This chapter is the literature review of some journals which are related to capital structure and some of its determinants. Specially, asset liquidity is studied to be found more about its relationship with capital structure. In this chapter, different results from different studies and countries on the relationship between capital structure and its determinants are discussed through different theories like pecking order, trade-off and agency theory.
Review of literature
Williamson (1988) analyzed the effects of tangible assets and probability of bankruptcy on the relationship between capital structure, leverage, and asset liquidity. He predicted that asset liquidity will increase optimal leverage, which means he concluded a positive relationship between asset liquidity and capital structure.
Shleifer and Vishny (1992) discussed the relationship between asset liquidity and optimal leverage. They argue that in costs of financial distresses, asset liquidity plays an important role as a determinant. Their paper is focused on industry and economy wide determinants of liquidity. They also believe that optimal leverage levels and asset liquidity change over time. They predict that asset liquidity increases optimal leverage by analyzing the industry environment through different common ways to sell a firm assets and market equilibrium approach.
Rajan and Zingales (1995) analyzed the German market to explain the relationship between capital structure and its components. Their result can be an explanation of the empirical finding in which firm size is negatively related to leverage in Germany. This negative effect is for German capital markets which are less developed and just large firms are traded in public.
Myers and Rajan (1998) argue that the effect of asset liquidity on capital structure is negative or curvilinear. They define asset liquidity the ease of selling or trading assets in the market. They believe a firm with more liquid assets has greater value in short term liquidity. If other components are considered equal, asset liquidity is commonly seen as increasing leverage capacity and in some contexts not liquid have meaningfully less value than readily tradable ones. This article is focused on the specific side of liquidity which shows that greater liquidity decreases the power of borrowers to commit to their course of action. This paper examines the effects of asset liquidity fluctuation on debt level. Myers and Rajan (1998) “suggest an alternative theory of financial intermediation and disintermediation”.
Myers and Rajan (1998) say that “asset liquidity is almost always a plus for nonfinancial corporations or individual investors”. However increased liquidity can be a negative point for financial institutions. Although assets with more liquidity increase the ability of firms to increase cash on short notice, this also decreases the ability of management to commit reasonably to an investment and financing strategy which will protect the firm’s creditors.
Firms which invest mainly on illiquid assets like financial institutions will find long-term financing and investment easier to enhance. Illiquidity will give less to creditors if they hold the assets, so it also gives more time to them to estimate interest rate and credit risk. They believe that “today’s risks would change slowly – – illiquid portfolios do not change overnight”.
Myers and Rajan (1998) believe “liquid assets give creditors greater value in liquidation, but they also give borrowers more freedom to act at creditors’ expense. While both issues have been separately recognized, their interactions arc largely unexplored”. They show in their paper that a firm with initial use of liquid core assets will be able to have a total advantage in earning external finances for projects with lower liquidity. The increasing debt level which the firm will generate by accepting the less liquid project will exceed the level and capacity of the project itself. In contrast with, two firm or projects which are less liquid could have less debt level and capacity combined in comparison to its stand-alone status.
Weiss and Wruck (1998) believe that the relationship between asset liquidity and leverage is negative. They are of the opinion that distressed firms selling assets are probably going to face a less liquid or illiquid market because their industry companions are also distressed. Thus firms can sell assets only at minimum price which is a “fire sale”. They find that this illiquidity will decrease a firm’s leverage level or debt capacity. Less liquid assets would provide creditors with defense of such operations. “Unless a credible promise can be made not to engage in asset stripping, asset liquidity will reduce, not increase, a firm’s ability to issue debt securities”.
The research on capital structure and leverage by Rajan and Zingales (1995) suggested that the leverage level in UK firms is positively related to firm size and tangible assets, and the relationship between leverage level with profitability and growth opportunity levels is negative. However, as explained by Harris and Raviv (1991), “The interpretation of results must be tempered by an awareness of the difficulties involved in measuring both leverage and the explanatory variables of interest”. In their paper, Bevan and Danbolt (2000) focus on the difficulties in measuring leverage, and testing Rajan and Zingales’ results’ sensitivity to deviations in leverage levels. They perform analysis on 822 UK firms capital structure and leverage level and find the result of Rajan and Zingales’ (1995) study to be highly dependent in definition. Especially, they find significant differences in the long term and short term debt determinants.
Morellec (2001) argues that the effect of asset liquidity on capital structure is negative or curvilinear. This paper investigates the effect that asset liquidity has on securities valuation and the firm’s financial decision making. Morellec (2001) shows in his paper that asset liquidity will have positive relation with debt capacity only when bond conditions limit the nature of assets. He demonstrates that, using unsecured debt with greater asset liquidity will cause an increase in credit spreads on debt and will decrease optimal level of leverage. At the end he concluded that bond and security conditions and asset liquidity will explain leverage ratios and credit expansions.
In contrast to Weiss and Wruck (1998), they argue that asset liquidity could reduce a firm’s ability for issuing debt, Morellec (2001) finds that liquidity will increase debt capacity just at the time bond contracts enforce limitations on the assets condition. He extracts simple estimation formulas when the firm’s assets are liquid or divisible for debt and equity. Valuable options to decrease debt capacity will arise during worsening economic circumstances because of liquidity. He believes that asset liquidity’s net effect on firm total value will be a result of a trade-off between the reduction and increase in debt and equity value. If the operating flexibility value which is provided by asset liquidity in comparison with the reduction in debt level or value is lower, it will be optimum for the firm to issue secured debt. If the reverse is true, it will be optimum for the firm to issue unsecured debt.
The equity and debt value that he obtained in his study also allows for a study of the impact of asset liquidity on optimum leverage. Higher liquidity in asset will decrease the firm’s ability to issue debt because firm size is highly depended on the readiness of the firm to sell assets. In addition, selling asset will increase the equity value while the decrease value of debt, the ratio of optimal leverage is decreased. His model resulted in an increase of 10 to 30 percent of default spreads and simultaneously a reduction of 30 to 60 percent of optimum leverage.
Morellec (2001) analyzes the effect that asset liquidity has on the securities value and firm’s financial making decisions. He demonstrated that an increase in asset liquidity of the firm when it is measured by liquidation of the firm’s assets reduces the corporate spread and raise optimal leverage. Asset liquidity when it is calculated by selling price of the firm’s asset, since the establishment of the firm, decreases corporate debt value opening the space of the strategy to the borrower.
Minton and Wruck (2001) argue that conservative firms have comparatively high price to book ratios and operate comparatively often in industries to be responsive to economical distress. They believe the former attribute is coherent with a large body of earlier process documenting an opposite relationship between price to book value and leverage. Cautious firm’s strong funds flow, clear shortage of serious data problems and huge cash balances will suggest that firms’ high price to book ratios are more probably because of market anticipations of continued strong cash flow, instead of new technologies or products finding.
Amongst the rest, Fama and French (2002) defend the situation of cross-sectional leverage regressions on firm size. This and default probability interpretations have relation inasmuch, limitation on the financial structure, low volatility firms are less probably to default.
Huang and Song (2002) include accounting information and the market from more than 1000 listed firms in the Chinese market up to the year 2000 in order to collect their information of these firms to analyze capital structure. Similar to other countries in leverage also arises with firm size, and reduces with profitability and has interaction with industries in China. One thing that they find is different from other countries is that in Chinese firms volatility raises leverage and firms intend to decrease long term debt. They also find to explain the features of Chinese firms’ capital structure, it is better to use static tradeoff theory instead of pecking order theory.
Rao and Jijo (2002) suggest that firms with high risk or firms that have high probability to default should not be much levered. They use standard deviation of firm’s cash flow for five year period for the “pre liberalization” and “post liberalization” period as proxy for the firm business risk and financial distress probability. They argue that leverage and business risk is negatively related.
Gaud et al. (2003) analyze the capital structure determinants for 106 listed firms on the Swiss stock exchange. They do their analysis during 1991-200. They find that firm size, its tangible assets and business risk have positive relationship with leverage. Also they conclude growth and profitability have negative relationship with leverage. These relations suggest that both tradeoff theory and pecking order theory are used to describe the Swiss firms’ capital structure, in spite of the fact that “more evidence exists to validate the later theory”.
While pecking order prediction of financing choice is made easier by debt level impact, then it will be difficult to differentiate experimentally trade off theory and pecking order hypothesis. Dasgupta (2003) extends the Myers and Majluf (1984) model to extract new empirical implications of the interrelation between adverse selection and debt level restrictions. They predict in their model that debt issuance probability will not be a monotonic function of the financing shortage size, initial increasing in the size of the deficit, after that decreasing and finally increment again. They find that likelihood of debt issuing is higher (lower) for firms which are below (above) an appraised ratio of target debt, and higher for firms which have higher past profitability, less price to book, and weak late performance of stock price. Therefore, their findings demonstrate that both adverse selection and Tradeoff theoretic problems will affect capital structure and debt-equity choices of firms.
In the midst of frictions, firms modify their capital structure rarely. As a result, the leverage of most firms in a dynamic economy, often, is probably different from the optimal leverage level at the new modification time. Strebulaev (2004) explores in his paper the results of his observation. An adjusted dynamic trade off theory with calibration expenses will be used for simulating firm’s capital structure directions.
Especially, in the results of simulated standard cross-sectional tests on the collected data, he found leverage: (1) is negatively related to profitability (Return on Asset); (2) can be highly described by stock (3) is mean-reverting. In the midst of occasional adjustment, the results of the research suggest that “cross-sectional properties of economic variables in dynamics may be fundamentally different from those derived assuming that they are always at their target levels.”
Chen and Hammes (2004) analyze some determinants which are influencing leverage. They use ratios of market capital, book capital and book debt as measures of leverage. They use panel data of seven countries: Germany, Sweden, Canada, US, UK, Italy and Denmark. They found that asset tangibility has positive relation with leverage, while profitability is negatively related to leverage in all these countries. More profitable firms watch over borrowing less. They believe firm size is significantly and positively related to firm’s financial leverage. They conclude that the impact of the price to book ratio fluctuate when book leverage is used and demonstrate a negative and significant relationship when market leverage is used for all countries except for Denmark, which demonstrates an insignificant value. They argue that all their documents and finding are consistent with the results from related financial theories like pecking order theory and trade off theory, for example risky firms borrow less.
Kurshev and Strebulaev (2005) empirically found that firm size is strongly positively is related to capital structure. Many sensitive explanations can be brought for this fact, but none of them has been thought over theoretically. They try in their paper to start bridging the gap by exploring ability of a dynamic capital structure model to explain the relationship between firm size and leverage. They find four types of company size impact on leverage. Small firms will choose higher level of debt at the time of refinancing to pay back for lower regular rebalancing. The relation between leverage and firm size within a refinancing cycle is negative. At last, there are many firms which choose no leverage. They analyzed a dynamic economy to show that cross sectional relation between leverage and size is positive, therefore financing fixed cost cause to the description of the stylized leverage and firm size relation. However, when they control the appearance of unlevered firms, this relationship changes the sign.
Högfeldt and Oborenko (2005) believe that higher profitability which is return on assets and higher current M/B which is delayed one period are negatively related to leverage, mainly on market leverage, like equity has much more value.
Duffie et al. (2005) report in their research that a 10 percent increase in value of the asset will cause a reduction in the default probability of firm by roughly 2 percent conditional on a firm’s financial arrangements.
Chen and Zhao (2005) search for economic explanations to two experimental regularities. First of all, it is apparent that firms with high profitability tend to have lower debt levels. Some new theoretical development has used two different factors like transaction costs or dynamic tax payments to describe this phenomenon. They demonstrate that even after controlling these factors, the phenomenon will largely remain. Secondly, with both empirical and theoretical descriptions, they demonstrate that leverage level can refer mean physically regardless of which theory is explaining financial decisions well. Firms with higher profitability increase lower level of debt because they have enough and more inner funds to count on. They believe the negative relationship between leverage ratios and profitability suggests that tax shields are in second level of concerns. Some new expansions of the tradeoff hypothesis to a multi period, dynamic framework have opposite effects that if relationship between leverage and profitability is negative, it will be actually coherent with the tradeoff hypothesis.
Liu (2005) believes there is no significantly negative relationship between the current debt level and other proxies of market timing: “the historical insider selling percentage”. This conclusion infers that the price to book ratio has a negative relationship with the current leverage for the reasons other than market timing.
Chen and Zhao (2006) believe that the relationship between the price to book ratio and leverage is negative and one of the most greatly documented experimental regularities in the leverage and capital structure history. Some related studies use this negative relationship as given and argue about its economic explanation. They demonstrate that firms with higher price-to-book ratios will have less debt financing costs and use more borrowing. They argue in their research that the relationship between the price to book ratio and leverage level is not monotonic and for most of the firms is positive (as they find, more than 95 percent of total market capitalization and more than 88 percent of COMPUSTAT firms). The antecedently proven negative relationship is directed by a subset of firms with high price-to-book ratios.
Many theories in finance say that structure of capital has impact on value of the firms. This prediction suggests that any change in leverage has an effect on stock return. Many literatures in finance field have been focused on the capital structure determinants. Cai and Zhang (2006) use a sample of U.S. listed firms during 1975 and 2002 and they conclude that a significantly negative impact of debt level changes on standard deviation of stock returns. This negative affect stays significant after adding other determinants like ROE, price to book ratio, firm size and past returns to the analysis. They use and implement many hypotheses and theories to describe the observed effect. They conclude that firms with higher levels of leverage have stronger negative effect. This is coherent with a prediction of the pecking order theory where an increase in leverage level will cause a reduction in debt capacity of firms and will result in lack of investment in the future. More analyses confirm this negative relation between leverage changes and investment in future.
Kasbi (2007) examines the effect of market timing and price to book ratio on capital structure in her study. She uses a decomposition of determinants of price to book ratio into misevaluation and growth opportunities, which is developed in the study by Rhodes-Kropf et al. (2005). She demonstrates that this negative relation between the historical price to book ratio and leverage, which is argued in Baker and Wurgler (2002) sends back the constant effect of past timing efforts and therefore, may not be attributed to growth opportunities.
Antoniou et al. (2007) investigate how firms perform in countries with capital market tendency economy like the U.K. and U.S. and countries with bank tendency economy like France, Germany and Japan, to determine their capital structure. They use panel data and a procedure of two-step system to find that the relation between leverage and asset tangibility and firm size is positive, but its relationship with profitability, growth opportunities and performance of share price in both economy types is negative. The market circumstances in which the firm operates, affect the leverage ratio. Country’s law and financial traditions are two main factors that have impact on degree and effectiveness of capital structure determinants. The results that they find confirm that firms have target leverage ratios, French firms are the fastest in adopting their capital structure close to their goal that they have for leverage ratio, and Japanese firms are the slowest in adjusting to the leverage ratio target.
Sibilkov (2007) checks different theories about the impact of asset liquidity on leverage. A collection of data from a wide sample of U.S. listed firms is used and she finds that leverage ratio has a positive relationship with asset liquidity. Further research shows that asset liquidity and secured debt are positively related, inasmuch as asset liquidity and unsecured debt is curvilinear. He finds in his study that financial distress and inefficient liquidation are important in this relation and they have impact on decisions of capital structure. In addition, his results are coherent with this hypothesis that increase in asset liquidity will raise managerial discretion costs. The rationale for a positive relationship between asset liquidity and leverage leans on the opinion that asset with lower liquidity will sell at higher costs, which rises the liquidation costs, debt level and probability of bankruptcy. Also, less asset liquidity creates the necessity to decrease the costly default probability by reducing leverage. The rationale for a negative relationship between asset liquidity and leverage claim is that it is more costly for directors to take away value from debtors. Therefore, less asset liquidity decreases the debt cost, and so as a conclusion, firm exploit more debt.
Westgaard et al. (2007) address the theoretical substructures of default probability. They use the capital structure neoclassical theory as a beginning point. A pattern of optimum capital structure is created and reworked into a default probability pattern. The relative static analyses demonstrate that optimum capital structure and default probability are business risk factors which are U shaped, and they are calculated by volatility. This result is in comparison with many articles which assume a relationship between capital structure and business risk is linear and negative and the relationship between default probability and business risk is linear and positive. The rest relative statics demonstrate sincere findings, either by examining (capital structure) or in terms of numbers (default probability). As it is, the pattern can be an important contribution when they compare to the large quantity of experimental studies which do not have any theory and a suitable option to the theory which is on the foundation of option pricing.
Correa et al.(2007) seek to examine the hypothetical elements of listed Brazilian firms capital structure, in the way of trade off theory and pecking order theory, analyzing the experimental legitimacy of spoken theories in the domestic script. Their research is an adjustment of the study by Gaud et al., (2005), whose paper was used as a foundation of some variables and also as a base of econometric analysis guided, and it implements the methodology of panel data. They perform dynamic tests in joining to static tests, to analyze the adaptation of the capital structure through time. They analyze variances to complement tests. The findings show that the asset tangibility importance and profitability have negative effect on leverage, while business risk has positive effect on leverage. They also argue that foreign firms use more debt than local firms. They conclude from the analysis and results that the pecking order theory is more likely to explain the listed Brazilian firms’ capital structure than trade off theory.
Fan et al. (2008) find that the leverage cross-sectional factors are approximately coherent across different countries. However they discover some specific differences across countries. As an example, in spite of the fact that in most of the countries’ past profitability will negatively impact on leverage, this impact is a little lower in countries with less tax incentive on retain earnings, and this impact is more effective in more corrupt countries.
Qiu and La (2009) examine the relationship between firm attributes and capital structure in Australian listed firms. They analyze unbalanced group of roughly 370 firms from 92 to 2006 by using panel data regression. They conclude that the relationship between debt to asset ratio and asset tangibility is positive but its relationship with business risk (calculated by unlevered equity beta) and growth prospects is negative. They also conclude that in spite of the fact that levered firms have more profitability in comparison with unlevered, profitability will reduce levered firms debt ratio. They did not find any effect of firm size on capital structure in Australian listed firms. Their findings are in line with the agency cost and pecking order theories but opposite to the tradeoff theory.
Smith (2009) studies capital structure determinants without tax encouragement. He finds that the relationship between usage of debt and asset tangibility, sales growth, and firm size is positive, and its relationship with firm age, asset liquidity, and profitability is negative.
Chen et al., (1997), Barclay and Smith (1996), Rajan and Zingales (1995), Titman Barclay et al., (1995), Lasfer (1995), Chung (1993) and Wessels (1988) all discover the negative effect of growth opportunities on the long run debt or total borrowings. These findings are strong to the assessment method and the economical environment of country under study. Michaelas et al., (1999) conclude long run and total borrowing have positive relationship with price to book ratio. Bevan and Danbolt (2001) discover that gearing and long run debt are negatively related, they also discover that growth opportunities level has positive effect on gearing. Correspondingly, Berger et al., (1997) discover price to book ratio has positive impact on up and down in total gearing ratios.
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