Theories Concerning Capital Structure

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02 Nov 2017

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1. Introduction

1.1. Problem definition

he choice between debt and equity for the funding of activities is for every firm an Timportant 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.

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.

2. Literature review

2.1. Theories concerning capital structure

here is no universal theory of the debt-equity choice, and no reason to expect one T(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.

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

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

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.

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

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.

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

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.

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.

.

3. Empirical research

n my empirical research, I will investigate the main determinants of financial and non-

Ifinancial 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= #0+ #1X1 +...+ #kXk + e

Y is the dependent variable. This will be the leverage, the debt-equity ratio. X1,...Xk are the

independent variables, the several determinants. #0 is the y-intercept and #1,... #k are the

coefficients of the different determinants on leverage. The variable e

is the error variable. This

leads to the following model for financial and non-financial Dutch firms:

Debt-equity ratio = #0+ #1*Tangibility + #2*Debt tax shield + #3*Non debt tax shield

+ #4*Profitability + #5*Size + #6*Growth + #7*D1 + #8*D2 + #9*D3.......... #k*Dk.

2 CBS. Centraal Bureau voor de Statistiek.

The effect of industries on the leverage ratio is described by dummies (D1 till Dk). 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: depreciationyear t

= total assetsyear t + total investmentsyear t -/-total assetsyear 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.

.

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.

4. Empirical results

n chapter 3 the data and variables for my research were mentioned. In this chapter I will

Iexplain 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

a. Dependent variable: Debt-Equity ratio

b. Rejection region for the test statistic: t#/2;n-2 = t0,025;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

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*

Specialized Governmental Credit Institutions 12,038 2,213 0,027*

a. Dependent variable: Debt-Equity ratio

b. Rejection region for the test statistic: t#/2;n-2 = t0,025;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).

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.

5. Conclusion

he main research question of my thesis is:

T 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.

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.

References

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Appendix 1

Table IV

The several industries for the non-financial and financial Dutch sector

Non-financial sector Financial sector

1. Accommodation & Food Services 1. Bank Holding & Holding Companies

2. Administrative, Support, Waste 2. Central Banks

Management & Remediation Services

3. Arts, Entertainment & Recreation 3. Clearing Institutions & Custody

4. Construction 4. Commercial Banks

5. Finance & Insurance 5. Cooperative Banks

6. Information 6. Finance Companies (Credit card,

Factoring & Leasing

7. Management of Companies & Enterprises 7. Group Finance Companies

8. Manufacturing 8. Investment & Trust Corporations

9. Mining 9. Investment Banks

10. Professional, Scientific & Technical 10. Multi-lateral Government Banks

11. Real Estate, Rental & Leasing 11. Other non-banking Credit Institutions

12. Retail trade 12. Private Banking & Asset Mgt. Companies

13. Transporting & Warehousing 13. Real Estate & Mortgage Banks

14. Wholesale trade 14. Savings Banks

15. Securities Firms

16. Specialized Governmental Credit

Institutions

Appendix 2

To test the usefulness of the linear regression model, we can use a F-test. The steps are as

follows:

(i) Hypothesis test: H0: #1= #2= �� = #18 = 0 vs. H1: At least one of #k .

0;

a

= 0.05

(ii) Test statistic: F =

(SST-SSE)/ k

SSE/(n � (k + 1))

(iii) Rejection region: f =

F0,05; 18; 668 = 1,619

(iv) Val = [(297,203 � 230,265)/18] / [230,265/668] = 10,788

P-value = P(F18;668 > 10,788) = FDIST(10,788;18;668) = 2,975�10-27

(v) Conclusion: Reject H0, since �Val� falls in the rejection region. With 95% confidence we

can conclude that the model is useful.

In the table below the correlation matrix of the measured variables of the non-financial Dutch

firms is reproduced. The industry dummies are excluded because of the fact that the table

would be too large.

Table V

The correlation matrix of the non-financial Dutch firms



rev

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