An Empirical Analysis of Corporate Financial Structure in the UAE

An Empirical Analysis of Corporate Financial Structure in the UAE Dr. Manuel Fernandez Associate Professor Skyline University College PO Box 1797 University City Sharjah, UAE qln_manuel@yahoo.com Abstract Capital structure decisions have important implications on the value of the firm, as the components of the capital determine the cost of capital. The guiding principle is to choose the capital structure that maximizes the value of the firm. The objective of this study is to find out the capital structure mostly preferred by the corporate in the UAE and the factors influencing this borrowing cost, agency cost, corporate tax and other UAE-specific factors, if any. This study is based on the financial data collected from the balance sheets and income statements of all companies listed in the Abu Dhabi Securities Exchange and Dubai Financial Market excluding banks, financial institutions and insurance companies. The sample includes 51 firms. The period of study is five years from 2006 to 2010 The study shows that there is a significant negative relationship between financial leverage and profitability of the firms; and positive relationship between size and financial leverage. The study also reveals that lower profitable firms in the UAE generally use more leverage in the capital structure; and as the firms grow bigger, they tend to use more financial leverage. Keywords: Capital structure, debt-equity ratio, cost of capital, financial leverage Track Name Finance (Corporate Finance) Introduction Capital structure decisions are very important as it has important implications on the value of the firm. It refers to the mix of equity and debt for financing the overall operations and growth of a firm. The primary objective of the financial management of the firm is to maximize the shareholders wealth by the appropriate mix of various sources of finance including retained earnings, equity shares, preference shares and debt. Debt financing involves issuing of bonds, long term notes payable, leasing and loans from banks. But excess debt financing makes the firm risky due to bankruptcy cost. Debt financing increases the risk of bankruptcy, but helps to avail tax shield. Most of the countries impose tax on the corporate profits, hence profitable firms operating in these countries may avail the tax shield by using debt 1

financing. The objective of this study is to find out the capital structure mostly preferred by the corporate in the UAE and the factors influencing this financing decision. The details of selected economic variables and market capitalization of the UAE is given in Table 1 and II respectively. Table 1 Selected Economic Variables: UAE GDP (2011 estimate) (PPP) $260.8 billion* Per capita income (2011 estimate) (PPP) $48,500* Currency Arab Emirates Dirham (AED or DH) Exchange Rate AED 3.673 = US$ 1* Stock markets Abu Dhabi Securities Exchange (ADX) Dubai Financial Market (DFM) (Both established in 2000)*** # of listed companies 129 (ADX 67, DFM 62)*** Corporate tax rate 20% for Foreign banks, 55% for oil companies Personal tax rate on dividends 0% Population (mid 2010 estimate) 8.264 million** (national.948 million and non-national 7.316 million) Unemployment rate (2011 estimate) 2.4%* *www.cia.gov/the-world-factbook **National Bureau of Statistics, UAE *** www.dfm.ae & www.adx.ae Table I1 Market Capitalization (in Millions U.S. $) Stock 2006 2007 2008 2009 2010 2011 Exchange \ Year Abu Dhabi Securities 71688.79 112159.5 61887.63 72,967.81 71,268.62 64,435.24 Exchange Dubai Financial Market 86871.72 138697.8 65217.73 58,829.91 54,722.23 49,548.92 Total 158560.5 250857.3 127105.36 131797.72 125990.85 113984.16 Compiled from www.amf.org.ae Literature Review The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller (1958), forms the basis for modern thinking on capital structure. The theorem states that firms should be indifferent choosing between debt and equity financing in an efficient capital market. However, Miller (1977, 1988) and Modigliani and Miller (1963) demonstrated that debt financing increases corporate value when interest costs of debt are tax-deductible while equity costs are non tax-deductible. DeAngelo and Masulis (1980) subsequently proposed the static trade-off theory, whereby the advantage conferred by debt in the form of a decreased tax bill was offset by an increase in business risk. They proposed a theoretical optimum level of debt for a firm, where the present value of tax savings due to further borrowing is just offset by increases in the present value of costs of distress. Pecking Order Theory presented by Stewart C. Myers (1984) states that, because of asymmetries of information between insiders and outsiders the firms prefer internal sources of financing to equity financing. If internal financing is insufficient then they go for external financing, first they apply for bank loans, then for public debts and as a last resort, equity financing is used. Profitable firms are less likely to opt for debt financing for new projects as they would be having sufficient funds in the form of retained earnings. The agency theory presented by Jensen and Meckling (1976) highlights the possible conflict between shareholders and managers. The managers are agents of the shareholders entrusted with the day to day affairs of the firm, they try to transfer wealth from bondholders to shareholders by borrowing more debt and investing in risky projects. Different researchers have studied the capital structure decision from different point of views and in different environments related to developed and developing economies; a few of them are cited here. 2

The studies by Kakani and Reddy (1996) and Kakani (1999) revealed profitability, capital intensity and non-debt tax shields were important determinants of capital structure. The study by Cassar and Holmes (2003) showed that the asset structure, profitability and growth were important factors which affected the debt equity ratio of firms. Harris and Raviv (1991) found that financial leverage is positively related to firm size, asset tangibility and growth opportunity, but is negatively related to firm risk and profitability. The study of Jong et. al. (2008) stated that the debt equity ratio was related to a number of country-specific factors such as bond market development, protection of creditors and growth rate of gross domestic product. The study by Bhaduri (2002), exhibited that the optimal capital structure choice in developing countries is strongly influenced by factors such as size, asset structure, profitability and financial distress cost. The study by Titman and Wessels (1988) found that financing with debt was negatively related to firm s uniqueness regarding its type of business. Research Methodology This study is based on the financial data collected from the balance sheets and income statements and of all companies listed in the Abu Dhabi Securities Exchange and Dubai Financial Market excluding banks, financial institutions and insurance companies. Data on company balance sheets and income statements were obtained from the websites www.adx.ae and www.dfm.ae. Further, the respective websites of the sample companies were also searched for as when required. The sample includes 51 firms. The data have been taken for five year period of 2006 to 2010. On account of non availability of data, some of the data have been truncated. Analysis and Findings Multiple regression analysis was used to examine the determinants of financial leverage. The financial model used is given by: LEV= β 1 TA+ β 2 SA1+ β 3 TASA+ β 4 CF+ β 5 NI+ β 6 CFROA+ β 7 CFROS+ β 8 ROA Table III Description of Variables Variables Definition LEV Leverage defined by debt equity ratio SA1 The log of sales TA The log of total assets TASA The ratio of total sales to total assets CF The log of cash flow measured by operating cash flow NI The log of net income CFROA The ratio of cash flow to total assets (cash flow return on assets) CFROS The ratio of cash flow to total sales (cash flow return on sales ) ROA Return on Assets The model assumes that financial leverage is determined by the size as measured by the log of sales, log of assets, profitability measured by cash flow return on assets and sales. The correlation analysis was conducted in order to check multicollenearity. Table IV Correlation Analysis CF CFROA CFROS NI ROA SA1 TA TASA CF 1.000000 3

CFROA 0.324172 1.000000 CFROS 0.462170 0.486307 1.000000 NI 0.858165 0.240116 0.391563 1.000000 ROA -0.070052 0.608135 0.230077 0.223439 1.000000 SA1 0.906915 0.137294 0.111614 0.806936-0.169001 1.000000 TA 0.859875-0.100797 0.277287 0.823017-0.241796 0.867565 1.000000 TASA -0.129149 0.339273-0.394912-0.190049 0.177531 0.065846-0.380055 1.000000 Net profit and cash flow were highly correlated. Similarly sales and cash flows are also found to be highly correlated. Net income and total assets are also highly correlated. Sales and asset figures were also highly correlated. Altogether five models were used for the analysis. Model 1 In model 1, all the variables were used for regression analysis. The results were found to be statistically insignificant on account of multicollenearity problems. Hence the following models were analyzed by utilizing the variables which showed low correlations. Dependent Variable: LEV C -3.735115 1.233861-3.027177 0.0028 TA 0.269839 0.258362 1.044423 0.2975 SA1 0.210415 0.345057 0.609797 0.5427 TASA 0.191815 0.485726 0.394903 0.6933 CF -0.040275 0.243517-0.165387 0.8688 NI -0.122657 0.169887-0.721993 0.4711 CFROA -2.655953 3.867665-0.686707 0.4930 CFROS 0.095616 1.167258 0.081915 0.9348 ROA -0.769624 2.796187-0.275241 0.7834 R-squared 0.190239 Mean dependent var 0.987427 Adjusted R-squared 0.159391 S.D. dependent var 1.377382 S.E. of regression 1.262849 Akaike info criterion 3.344846 Sum squared resid 334.9056 Schwarz criterion 3.484123 Log likelihood -357.2606 F-statistic 6.166972 Durbin-Watson stat 0.441036 Prob(F-statistic) 0.000000 Model 2 In model 2, the leverage variable was regressed upon the ratio of sales to total assets which measures the asset productivity; cash flow return on assets; cash flow return on sales; and return on assets measured by net income divided by total assets. In this model the hypothesis assumed is that financial leverage is determined by the profitability of the firm. The results show that financial leverage is negatively related to return on assets. The results are statistically significant at all levels of significance (1%, 5%, and 10%). 4

Dependent Variable: LEV C 1.367036 0.245621 5.565641 0.0000 TASA 0.010548 0.330072 0.031956 0.9745 CFROA -1.097331 2.743332-0.399999 0.6896 CFROS 0.280830 0.895256 0.313687 0.7541 ROA -4.380385 1.583780-2.765779 0.0062 R-squared 0.066028 Mean dependent var 0.987427 Adjusted R-squared 0.048571 S.D. dependent var 1.377382 S.E. of regression 1.343516 Akaike info criterion 3.451023 Sum squared resid 386.2773 Schwarz criterion 3.528399 Log likelihood -372.8870 F-statistic 3.782260 Durbin-Watson stat 0.453262 Prob(F-statistic) 0.005399 Model 3 In this model, the variable of financial leverage was regressed upon variables of assets, sales, cash flow return on sales and return on assets. The results signify the relationship of total assets and return on assets on financial leverage. Total assets are positively related to financial leverage and return on assets is negatively related to financial leverage. Dependent Variable: LEV C -3.038625 0.804404-3.777487 0.0002 TA 0.228434 0.113086 2.019992 0.0446 SA1 0.081535 0.108923 0.748554 0.4549 CFROS -0.868833 0.610682-1.422726 0.1563 ROA -2.735351 1.281818-2.133962 0.0340 R-squared 0.183968 Mean dependent var 0.987427 Adjusted R-squared 0.168715 S.D. dependent var 1.377382 S.E. of regression 1.255826 Akaike info criterion 3.316030 Sum squared resid 337.4991 Schwarz criterion 3.393406 Log likelihood -358.1053 F-statistic 12.06117 Durbin-Watson stat 0.438791 Prob(F-statistic) 0.000000 5

Model 4 In Model 4, the variable of sales is positively related to financial leverage. The results of this relationship are statistically significant at all levels. Return on assets is negatively related to the use of financial leverage. Dependent Variable: LEV C -2.362698 0.736724-3.207033 0.0015 SA1 0.274155 0.053017 5.171045 0.0000 CFROS -0.329922 0.553244-0.596341 0.5516 ROA -3.560603 1.223642-2.909841 0.0040 R-squared 0.168409 Mean dependent var 0.987427 Adjusted R-squared 0.156805 S.D. dependent var 1.377382 S.E. of regression 1.264790 Akaike info criterion 3.325786 Sum squared resid 343.9343 Schwarz criterion 3.387686 Log likelihood -360.1735 F-statistic 14.51350 Durbin-Watson stat 0.442982 Prob(F-statistic) 0.000000 Model 5 In this model the financial leverage variable was assumed to be dependent on the variables of size as measured by total assets (log assets), profitability variables of cash flow return on sales and return on assets. The results show statistically significance suggesting the positive relationship between leverage and size and the negative relationship between profitability and leverage. Dependent Variable: LEV C -2.999522 0.801885-3.740590 0.0002 TA 0.302542 0.054598 5.541267 0.0000 CFROS -1.012485 0.579152-1.748221 0.0819 ROA -2.556104 1.257965-2.031936 0.0434 R-squared 0.181831 Mean dependent var 0.987427 Adjusted R-squared 0.170415 S.D. dependent var 1.377382 S.E. of regression 1.254541 Akaike info criterion 3.309513 Sum squared resid 338.3828 Schwarz criterion 3.371414 Log likelihood -358.3917 F-statistic 15.92735 6

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