Determinants of Corporate Capital Structure Under Different Debt Maturities (2011)
Determinants of Corporate Capital Structure Under Different Debt Maturities (2011)
Determinants of Corporate Capital Structure Under Different Debt Maturities (2011)
Ho-Yin Yue
School of Finance, Shanghai University of Finance and Economics, Shanghai, China
E-mail: [email protected]
Abstract
The main purpose of this study is to examine the trade-off model and pecking order
model of capital structure under different debt maturities for a sample of 1445 corporates
listed in the Hong Kong exchange market. Empirical results provide evidences that trade-
off model and pecking order are not mutually exclusive. Both trade-off model and pecking
order model play a significant role in determining the total debt level of corporates.
However, empirical results of short-term debt level consistent only with pecking order
model but not trade-off model. This may because financial institutions in Hong Kong do
not concern seriously on the risk of insolvency. Firms with higher risk can access short-
term debt financing as easy as firms with less risk.
1. Introduction
In any firm, one of the major duties of manager is determining the capital structure of the firm. In
general, manager can choose any mix of different types of assets to form their capital structure. Firms
can either issue a large amount of debt or very little debt. It can also use lease financing, warrants,
convertible bonds or trade bond swap. However, no matter which combination does the firm chosen,
the aim of the selection is trying to maximize its market value. A number of theories have been
suggested in explaining the capital structure of firms. However, there is no specific method for firms to
choose their optimal debt level yet.
This paper shed some light on the determinants of the capital structure using 1445 firms listed
in the Hong Kong Stock exchange market. We include variables based on different capital structure
theories. I also examine how the variables affect on debt with different maturity i.e. short term, long
term and total debt level of firms. The conclusions of this paper are expected to shed some light on the
possibility that firms choose their capital structures based on several but not one capital structure
theories. Also, this paper helps to understand better whether the determinants of short term and long
term debt are different.
This paper is organized as follows. The next section gives a literature review on the
determinants and effects on the capital structure of firms. Then, data description and justification of the
choice of the variables used in the analysis are discussed in section three. The fourth section presents
the results of the empirical analysis and discusses the conclusion which can be derived from the results.
Finally, I summarize the findings of the research in the last section.
International Research Journal of Finance and Economics - Issue 66 (2011) 100
investors. Managers know more about the firm’s true value than outside investors. To maximize the
welth of existing shareholders, managers avoid issuing undervalued new share to finance new projects.
Thus, issuing new equity is interpreted as a negative signal, in the snese that the equity is being
overvalued. This negative signal results in the decline of stock price. The relation between the issue of
new shares and the decline of stock price is confirmed in several studies (Asquith & Mullins, 1986).
According to pecking order model, managers tend to finance a new project initally by
undistributed earnings which is no existence of information asymmetry and will not be undervalued.
Then, they will try on debt capital if extra funds are still needed. Issuing new share is treat as the final
source of funds.
Fllowing the idea of pecking order model, firms with higher profitability generate more
earning. Therefore, firms with higher profitability depend more on internal funds while less depend on
debt capital. Several researches have tested the effects of profitability on debt level. Kester (1986),
Friend and Lang (1988) and Shyam-Sunder and Myers (1999) concluded that there is a significant
negitive relation between profitability and debt level. Wald (1999) found a significant negitive relation
between profitability and debt level for firms in seveal countries.
market price per share by the annual earnings per share. I expected that growth opportunities is
negative related to debt level.
3.1.3. Profitability
Profitability represents the power of making profit of firms. According to the trade-off model,
profitable firms have high tax burden and low bankruptcy risk. Therefore, profitable firms are more
likey to employ a higher leverage than those less profitable (Ooi, 1999). Empirical evidences can be
found in studies ((Bowen, Daley, & Huber, 1982), (Dammon & Senbet, 1988) and (Givoly, Hayn,
Ofer, & Sarig, 1992)) which support trade-off mdoel.
Contray to trade-off model, according to pecking order model, profitable firms tend to have
lower debt level (Myers, 1984). Barton and Hill (1989) agrees that firms with higher profitability have
lower debt level because they can generate much internal funds than firms less profitable. Empirical
studies ( (Al-Sakran, 2001), (Chittenden, Hall, & Hutchinson, 1996), (Coleman & Cole, 2000) and
(Griner & Gordon, 1995)) suggest pecking order model is more approiate in explaining the relation
between firm’s profitability and debt level. Among different studies, most of them found a negative
relation between profitability and debt level.
I use the return on total asset (roa) as a proxy of profitability in this paper. Return on total assets
is calculated by dividing a firm’s annual earnings by its total assets. Return on total assets indicate how
efficient managerment is at using its assets to make profit. Other possibile measures of profitability are
the ratio of earnings before tax, interest payments, and depreciation to the book value of assets
(EBITDA) or the ratio of operating cash flow to total assets. EBITDA measures firm’s profitability
ignoring the effect of different taxation system while the ratio of operating cash flow to total assets
measures firms’ internal cash generating ability.
I expect the profitability is inverse related to debt level.
5. Conclusion
The empirical results of the factors affecting the debt level of firms in Hong Kong suggest that pecking
order model and trade-off model are not mutually exclusive. My results agree with the findings of
Fama and French (2002). Firms tend to select their levelage level according to both pecking order
model and trade-off model. However, factors affecting the short-term debt level and long-term debt
level are different. The empirical results suggest that, short-term debt level consistent with pecking
order model. On the other hand, factors related to the risk of insolvency do not affect short-term debt
level of firms. The empirical results agree with Hovakimian, Opler, and Titman (2001). They
concluded that debt ratio and debt-equity issue choice appear to be consistent with pecking order
behavior in short-run. In short, empirical results suggest that short-term debt level of firms in Hong
Kong consistent with pecking order model. Apart from this, the long-term debt level and the total debt
105 International Research Journal of Finance and Economics - Issue 66 (2011)
level of firms in Hong Kong consistent with both pecking order model and trade-off model. Evidences
show that pecking order model and trade-off model are not mutually exclusive.
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