Optimal financing structure of companies listed on stock market Author: Brande George Coordinator: Laura Obreja Braşoveanu Introduction Optimal capital structure theory has been one of the most enigmatic issues in finance since the beginning of modern theory sustained by Modigliani and Miller. Many researchers have tried through different ways to discover the optimal financing structure of a firm, the optimal quantity of debt and equity. Optimal financing structure signifies the different decisions managers around the world try to make to maximize the firm value. They have to provide shareholders bigger winnings than the ones they would earn at a firm financed entirely with equity. In the first part of the study I will analyze the determinants of capital structure of Romanian firms listed at Bucharest Stock Exchange. Secondly, I will discover the impact of financing structure on the performance of the firms. My database contains 63 firms on a 3 year period, form 2008 to 2010, to form a panel data of 189 observations. The database does not contain financing institutions because they have different capital structure which will distort the overall results. I will use multiple linear regressions in Eviews statistical program which will reveal correlations between debt and determinant factors. In my opinion this study is important because Romania lacks of capital structure research studies. The study analyzes the companies listed on the stock exchange which represents the industrial force of Romania and thus, the results will clearly show how the Romanian firms finance the capital structure. Literature Review The capital structure consist of classic theories and modern theories: Modigliani and Miller developed the classic theory and several authors developed the modern theories such as trade-off theory, pecking order, agency costs, signaling theory and market timing theory.
The first capital structure theory has been submitted by Modigliani and Miller in 1958. The authors constructed a model with great limitations: perfect stock market, zero transactions cots, no taxes, cost of debt is zero and there are no bankruptcy costs. The value of the firm is the sum of the value of debt and the value of equity. Their theory sustained that the value of a firm is independent of capital structure. Kraus and Litzenberger 1973 elaborated a classic version of trade-off theory that claims that the optimal debt level reflects a trade off between interest tax shield and bankruptcy costs. Berk and Demarzo introduce the cost of financial distress that appear when a firm has problems to pay its financial debts. When a firm has a big ratio of debt and equity, the probability of a bankruptcy becomes greater. There are two types of costs arisen from financial distress: direct costs and indirect costs. A firm constantly searches for the optimal capital structure that balances the fiscal advantages in opposition with the cost of bankruptcy. A firm will contract debt until the point when the marginal value of tax shield is balanced by the growth of bankruptcy costs (Myers 2001). The trade-off theory suggests that profitability and size are positively correlated with leverage. Pecking order theory is a consequence of informational asymmetry- the management is supposed to know more than the outside investors. This theory suggests that greater firms have the possibility of internal financing. The primary method of financing is internal, afterwards the cheap debt and the last choice is equity financing. The theory predicts why the most profitable firms borrow less- not because they have low leverage targets, but because the have adequate internal funds for financing the activity. The agency theory has been defined by Jensen and Meckling (1976). They suggested the existence of inevitable agency costs in corporative finance. The agency costs arise from two relationships: between shareholders and lenders and between shareholders and managers, both a consequence of informational asymmetry. The conflict between shareholders and lenders is described by Jensen and Meckling. In the case of a default, the conflict is well documented by Myers. He suggests that when a firm will go bankrupt, the shareholders are not motivated to bring new equity, even if the money will be invested in projects with positive NPV. The reason is that the shareholders suport all the costs and some of the earnings will be taken by the lenders. Diamond produces a model which proves the need of good reputation because the firm with good reputation can contract credits with lower interest. The conflict between shareholders and managers is a classic relation principal-agent. It suggests that managers have some purposes to follow their own interests on the shareholders costs because of the asymmetric information. Amihud and Lev suggests that managers will be
more hostile to risk than the shareholders, if both had equal money. This results in the preposition that a manager will prefer a constant cash flow than a cash flow which, is bigger totally, but has greater volatility. The signaling theory, first introduced by Ross 1977, is based on the informational asymmetry, revealing debt as a signal which shows the type of a firm. Between a good firm and a bad firm, the debt will show the difference between them. The managers of the good firms will choose the minimum level of debt to signal their type of firm. In cross section, the value of the firms will rise with debt, as growth in debt grows the perception of value. A theory of capital structure more recent is market timing theory. This is used when companies issue shares at a high price and repurchase them at a lower price. Because the existent shareholders are the ones who benefit from this tactic on the expense of the new shareholders, the managers must time the markets behavior. Figure nr. 1 Capital structure theorems Teorem Modigliani Miller Trade-off theory Pecking order theory Agency theory Signaling theory Market timing theory The value of the firm is determined by the left side of the balance sheet, by the assets, and will stay unaffected if the liabilities have more or less debt A firm contracts debt untill the point in which marginal value of tax shield of aditional debt balances the growth in the prezent value of bankrupcty costs Firms choose internal financing first. If external financing is nessesary, the second option is cheap debt and the third is issuing equity Choosing more debt has the potential to reduce agency costs. The firms signal the type through debt Firms will issue equity at high prices and repurchase them at low prices Bevan and Danbolt accomplished an analysis of the determinant factors of capital structure in UK. The results have shown that debt is positively correlated with tangibility and size and negatively correlated with growth and profitability, meaning that small firms have problems contracting a credit.
Rajan and Zingales made an empiric study on about 8000 firms in G-7 countries (USA, Japan, Germany, France, UK, Italy,Canada) which revealed a positive correlation of tangibility with debt and a negative correlation of profitability with debt. Size it s positively correlated with debt, with the exception of Germany, where it is negatively correlated. Chen (2003) wrote a study in which he analyses the determinant factors of capital structure in China. The results respected the literature review: profitability negative correlation with debt, growth, tangibility and size positive correlation. Chinese firms have been reported financing their activities through short term debt rather than long term debt. A study realized by Bauer from Czech Republic showed some easy predicted results: growth and tax shield are negatively correlated with debt, size positively correlated and profitability negatively correlated. These results show the presence of the pecking order theory. Figure nr. 2 Empirical research Author (year) Database Determinant factors of capital: Profitability(P) Size(S) Growth (G) Tangibility (T) Liquidity(L) Tax-shield (TS) Volatility(V) and the correlation Bevan and Danbolt(2000) Sinan Akdal (2010) Song (2005) Nikolaos Eriotis Rajan Zingales 1995 Chen Yanmin Qian Yao Tian Non financial companies in UK Companies form the FTSE 250 UK Swedish listed companies Listed companies from Greece Listed companies from G-7 companies Listed companies from China Listed companies from China P -, S +, G -, T + P -, S +, G -, T +, TS -, L-, V - P -, S +, G+, T+, TS - S +, L -, TS -, G - P -, S +, T+ P -, S +, G +, T + P -, S +, G -, T+, TS-, V - I think the literature lacks of research studies that investigate the impact of capital structure on the performance of companies. I also consider that there are not enough empirical studies that analyze the capital structure of Romanian firms. A. The determinants of capital structure
Objectives The objective of this study is to find the determinant factors of capital structure of firms listed at Bucharest Stock Exchange and reveal the impact of capital structure on the performance of firms. Figure nr. 3 Independent variabiles Independent variable Anticipated correlation Size Profitability Liquidity Growth Tangibility -(pecking order) +(trade-off) -(pecking order) +(trade-off, signal) -(pecking order) -(trade off) +(signal pecking order) +(trade off, pecking order) - First we have to analyze the statistic signification of determinant factors of capital structure and then explain the correlations between debt and the determinants. The assumptions are that profitability is negatively correlated with debt- pecking order theory, size is negatively correlated- pecking order theory, liquidity- negatively correlated, growthnegatively correlated and tangibility is positively correlated. Data description methodology The database is formed out of 63 companies listed at the bvb category of Bucharest Stock Exchange on a period of 3 years (2008-2010) that form a panel data. The data is extracted from the financial statements of the listed firms which I studied from the website of Bucharest Stock Exchange www.bvb.ro. I will analyze the observations in Eviews Statistical Program using linear multiple regressions in three methods: ordinary least squares, fixed effects and random effects. Each model is subject of several limitations and using only one method will not be efficient.
After comparing the 3 methods, using Hausman Test and F-statistic, the tests concluded that fixed effects shows the best results for our data. The variables used are dependent variables and independent variables. The dependent variables represent debt total debt, short term debt, long term debt, and independent variables show the determinants of capital structure: size, profitability, liquidity, growth and tangibility. Results Below there are results of the multiple linear regression with total debt as dependent variable. The results show that all the determinant factors are statistic significant, with the exception of growth in fixed effects. Profitability is negatively correlated, size is positively correlated, liquidity is negatively correlated, growth is positively correlated, and tangibility is negatively correlated. Basically, all the determinants respect the literature review and follow pecking order theory. Tangibility is negatively correlated with total debt and short term debt contradicting the literature review, but is positively correlated with long term debt. These results suggest that firms use short term debt to finance current assets and long term debt to finance tangible assets. Figure nr. 4 Total debt regression(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) TD ols fixed random Constanta 0,195663-0,86315*** -0,09486 size 0,0615*** 0,177943*** 0,091874*** Profitability -1,129382*** -0,6976*** -0,7557*** Liquidity -0,029699*** -0,01064*** -0,01703*** Growth 0,099282*** 0,009067 0,024731* Tangiblity -0,415864*** -0,2853*** -0,39186*** R-squared 0,572944 0,949012 0,424589 Adjusted R-sq 0,561276 0,920778 0,408867 Figure nr. 5 Short term debt(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) STD ol fixed random Constanta 0,284522** -0,70511 0,148452 size 0,043391*** 0,152098*** 0,05755***
Profitability -0,81967*** -0,62062*** -0,66233*** Liquidity -0,026*** -0,01491*** -0,0209*** Growth 0,061975** 0,004483 0,021185 Tangiblity -0,48896*** -0,33179** -0,47106 R-squared 0,597898 0,911098 0,453024 Adjusted R-sq 0,586911 0,861871 0,438079 Figure nr. 6 Long term debt(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) LTD ols fixed random Constant -0,08886-0,15805-0,1419 Size 0,018109 0,025845 0,023494 Profitability -0,30971** -0,07698-0,13667* Liquidity -0,0037 0,004277 0,001417 Growth 0,037307* 0,004585 0,011129 Tangibility 0,073096* 0,046494 0,065424 R-squared 0,091756 0,834412 0,025229 Adjusted R-sq 0,066941 0,742723-0,0014 These results show that Romanian listed firms use more short term debt and less long term debt. Actually, they use short term debt to finance short term assets and use long term debt to finance long term assets, following the matching maturity principle. The long term debt results are not so relevant because they are not statistically significant. B. The impact of capital structure on firm s performance Objectives The objective of this part of the study is to reveal the impact of capital structure on firm s performance. The literature review has several hypothesis suggested in the following table. The goal is to test these hypothesizes through empirical work. Figure nr. 7 Hipothesis(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) Independent variable Expected correlation with performance Leverage -
Size + Liquidity - Growth + Tangibility + These are the expected correlation in respect with the literature in the finance field. We will produce 3 types of regressions: ols, fixed and random. Data description - methodology The second part of the study, the impact of capital structure on performance of companies listed on Bucharest Stock Exchange, begins with analyzing the performance of the companies. We will use, as well, multiple linear regressions in Eviews Statistical Program and the same companies at first part of study. For this, we will use return on equity roe and return on assets-roa. as dependent variables. The independent variables will be leverage, with its 3 types: short term, long term and total leverage, size, liquidity, growth and tangibility. Using the dependent and independent variables we will form a panel data system. Results Figure nr. 8 Regression with roe as dependent variable(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) ROE ols fixed random CONSTANT 0.384475-2.440.811 0.383452 LEVERAGE -0.941291*** -2.928.614*** -1.132.846*** SIZE 0.021560 0.481204** 0.037204 LIQUIDITY -0.023740** -0.030366** -0.027678*** GROWTH 0.164569** 0.038505 0.128448** TANGIBILITY -0.350565*** -0.553336-0.421853*** R-squared 0.207683 0.670000 0.214281 Adjusted R-squared 0.186035 0.487273 0.192813 Durbin-Watson stat 1.134.801 2.140.202 1.373.203 These results, provided by using roe as dependent variable, reveal negative and strong correlation between roe and leverage in fixed model. Size is positive correlated, liquidity negative, growth positive and tangibility negative. They are all significantly respecting the p-
value but growth and tangibility in fixed effects. The R-squared is 67% which show great explicability by these factors on the performance of the firms. Figure nr. 9 Regression with roa as dependent variable(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) ROA ols fixed random CONSTANT -0.086589-1.026.557*** -0.099579 LEVERAGE -0.201770*** -0.436460*** -0.232938*** SIZE 0.028411*** 0.160905*** 0.032955*** LIQUIDITY -0.001813-0.004086* -0.002807* GROWTH 0.040450*** 0.006942 0.030281*** TANGIBLITY -0.096553*** -0.146519* -0.111222*** R-squared 0.313812 0.718650 0.284726 Adjusted R-squared 0.295063 0.562861 0.265183 Durbin-Watson stat 1.263.915 2.514.667 1.701.776 The results, provided by using roa as dependent variable, reveal negative correlation between leverage and roa and positive correlation between size and roa. Liquidity is negatively correlated and growth positively but tangibility is negatively correlated. These all factors are statistically significant, except growth which is not statistically significant in the fixed effect model. Figura nr. 10 Regression with comparison(note: *, ** and *** siqnificant at 10%, 5% and 1% significance level) Fixed effects ROE ROA CONSTANT -2.440.811-1.026.557*** LEVERAGE -2.928.614*** -0.436460*** SIZE 0.481204** 0.160905*** LIQUIDITY -0.030366** -0.004086* GROWTH 0.038505 0.006942 TANGIBILITY -0.553336-0.146519* R-squared 0.670000 0.718650 Adjusted R-squared 0.487273 0.562861 Durbin-Watson stat 2.140.202 2.514.667 The table above shows the correlations between the capital structure determinants and the indicators of profitability: roe and roa.
Leverage is clearly negatively correlated with roe and roa, with respect to the literature in the finance field. Size is positively correlated and this is easy to demonstrate because usually bigger firms make bigger profits. Liquidity is negatively correlated with performance and tangibility as well. Growth is positively correlated, but in small amount. Conclusions In this study I have analyzed the determinants factors of capital structure of Romanian companies listed on the Bucharest Stock Exchange. The results showed that all the determinants were statistically significant and that they respect the literature review, except tangibility which follows a matching maturity principle. After we determined the factors, we investigated the impact of capital structure on the performance of firms in Bucharest Stock Exchange. The results show that contracting more debt reduces profitability.