Capital structure decisions

Capital structure decisions The main determinants of the capital structure of Dutch firms Bachelor thesis Finance Mark Matthijssen ANR: 421832 27-05-2011 Tilburg University Faculty of Economics and Business Administration Department of Finance Supervisor: Mrs. Dwarkasing

Table of contents 1. Introduction... 4 1.1. Problem definition... 4 1.2. Background... 4 1.3. Research questions... 5 1.4. Composition of the thesis... 5 2. Literature review... 6 2.1. Theories concerning capital structure... 6 2.1.1. Modigliani & Miller (1958)... 6 2.1.2. Modigliani & Miller (1963)... 7 2.1.3. Static trade-off theory... 7 2.1.4. Pecking order theory... 7 2.1.5. Agency theory... 8 2.1.6. Free cash flow theory... 8 2.1.7. Market timing theory... 9 2.2. Determinants capital structure... 10 2.2.1. Tangibility... 11 2.2.2. Debt tax shield... 11 2.2.3. Non-debt tax shield... 12 2.2.4. Profitability... 12 2.2.5. Growth... 12 2.2.6. Size... 13 2.2.7. Industry... 13 2.2.8. Uniqueness... 14 3. Empirical research... 15 3.1. Data description... 15 3.2. Variables... 15 3.3. Hypotheses... 17 4. Empirical results... 19 4.1. Non-financial firms... 19 4.2. Financial firms... 21 5. Conclusion... 24 References... 26 Appendix 1... 29 Appendix 2... 30 Appendix 3... 31 2

Summary M any researchers have analyzed the effect of several determinants on the capital structure of firms. The most investigated determinants in theory are tangibility, debt tax shield, non-debt tax shield, profitability, growth, size and industry. In my empirical research I have investigated the effect of these determinants on the capital structure of non-financial and financial Dutch firms. The reason for this is that the differences between non-financial and financial firms are not much investigated yet. The capital structure is measured by the debt-equity ratio. Although there is a difference between long term and short term debt, I have only used one leverage ratio. For the non-financial firms debt equals total non-current liabilities. The reason is that the overstating of leverage will be reduced in this way. Equity is measured by total shareholders funds. For financial firms debt is measured by the total liabilities and equity by the total value of equity. The reason why total values are taken here is because of the fact that specialized data is not available for most firms. I find that debt tax shield, profitability and size significantly influence a firm s leverage. This result holds for both non-financial and financial firms. Furthermore, when controlling for specific industry effects, firms in non-financial industries such as Construction and Finance and Insurance and firms in financial industries such as Group Finance Companies and Savings banks have significant different leverage ratios compared to firms in others industries. It can be concluded that the capital structure of non-financial and financial Dutch firms is determined by some important determinants. 3

1. Introduction 1.1. Problem definition T he choice between debt and equity for the funding of activities is for every firm an important and difficult decision. There are many determinants of the capital structure and every firm has to select which determinants are important to them and why. The irrelevance proposition of Modigliani and Miller (1958) was the start of consecutive theories about capital structure. Modigliani and Miller (1958) argue that in a perfect capital market, a market with no taxes, no bankruptcy costs and asymmetric information, the firm s value is independent of its capital structure. This means that debt and equity are perfect substitutes for each other. However, the assumption of a perfect market is not realistic. This means that in reality capital structure probably does matter. 1.2. Background Several researchers have investigated issues concerning capital structure already. For instance, Myers (2001) gives a review of some important theories about capital structure: the trade-off theory, the pecking-order theory and the free cash flow theory. The importance of factors in the capital structure decisions of publicly traded American firms from 1950 to 2003, is the main subject of Frank and Goyal (2009). They found that a set of six factors provides a solid basic account of the patterns in leverage. Another useful paper is the paper What do we know about capital structure from Rajan and Zingales (1995). In this paper the determinants of capital structure of public firms in the major industrialized countries are explored. The primary objective of the paper is to establish whether capital structure in other countries is related to factors similar to those appearing to influence the capital structure of U.S. firms. Rajan and Zingales (1995) show that capital structure decisions differ across countries. They study several determinants: tangibility, profitability, market-to-book ratio and size. Differences in accounting rules between countries are corrected. Moreover, they show that it is important if a country is market-based (Anglo-Saxon model) or bank-based (continental Europe model). In market-based economies there are many listed companies and the stock markets are highly active. Banks act sometimes as the last lenders. In a bank-based country banks indeed play a central role in the economy and the stock markets are less developed. However, also in one country the determinants differ per firm. This paper focuses on the determinants of capital structure of financial and non-financial Dutch firms and the differences between them. 4

1.3. Research questions The main research question of this paper is: What are the main determinants of the capital structure of Dutch firms? In order to answer the main question, the following sub-questions will be used: 1) What are the main theories concerning the capital structure of firms? 2) Which determinants can be relevant for the capital structure of firms? 3) What is the difference in capital structure between financial and non-financial Dutch firms? The reason why I have chosen for the differences in capital structure between financial and non-financial firms, is because there is already quite much research about small, medium and large Dutch firms and about the differences between countries. The differences between financial and non-financial firms are less studied. The sub-questions 1 and 2 will be worked out in chapter 2 and I will try to find an answer on question 3 in my empirical research in chapters 3 and 4. 1.4. Composition of the thesis First, in chapter 2, I will discuss the most influential theories of capital structure: the theory of Modigliani and Miller (1958 and 1963), the static trade-off theory, the pecking order theory, the agency theory, the free cash flow theory and the market timing theory. Then I will analyse what are (theoretical) the most important determinants for the capital structure of firms. Chapter 3 contains my research data and chapter 4 contains the results of my empirical research. In this empirical research I will test the theoretical part of my study by investigating the capital structure of Dutch firms. I will analyze the differences in determinants between financial and non-financial Dutch firms. To start, I will give some hypotheses about the correlation between several determinants and the leverage ratio of Dutch firms. The main conclusions and an answer on the main research question will be part of the last chapter, chapter 5. 5

2. Literature review 2.1. Theories concerning capital structure T here is no universal theory of the debt-equity choice, and no reason to expect one (Myers, 2001). But there are several useful theories which (can) have an effect on the capital structure decisions of firms. These will be discussed below. 2.1.1. Modigliani & Miller (1958) The discussion about the capital structure of firms started with the propositions of Modigliani and Miller (1958). They state that in perfect capital markets, leverage does not affect the total value of a firm. According to Berk and Demarzo (2007) perfect capital markets are markets where: 1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. 2. There are no taxes, transaction costs, or issuance costs associated with security trading. 3. A firm s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. Proposition I: The market value of any firms is independent of its capital structure and is given by capitalizing its expected return at the rate appropriate to its class (Modigliani and Miller, 1958). This means that the total value of a firms is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. Given perfect capital markets, the financial structure of firms is irrelevant. The underlying of proposition I is the Law of One Price. If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price (Berk & DeMarzo, 2007). Proposition II: The average costs of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class (Modigliani and Miller, 1958). Proposition I leads to the fact that the weighted average cost of capital (WACC) is constant. This means that leverage does not have any effect on the average costs. Although debt is cheaper, leverage increases the risk and therefore the costs of equity. 6

2.1.2. Modigliani & Miller (1963) In 1963, Modigliani and Miller come with a correction to their model of 1958. They include a market imperfection in their model, namely taxes. This changes proposition I and lead to the fact that capital structure does matter. Interest is a tax-deductible expense. A firm that pays interest, receives an interest tax shield in the form of lower taxes paid. Financing with debt instead of equity increases the total after-tax dollar return to debt and equity investors, and should increase firm value (Myers, 2001). This means also that proposition II of the MM-58 model changes. The costs of capital does not remain constant. The equity cost increase with leverage, but this increase is not entirely offset by the cost of debt through the tax shield (Modigliani & Miller, 1963). 2.1.3. Static trade-off theory The static trade-off theory is based on the model of Modigliani and Miller (1963). It argues that firms borrow up to the debt level where the marginal value of the tax shields is just offset by the increase in the present value of financial distress costs (Myers 2001). Financial distress costs are the costs of bankruptcy of reorganization and the agency costs when a firm s creditworthiness is in doubt. This is shown in figure 1. When the trade-off theory is correct, every firm s debt-to-value ratio, should be its optimal ratio. However, there are costs in adjusting to the optimum, so there is some dispersion of actual debt ratios across firms having the same target ratio (Myers, 1984). Also, when the trade-off theory is right, a valuemaximizing firm should never pass up interest tax shields when the probability of financial distress is remotely low (Myers, 1984). But there are many firms with high credit ratings and low debt ratio s. This seems contradictory and shows that the relation between high profitability (and high credit ratings) and low debt ratio s is difficult to describe by the trade-off theory. Figure 1: The balance between the value of tax shields and the costs of financial distress. 2.1.4. Pecking order theory The pecking order theory of Myers and Majluf (1984) argues that firms prefer internal to external finance. If external finance is required, firms will issue debt before equity, because 7

debt is the safest. Debt has the prior claim on assets and earnings, and investors in debt are therefore less exposed to errors in valuing the firm (Myers, 2001). If the internally generated cash flow exceeds the investment, the surplus is used to repay debt instead of repurchasing equity. The pecking order theory explains why high-profitable firms borrow less: they have more internal financing available. This seems contradictory to the trade-off theory. In this theory high profitable firms should borrow more, because they have more taxable income to shield and their probability of financial distress is less (Myers, 2001). The pecking order theory is particularly relevant for small firms since their costs of external equity may be higher than for large firms (Michaelas, Chittenden & Poutziouris, 1999). 2.1.5. Agency theory The agency theory is introduced by Jensen and Meckling (1976). They argue that in an agency relationship a person (the principal) engages another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. But if both parties are utility maximizers, the agent will not always act in the best interest of the principal. The separation between ownership and control in a firm is a typical example of the agency relationship. Jensen and Meckling (1976) define agency costs as the sum of the monitoring expenditures by the principal (shareholders), the bonding expenditures by the agent (managers) and the residual loss. Agency costs are triggered by conflicts between managers and stockholders, but also between debt and equity holders. Managers will act in their own economic self-interest and the alignment between shareholders and managers objectives is often imperfect. The conflicts between debt and equity holders arise when there is a risk of default so that shareholders can gain at the expense of debt holders (Myers, 2001). The agency costs are comparatively high for small and young firms, because of the lack of formal financial control and the firms flexibility to changes in assets (Van der Wijst, Nico and Roy Thurik, 1993). Pettit and Singer (1985) explained that the higher agency cost of small firms was due to the fact that the quality of their financial statements varies. 2.1.6. Free cash flow theory The free cash flow theory of Jensen (1986) contains that high debt levels increase value, despite the threat of financial distress, when a firm s operating cash flow significantly exceeds its profitable investment opportunities. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital (Jensen, 1986). Managers must be motivated to disgorge the cash on a way that 8

conflicts between shareholders and managers (agency costs) are avoided as much as possible. But when the free cash flow is high, managers have the incentive to overinvest (invest in projects with a negative NPV; the asset substitution problem). The reason is that the compensation of managers is mostly related to the growth of the firm. The free cash flow theory is for that reason important for firms with large cash flows and low growth. Debt can reduce the agency costs of free cash flows and it can substitute for dividends (Jensen, 1986). Managers who have a substantial free cash flow can promise to increase the dividends, but these promises are weak because dividends can be reduced in the future. The market will react with large stock price reductions. Issuing debt enables managers to bond their promise to pay out future cash flows. Thus debt reduces the agency costs by reducing the free cash flow available for spending at value-destroying investments. It is important that a balance is found between debt and equity, because an increase in debt also has its costs. The optimal debt-equity ratio is the point at which the firm s value is maximized (Jensen, 1986). 2.1.7. Market timing theory The market timing theory is based on the fact that capital structure evolves as the cumulative outcome of past attempts to time the equity market (Baker & Wurgler, 2002). In general, firms tend to issue equity instead of debt when the market value of equity is high. They tend to repurchase equity when the market value is low. Also, managers tend to issue equity when they think the costs are relatively low and they repurchase equity when its costs are high. The critical assumption is that managers believe that they can time the market (Baker & Wurgler, 2002). The market-to-book ratio is important here, because it is related to the future equity returns and it shows when a firm is under- or overvalued. According to Baker and Wurgler (2002) there are two types of market timing: 1) rational behaviour of managers and 2) irrational behaviour of managers. The former assumes the existence of adverse selection costs; the latter assumes mispricing of stocks in the market in order that managers can predict the market. However, both types of market timing lead to the same capital structure decisions. 9

2.2. Determinants capital structure Several determinants can affect a firms capital structure. I will restrict myself to the most mentioned determinants in theory. Graham and Harvey (2002) have investigated which factors are important for CFO s to issue debt. From figure 2 it can be concluded that the financial flexibility and the credit rating are the two most important determinants. Figure 2: Factors that affect the decision to issue debt Although in figure 2 there are a lot of determinants of capital structure, I will look at more modal determinants. These are the determinants who are mentioned the most in theory and who are studied the most in practice: 1) Tangibility (asset structure) 2) Debt tax shield 3) Non-debt tax shield 4) Profitability 5) Growth 6) Size 7) Industry 8) Uniqueness 10

2.2.1. Tangibility Tangibility is the ratio of fixed (tangible) assets to total assets. Tangible assets are easy to collateralize and therefore they reduce the agency costs of debt (Rajan & Zingales, 1995). Besides, they reduce the bankruptcy costs, because debt holders can sell their collateral. This reduces credit risk. Moreover, tangibility reduces the problem of information asymmetry. Both the trade-off and the pecking order theory predict a positive relationship between collateral and leverage. Myers and Majluf (1984) show that firms may find it advantageous to sell secured debt (debt backed by collateral). Issuing secured debt avoid agency costs. This means that firms with assets that can be used as collateral may be expected to issue more debt to take advantage of this opportunity (Titman & Wessels, 1988). Smaller firms with lower ratios of collateral assets, which are considered risky by financial institutions, have to rely on lower levels of external debt finance (Michaelas, Chittenden & Poutziouris, 1999). Van der Wijst and Thurik (1993) have tested that a high fixed asset component is associated with more long term and less short term debt. This may evidence the maturity matching principle in small and medium sized firms (SME s), where they try to finance their fixed assets with long term debts, and their current assets with short-term debts (Sogorb-Mira, 2005). 2.2.2. Debt tax shield The debt tax shield (interest tax shield) encloses the tax benefits of debt financing. When a firm has debt, the interest on that debt is tax deductable. The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage (Berk & DeMarzo, 2007). Debt financing has an advantage over equity, since the interest tax shield under debt provide additional income to debt and equity holders (Palepu, Healy & Bernard, 2004). According to Modigliani and Miller (1963) a positive relationship can be expected between taxes and leverage. High tax rates increase the tax benefits of debt. The trade-off theory predicts that to take advantage of higher interest tax shields, firms will issue more debt when tax rates are higher (Frank & Goyal, 2009). But several researchers found that taxes negatively affect debt levels. Jordan, Lowe and Taylor (1998) and Michaelas, Chittenden & Poutziouris (1999) argue that smaller firms are expected to be less profitable and have a greater bankruptcy risk. This increases the risk of debt and implies that smaller firms use less debt than larger firms. Taxes decrease the profitability, so they make less use of tax shields. 11

2.2.3. Non-debt tax shield DeAngelo and Masulis (1980) show that non-debt tax shields are substitutes for debt tax shields. Interest payments reduce taxable income, but non-debt tax shields, like depreciation and investment tax credits, can also produce a tax advantage. This means that when non-debt tax deductions increase, the amount of leverage decrease. A measure of the non-debt tax shield can be the ratio of tax credits over total assets and the ratio of depreciation over total assets (Titman and Wessels, 1988). According to the trade-off theory, firms with more nondebt tax shields, have less leverage (Fama & French, 2002). 2.2.4. Profitability Studies of the determinants of debt ratios find that the most profitable companies tend to borrow the least, because high profits mean low interest and therefore low debt. But Myers (2001) itself does not agree with this point. Because of the fact that firms can exploit interest tax shields, the opposite relationship should be observed. High profitability means that a firm has more taxable income to shield, and that the firm can service more debt without risking financial distress (Myers, 2001; Frank & Goyal, 2009). Jensen (1986) argue that more debt should be used when free cash flows increase. Myers (1984) states the opposite: firms prefer internal to external funds, so if profits are high, the necessity to raise debt is less. Fama and French (2002) argue that according to the trade-off theory, more profitable firms have more leverage. Michaelas, Chittenden and Poutziouris (1999) state that the relation between profitability and debt for SME-firms was larger for long term debt than for short term debt, because those firms rely more on short term debt for their financing and the preference for long term debt is less when retained earnings are available. However, Van der Wijst and Thurik (1993) argue that short term debt had a stronger negative correlation with profitability than long term debt because firms are committed to long term debt and the interest rates of short term debt are higher. As you can see, there is no uniform point of view. 2.2.5. Growth Titman and Wessels (1988) found a negative relationship for growth and leverage. They argue that managers of firms in growing industries have a tendency to invest in too risky projects (asset substitution problem / overinvestment problem). The result is that the costs of debt increase because debt holders anticipate on this (Jensen & Meckling, 1976). Myers (1977) states that managers due to high interest rates may not invest in positive net present value project (the underinvestment problem), thus expected growth should be negatively related to 12

the debt level. However, he noted that this agency problem is mitigated when firms issues short-term rather than long-term debt. Jensen and Meckling (1976) argue that the agency costs will be reduced if firms issue convertible debt. This suggests a positive relationship between debt and growth. The pecking order theory also predicts a positive relationship since higher growth implies a higher demand for funds. Graham and Harvey (2001) note on the other hand that firms with higher growth prefer a low debt level because of their future debt risk. Michaelas, Chittenden and Poutziouris (1999) show that for SME-firms during economic recession, the short-term debt ratios of small firms increase, while in periods of booms, the short term debt ratios decrease. Also they notice that long term debt has a positive relationship with economic growth. 2.2.6. Size In general, larger firms may issue debt at lower costs than smaller firms. Rajan and Zingales (1995) proved that leverage increases with size in all the G-7 countries, except in Germany. 1 This can be explained by the fact that larger firms are better diversified and have a lower probability of financial distress. The consequence is that the lower bankruptcy costs enable them to take on more leverage. Both the pecking order as the trade-off theory predicts positive relationships. Fama and French (2002) argue that larger firms are less volatile. This reduces bankruptcy costs and increases debt (trade-off theory). Besides, when a firm is more diversified and less volatile, this decreases information asymmetry (pecking-order theory). Hall, Hutchinson and Michaelas (2004) and Sogorb-Mira (2005) found that the size of the SME-firm is positively related to the level of debt. Michaelas, Chittenden and Poutziouris (1999) and Hall, Hutchinson and Michaelas (2004) notice a negative effect of size on short term debt. Small firms have to rely more on short term debt due to high business risk, high transactions costs, weak positions towards debt lenders and information asymmetry. 2.2.7. Industry Leverage ratios differ across industries. A possible argument is that managers use industry median leverage as a benchmark as they contemplate their own firm s leverage (Frank & Goyal, 2009). Another argument is that firms in an industry face common forces that affect their financing decisions. According to Graham and Harvey (2001), the differences in leverage ratios across industries, is due to the important differences in the product market environment or nature of competition in various industries. In figure 2 you can see that about 1 The G-7 countries are the United States, Japan, Germany, France, Italy, the United Kingdom and Canada. 13

25% of the CFO s says that their capital structure decisions are affected by the financing policy of other firms in their industry. The trade-off theory states that higher industry leverage should result in more debt. The market timing theory predicts that the kind of industry should only matter if valuations across firms in an industry are correlated (Frank & Goyal, 2009). 2.2.8. Uniqueness According to Titman and Wessels (1988) uniqueness is the ratio of expenditures on research and development over sales. Firms that sell products with many substitutes are likely to do less research because their innovations can easily be duplicated. Titman (1984) argues that a unique firm is mostly present in a narrow market. This means that lenders are less willing to lend those companies. Moreover, those firms suffer relatively high liquidation costs. Their workers and suppliers have job-specific skills and capital, and their customers may find it difficult to find alternative servicing (Titman & Wessels, 1988). Those companies are likely to use less debt (Graham and Harvey, 2001). However, figure 2 shows that less than 20% of the CFO s says that limiting debt to reassure the customers or suppliers was an important factor for the level of debt.. 14

3. Empirical research I n my empirical research, I will investigate the main determinants of financial and nonfinancial Dutch firms. Before I start, it is relevant to know how financial and nonfinancial firms are defined. Financial firms have the aim to engage, transform and distribute financial products. Banks, insurance companies and pension companies are the main firms of the financial sector. Non-financial firms produce goods or trade non-financial services. Both private and public firms can belong to the non-financial sector. 2 3.1. Data description For obtaining the data concerning non-financial firms I use Amadeus. Amadeus is a financial database containing information from public and private European companies. For the data of financial firms I use Bankscope. Bankscope contains financial information of banks in the world, including Dutch banks. The sample period is 2000-2008, meaning that the influence of the financial crisis is omitted. The number of observations of non-financial firms is 1.155. The number of observations of financial firms is 1.072. To analyse the effects of the several determinants on capital structure (by making a regression analysis), I use SPSS. 3.2. Variables The regression model will have the following form: Y = β 0 + β 1 X 1 +...+ β k X k + ε Y is the dependent variable. This will be the leverage, the debt-equity ratio. X 1,...X k are the independent variables, the several determinants. β 0 is the y-intercept and β 1,... β k are the coefficients of the different determinants on leverage. The variable ε is the error variable. This leads to the following model for financial and non-financial Dutch firms: Debt-equity ratio = β 0 + β 1 *Tangibility + β 2 *Debt tax shield + β 3 *Non debt tax shield + β 4 *Profitability + β 5 *Size + β 6 *Growth + β 7 *D 1 + β 8 *D 2 + β 9 *D 3... β k *D k. 2 CBS. Centraal Bureau voor de Statistiek. 15

The effect of industries on the leverage ratio is described by dummies (D 1 till D k ). In SPSS, for each industry a dummy variable will be made. For this I have observed the 2002 industry list of the North American Industry Classification System (NAICS). In appendix 1 the several industries are reproduced. I will use the debt-equity ratio as measure for leverage. Although debt can be subdivided in short and long term debt, this study will only look to the total debt and the total equity. For the debt and equity the book values will be used. The choice for a book value measure of leverage above market value is mainly because market values are too volatile (Song, 2004). Brealey and Myers (2003) argue that it should not matter if only book values are used, since the market value includes also the value of intangible assets. In the table below, it is explained how the independent variables will be measured. Table I Independent variables for the capital structure of non-financial and financial firms Independent variable Non-financial firms Financial firms Tangibility Tangible fixed assets / total assets Total loans net / total assets Debt tax shield Taxation / pretax income Taxation / pretax income Non-debt tax shield Depreciation / total assets Depreciation / total assets Profitability Pretax income / total assets Pretax income / total assets Size(ratio) Total assets / 100.000 Total assets / 100.000 Growth Percentage change in total sales Percentage change in total operating income Industry Type of sector Type of sector In Bankscope there is not much data for assets items like land and buildings and total fixed assets. This is logic as banks main assets are their loans. That is the reason that I have chosen for total loans net as measure for the tangibility. In Bankscope there is also no information available on the depreciation of banks. However, I need this for the measure of the non-debt tax shield. Therefore I have measured the depreciation on an alternative way: depreciation year t = total assets year t + total investments year t -/- total assets year t+1 ). Maybe this measure is not completely accurate, but specific information about depreciation is not available. It is important to mention that I cannot investigate the independent variable uniqueness. Uniqueness could be measured as the amount of research and development divided by the sales. Because of the fact that research and development expenses are not available, I will not 16

take this variable into my research. Before making the regression analysis, I have to check for outliers and correlation between determinants. This can affect the significance of my results. 3.3. Hypotheses Before I start with my research, I will formulate some hypotheses. I do not make a separation between financial and non-financial firms, although in chapter 4 I will analyze if the capital structure of financial and non-financial Dutch firms correspond with my hypotheses. Hypothesis 1: The leverage ratio for Dutch firms is positively related to the tangibility. Assets can be used as collateral. When there are more tangible assets, lenders are more willing to supply loans because of the decreased risk (financial distress and/or agency problems) for lenders. Hypothesis 2: The leverage ratio for Dutch firms is positively related to the tax rate. I expect that the leverage ratio is positively related to the tax rate. Firms want to pay as little as possible taxes. When debt can reduce the amount of the taxes, firms will make use of this. Hypothesis 3: The leverage ratio of Dutch firms is negatively related to the non-debt tax shield. Firms that have tax shield substitutes for interest, such as depreciation, or that have operating loss carryforwards and hence do not expect to pay taxes, should have capital structures that are largely equity. Therefore the non-debt tax shields will affect the debt-equity ratio negatively. Hypothesis 4: The leverage ratio of Dutch firms is positively related to the profitability of the firm. I expect that for Dutch firms the leverage ratio is positively related to the profitability. More profitable firms have more debt because of the lower probability of financial distress. Hypothesis 5: The leverage ratio is positively related to the growth opportunities. Higher growth opportunities imply a higher demand for external financing. My expectation is that leverage is positively correlated with growth, also because, according to the pecking order theory, debt is preferable above equity. 17

Hypothesis 6: The leverage ratio of Dutch firms is positively related to the size of the firm. Larger firms are more diversified and are less sensitive to bankruptcy. Moreover, larger firms may issue debt at lower costs than small firms, so the leverage ratio is positively related to size. Hypothesis 7: The type of industry has a significant effect on leverage. The financial and non-financial sectors are quite broad. There are many types of industries. I expect differences in leverage ratios across industries because of the differences in the environment and nature of competition in various industries. 18

4. Empirical results I n chapter 3 the data and variables for my research were mentioned. In this chapter I will explain the main results. First I analyse the effect of several determinants on the capital structure of non-financial Dutch firms. After this, I will analyse the effect on the capital structure of financial Dutch firms. 4.1. Non-financial firms In SPSS a regression model is made for the determinants of leverage for non-financial Dutch firms. This model is reproduced below. Table II The main determinants of leverage for non-financial Dutch firms Independent variable Beta Test statistic Significance (Constant) 0,492 7,361 0,000* Tangibility 0,037 0,210 0,834 Debt tax shield 0,299 2,915 0,004* Non-debt tax shield -0,131-0,141 0,888 Profitability -0,760-4,072 0,000* Growth -0,039-0,448 0,655 Size 0,034 9.862 0,000* Administrative and Support 0,026 0,061 0,952 Arts, Entertainment and Recreation -0,457-1,702 0,089** Construction 0,259 2,516 0,012* Finance and Insurance 1,058 3,512 0,000* Information 0,113 1,142 0,254 Management of Companies and Enterprises 0,217 1,193 0,233 Mining 0,443 1,909 0,057** Professional, Scientific and Technical Services -0,036-0,537 0,592 Real Estate and Rental and Leasing -0,450-1,063 0,288 Retail Trade 0,123 0,998 0,319 Transporting and Warehousing 0,366 3,584 0,000* Wholesale Trade 0,018 0,183 0,855 19

a. Dependent variable: Debt-Equity ratio b. Rejection region for the test statistic: t α/2;n-2 = t 0,025;685 = t -1,963 or t 1,963 c. * Significant at the 5 percent level **Significant at the 10 percent level The test for the usefulness of the regression model, is reproduced in appendix 2. The correlation matrix of the variables is also described here. The correlation is absent which means that I assume that the independent variables are correctly chosen. The industry Accommodation and Food Services is the base level for the several industries. The industry Manufacturing is excluded because of a strong indication for multicollinearity. Debt in the leverage ratio is measured as the non-current liabilities (long-term debt plus other non-current liabilities). The shareholders funds are the measure for the equity. As can be derived from the table mentioned above, the tangibility is positively related to leverage, although the coefficient of tangibility is relatively small. It seems that more collateral leads to more debt. This positive correlation is in line with my hypothesis. The debt tax shield is positively correlated to leverage, while the non-debt tax shield is negatively correlated. This is also in accordance with my hypotheses. Firms with a higher taxation have more debt and firms with larger depreciations have less debt. The profitability is negatively correlated with the debt-equity ratio, which does not correspond to my hypothesis. The negative correlation is in accordance with Myers (2001) and Titman and Wessels (1988). Less debt means low interest expenses and these results in higher profits. Growth is also negatively correlated, although this correlation is relatively small. Non-financial Dutch firms with higher growth have a lower demand for external financing. Myers (1977) argue that managers due to high interest rates may not invest in positive net present value projects, which results in a negative relationship. For size, both the pecking order and the trade-off theory predict positive relationships. The positive relation found in this research corresponds to this. The lower probability of financial distress causes lower bankruptcy costs and the result is that large firms can take on more debt. An argument for the insignificance of the growth can be that the change in sales from year to year is not the best measure for growth. The determinants tangibility and non-debt tax shield are also insignificant. The reason why tangibility is insignificant can be explained by the fact that a histogram of the frequency of the values of tangibility shows that the distribution is far away from a normal distribution. There are many values close to zero and the higher the 20

values, the lower the frequencies. A possible argument for the insignificance of the non-debt tax shield is that firms have too little influence on depreciation. The industries Arts, Entertainment and Recreation, Construction, Finance and Insurance, Mining, and Transporting and Warehousing, present significant effects on leverage. The nature of these industries seems an important determinant for the amount of debt. The industry Finance and Insurance has the highest coefficient. The reason can be that firms in this industry have leverage ratios which show some similarities with firms in the financial sector (4.2. Financial firms). 4.2. Financial firms In the table below the main determinants of leverage of financial firms are described. Table III The main determinants of leverage for financial Dutch firms Independent variable Beta Test statistic Significance (Constant) 9,540 2,630 0,009* Tangibility -0,757-0,328 0,743 Debt tax shield 0,337 6,184 0,000* Non-debt tax shield -4,706-0,821 0,412 Profitability -131,147-6,294 0,000* Growth 1,672 0,931 0,352 Size 30,504 7,768 0,000* Bank Holding & Holding Companies 4,554 1,099 0,273 Commercial Banks 5,822 1,521 0,129 Cooperative Banks -7,215-1,311 0,191 Finance Companies 9,230 1,684 0,368 Group Finance Companies 7,622 1,152 0,093** Multi-Lateral Government Banks -4,364-0,946 0,250 Private Banking & Asset Mgt. Companies 3,636 0,711 0,478 Real Estate & Mortgage Banks 9,578 2,098 0,037* Savings Banks 25,220 2,334 0,020* Securities Firms 16,017 3,861 0,000* 21

Specialized Governmental Credit Institutions 12,038 2,213 0,027* a. Dependent variable: Debt-Equity ratio b. Rejection region for the test statistic: t α/2;n-2 = t 0,025;389 = t -1,966 or t 1,966 c. * Significant at the 5 percent level **Significant at the 10 percent level The test for the usefulness of the model and the correlation matrix of the variables of the financial firms are reproduced in appendix 3. I assume that the independent variables are correctly chosen, because no strong correlation is established. The industry Central Banks is the base level for the several industries. The industries Clearing Institutions and Custody, Investment and Trust Corporations, Investment banks and Other non-banking credit institutions are excluded because of missing data or they are filtered out because of the reason that they are outliers. It can be seen that tangibility is negatively correlated with leverage. This means that the amount of debt is not influenced by the amount of collateral. Diamond and Dybvig (1983) argue that bank assets in comparing with non-financial firms assets, are similarly illiquid, yet their composition can be changed quickly. This could explain the negative relation. The positive correlation of the debt tax shield with leverage is in line with my hypothesis, although the coefficient of the debt tax shield is not very high. A possible explanation could be that the amount of taxes paid by Dutch financial firms is relatively low. The non-debt tax shield and the profitability are negatively correlated with the debt-equity ratio. The former is in accordance with my hypothesis, the latter is not. Moreover, the negative correlation is very high. This proves that more profitable financial firms have less debt than less profitable financial firms. The explanation could be that the necessity to raise debt is less when the profits are higher, but this is difficult to say since the debt-like liabilities of financial firms are not strictly comparable to the debt of non-financial firms. Banks often have many short-term liabilities to manage liquidity risk due to the high leverage (Flannery, 1994). Besides, the leverage of financial firms is strongly influenced by explicit (or implicit) investor insurance schemes such as deposit insurance (Rajan & Zingales, 1995). Deposit insurance is meant to manage the liquidity risks (depositor runs) banks have. It guarantees that the promised return will be paid to all who withdraw (Diamond & Dybvig, 1983). Finally, regulations such as minimum levels of capital may directly affect capital structure (Rajan & Zingales, 1995). 22

The growth of Dutch banks is positively correlated to the leverage, which is in line with my hypothesis. Growing banks need extra external funds to realize that growth. The positive relation of the size is also in accordance with my hypothesis and also with the pecking order and trade-off theory. Larger banks have (relatively) more debt. Banks in the industries Group Finance Companies, Real Estate and Mortgage Banks, Savings Banks, Securities Firms and Specialized Governmental Credit Institutions have significant differing leverage ratios compared to banks in other industries. For all those industries there is a strong positive relation with leverage. Therefore banks in these industry will have relatively much debt. The variables tangibility, non-debt tax shield and growth are insignificant. Tangibility is measured as the total amount of net loans dividend by the total amount of assets. Maybe this measure is not sufficiently accurate. The value of loans for several firms is very low; this can have an influence on the results. For the measure of the non-debt tax shield, I have used a formula for the depreciation. Because this formula is not universal, this can have a negative effect on the significance. The growth is measured as the percentage change on operating income, however its effect on leverage is insignificant. Something what attracts attention is that the value of the debt-equity ratios of most financial firms is relatively high. The mean leverage ratio of financial Dutch firms is 16,68 with a standard deviation of 23,81. The mean leverage ratio of non-financial Dutch firms is 0,64 with a standard deviation of 0,75. The high leverage can be explained out of three arguments, which are made by Harris and Raviv (1990). First, they argue that debt limits managerial discretion. Managerial discretion, defined as managers decision-making latitude, allows managers to serve their own rather than shareholders objectives. This is especially important for banks because of the high cash flows and numerous investment opportunities. Second, with a smaller amount of outstanding equity, managers can own a larger share of the firm. This means that there are better incentives to monitor loan customers. Finally, debt is the best security to sell to outside investors when they cannot observe a firm s actual cash flows. 23

5. Conclusion T he main research question of my thesis is: What are the main determinants of the capital structure of Dutch firms? In chapter 2 I have first described the main theories concerning the capital structure of firms. Important theories were the pecking-order and the trade-off theory. The static trade-off theory argues that firms borrow up to the debt level where the marginal value of the tax shields is offset by the increase in the present value of the costs of financial distress (Myers 2001). The pecking order theory of Myers and Majluf (1984) states that if external finance is required, firms will issue debt before equity. Several determinants which are relevant for the capital structure of firms, were described in the second part of chapter 2. These were tangibility, debt tax shield, non-debt tax shield, profitability, growth, size, industry and uniqueness. It is obvious that there is no uniform point of view between researchers on the effect of determinants on capital structure. This is especially the case for profitability and growth. Some researchers notice a positive relationship, while others say that the correlation is negative. In chapter 3 I have investigated the effect of several determinants on the leverage of non-financial and financial Dutch firms. I have found significant results for the effect of these determinants on the leverage ratio. In my research I have made no distinction between long term and short term debt. There is only one leverage ratio. The variable uniqueness is not taken along into my research, because data on research and development was not available. For non-financial firms the tangibility, debt tax shield and size are positively correlated to leverage and the non-debt tax shield, profitability and growth are negatively correlated. It is important to mention that the determinants tangibility, non-debt tax shield and growth are insignificant. There are some industries which are significant in explaining the relation to leverage. These are the industries Arts, Entertainment and Recreation, Construction, Finance and Insurance, Mining, and Transporting and Warehousing. Firms in these industries have significant differing leverage ratios compared to firms in other industries. 24

For financial Dutch firms it is obvious that the determinants debt tax shield, growth and size have a positive correlation with leverage, while the tangibility, non-debt tax shield and profitability are negatively correlated with leverage. Most of the results are in line with my hypotheses. Also here there are some industries with a significant different leverage ratio compared to other industries. These are the industries Group Finance Companies, Real Estate and Mortgage Banks, Savings Banks, Securities Firms and Specialized Governmental Credit Institutions. The main differences between non-financial and financial Dutch firms are that for nonfinancial firms the tangibility is positively correlated (although the coefficient is small), while for financial firms the tangibility is negatively correlated. The opposite holds for growth. Also here the coefficient for non-financial firms is small. In general, the coefficients of financial firms are much larger than those of non-financial firms. A possible explanation is the difference in the mean leverage ratio. For non-financial Dutch firms, the mean leverage ratio is 0,64. For financial Dutch firms this is 16,86. The difference is large, but this matches a survey of Flannery (1994) concerning U.S. firms. He found that at year-end 1990, the capital ratio (equity divided by total capital) for financial firms was between 2,9% and 8,1%. By contrast, the average U.S. non-financial firms capital was about 55%. It is relevant to take along the differences in debt-like liabilities between non-financial and financial firms. Banks encounter higher liquidity risks, so that they have often many shortterm liabilities. Besides, the leverage is strongly influenced by investor insurance schemes such as deposit insurance. Moreover, there are regulations like minimal capital requirements. These facts influence the capital structure of financial firms, although they do not completely determine the effect on capital structure. Many researchers have compared their results with the characteristics of other countries in the world. To take the differences between countries into account, it is important to pay attention to differences in accounting. For example, German firms segregate reserves from equity, where U.S. firms include reserves in equity (Myers, 2001). However, making the distinction between financial and non-financial firms for the Netherlands does give extra insights into the specific determinants in this particular country. 25

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