the award of any other degree or diploma at UNSW or any other educational institution, except where due acknowledgment is made in the thesis. Any contribution made to the research by others, with whom I have worked at UNSW or elsewhere, is explicitly acknowledged in the thesis. I also declare that the intellectual content of this thesis is the product of my own work, except to the extent that assistance from others in the project s design and conception or in style, presentation and linguistic expression is acknowledged. Signed Date ii

3 COPYRIGHT STATEMENT I hereby grant the University of New South Wales or its agents the right to archive and to make available my thesis or dissertation in whole or part in the University libraries in all forms of media, now or here after known, subject to the provisions of the Copyright Act I retain all proprietary rights, such as patent rights. I also retain the right to use in future works (such as articles or books) all or part of this thesis or dissertation. I also authorise University Microfilms to use the 350 word abstract of my thesis in Dissertation Abstract International. I have either used no substantial portions of copyright material in my thesis or I have obtained permission to use copyright material; where permission has not been granted I have applied/will apply for a partial restriction of the digital copy of my thesis or dissertation. Signed Date iii

4 AUTHENTICITY STATEMENT I certify that the library deposit digital copy is a direct equivalent of the final officially approved version of my thesis. No emendation of content has occurred and if there are any minor variations in formatting, they are the result of the conversion to digital format. Signed Date iv

5 ABSTRACT This dissertation examines four specific aspects of capital structure and dividend policy. The first issue concerns the determinants of capital structure dynamics. The primary objective is to examine whether stock returns are important factors in firm s capital structure choice, and if so, whether this effect is persistent. In so doing, we use a data set which (1) avoids the complexity of tax rates faced by previous studies, (2) we introduce new variables that are unique to Oman, and (3) we distinguish empirically between bank debt and non-bank debt. We find stock returns are a first order determinant of capital structure. Firms do show some tendency to rebalance towards their target capital structure. However, the impact of stock returns dominates the effects of rebalancing. We also find new evidence that firms do take countermeasures to offset changes in their leverage that stem from equity value variations, but do so at a low speed. The next topic studied concerns the ex-dividend day behaviour. We investigate this issue using a unique data set where there are no taxes on dividends and capital gains and stock prices are decimalized. In this economy, any price decline that is smaller than the dividends can not be attributed to taxes and price discreteness. We find that the stock price drops by less than the amount of dividends and there is a significant positive ex-day return. We are able to account for our results using market microstructure models. The third issue investigated is the stock price reaction to dividend announcements. Tax-based signaling models argue that dividends would not have v

6 information and be informative if it is not for the higher taxes on dividends relative to capital gains that they apply to shareholders. The absence of personal taxes in Oman presents a valuable opportunity to test this prediction. Our results show that the announcements of dividend increases (decreases) are associated with a stock price increase (decrease) which contradicts the tax-based signaling models. The final chapter analyzes the determinants and stability of dividend policy of financial and non-financial firms. Investigating this issue is important for at least two reasons. First, Omani firms distribute almost 100% of their profits in dividends which led the Capital Market Authority (CMA) to issue a circular (number 12/2003) arguing that firms should retain some of their earnings for rainy days. This allows us understand the characteristics of firms that pay dividends. Second, firms are highly levered mainly through bank loans which render the role of dividends in reducing the agency costs less important. Unlike most previous studies, we include both dividend paying and non-dividend paying firms to avoid a selection bias. We find that there are some common factors that determine dividend policy of both financial and non-financial firms and there are some factors that affect only non-financial firms. We also find that the factors that influence the probability to pay dividends are the same factors that drive the amount of dividends paid for both financial and non-financial firms. We document that non-financial firms adopt a policy of smoothing dividends while financial firms do not have a stable dividend policy. vi

7 ACKNOWLEDGMENTS Above all, I would like to express my gratitude to Professor Terry Walter, my thesis advisor, for exceptional guidance, detailed comments, critical inputs, and his time. Without his support and assistance, this thesis would have never been completed. I would also like to express my indebtedness to Associate Professor Toan Pham, my cosupervisor, for his valuable feedback, warm encouragement, and support. I am also thankful to Associate Professor Ah Boon Sim for valuable advice on econometric issues and to Dr. Jason Zien for his assistance in some parts of this thesis. I would also like to thank the participants at the 18 th PhD Conference in Economics and Business and in particular to Professor Tom Smith and Professor Richard Heaney for their valuable suggestions and insights. I am also thankful to the participants at the 17 th Asian FA/FMA Conference and in particular to Associate Professor Ronal Hoffmeister, Dr. Otto Reich, and Dr. Ravi Jain. I extend my appreciation to Professor Ivo Welch for helping with some data and methodology issues. I would also like to acknowledge useful comments from Professor John Graham, Professor Palani-Rajan Kadapakkam, and Professor Keith Jakob. I am also grateful to Dr. Hatem Al Shanfari and Dr. Fahim Al Marhubi for their support and assistance in obtaining the data. I must thank the Muscat Securities Market, Capital Market Authority, the Central Bank of Oman, and SIRCA for providing the data used in this thesis. The support of my family can not be acknowledged enough. I am dearly grateful to my parents for their endless encouragement and continued support to finish this work. vii

8 I am indebted for life to my wife for her love, sacrifice, and for sharing the burden of graduate study. I am very fortunate to have such a wonderful and considerate wife. Additionally, I thank my lovely daughter, Hadil, for her being with me. viii

9 TABLE OF CONTENTS CERTIFICATION COPYRIGHT STATEMENT AUTHENTICITY STATEMENT ABSTRACT ACKNOWLEDGEMENTS TABLE OF CONTENTS LIST OF TABLES ii iii iv v vii ix xv CHAPTER 1: INTRODUCTION...1 CHAPTER 2: WHAT ARE THE DETERMINANTS OF CAPITAL STRUCTURE? EVIDENCE FROM A COUNTRY WITH UNIQUE FINANCING ARRANGEMENTS INTRODUCTION DATA AND METHODOLOGY Data Measures of Leverage Empirical Model Descriptive Statistics ESTIMATION RESULTS Regression Specification Changes in Capital Structure Does the Form of Debt Matter? Can Adjustment Costs Explain the Inertia Behaviour?...31 ix

10 Variance Decomposition OTHER DETERMINANTS OF CAPITAL STRUCTURE Tax Government Ownership Soft Loans Signaling Profitability Tangibility Size Non Debt Tax Shields (NDTS) Growth Volatility Interest Coverage Industry Liquidity Future Stock Return Reversals DETERMINANTS OF CHANGE IN LEVERAGE ARE THE RESULTS SENSITIVE TO THE USE OF BANK DEBT? COMPARISONS WITH THE CURRENT LITERATURE CONCLUSION...67 CHAPTER 3: EX-DIVIDEND DAY BEHAVIOUR IN THE ABSENCE OF TAXES AND PRICE DISCRETENESS INTRODUCTION THEORY, HYPOTHESIS, AND EMPIRICAL EVIDENCE Tax Explanations Empirical Evidence...76 x

11 The Interactions of Taxes, Transaction Costs and Risk Empirical Evidence Market Microstructure Theories Empirical Evidence OMAN STOCK MARKET: INSTITUTIONAL ASPECTS Trading Rules and Practices Dividends Data EMPIRICAL RESULTS Price Behaviour on Ex-Dividend Day Abnormal Returns on Ex-Dividend Day Transaction Costs and Risk Behaviour of Trading Volume around Ex-Days Midpoint Pricing Using RASP Data Volume Analysis Using RASP Data CONCLUSION CHAPTER 4: THE INFORMATION CONTENT OF CASH DIVIDEND ANNOUNCEMENTS IN A UNIQUE ENVIRONMENT INTRODUCTION THEORETICAL AND EMPIRICAL STUDIES Theoretical Studies Empirical Literature DATA METHODOLOGY EMPIRICAL RESULTS xi

12 Dividend Increase Dividend Decrease No Change Cumulative Abnormal Returns Regression Results on Changes in Dividends and Earnings Market Efficiency BID-ASK BOUNCE CONCLUSION CHAPTER 5: DIVIDEND POLICY IN THE ABSENCE OF TAXES INTRODUCTION THEORETICAL AND EMPIRICAL STUDIES Dividend Irrelevance Hypothesis Empirical Evidence Bird-In-The-Hand Hypothesis Empirical Evidence Tax Effect Hypothesis Empirical Evidence Agency Costs and Free Cash Flow Hypothesis Empirical Evidence FACTORS THAT INFLUENCE DIVIDEND POLICY Profitability Firm Size Leverage Agency Costs Business Risk Ownership Structure Maturity Hypothesis xii

13 Tangibility Growth Opportunities DATA Estimation Model Payment of Dividends Descriptive Statistics DETERMINANTS OF DIVIDEND POLICY Non-Financial Firms Financial Firms DETERMINANTS OF THE DECISION TO PAY DIVIDENDS Non-Financial Firms Financial Firms THE LINTNER MODEL Empirical Results for the Lintner Model Non-Financial Firms Financial Firms CONCLUSION CHAPTER 6: CONCLUSION APPENDICES APPENDIX A APPENDIX B APPENDIX C APPENDIX D xiii

14 APPENDIX E REFERENCES xiv

15 LIST OF TABLES TABLE 2.1. DESCRIPTIVE STATISTICS...21 TABLE 2.2. CORPORATE ACTIVITY, EQUITY GROWTH, AND CAPITAL STRUCTURE, CLASSIFIED BY STOCK RETURNS (YEAR-ADJUSTED AND SALES ADJUSTED)...23 TABLE 2.3. FAMA-MACBETH REGRESSIONS PREDICTING ADRT+K WITH ADRT AND IDRT,T+K TABLE 2.4. ALTERNATIVE DEBT DEFINITIONS...31 TABLE 2.5. CAN THE RESULTS BE EXPLAINED BY ADJUSTMENT COSTS?...32 TABLE 2.6. EXPLANATORY POWER OF COMPONENTS OF DEBT RATIOS AND DEBT RATIO DYNAMICS...34 TABLE 2.7. F-M REGRESSIONS EXPLAINING DEBT RATIO CHANGES (ADRT+K, -ADRT) ADDING VARIABLES USED IN PRIOR LITERATURE TABLE 2.8. F-M REGRESSIONS EXPLAINING BANK DEBT RATIO CHANGES (ADRT+K - ADRT) ADDING VARIABLES USED IN PRIOR LITERATURE...59 TABLE 2.9. FLANNERY AND RANGAN MODEL EXPLAINING ACTUAL DEBT RATIO (ADRI,T+1) ADDING VARIABLES USED IN PRIOR LITERATURE TABLE 3.1. SAMPLE CHARACTERISTICS...94 TABLE 3.2. PREMIUM SUMMARY STATISTICS...95 TABLE 3.3. EX-DAY ABNORMAL RETURNS SUMMARY STATISTICS...97 TABLE 3.4. THE EFFECT OF DIVIDEND YIELD, TRANSACTION COSTS, AND RISK ON EX- DAY ABNORMAL RETURNS TABLE 3.5. DAILY ABNORMAL TRADING VOLUME TABLE 3.6. PREMIUM AND EX-DAY ABNORMAL RETURN (AR) USING RASP CLOSING TRANSACTION PRICES TABLE 3.7. PREMIUM AND EX-DAY ABNORMAL RETURN (AR) USING RASP CLOSING QUOTE MIDPOINTS xv

16 TABLE 3.8. PREMIUM AND EX-DAY ABNORMAL RETURN (AR) USING RASP OPENING QUOTE MIDPOINTS TABLE 3.9. PREMIUM AND EX-DAY ABNORMAL RETURN (AR) USING RASP CLOSING BID AND ASK QUOTES TABLE PREMIUM AND EX-DAY ABNORMAL RETURN (AR) USING RASP OPENING BID AND ASK QUOTES TABLE DAILY ABNORMAL TRADING VOLUME USING RASP DATA TABLE 4.1. FREQUENCY OF FIRM-YEAR OBSERVATIONS TABLE 4.2. CASH DIVIDEND DISTRIBUTIONS TABLE 4.3. DESCRIPTIVE STATISTICS TABLE 4.4. THE STOCK MARKET REACTION TO DIVIDEND INCREASE IN THE MUSCAT SECURITIES MARKET TABLE 4.5. THE STOCK MARKET REACTION TO DIVIDEND DECREASE IN THE MUSCAT SECURITIES MARKET TABLE 4.6. THE STOCK MARKET REACTION TO NO CHANGE IN DIVIDENDS IN THE MUSCAT SECURITIES MARKET TABLE 4.7. CUMULATIVE ABNORMAL RETURNS FOR DIVIDEND INCREASE, DIVIDEND DECREASE, AND NO CHANGE IN DIVIDENDS TABLE 4.8. REGRESSION RESULTS OF ABNORMAL RETURNS ON DIVIDEND CHANGES AND EARNINGS CHANGES RELATIVE TO STOCK PRICE TABLE 4.9. REGRESSION RESULTS OF ABNORMAL RETURNS ON DIVIDEND CHANGES AND EARNINGS CHANGES TABLE MEAN ABNORMAL RETURN (AR) USING RASP QUOTE MIDPOINTS TABLE 5.1. SUMMARY OF TESTABLE HYPOTHESIS AND PROXY VARIABLES TABLE 5.2. DIVIDEND PAYOUT RATIO FOR ALL, FINANCIAL, AND NON-FINANCIAL FIRMS OVER THE PERIOD TABLE 5.3. DESCRIPTIVE STATISTICS FOR NON-FINANCIAL FIRMS TABLE 5.4. DESCRIPTIVE STATISTICS FOR FINANCIAL FIRMS xvi

17 TABLE 5.5. NUMBER AND FRACTION OF NON-FINANCIAL FIRMS PAYING DIVIDENDS TABLE 5.6. NUMBER AND FRACTION OF FINANCIAL FIRMS PAYING DIVIDENDS TABLE 5.7. TOBIT REGRESSION FOR THE DETERMINANTS OF DIVIDEND POLICY OF NON- FINANCIAL FIRMS TABLE 5.8. TOBIT REGRESSION FOR THE DETERMINANTS OF DIVIDEND POLICY OF FINANCIAL FIRMS TABLE 5.9. PROBIT REGRESSIONS TO EXPLAIN WHICH NON-FINANCIAL FIRMS PAY DIVIDENDS TABLE PROBIT REGRESSIONS TO EXPLAIN WHICH FINANCIAL FIRMS PAY DIVIDENDS TABLE LINTNER MODEL ESTIMATES FOR NON-FINANCIAL FIRMS TABLE LINTNER MODEL ESTIMATES FOR FINANCIAL FIRMS xvii

18 Chapter 1: Introduction Capital structure and dividend policy remain among the most controversial issues in corporate finance. This controversy is related to the complexity of the tax codes, price discreteness, and disperse ownership in western countries where most studies are undertaken. In this thesis, we use a unique data set from Oman where the above factors are either absent or limited. First, there are no taxes on dividends and capital gains in Oman. The country s main tax is corporate income tax where Omani companies are taxed at a flat rate of 12%. This makes Oman taxing system one of the simplest in the world. Second, Omani firms distribute almost 100% of their profits in dividends. In addition, dividends are distributed annually. These factors have important implications on the ex-dividend day behaviour. Third, Omani firms are highly levered through bank loans. In addition, the majority of Omani firms are owned by a small number of investors who have controlling interests. This concentrated ownership can reach up to 80% in some firms for a single group of investors. These two factors should have a positive impact on the agency problem between shareholders and management. They also suggest a diminished role for dividends as a signaling mechanism in Oman. Fourth, transparency in Oman is low and corporate disclosure requirements are loose (Islam (2002)). There is a scarcity of professional financial analysts and there are no management forecasts are provided. Investors have few other sources of information on Omani companies which makes cash dividend announcements an important piece of 1

19 information that can assist investors in pricing Omani shares. It is important to examine whether this is indeed true. Fifth, as part of its efforts to attract investment and activate the private sector, Oman offers several financial incentives and support for investors. The country is subsidizing certain companies by giving them soft loans that are interest free. These loans are given for acquiring fixed assets for new projects, buying machinery and equipment required for expansion of existing projects, and infusion of finance into a sick industry. The eligibility of the company to get this subsidy increases its willingness to borrow. We test whether this is indeed the case. We use this unique data set to examine four distinct and specific aspects of capital structure and dividend policy. In doing so, we present four independent chapters which concern capital structure and dividend policy. The first topic examined in this dissertation relates to capital structure while the other three topics investigate issues related to dividend policy. The first issue investigated in this thesis in Chapter 2, concerns the determinants of capital structure dynamics. Previous studies examining this issue use data from western countries which are characterized by the complexity of the tax code which makes it hard to evaluate the importance of taxes on firm s capital structure (Myers (1984) and Graham (2000)). The simplicity of the Oman tax system may help us to provide clearer results on the impact of taxes on capital structure. Moreover, while there is a wide agreement that stock returns are an important determinant of capital structure, there is an intensive debate on whether this effect is persistent. These findings are mainly derived using data from the US. We provide independent evidence from Oman. 2

20 We also investigate whether firms try to counteract the mechanistic effect of stock returns, and if so, how quickly managers offset the impact of stock return surprises. This is an important issue since the current literature provides mixed results with some studies finding evidence supporting and others failing to do so. In addition, the vast majority of theoretical models on the choice of debt structure assume that bank debt and non-bank debt are equivalent, and as a result most empirical studies either exclude bank debt or combine it with non-bank debt (Hooks and Opler (1993)). In this study, a distinction is made between bank debt and non-bank debt in an effort to enhance our understanding about the characteristics of firms that use them. This distinction is important since bank debt may exhibit different characteristics to those of non-bank debt. We find stock returns are a first order determinant of capital structure. Firms do show some tendency to rebalance towards their target capital structure. However, the impact of stock returns dominates the effects of rebalancing. We also find new evidence that firms do take countermeasures to offset changes in their leverage that stem from equity value variations, but do so at a low speed. Adding previously popular determinates of capital structure has only modest economic impact on capital structure dynamics. When used with bank debt, stock returns continue to dominate other determinants of capital structure. The results are robust to several alternative estimation techniques. The second issue examined in Chapter 3 relates to the ex-dividend day behaviour. Previous research documents that stock prices drop by significantly less than the dividend on the ex-day. Several interpretations are advanced in the literature to 3

21 explain the ex-dividend day behaviour including taxes, price discreteness, and transaction costs. In this chapter, we use a unique data set from Oman where the above factors are either absent or limited. These data offer significant advantages over data used by previous studies. First, the absence of taxation of dividends and capital gains in Oman provides an ideal opportunity to examine the ex-dividend behaviour without any ambiguity regarding effective marginal tax rates on dividends and capital gains. Second, the fact that stock prices are decimalized in Oman implies that the confounding effects of stock price discreteness on ex-day behaviour are much smaller compared to other market where prices are not decimalized (until recently the minimum tick size was oneeighth of a dollar in the US). In addition, dividends are usually paid once a year in Oman, whereas in many other countries (e.g., US, UK, Australia) dividends are paid quarterly or semi-annually. These factors increase the size of the dividends relative to the minimum tick size for the stock compared to other countries, and this reduces the importance of the tick size as a driver of the ex-day behaviour. Third, transaction costs become more important when dividends are relatively small, and act like a barrier against short-term trading. However, since dividends are usually distributed annually rather than quarterly, this would suggest that transaction cost models may not be important in Oman. Fourth, in addition to the daily stock prices, the data set contains intra-daily data which allow us to directly test the Frank and Jagannathan (1998) market microstructure model. Because of these data advantages, we can examine the exdividend day behaviour in a less noisy and a more powerful manner than previous studies. 4

22 Like previous studies, we find that the stock price drops by less than the amount of dividends and there is a significant positive ex-day return. By examining abnormal volumes around the ex-dividend day, we find no evidence of short-term trading. We are however able to account for our results using market microstructure models. The third topic analyzed in Chapter 4 is the stock price reaction to dividend announcements. Tax-based signaling models argue that dividends would not have information and be informative if it is not for the higher taxes on dividends relative to capital gains that they apply to shareholders (Amihud and Murgia (1997)). The absence of personal taxes presents us a golden opportunity to examine this prediction. If we find that the stock price reacts to cash dividend announcements, then this would suggest that the higher taxation on dividends relative to capital gains is not a necessary condition for them to have information and be informative. It would also suggest that there are other factors, beyond higher taxation, that make dividends informative. Moreover, Omani companies rely heavily on bank financing. If bank monitoring is effective, then dividend payments may not be necessary to reduce managers tendency to overinvest free cash flow. This should reduce the announcement effects of dividend on stock prices. In addition, the concentration of ownership structure in Oman should reduce the agency cost between managers and shareholders. If the concentration of ownership leads to less information asymmetry between managers and shareholders, dividend announcements should have a smaller pricing effects compared to countries where companies are owned by a diverse group of investors. Both of these arguments, together with the absence of taxes on dividends and capital gains, suggest that dividends do not act as a signal of information or as a disciplinary mechanism, or at least suggest a 5

23 diminished role for dividends in Oman. On the other hand, the low corporate transparency in Oman suggests a positive effect of dividends. It is an empirical issue as to how the Omani market balances the negative pricing effect of non-taxability of dividends, bank leverage, and ownership concentration and the positive pricing effect of low transparency on dividends. Our results show that the announcements of dividend increases (decreases) are associated with a stock price increase (decrease). Firms that do not change their dividends experience insignificant negative returns. These results contradict the taxbased signaling models which argue that higher taxes on dividends relative to capital gains are a necessary condition for dividends to have information and be informative. The final topic examined in Chapter 5 is the determinants and stability of dividend policy for financial and non-financial firms. Investigating this issue is important because Omani firms have high dividend payout ratios which led the CMA to issue a circular (number 12/2003) arguing that firms should retain some of their earnings for rainy days. This allows us understand the characteristics of firms that pay dividends. In addition, dividend policy remains a puzzle. A major part of the puzzle stems from the fact that firms continue to pay dividends despite the tax disadvantage. While this is true in the U.S. and other western countries, Oman poses a unique case. The absence of taxes means that a major source of the puzzle is eliminated. Moreover, the determinants of dividend policy are controversial and there is no unanimity among researchers on the factors that affect dividend policy. This controversy motivates this research to provide new evidence on the factors that affect dividend policy. Unlike most previous studies, we include both dividend paying and non-dividend paying firms. This 6

24 is important since the exclusion of the non-dividend paying firms from the analysis may create a selection bias (Kim and Maddala (1992) and Deshmukh (2003)). We find that there are some common factors that determine dividend policy of both financial and non-financial firms and there are some factors that affect only nonfinancial firms. In particular, the common factors are profitability, size, and business risk. Government ownership, leverage, and age have a significant impact on the dividend policy of non-financial firms but no effect on financial firms. Our results also show that agency costs are not a critical driver of dividend policy of Omani firms which is not surprising given that Omani firms have high debt ratios. We also find that the factors that influence the probability to pay dividends are the same factors that drive the amount of dividends paid for both financial and non-financial firms. We document that non-financial firms adopt a policy of smoothing dividends while financial firms do not have a stable dividend policy. In Appendix A we provide a general overview of the Oman economy and its financial sector. In particular, we discuss the performance and the unique characteristics of Oman and describe the major features of the Muscat Securities Market (MSM). 1 The Appendix also provides a brief description of the financial sector with an emphasis on those aspects of the MSM and debt market that are of particular interest and relevance to the current study on capital structure and dividend policy. 1 The MSM is the only securities market in Oman where shares are traded. 7

25 Chapter 2: What are the Determinants of Capital Structure? Evidence from a Country with Unique Financing Arrangements 2.1. Introduction Capital structure decisions are enigmatic. 2 Economists have neither a persuasive theory nor a clear understanding of what factors affect capital structure decisions. This led Myers (1984) to call it the capital structure puzzle. In the same paper, Myers (1984, p. 575) asked How do firms choose their capital structures?...the answer is, We don t know we know very little about capital structure. We do not know how firms choose the debt, equity or hybrid securities they issue In general, we have inadequate understanding of corporate financing behavior, and of how that behavior affects security returns. In an influential paper, Welch (2004) provides some answers to Myers questions. For instance, Welch (2004) provides evidence that firms are basically inert and their capital structure changes are mainly driven by their stock returns. Moreover, he documents that US firms do not issue debt or equity to counter the effect of stock returns on their capital structure. Welch also shows that after controlling for stock return effects, many previously used proxies play a minor role in explaining capital structure dynamics. But how general is the inertia theory? Are the Welch results general or unique to a US-style institutional setting? 2 See Appendix B for a detailed review of the capital structure literature. 8

26 There are some institutional factors that differentiate the US from Oman. For example, Welch argues that long-term debt issuing activity is the most capital structure relevant for the US, however, as we will demonstrate later, Oman depends mostly on short-term financing where banks play a pivotal role in financing firms listed on the Muscat Securities Market. The question of whether the institutional setting affects the results can be tested empirically by conducting similar studies in emerging countries. So it is yet to be seen whether the Welch findings hold in environments that are different from the US. In fact, Rajan and Zingales (1995, p. 1421) stress that without testing the robustness of this finding outside the environment in which they were uncovered, it is hard to determine whether these empirical regularities are merely spurious correlations, let alone whether they support one theory or another. Oman is of interest for many reasons. First, as we will show later, Oman has unique financing arrangements that are characterized by high leverage and high reliance on bank debt. The fact that Omani firms depends on banks to finance their activities adds further importance to the study. The literature has often described banks as being particularly good at investigating informationally-opaque firms and deciding which are viable borrowers. Banks have an advantage at collecting information but are potentially more expensive sources of capital than the public debt markets. The costs of monitoring and imperfect financial contracting should raise the costs of debt for firms borrowing from banks, and hence lower their debt ratios (Faulkender and Petersen (2006)). The fact that Omani firms are highly levered seems surprising given the high costs of obtaining debt in Oman. 9

27 Second, due to the simplicity of the tax system, Oman is an important case to test financial theories. In Oman there are neither personal taxes nor taxes on dividends and capital gains. This is different from western countries, where most studies are undertaken, which are characterized by the complexity of the tax code, making it hard to evaluate the importance of debt. Indeed, the dynamic nature of the treatment of tax shields in the American tax system makes it difficult to evaluate the quantitative importance of debt. In fact, Myers (1984, p. 588) concludes after reviewing the available empirical work that there was no study clearly demonstrating that a firm s tax status has a predictable, material effect on its debt policy. I think the wait for such a study will be protracted. One of the reasons for this conclusion by Myers is the complexity of the tax system in most western countries which makes such study a difficult task. Actually, Graham (2000, p. 1901) notes that Researchers face several problems when they investigate how tax incentives affect corporate financial policy and firm value. Chief among these problems is the difficulty of calculating corporate tax rates due to data problems and the complexity of the tax code. Other challenges include quantifying the effects of interest taxation at the personal level. Thus, this may contribute to the capital structure puzzle. Indeed, one of the problems that led to Myers capital structure puzzle is related to properly quantifying corporate tax rates and incentives. While complexity is true for the US, it is clearly not true for some other countries including Oman where firms are taxed at flat rate of 12%. Thus, Oman offers a unique environment that enables us to avoid the complexity of tax rates. As a result, it may help get clearer result on the impact of taxes on firm financing decisions. This is one of the objectives of this study. A finding of a positive association between leverage 10

28 and taxes would help in resolving the capital structure puzzle. In fact, Graham, Lemmon, and Schallheim (1998, p. 153) state finding a positive relation between debt levels and taxes helps resolve the capital structure puzzle. Apart from the contribution to the sparse literature on capital structure in emerging markets, this study extends the capital structure literature along a number of dimensions. Firstly, we provide evidence about the broad patterns of financing activity in Oman. This provides the empirical context for the more formal tests on the factors that affect capital structure dynamics. Secondly, while there is a wide agreement that stock returns are an important determinant of capital structure, there is an intensive debate on whether this effect is persistent. These findings are mainly derived using data from the US. We provide independent evidence from Oman. Thirdly, in comparison to previous work on this topic, we examine a boarder set of explanatory variables and introduce some factors that are unique to Oman. Much of the analysis is devoted to determining which variables are economically important in predicting leverage, with a central focus on stock returns. In particular, this study is designed to explain the variation in debt ratios across all publicly traded Omani firms and, hence, to identify empirically the determinants of capital structure dynamics. The primary objective of the study is to examine whether stock returns are important factors in firms capital structure choices. The relationship between debt ratios and stock returns will be investigated with various determinants commonly found in previous studies, such as firm size, type of asset, growth opportunities, profitability, uniqueness, etc. Moreover, since the theories have different empirical implications in regard to different types of debt instruments, the study uses separate measures of short-term, long-term and an aggregate measure of 11

29 leverage to check the robustness of our model. Fourthly, the simplicity of the tax code in Oman provides us with a unique opportunity to avoid the complexities faced by previous studies. These may enable us to get clearer results on the impact of taxes on capital structure. Fifthly, we investigate whether firms try to counteract the mechanistic effect of stock returns, and if so, how quickly managers offset the impact of stock return surprises. This is an important issue since the current literature provides mixed results with some studies finding evidence supporting and others failing to do so. Sixthly, the vast majority of theoretical models on the choice of debt structure assume that bank debt and non-bank debt are equivalent, and as a result most empirical studies either exclude bank debt or combine it with non-bank debt (Hooks and Opler (1993)). In this study, a distinction is made between bank debt and non-bank debt in an effort to enhance our understanding about the characteristics of firms that use them. This distinction is important since it is possible that bank debt may exhibit different characteristics than non-bank debt. Finally, the results of the study can be effectively used by both the management of firms and the government. It should also narrow the gap between empirical research in developed and developing countries and hence identify whether the determinants are critically different for these two classes of markets. In addition, this study will not only improve the understanding of the Omani capital structure, but it also tests for the robustness of the evidence brought forward by studies on other countries. Our results show that Omani firms have high leverage ratios and the main source of debt is short-term bank financing. The limited bond market leaves room for banks to 12

30 play an important role in financing Omani firms. Banks mainly provide short-term loans which explain the high reliance of Omani firms on this form of financing. We find robust evidence that stock price changes have a strong and primary effect on observed market-based debt ratios. Firm s capital structure seems to move practically in line with that mechanistically induced by their stock returns. We also find that firms show some tendency to nudge back to their old debt ratios. However, the impact of stock returns dominates the effects of readjustment. Adding previously popular determinates of capital structure has only modest economic impact on capital structure dynamics. In essence, when we include other featured variables into our model, stock returns subsume other factors. Nevertheless, there are non-stock return variables that have both statistical and economic significance. For example, taxes show some incremental explanatory power over five years. However, tax s impact is far less than that of stock returns. When used with bank debt, stock returns continue to subsume other determinants of capital structure. Nonetheless, it is important to note that there are some differences between the findings of this study and Welch. First, the impact of stock returns is much less than that reported by Welch for the US. Similarly, firm s tendencies to rebalance towards their target capital structure are much higher for Oman compared to the US. Second, in contrast to Welch, short-term debt issuing activity is the most capital structure relevant corporate activity, explaining 19.9% of the variation in leverage changes. Third, we find new evidence that firms show some tendency to counteract the effect of stock return surprises. However, the speed of adjustment to offset the mechanistic effects of stock 13

31 returns is slow. This view differs from Welch who claims that firms do nothing to counteract the impact of stock returns for the US. A recent study by Leary and Roberts (2005a) argues that the persistent effects of shocks on leverage documented in previous studies are due to adjustment costs. We examine these results and we find evidence that adjustment costs are unlikely to be the main reason behind our results. In a similar vein, Flannery and Rangan (2006) claim that the Fama and MacBeth (F-M) regression used in Welch fail to recognize the panel aspect of the data. They argue that partial adjustment with fixed effects is a more appropriate estimator. We employ Flannery and Rangan partial adjustment model and we estimate it using F-M, fixed effects, and the System (extended) General Method of Moments (GMM). We find that our results are robust to these methods. In general, our results that stock returns are a primary determinant of capital structure is consistent with the recent work by Cai and Zhang (2005), Chen and Zhao (2005a), and Kayhan and Titman (2006). The slow adjustment we find is in line with the evidence reported by Jalilvand and Harris (1984), Fama and French (2002), Baker and Wurgler (2002), Kayhan and Titman (2006), Huang and Ritter (2005), and Titman and Tsyplakov (2005). The remainder of the chapter proceeds as follows. Section 2.2 describes the data and presents the measures that we construct to estimate the impact of stock returns on capital structure dynamics. Section 2.3 develops the regression specification, and examines whether the form of debt matters and presents the estimation results. Section 2.4 briefly discusses other potential determinants of capital structure used in the study. Section 2.5 presents the results for the determinants of change in leverage followed by an investigation of the extent to which these effects hold with bank debt in Section

32 In Section 2.7 we provide comparison with the current literature. Section 2.8 concludes the chapter Data and Methodology Data The data for this study are taken from Share-Holding Guide of MSM Listed Companies published by the MSM. The MSM collects annual financial statements and stock price data of all firms listed on MSM and it has a website to provide information and financial data related to the performance of MSM and all listed companies. Every year it publishes a book called Share-Holding Guide of MSM Listed Companies which comprises accounting information from financial statements as well as stock return data and data on ownership structure. We complement the data from the MSM Guide with MSM index which we obtain from the MSM. As the data were available in hard copy only, the first task was to input the data into a computer database. The data set comprise all publicly traded firms listed at the MSM. In the sample, firms come from all four sectors that comprise the MSM namely, financial and banking sector, service sector, industry sector, and insurance sector. These sectors contain firms from hotels, poultry, leasing, fisheries, oil, agriculture, energy, power, aviation, banks, investment firms, and manufacturing firms. The data are time series cross-sectional variables which are collected over the entire life of the MSM from 1989 to To check for the accuracy of the data, we compare the figures from the MSM Guide with the data from the firm s financial statements available on the internet, where 15

33 possible. Any observations with missing data for the book value of debt, and/or market value of equity are deleted because these variables are required to calculate our dependent and independent variables. Because our regression specification includes lagged variables, we also exclude any firm with fewer than two consecutive years of data. The number of firms included in the study changes from one year to another, with a range from 60 to 142. These resulted in a data set of an unbalanced panel containing 1,263 firm-year observations Measures of Leverage The definition of leverage is important since an ill-defined measure of debt may not only lead to spurious relationships, but more importantly the researcher will be unable to capture the full response of the firms (Plesko (2001)). Several definitions of leverage have been used in the literature where most studies consider some form of a debt ratio. The difference between these studies is whether book value measures or market value measures are employed. Most of the current academic literature focuses on market debt ratios (e.g., Hovakimian, Opler, and Titman (2001), Frank and Goyal (2004), Welch (2004), Leary and Roberts (2005a), Hovakimian (2006), and Flannery and Rangan (2006)), whereas the older academic literature tends to focus on book value (e.g., Rajan and Zingales (1995), and Booth, Aivazian, Demirguc-Kunt, and Maksimovic (2001)). However, most of the finance literature supports the concept that market value is a more accurate measure because it presents the present value of the firm s equity as a going concern, as reflected in the stock market of the publicly traded firms, that is, it reflects the present value of the firm s expected future cash flows. In 16

34 fact, Welch and Hoberg (2002) provide evidence that book value of equity is a problematic measure of value. 3 They suggest that it is a plug number used to balance the left-hand side and the right-hand side of the balance sheet and it has little economic significance. Moreover, it has low correlation with the market value of equity. As a result, they argue that market value of equity is much a better measure of value. Consequently, this study employs market value of equity to calculate debt ratios Empirical Model The primary objective of the chapter is to examine the determinants of capital structure decisions with a focus on stock returns. The main research question of this study is whether variation in market leverage ratio is caused primarily by stock returns or deliberate managerial choices to adjust to their past target debt ratios. The basic empirical model is a time series cross sectional regression of firm s debt ratios against the lagged market leverage ratio and the stock return induced changes in market value of equity. This estimating equation extends the model used by Welch (2004) to Oman. As with previous studies, the dependent variable in our regressions is market leverage ratio or as Welch calls it the Actual Debt Ratio (ADR t ). We define accounting measures in accordance with Welch (2004). Specifically, ADR is defined as the ratio of book value of debt (D) to the sum of book value of debt and the market value of equity (E), ADR t t = (2.1) D + E t D t 3 For more detail, see Welch and Hoberg (2002). 17

35 Where D t is the sum of both current liabilities and long-term liabilities at time t and E t is the market value of equity (computed as the number of outstanding shares multiplied by the market price) at time t. As in Welch (2004), our explanatory variables are the lagged ADR and the IDR t,t+k. IDR t,t+k is the implied debt ratio that results if the firm does nothing, i.e., neither issues nor retires debt or equity. It is constructed to measure the extent to which market leverage ratios are expected to change in response to stock returns. Specifically, IDR measure the degree to which the market leverage ratio changes mechanically because of stock return induced changes in the market value of equity. By design, IDR moves mechanistically with stock returns, and not with managerial capital structure decisions. Consistent with Welch (2004) notation, the IDR is: IDR D t t t+ k = Et.( 1+ xt t+ k ) + D (2.2),, t Where D t and E t is as defined above, x t,t+k is the stock return experienced by the firm s equity from t to t+k net of dividend, t is a random error, and k is the horizon measured in years. Hence, the basic regression equation is: ADR t+ k = 0 + α1 ADRt + α 2 IDRt, t+ k α + (2.3) t As a robustness checks, we also perform the analysis on short-tem debt, longterm debt, and bank debt. As in Welch (2004), the hypothesis of this study is the following: Perfect readjustment hypothesis: α =, α 0 (2.4) = Perfect non-readjustment hypothesis: α =, α = 18

36 Under the hypothesis of optimizing behaviour, the readjustment hypothesis should reflect a target that managers wish to achieve and hence wish to readjust to. On the other hand, the inertia (non-readjustment) hypothesis implies that any change in leverage between t and t+k is due to changes in stock return over the period, as opposed to adjustment to the past debt ratio. We estimate equation 2.3 twice, with and without an intercept. When we include the interceptα 0, it is used to capture a constant target debt ratio. If firms follow an optimizing behaviour in which higher firm value induce higher debt ratios, then the coefficient on ADR should be 100%. On the other hand, if debt ratios are driven mechanistically by stock returns, then the coefficient on IDR should be 100%. Since our focus is on the dynamics of firms capital structure choice, we express the capital structure adjustment in equation (2.3) as follows. Leverage changes with new debt issues, debt retirements, coupon payments, and debt value changes. As a result, corporate debt can be expressed as D t+ k Dt + TDNI t t+ k +, (2.5) Where TDNI stands for total debt net issuing activity. As in Welch (2004), we define TDNI as the difference in total debt value between t+k and t. Similarly, corporate equity changes with stock returns (net of dividends), and new equity issues net of equity repurchases. Consequently, corporate equity can be expressed as: E t+ k = Et 1+ xt, t+ k ) + ENI t, t+ k.( (2.6) Where ENI reflects firm s net equity issuing and stock repurchasing activity. ENI is then defined as the difference in total equity value between t+k and t without return and dividend effects. Under this definition, actual debt ratios can be expressed as: 19

37 ADR t, t+ k = D D t+ k t+ k + E t+ k = D t + TDNI D + TDNI t, t+ k t t t, t+ k + E.(1 + x t, t+ k ) + ENI t, t+ k (2.7) More detailed data definitions are in Appendix C Descriptive Statistics Table 2.1 presents summary statistics of basic variables after performing modifications to address outlier values. Specifically, we trim the upper and lower two percentile of each variable s distribution in the normalized series. Using these criteria, we identify 1,212 firm-years observations for the one-year regression and 612 for the 5- year regressions, covering corporate financing behaviour from 1989 to All variables are measured in percentages, unless otherwise indicated. On average, Omani companies have a total accounting assets of RO 40 million, with around 47% of the assets being short-term. These assets are employed to earn RO 8.1 million in revenue. The mean market value of sample firms is about 1.33 times accounting assets. However, the median market value is much smaller than the accounting assets. Similarly, the median market value is considerably smaller than the mean market value. The actual debt ratio is around 48%, financed mostly through bank loans. 4 The mean short-term actual debt ratio is higher than long-term actual debt ratio during the period under investigation. The standard deviation for short-term actual debt ratio exhibits a similar pattern. The summary statistics of Table 2.1 show the importance of the dynamic components of debt ratios. During the period of study, the average sample firm achieves 4 This is much higher than the 29.8% reported by Welch (2004) for the US. 20