The Role of Capital Market in Determining Capital Structure
Of Slovene Corporations
Vloga trga kapitala pri opredeljevanju strukture kapitala slovenskih delniških družb
Aleš Berk
University of Ljubljana, Faculty of Economics, Kardeljeva ploscad 17
1000 Ljubljana,
e-mail:
Abstract
Capital structure theories are among the most frequently tested in financial literature. However, empirical work is almost exclusively directed towards public firms, whereas determinants of the capital mix in privately held firms are far less frequently studied. Usually, authors discuss different incentives for leveraging operations and test validity of specific target capital structure (as predicted by trade-off theory) or pecking order of financial sources firms follow by capital budgeting and recap decisions. This article presents the most frequently argued and empirically tested variables that determine the use of debt in Slovene corporations. By separating them into listed in Ljubljana Stock Exchange and non-listed (privately held), I can test for the role of the Slovene capital market in determining their capital structure. I conclude that despite the fact that private corporations exhibit higher debt levels, dynamics is not governed in a substantial different way. One of the potential reasons could be poorly developed primary market, which causes similar external barriers to raising capital for both types of corporations.
Key words: capital structure, financing policy, capital market, trade-off theory, pecking order hypothesis
JEL Classification: G32, G10
Povzetek
Kljub obsežnosti literature s področja strukture kapitala, obstaja le malo empiričnih prispevkov, ki so osredotočeni na zaprte delniške družbe. Članek predstavlja dejavnike strukture kapitala vseh slovenskih delniških družb, torej tistih, katerih delnice kotirajo na Ljubljanski borzi (t.j. javne), in tiste, katerih število lastnikov je omejeno in katerih delnice niso uvrščene na organiziran trg (t.j. zaprte delniške družbe). Delitev omogoča proučevanje vloge, ki jo pri finančnih odločitvah o strukturi kapitala posamezne skupine delniških družb igra kapitalski trg. Ugotovim, da so sicer zaprte družbe bolj zadolžene, dejavniki, ki vplivajo na dinamiko zadolževanja, pa niso značilno drugačni kot pri javnih delniških družbah. Razlaga, ki se ponuja, je nerazvit domači primarni trg kapitala, ki pri financiranju družb obeh skupin povzroča podobne omejitve.
Ključne besede: struktura kapitala, finančna politika, trg kapitala, teorija izključevanja, hipoteza vrstnega reda fiunanciranja
Introduction
Capital structure theory started in 1958 when Modegliani and Miller (1958) published their pioneering work. They introduced a world without transaction costs and taxes and derived the conclusion about capital mix irrelevance for reaching the goal of the firm. However, after the inclusion of corporate taxes different conclusion was offered. Companies facing corporate taxes should be all-debt financed. Additionally, after inclusion of personal taxes Miller (1977) suggested the solution with somewhat lesser benefit to investors. Trade-off theory was finally completed with the contribution of Jensen and Meckling (1976), who introduced costs of financial distress. According to this final setting, the firm should use leverage to the extent where marginal benefits (tax savings) of additional debt and its costs of financial distress equalize (Jensen and Meckling, 1976). When firms follow this trade-off, they determine the optimal/target capital mix to support their activities.
Ross (1977) argues that usage of debt also serves as a good signaling device in case of business excellence. Beside Ross (1977), Myers and Majluf (1984) are often cited to be the three founders of information asymmetry hypothesis (signaling hypothesis) which is part of the pecking order theory. Asymmetric information affects capital structure by limiting access to outside finance. Due to the insider information and asymmetry of payoff to creditors (to them the upside potential of the project is not available) managers prefer to issue debt in cases of positive perceptions about future operations of the firm. In cases where the prospects of future are poor, managers (and owners) prefer equity financing, which causes potential loss-sharing with new owners. As a result, additional debt financing causes positive signals, whereas new issues of common stock, negative ones (Frydenberg, 2004).[1] In addition to agency relationships among owners, managers and creditors, pecking order is motivated by taxes and transactions costs. The direct cost of retained earnings may be less than those on new equity issues (due to banker’s costs, lower taxable current dividends when firm limits security issues). Moreover, transactions costs are generally smaller on debt than on equity issues. Pecking order sets a hierarchy; firms use retained earnings first, which are followed by new levels of debt, issued preferred stock, and only then new equity).[2] Managers avoid issuing undervalued securities by financing first with internal equity and then with external claims that are least likely to be mispriced (Pinegar and Wilbricht, 1989). Thus, in this setting firms do not determine their optimal/target leverage.
As a contrast to trade-off, firms leave some free borrowing capacity open for eventual occurrence of profitable project that can be made. Thus, they maintain some financial slack in the form of greater extent of equity (e.g. they may issue more shares than needed). In cases firm needs to raise new sources of finance, they can issue debt. Stock prices are more sensitive to signaling in times information available to management substantially deviates from information available to investors in the capital market (i.e. in times of greater asymmetry of information). Vice versa, signaling does not have great impact in times when information is well shared and observed by investors.
Literature about capital structure is substantial. Authors study determinants of capital mix that is observed in the market. They employ various techniques in numerous markets over different time-horizons (see Fama and French, 2002; Watson and Wilson, 2002, Shynam-Sunder in Myers, 1999). Despite reach research in the area, conclusions are still far from following convergence. In general, one can expect stricter following pecking order in times, when information asymmetries are large; and "following the rules" (i.e. optimal capital structure) in times when the opposite holds. Then, extent of debt financing is determined by tangibility of assets (positive relation), non-debt tax-shields available (negative relationship), tax rate (positive relationship), volatility of operating profit (negative relationship), etc.[3]
Despite substantial empirical testing of determinants of leverage, literature focuses almost exclusively on public firms. This can to some extent be explained by data availability. Therefore, relatively little is known about financing behavior of privately-held firms. Despite this negligence, private firms produce the major part of value added. In Slovenia (in 2003), there were 967 incorporated firms (in the following text I use term 'corporations'); 32 listed in the prime market and additional 100 in the free market (Annual Statistical Report, 2004). There were 23 non-financial corporations with actively traded stock included in the prime market, and additional 16 in the free market. Measured by number of firms, private corporations represented around 96 percent of all corporations. They represented 79.71 percent of assets, 76.05 percent of sales, and 84.50 percent of employees.[4] There are differences between public and private firms with respect to capital structure, as already documented by Brav (2005) for the sample of UK corporations. Private firms are more leveraged, and their maturity structure of debt is much shorter.[5]
These differences reveal an aversion to equity financing by private corporations that stems from the presence of market frictions. Unlike public equity, private equity is highly illiquid asset, its holder may not be well diversified. Moreover, selling private equity involves high search costs (Brav, 2005). Due to transaction costs, financing policies of public and private corporations differ because of two separate effects. Firstly, private firms are expected to have stronger preference for debt issuance (loans) relative to equity issuance, i.e. level effect (see Hennesy and Whited (2003) for the dynamic trade-off model). When equity floatation cost increase in their model, firms finance their financial gap more with debt and less with equity. Thus private corporations are less likely to choose equity relative to debt alternative.[6] Secondly, there is sensitivity effect. Namely, private corporations are more passive with regard to financing decisions. Relative to public corporations, private firms are less likely to raise or retire capital versus the alternative policy of doing nothing (Brav, 2005). Both effects together are expected to make private corporations relatively more leveraged and more distanced to optimal/target structure, compared to public corporations. Therefore, private firms are expected to be more sensitive to profitability (greater negative relation is being expected) and less sensitive to other variables that determine capital structure, e.g. tangibility, levels and growth of sales, etc. (those explaining trade-off theory).
Capital structure in slovene corporations and their dynamics
In the last decade during the process of transition, Slovene firms made substantial progress. On that path though, various changes in the business environment were making the progress tougher. In addition to that, firms were expected to make a gradual transition towards grater extent of use of debt and to more closely follow shareholder value approach. Namely, at the beginning of the nineties, even the largest Slovene firms used only modest levels of debt and to largest extent followed wage-maximization. Mramor and Valentincic (2001) provide reasons why this strategy was reasonable to follow in the period of economic transition. Firms only used debt vehicles when internal rate of return allowed for servicing debt contracts, which carried higher cost than equity which was nearly zero (Mramor et.al, 1999). However, the reason why Slovene firms in the past financed new projects with more expensive debt was not to maximize value of equity, but to increase wages. Namely, despite the privatization done via voucher scheme cash flow distributed through wages was greater than benefits of internal ownership. However, this could only be done when creditors were ready to lend. This was rather uncommon, since majority of firms operated with losses. Additionally, weak possibilities for external debt financing were created by potential internal owners (managers and employees) wanting to picture weaker financial position of the firm with the goal of buying-out the firm (Mramor et.al, 1999).
It is a known fact that Slovene firms did not follow the objective of shareholder value maximization, but goals of the employees, which supports the institutional argumentation of capital structure of Rajan and Zingales (1995). Figure 1 shows the dynamics of extent of debt sources of finance used in all Slovene corporations in the period 1998-2003, broken-down by ownership status (public or private). In the last couple of years, Slovene corporations increased debt-to-capital ratios, and were expected to make moves away from determinants from the circumstances described in the previous paragraph. Average leverage of private corporations in higher than average leverage of public corporations.[7] In 2003, debt-to-capital ratio was 19.23 percent and 29.49 percent for public and private corporations, respectively. In the studied period leverage dynamics is approximately the same for both groups (Figure ).
Figure 1
The debt-to-capital ratio dynamics for listed (23) and all corporations (742)
Number of included companies is 23 for the group of listed corporations and 742 for the group of all private corporations in the Slovene economy. Debt-to-capital ratio includes short-term liabilities to banks.
Source: AJPES 1998-2003 database; author's calculation.
Firms are further grouped by industry (manufacturing, trade, transport and communication, and real estate), since industry to a large extent determines the risk profile of firms through similar cost structures. Therefore, similar within-industry patterns are expected. Among Slovene listed corporations, the highest average debt ratio in 2003 was reached by group of firms that operate in the real estate industry (28.5 percent). Those corporations are followed by 26.4 percent in trade, 18.1 percent in manufacturing, and 7.4 percent in transport and communication. Although debt levels differ, relatively levels among industries and dynamics is the same for the private corporations.[8] However the two groups are different in two ways. First, ten public manufacturers relatively decreased their leverage in 2002 and 2003, but private firms increased it. Second, private firms in transport and communication are much more leveraged than their public counterparts.[9]
Figure 2
The debt-to-capital dynamics for listed and all corporations
In the group of listed corporations there are 10 represented in manufacturing, 6 in trade, 4 in transport and communication, and 2 in real estate. In the group of remaining corporations, there are 296 companies represented in manufacturing, 90 in trade, 37 in transport and communication, and 62 in real estate.
Source: AJPES 1998-2003 database; author's calculation.
Comparison of Slovene largest firms and their European (EU15) counterparts as of December 31, 2002, reveals that extent of debt financing is substantially different. Data, used for that purpose, was obtained from AJPES tape for Slovene firms and Bank for the accounts of Companies Harmonized (BACH) database for EU15 firms (see Table 6 in appendix I). Although, not entirely methodologically consistent, comparison still reveals important differences in usage of debt among the studied countries.[10] Data show that on average Slovene firms reach level of about a half of the leverage of European firms in the comparable industry and size.
Empirical work suggests that in Slovene largest firms (e.g. those with actively traded stock), the extent of debt financing can to a larger extent be explained by pecking order hypothesis rather than by trade-off theory (Berk, 2005). Namely, the use of debt is partly explained by return on invested capital and future growth opportunities (market-to-book ratio was used as a proxy). Better performance decreases the extent to which Slovene firms are debt financed. This can be explained with greater amount of internally generated funds that can be invested into new productive capacity. Growth opportunities increase leverage (though relation was not found significant in the (statistically) preferred model for the period of 2002-2003). This can be explained by the trade-off theory, since greater growth opportunities allow more external financing, since the revenue generation is stronger; by pecking order hypothesis, since after the depletion of retained earnings more debt is second-best to finance growth; and even by post-Keynesian theory proposed by Mramor and Valentincic (2001) in case that new growth comes from new risky projects.
This finding well supports the Slovene corporate reality, which shows that firms do not issue new equity, at least not in bid offers.[11] In that aspect Slovene firms act differently compared to European firms, for which Bancel and Mittoo (2003) argue, that capital structure depends on current capital market conditions. They try to maintain flexibility and use cheap equity sources when stock price is high (when market-to-book is high).[12] What seems to be counter-intuitive, is negative impact of tangibility (Berk, 2005). Namely, greater relative fixed assets improve possibilities of using debt sources of finance. But this capacity is certainly not being capitalized. Mramor and Valentincic (2001), who documented negative relation as well, argued that this can indicate that Slovene firms listed on the Ljubljana Stock Exchange follow predominantly post-Keynesian theory, whereby less risky operations (operations supported with more fixed assets are assumed less risky) are financed less with debt and more with equity.[13]