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Review of Empirical Research on Determinants

of Capital Structure in Public Companies from
Developed Countrie s

Bachelor Thesis Finance

Tilburg University

Qi Song

263153

Supervisor: Drs. Igor Loncarski

Table of content

Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Chapter 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Problem statement, research questions and planning of chapters . . . . . . . . . . . . . . . . . . . . . . . 5

Chapter 2 : Capital structure theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Trade-off theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Pecking order theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Signaling theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Chapter 3 : Determinants of capital structure and empirical evidence . . . . . . . . . . . . 10

Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Size of the firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Growth opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Tangibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Non-debt tax shields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Cost of financial distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

A short summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 7

Chapter 4 : Conclusion, limitations and further studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Further studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

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Abstract

Through a literature review of empirical research on determinants of capital structure

in public companies from developed countries, this thesis gives a general overview on

the relationship between determinants of capital structure and leverage based on the

trade-off theory, pecking-order theory and signaling theory .

Chapter 1 : Introductio n
The Capital structure of is also referred to as its financial structure . It deals with the

financing of a firm's investment activities through the use of debt, owner's equity or

intermediate securities . Ross, Westerfield and Jaffe (2002) give a brief definition of

capital structure as the mix of various debt and equity securities that are maintained

by a firm . In other words, a firm's capital structure is the composition of a

corporation's securities used to finance its investment activities, its relative

proportions of short-term debt, long-term debt, and owner's equity. Since Modigliani

and Miller's (1958) (MM) seminal work, a theoretical framework has been developed,

which aims to explain the decisions of financial managers for certain capital structures

and also indicates the possible determinants of capital structure . They helped in

establishing the theoretical framework for the trade-off theory of tax benefits,

bankruptcy cost and agency problems (Borunen, De Jong, Koedijk 2005) . MM's

theory is only a basic model to understand capital structure issues and is obviously not

perfect, since the choice regarding a certain capital structure cannot be based on one

single theory. Therefore, over the past four decades, many researchers have

contributed to advanced theories with empirical evidence on the determinants of

capital structure . The pecking-order theory describes the choice for a certain capital

structure, stating that firms prefer internal to external funds and debt to equity if

external funds are needed . Thus the debt ratio reflects a cumulative requirement for

external financing and suggests that firms do not have leverage targets and use debt

only when retained earnings are insufficient (Myers, 1984) . Another theory which is

trying to complete the analysis of the choice of capital structure is called the signaling

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theory. Ross, Westerfield and Jaffe (2002, p .930) highlight the importance of the

signaling approach in the determination of the optimal capital structure, asserting that

insiders in a firm have information that the markets lack . Therefore the choice for a

certain capital structure by insiders can signal information to outsiders and change the

value of the firm . This theory is based on the concept of asymmetric information .

Over the past four decades, capital structure theory has evolved rapidly . The theories

of trade-off, pecking-order and signaling are all well established, there are substantial

bodies of literature on the determinants of capital structure based on each of these

theories, which are again founded on research results of many researchers . Even

though, how firms choose their capital structure has still not been well answered . In

the traditional trade-off theory, Kim (1978) and Kraus and Litzenberger (1973) argue

that optimal capital structure involves balancing the corporate tax advantage of debt

financing against the present value of bankruptcy costs . But Bradley, Jarrel and kim

(1984) finds no clear evidence for that assumption . In the pecking-order theory,

Myers (1984) suggests that firms do not have leverage and they use debt only when

retained earnings are insufficient . Harris and Raviv (1991) state that the leverage is

positively related to non-debt tax shields, size of the firm, tangibility of assets, and

investment opportunities but is inversely related to bankruptcy risk, RBzD expenditure,

advertising expenditure and a firm's uniqueness . We can conclude that the empirical

research is lagging behind the many theories presented above .

According to data, many previous studies on the determinants of capital structure have

found strong evidence of close relations between some determinants and leverage . For

instance, Akita's (2005) empirical research has found evidence that the types of

corporations, their growth, profitability as well as their size are significant

determinants of leverage in Australian companies . Antoniou, Guney and Paudyal

(2001) have also found that the size of the firm positively affects the leverage ratio,

but is inversely affected by the market to book ratio, term-structure of interest rates

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and the sharc price performance in all of~ their sample countries . llowever, so many

determinants have been found by previous studies, a few articles have to be devoted to

a general overview of these determinants .

Most empirical evidence on the determinants of capital structure is based on one or

two capital structure theories such as on the theory of pecking-order or of trade-off.

However, studies based on one or the other of the two theories may not represent the

two viewpoints in finding the determinants of capital structure . Therefore, we will

commence with a literature review of previous studies on the determinants of capital

structure based on the three capital structure theories, pecking-order, trade-off and

signaling . This thesis will summarize the results from those studies and will give a

comprehensive review of the main determinants of capital structure in each theory and

how these determinants influence the leverage level, particularly on the aspects of

public companies in developed countries .

Problem statement, research questions and planning of chapters

The main question of this thesis can be answered by solving the following three parts .

First of all, this thesis is based on the three capital structure theories, with the first

being theoretical support. Second, through a literature review of previous studies on

the determinants of capital structure, this thesis summarizes the results fróm those

studies . Third, I will compare listed determinants with the three main theories of

capital structure, and find the capital structure theories and empirical evidence on the

relationship of capital structure determinants.

This thesis is structured as following ; Chapter 2, starts with defining trade-off theory,

pecking-order theory and signaling theory from the prior theoretical literatures in

order to give an overview of the contributions of the many researchers on capital

structure choice in the past decades . Chapter 3 gives a list of determinants that affect

the choice of capital structure in public companies, identified in previous empirical

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literatures . The chapter will examine these determinants on the choice of capital

structure, and find the relations between them . Chapter 4 concludes .

Chapter 2 : Capital Structure Theories

2 .1 Trade-off Theory
The trade-off theory is explained in several ways . In the beginning, Modigliani and

Miller (1958) state that increasing firm leverage always increases a firm's, implying

that firms should maximize debt, but it is inconsistent with the real world . So, the

static trade-off theory predicts a trade-off between the tax benefits of debt and the

costs of financial distress and bankruptcy (Ross, Westerfield and Jaffe, 2002) . Fischer,

Henikel and Zechner (1989) develop the dynamic trade-off theory which includes the

fixed costs of adjustment, implying that firms allow leverage to fluctuate until it

becomes too extreme, and only then releverage. This dynamic theory is different from

static theory ; an important distinction is that the firm is always at an optimal point

(Frank and Goyal, 2004) . The second distinction is that Bradley, Jarrel and Kim (1984)

state that it differs whether the benefits of debt stem from tax savings or from control

of agency conflicts (Morellec, 2004) . Some researchers also provide cash flows as

external, but in general investment is not separable from leverage (Frank and Goyal,

2004) . These distinct models are commonly termed trade-off theory .

The idea that an interior leverage optimum is determined by a balancing of the tax

savings advantage of debt against the deadweight costs of bankruptcy (Frank and

Goyal, 2004), is supported by Bradley, Jarrel and Kim (1984) theoretically .

Unfortunately, we still need to discover empirical evidence . Graham (2000) argues

that firms have to be highly leveraged, above realistic levels and the deadweight

bankruptcy must be immature for the tax savings to be large and certain. Myers (1984)

argues that there is no powerful empirical evidence supporting tax variables, and

suggests that the theory is not well connected by evidence .

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The agency theory of leverage has undergone fewer tests by researchers . Morellec

(2004) suggests that agency conflict provides some aspects of leverage, when conflict

affects both tax and agency concerns .

According to theory, it states trade-off between the tax benefits of debt and the costs

of financial distress and bankruptcy. The literature by Frank and Goyal, (2004) has

proved predictions on empirical evidence . It states that higher profitability implies

that the financial distress costs are lower and the desire for tax shield profits is higher .

The profitable firms will issue more debt than book assets . Therefore, the high

market-to-book ratio means higher growth opportunities but also increases the

financial distress costs . In this case, we can conclude that the financial distress cost is

more expensive in high-growth firms . It also means the firm should not issue more

debt in order to keep profits . Frank and Goyal (2004) also find a higher marginal tax

rate increases the tax shield benefit of debt . Non-debt tax shields are a substitute for

the interest deduction associated with debt and should be negatively related to

leverage .

Another empirical evidence has been found by Brounen, De Jong and Koedijk, (2005) .

They investigated European public companies for the determinants of leverage based

on static trade-off theory which are tax benefits and bankruptcy cost . The result shows

that tax advantages of interest expenses are considered to be important in European

and U . S firms .

2 .2 Pecking-Order Theory
There are many prior researchers that have contributed lots of theoretical and

empirical evidence to support the pecking-order theory . In 1984, pecking-order theory

was clearly articulated by Myers, which was a big step forward in this theory . He

states that firms prefer internal to external funds, and debt to equity if external funds

are needed, thus the debt ratio reflects the cumulative requirement for external

-~-
financing . The behavior of the pecking-order theory follows simple asymmetric

information (Myers, 1984) . The pecking-order theory compares with trade-off theory

in some points . Firstly, firms prefer internal finance . Secondly, if external finance is

required, firms issue the safest securities first . That is, they start with debt, then

possibly hybrid securities and then equity as a last resort . Thirdly, they separate their

target dividend payout ratio to their investment opportunities, although dividends are

sticky and target payout ratios are only gradually adjusted to shifts in the extent of

valuable investment opportunities (Myers, 1984) . According to this theory, we

conclude that when external financing is required, debt should be issued before equity .

On the other hand, firms also issue debt when the firm is overvalued, and when stock

is undervalued, firms issue debt instead of equity .

In the literature of Frank and Goyal (2004), pecking-order theory is defined by the

assumption that equity is subject to serious adverse selection, debt has less adverse

selection problems and retained earnings avoid problems . In this case, outside investor

will think equity is strictly riskier than debt, because of adverse selection, risk

premium will become larger on equity and outside investors will demand a higher rate

of return on equity than on debt . The point of view is that retained earnings are better

than outside financing, therefore retained earnings are used when possible . Equity is

only used in extreme situations . The empirical evidence on firm size has two sides .

On the one hand, large firms might have large assets in place and thus a greater

damage is inflicted by adverse selection (Myers and Majluf, 1984) . On the other hand,

Fama and French (2002) suggest that large firms might have less asymmetric

information and thus will suffer less damage by adverse selection . This suggestion is

also tested by Graham and Harvey (2001) . The result is that larger and dividend firms

have less asymmetry which explains the size and dividend .

Ross, Westerfield and Jaffe (2002, p .440) demonstrate the implication associated with

pecking-order theory which are at odds with trade-off theory . Firstly, there is no target

amount of leverage, the theory does not imply the target amount of leverage, and each

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firm chooses its leverage ratio according to financial needs . The firms should lower

the percentage of debt in capital structure, because the profit raises the book value and

market value of equity. Secondly, profitable firms use less debt, as they need less

outside finance, but generate cash internally . More profitable firms create more debt

capacity through higher cash flows . The debt capacity can capture the tax shield and

the other benefits of leverage . Thirdly, companies experience financial slack . The

difficulties of obtaining reasonable financing is very much dependant on the

pecking-order theory. If the manger issues more stock, it will mislead the skeptical

public investors who think that the stock is overvalued . However, firms can only issue

so much debt before encountering the potential costs of financial distress .

2 .3 The Signaling Theory

The signaling theory is the determination of the optimal capital structure which asserts

that insiders in a firm have information that the market does not . Therefore the choice

of capital structure by insiders can signal information to outsiders and affect the value

of the firm (Ross, Westerfield and Jaffe, 2002) . What kind of information is passed to

outsider from inside the firm is an important suggestion in the signaling theory .

Perfect and costly information flows often lead to the conclusion that corporate

financial decisions are inconsequential to the vale of the firm (Fama, 1978) . After

introducing various frictions and market imperfections, a large number of researchers

assume information asymmetry instead of perfect and costless information to exam

the optimality of financial decisions . The asymmetry is assumed to exist between the

corporate insiders who possess superior information about the firm's future earning

prospects and the outside investors (Bhattacharya, 1979) . The signaling theory can

change the value of the firm by helping firms avoid moral hazard or discover useful

information . Talmor (1981) concludes that signaling can highlight the intrinsic value

of the firm and has a real impact on the firm's cash flow . Therefore, the signaling

approach is also called asymmetric information approach .

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Firms can signal to investors using their capital structure decision based on signaling

theory (Ross, 1977) . Based on asymmetric information problems, different signaling

models of capital structure have been suggested . Ross (1977) suggests managers use

leverage to signal firm prospects to poorly informed outside investors who believe

theses signals because they are prohibitively costly for weak firms to mimic .

Chapter 3

Determinants of Capital Structure and Empirical Evidence

Through a review of previous studies on theory and empirics, we summarize six main

determinants based on trade-off, pecking-order and signaling theory of capital

structure, namely profitability, size of the firms, growth opportunities, tangibility, tax,

non-debt tax shields and cost of financial distress all influence the capital structure

choice .

3 .1 Profitability

The pecking-order theory suggests that firms that want to raise capital, initially prefer

to use internal financing, and then move to external financing . They issue debt, and

only lastly issue new capital (Myers, 1984 and Myers and Majluf, 1984) . This means

that profitable firms that have more internal funds to support, should have a lower

debt ratio in order to reduce their leverage ratio . The supply side is supported by this

positive relationship . Rajan and Zingales (1995) argue that creditors like to give loans

to high current cash flow firms . The proxy for profitability is operating income scaled

by total assets . Therefore, they both predict the negative relationship between leverage

and profitability. Antoniou, Guney and Paudyal (2002) investigate European firms

which are based in France, Germany and the UK and find significant negative

relationships between profitability and leverage in France and the UK . Akita (2005)

investigates Australian multinational and domestic companies in their capital structure

of choice . The result provides negative conelation between profitability and leverage

- to-
for both inultination and doinestic cornpanies . The evidence is consistent with pecking

order theory prediction .

On the other hand, Modigliani and Miller (1963) argue that, according to the tax

deductability of interest payments, firms may prefer debt to equity in trade-off theory .

In this case, the argument suggests that highly profitable firms would choose the high

debt ratio in order to get attractive tax shields . Therefore, the prediction is that

profitability is positively related to firm leverage according to trade-off theory .

DeAnglo and Masulis (1980) argue that the interest tax shield may not be important to

firms with other tax shields . But Huang (2004) states that a firm with more cash

should afford more debt, since in this case a firm can get more tax benefits . He also

provides empirical evidence that is consistent with trade-off theory prediction . Bowen,

Daly and Huber (1982) also provide empirical evidence on positive relationships

between profitability and leverage according to trade-off theory.

Alternatively, according to the free cash flow theory (Jensen, 1986) debt reduces the

agency cost of free cash flow. Harris and Raviv (1990) state that debt financing

ensures that the management is not affected by their individual purpose in order to

make efficient investment decisions, because management pursuing their own purpose

would increase the probability of bankruptcy . According to asymmetric information,

the profitable firms increase the debt ratio to signal the financial situation to outsiders .

Therefore, the free cash flow theory implies the positive relationship between

leverage and profitability.

3 .2 Size of the Firm

There are a number of previous studies suggesting that the leverage ratio may relate to

firm size . Rajan and Zingales (1995) argue that "larger firms tend to be more

diversified and fail less often, the size is an inverse proxy for the probability of

bankruptcy" . Warner (1977) and Ang, Chua and McConnell (1982) also state that

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direct bankruptcy costs decrease with firm size . Both of the two research groups

proved that the size of firms have a positive impact on the supply of debt . According

to the trade-off theory, large firms are expected to have a higher debt capacity and aze

able to be more highly geazed .

The size of firms is also related to the cost of issuing debt and equity securities . Smith

(1977) suggests that small firms issuing new equity will pay more than large firms

and also more when issuing long-term debt . Therefore, this suggests that small firms

may have lower long-term debt ratios and higher short-term debt ratios . Mazsh (1982)

concluded that large firms more often chose long-term debt and small firms chose

short-term debt . Since the probability of bankruptcy is negatively related to the size of

firms, the cost of raising debt capital might be less important for large firms . Thus,

size of firm is expected to be positively related to leverage based on the trade-off

theory. Another possibility is that large firms have less control over individual

managers because of more dilute ownership . Managers may then issue debt in order to

reduce the risk of personal loss in bankruptcy . Rajan and Zingales (1995) proved that

size of firms is positively related to leverage based on data from developed countries

with Germany being an exception . Antoniou, Guney and Paudyal (2002) also found a

positive relationship between size of the firm and leverage in the UK and France .

Wald (1999) also supports their results . All of this empirical evidence is consistent

with trade-off predictions .

However, the positive relationship may not be very strong if the costs of financial

distress aze low . Furthermore, according to pecking-order theory, information

asymmetries between insiders in a firm and the capital market are lower for larger

firms, so large firms should be more capable of issuing informationally sensitive

securities like equity (Chen, 2004) . Therefore, the prediction is a negative relationship

between the size of the firm and its leverage based on pecking-order theory . Bevan

and Danbolt (2000) found evidence to support the negative relationship .

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3 .3 Growth Opportunity

The firm's potential growth might affect the capital structure of choice . Myers (1977)

states that the possibility of shareholders to undertake actions is severe for firms who

have valuable future investment opportunities . It will be difficult for such firms to

borrow money. Growing firms may also have difficulty to take debt, so firms could

lose their future opportunities if the debt interest is too high . In other words, the firms

with greater growth opportunities have a tendency to invest suboptimally to

expropriate wealth from the firm's debt holders to its shareholders . Growth

opportunities imply a conflict between debt and equity interests . Therefore, the

negative relationship is between growth opportunities and debt . This prediction is

based on trade-off theory. To support this, Rajan and Zingales (1995) find empirical

evidence on negative relationship between growth opportunities and leverage .

However, the relationship between growth opportunities and leverage may be

different for short-term and long-term debt . The agency problem is mitigated if the

firm issues short-term rather than long-term debt . This suggests that short-term debt

might have a positive relationship with growth opportunities . But long-term debt is

also positively related to the market-to-book ratio (Chittenden, 1996). As we know,

the market-to-book ratio ( MBR) can also measure growth opportunities . So, there is a

positive relationship between growth opportunity and leverage . However, Rajan and

Zingales ( 1995) found evidence that the MBR is negatively related to leverage . The

reasons for this are that firms prefer to issue equity when stocks are overvalued and

the increase of MBR is also an increase in the cost of financial distress . Thus, the

MBR is predicting to be negatively related to leverage . Therefore, the evidence

showed the relationship on growth opportunity and leverage is rather mixed based on

pecking-ordertheory .

According to signaling theory, high value firms are able to use more debt financing

because debt has its dead weight costs, which make less valuable companies more

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likely to fall into bankruptcy . The theory also predicts that firms with more growth

opportunity will employ the most leverage (Chen, 2004) . Therefore, signaling theory

predicts the positive relationship between growth opportunities and leverage . Bevan

and Danbolt (2000) investigate companies in the UK and found evidence to support

the positive relationship . Titman and Wessels (1998) also found evidence to support

this result .

3 .4 Tangibility

Many researchers have proved that tangibility is positively related to the level of

leverage . The reason is that tangible assets are easy to collateralize for debt. It could

reduce the lender's risk when collateralizing tangible assets for debt (Williamson,

1988) . The lender may face risks of adverse selection and moral hazazd due to the

conflict between lender and shazeholder interests . But, if firms aze unable to

collateralize tangible assets, lenders may require higher lending terms . Thus, debt

financing is more expensive than equity financing . However, Myers (1977) states that

this asset substitution problem occurs less often when firms have more tangible assets .

Scott (1977) comes from the different argument, but his conclusions aze essentially

the same as Myers . Therefore, higher tangible assets will bring the firms a higher

leverage ratio . The agency cost of equity increases the underinvestment problem .

Issuing secured debt through tangible assets reduces agency costs . This confirms the

positive relationship between tangibility and a firm's leverage . It indicates that asset

tangibility is very important in banks' credit policy . According to both the trade-off

and pecking-order theories, this result is consistent with both predictions . Rajan and

Zingales (1995) find a significant positive relationship between the leverage and

tangibility in most developed countries . Antoniou, Guney and Paudyal (2002) found a

positive relationship in Germany . Bennett and Donnelly (1993) investigated the UK

and found significant evidence on a positive relationship to leverage .

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3 .5 Ta x

The main theme of study by Modigliani and Miller ( 1958) is the impact of tax on the

capital structure of choice . The view of MM indicates that the tax rate is directly

influenced by the debt-to equity ratio of the firms . The debt-equity ratio of the frm

increases with the tax rate . Nowadays, almost all of the researchers believe that tax is

important for the firm's capital structure . If the firm wants to obtain a better tax-shield

gain, it should use more debt and the firm needs a higher effective marginal tax rate .

Many previous studies have failed to find a significant tax effect on the behavior of

finance, which is inconsistent with MM theory. Mackie-Manson and Jeffrey (1990)

explain this by stating most tax shields have a small effect on the marginal tax rate in

most firms . They focus on the effect of taxes and find a positive relationship between

debt financing and the effective marginal tax . This evidence is consistent with MM

theory. Trade-off theory predicts a trade-off between tax advantages and bankruptcy

costs of debt . The tax benefit is one of the prevailing determinants of leverage .

Empirical research by Brounen, De Jong and Koedijk (2005) indicates that tax

advantages are considered to be of equal importance to European and U .S firms and

they find that firms with higher leverage and target debt ratio are considered tax

advantages through debt as an important factor. They find that tax advantages are

positively related to leverage based on data from European firms .

3 .6 Non-debt tax shields (NDTS )

Non-debt tax shields (NDTS) refer to the tax deduction for depreciation and

investment tax credits . DeAngelo and Masulis (1980) indicate that impact of

Non-debt tax shield, personal taxes and corporate taxes all incorporated constitutes an

optimal capital structure model . They argue that tax deductions for depreciation

together with investment tax credits are substitute for the tax benefits of debt

financing. Therefore, firms with higher NDTS are expected to use less debt, which

also means less leverage . The following researchers provide empirical evidence to

-is-
confirm this prediction . Based on NDTS is highly correlated with tangibility . Wald

(1999) use the depreciation ratio divide total assets to measure NDTS and Chaplinsky

and Niehaus (1993) use the sum of depreciation ratio and investment tax credits over

total assets to measure . Prowse (1990) obtain significant empirical results for the

negative relationship between debt and non-debt tax shields based on investigation in

US and Japanese firms . DeMiguel and Pindado (2001) investigated Spanish firms

found significant evidence on negative relationship between leverage and non-debt

tax shields . Both of studies are consistent with negative prediction .

However, the different answer is provided by Bradley et . al (1984) . They find a

positive relationship between firm leverage and non-debt tax shields . The reason for

this is that the tangibility that also affects the firms' leverage is ignored and tangibility

is also correlated with non-debt tax shields . Therefore, according to both studies, we

believe that the firms' leverage is negatively related to NTDS .

3 .7 Cost of financial distress

Myers (1984) states that the legal, administrative costs of bankruptcy, subtler agency,

moral hazard, monitoring and contracting costs are both belonged to cost of financial

distress . He denotes that "Risk firms ought to borrow less, other things equal . The

threatened or actual default caused the costs of distress, safe firms ought to borrow

more before expected costs of financial distress offset the tax advantages of

borrowing . The growth opportunities are more likely to less value in financial

distress ." Same idea support by Prowse (1990), the firms with greater business risk

tend to have low debt ratios and he also provide the empirical evident from US and

Japanese firms . Bhadual (2002) states that debt is one type of periodic payment,

highly leverage firms face a bankruptcy situation is susceptible to costs of financial

distress . The firms should be less leverage if with volatile income . Both of studies

showed the negative relationship between leverage and cost of financial distress .

DeMiguel and Pindado (2001) investigated the relationship between cost of financial

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distress and leverage from Spanish firms, they found the significant negative

correlation between leverage from all data in Spanish firms . Therefore, the empirical

evidence is consistent with negative prediction between cost of financial cost and

leverage.

3.8 A short summary on Chapter 3

Through a literature review on the determinants of capital structure and their

supportive capital structure theories, along with some empirical evidence found by

previous studies, we have found that profitability, size of the firms, growth

opportunities, tangibility, tax, non-debt tax shields and cost of financial distress have

influence on the capital structure decisions . However, for some determinants, the

relationship between the determinant and leverage is inconsistent based on different

capital structure theories . Here we summarize these relationships in a simple table to

give a more explicit view.

In the following table, a"~" means the determinant presented in row has a positive

relationship with leverage according to the theory presented in column, while a"-"

means the opposite .

Trade-off Pecking-order Signaling

Profitability ~ - ~

Size of the firm -~ - Support not found

Growth opportunity ~ ~~- f

Tangibility f ~- No relation

Tax -~ No relation No relation

Non-debt tax shields - No relation No relation

Cost of financial distress - No relation No relation

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Chapter 4 : Conclusion, limitation and further studies

4.1 Conclusio n

Through a literature review of empirical research on determinants of capital structure

in public companies from developed countries, this thesis gives a general overview on

the relationship between determinants of capital structure and leverage based on

different capital structure theories .

We had a review on the three main theories that have the most influence on capital

structure decisions over the past several decades . Trade-off theory states that the

capital structure is decided by taking the maximum benefit from the trade-off among

tax benefits, bankruptcy cost and agency problems (Borunen, De Jong, Koedijk 2005) .

The pecking-order theory describes the choice for a certain capital structure, stating

that firms prefer internal to external funds and debt to equity if external funds are

needed . Thus the debt ratio reflects a cumulative requirement for external financing

and suggests that firms do not have leverage targets and use debt only when retained

earnings are insufficient (Myers, 1984) . And signaling theory, based on the concept of

asymmetric information, stating that the choice for a certain capital structure by

insiders can signal information to outsiders and change the value of the firm (Ross,

Westerfield and Jaffe 2002, p .930) .

Based on the above three theories and the empirical evidence on the previous studies,

we found 7 main determinants influencing the capital structure, namely profitability,

size of the firms, growth opportunities, tangibility, tax, non-debt tax shields and cost

of financial distress . The relationships between these determinants and level of

leverage based on the three theories are presented in the table on the previous page .

As presented, some relationships are inconsistent when explained using different

theories . This inconsistent brings us more difficulties in making capital structure

decisions .

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4.2 Limitatio n

There are some noticeable limitations in this thesis . First, the determinants presented

in this thesis may not complete . This thesis only summarize the main determinants

found by previous studies, some other determinants either not found by anyone yet or

have not much influence on capital structure are not presented in this thesis . Second,

for some determinants, the relationship between the determinant and level of leverage

is inconsistent when explained using different theories . For example, according to

trade-off theory, the firm's profitability should be positively related to the level of

leverage, while pecking-order theory suggests the opposite . This is probably due to

the basic difference among the three capital structure theories, and the fact that the

previous studies on these aspects used empirical data in different countries, resulting

in different results of empirical research. This situation brings us further difficulties in

making decisions about capital structure in practice . Managers have to choose the

right lever of leverage according to the firm-specific situation . Unsurprisingly, this

inconsistence also brings us an interesting topic for further studies . Finally, a general

model for capital structure decisions is not achieved based on these determinants . This

is due to the inconsistency problem we have stated above, and the lack of research on

the correlation among the determinants .

4 .3 Further studies

Further studies can be made on explaining why some determinants influence the lever

of leverage differently according to different theories . Further more, a comparative

research based on the same group of sample should be made . Finally, further studies

can also be made on the correlation among the determinants we have presented in this

thesis .

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AI~IÍN I~~~~~ÍIÍ~V~Ïk~V~IN