Evidences on Determinants of Capital Structure

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CHAPTER THREE: EMPIRICAL LITERATURE

Introduction

Following the predictions of theoretical models, voluminous empirical studies on capital structure decision of firms have been documented for the past periods. These empirical studies have come along two main strands. That is, empirical studies which emphasize on the determinants of cross sectional variations of capital structure across firms in static framework and which focus on the dynamics of capital structure adjustment. However, these studies have been conducted focusing mainly on nonfinancial firms, excluding banks and other financial firms. The argument for their exclusion is that, as indicated earlier in Chapter 1, banking firms differ from other corporate firms in source of funds, relatively highly leveraged and regulated (Baranoff et al., 2008). Banking literatures primarily focus on regulatory forces rather than factors in corporate capital structure theoretical models (Gropp & Heider, 2009). However, despite these limitations, empirical studies are conducted to investigate determinants and dynamics of capital structure of banking and other financial firms.
Thus, this chapter constitutes the reviewed empirical literatures organized into three sections. The next section (3.2) presents empirical literatures reviewed on determinants of capital structure. Section 3.3 encompasses studies reviewed on dynamics of capital structure documented in both nonfinancial firms and banking firms operating in both developed and developing countries. Finally, section 3.4 concludes by reviewing the empirical studies and by pointing out gaps identified in the literatures reviewed.

Evidences on Determinants of Capital Structure

Different empirical studies on determinants of capital structure examined cross-sectional variations of leverage (or capital ratio) across firms based on the factors such as tax shield, cost of financial distress, agency costs and information asymmetry costs predicted in tradeoff and pecking order theoretical models. As different costs and benefits of debt and equity financing predicted in theoretical models are expected to differ in characteristics across firms, empirical studies use different firm characteristics as proxy for factors predicted in theoretical models (Frank & Goyal, 2004; Tan, 2010). However, regulatory pressure factors have also been considered in studies which focus on capital structure decision of banking firms. This section constitutes the review of existing evidences on determinants of capital structure documented in nonfinancial and banking firms.

Taxation

In tax shield-cost of distress theoretical model, firms tend to increase debt financing to take benefit of tax shield of interest payment (Modigilani & Miller, 1963). Hence, past empirical studies on capital structure determinants of non-financial firms examined the effect of tax shield of debt on leverage. Past studies on non-financial firms of developed countries (MacKie-Mason, 1990; Shum, 1996) examined the relationship between tax rate and leverage; consequently, they found a significant effect of marginal tax on capital structure decision of firms (Abor, 2008). Survey studies done on non-financial firms in US (Graham & Harvey, 2001), UK (Brounen et al., 2006; Beattie et al., 2006; Archbold & Lazirdis, 2010), and selected European countries¹⁴ (Bancel & Mitto, 2004) found tax shield of debt as one of the important or very important factor to be considered in their capital structure decision. These documented evidences are consistent with empirical studies conducted on banking firms of developed countries. Marcus (1983) examined the relations between tax shield disadvantage of equity and desired capital ratio of banks in US, and the result, in estimations, depicted that tax shield is significantly negatively related with capital ratio. Similarly, Hortuland (2005) provided evidence that corporate tax rate is negatively related with capital ratio of Swedish banks. Studying on Portuguese banking firms, Marques & Santos (2003) also predicted and found that tax economies of debt, rather than equity financing, as one of the important or very important internal factors to be considered in their capital structure decisions. However, Osterberg Thomson (1996) confirmed a statistically significant negative coefficient of corporate tax rate on US banks. This finding contradicts the theoretical prediction and finding of Marcus (1983). Sharp (1995) revealed a statistically insignificant coefficient of effective tax shield in regressing against capital ratio of Australian trading banks.
In cross border transition of determinants, past studies also examined the effect of tax shield on capital structure decision of firms in developing countries. Focusing on non-financial firms in ten selected developing countries¹⁵, Booth et al. (2001) investigated the relationship between average tax rate and leverage. Accordingly, they found a negative coefficient of average tax rate. This contradicts the theoretical prediction. However, this finding was positive for three countries (Booth et al., 2001). Similarly, Abor (2008) investigated the impact of tax shield of debt on capital structure decision of three groups of non-financial firms in Ghana. Consistent to the prediction, Abor (2008) found a positive relationship between effective tax rate and short term debt ratio of Small and Medium Enterprises (SMEs). Similarly, Amidu (2007) found statistically significant positive relations between corporate tax shield and leverage of Ghanaian banks. A survey study on banking firms in Nigeria, by Iwarere & Akinley (2010), also predicted and found that tax economies of debt, rather than equity financing, as one of the important or very important internal factors to be considered in their capital structure decisions. However, in contrast to the prediction, Abor (2008) found effective tax rate significantly negatively related to long term debt ratio of the quoted firms. Abor (2008) attributed this negative coefficient to the general tendency of the quoted firms to increase their equity financing to get listed and grab the special benefit of tax rebate (Abor, 2008). However, Chen & Strange (2006) found insignificant coefficient ofcorporate tax advantage in regressing against leverage of non-financial firms in China.
Based on the prediction of DeAngelo & Masulis (1980), different studies also examined non-debt tax shield as determinants. As a result, past studies on non financial firms of developed countries (MacKie-Mason, 1990; Wald, 1999; Ozkan, 2001; Song, 2005; Brinkhuis & Maeseneire, 2009) revealed significant relationship between non-debt tax shield and leverage. Similar studies (Céspedes et al., 2009; Vasiliou & Daskalakis, 2009; Usman, 2014) also identified that non-debt tax shield is significantly related to leverage of non-financial firms in developing countries. However, there are also empirical studies that found, in estimations, insignificant coefficient of non-debt tax shield (Titman & Wessels, 1988; Chen, 2004; Shah & Khan, 2007; Ramall, 2009).
Profitability
In tradeoff model, highly profitable firms imply low probability of distress (Myers, 1984) and high free cash flow available for management expropriations (Jenson & Meckling, 1976; Jenson, 1986). Hence, they tend to increase debt financing to minimize tax payments from interest tax deductibility (Modigilani & Miller, 1963) and to discipline managerial behavior (Jenson, 1986) . In pecking order theory, however, highly profitable firms choose to finance investment opportunities through internally generated funds to minimize information asymmetry related costs (Myers & Majluf, 1984; Myers, 1984).
Thus, past empirical studies on determinants of capital structure of non-financial firms also identified profitability as determinant of their capital structure decision. Such studies examined the relationship between profitability and leverage of non-financial firms in developed countries (Fried & Lang, 1988; Titman & Wessels, 1988; Van der Wijst & Thurik, 1993; Ozkan, 2001; Bevan & Danbolt, 2002; Frank & Goyal, 2004; Song, 2005), and identified a negative relationship between profitability and leverage (Prasad et al., 2001). Similarly, Rajan & Zinglas (1995) investigated the relationship between profitability and leverage of non-financial firms in G-7 countries¹⁶, and found a negative relationship between profitability and leverage of non-financial firms, except in Germany, in all G-7 countries. Kester (1986) and Hirota (1999) also documented similar negative result in non-financial firms of Japan. These evidences are generally consistent with the findings of survey studies of conducted on non-financial firms of developed countries. Survey studies performed on non-financial firms in US (Graham & Harvey, 2001), UK (Brounen et al., 2006; Beattie et al., 2006) and selected European countries (Bancel & Mitto, 2004) also identified financial flexibility or profitability as one of the important or very important factors to be considered in their capital structure decision. These evidences are also consistent with the documented evidences on capital structure decision of banking firms in developed countries (Sharp, 1995; Schaeuck & Cihak, 2007; Berger et al., 2008; Flannery & Rangan, 2008; Brewer et al., 2008; Gropp & Heider, 2009). Gropp & Heider (2009), for example, found a significant negative relationship between profitability and leverage of large banks in US and 15 European countries¹⁷. Studies conducted on the same large US banks over the same period (Berger et al., 2008; Flannery & Rangan, 2008), banks of ten European countries (Schaeuck&Cihak,2007), Australian trading banks (Sharp, 1995), Germany banks (Kleff & Weber, 2004) and banks from twelve selected developed countries¹⁸( Brewer et al., 2008) also documented, in estimations, a positive relationship between profitability and capital ratio. Further, A survey study done on Portuguese banks (Marques & Santos, 2003) proved that profitability or financial flexibility and size of free cash flows are two of the most important factors that influence their capital structure decisions. However, Boucihina & Robeiro (2007) found profitability negatively related with capital ratio of banks in Portugal. Focusing on non-financial firms of Central and Eastern Europe, Cornelli et al. (1996) documented a positive relationship between profitability and leverage.
Past empirical studies on capital structure decision of firms also investigated the relationship between profitability and leverage of non-financial firms in developing countries (Booth et al., 2001; Ignacio, 2002; Chen, 2004; Haung & Song, 2005; Abor, 2008; Céspedes et al., 2009). Some of these empirical studies conducted in selected developing countries (Booth et al., 2001), Uruguay (Ignacio, 2002), Ghana (Abor, 2008), China (Chen, 2004; Haung & Song, 2005), Pakistan (Shan & Khan, 2007) and on Ethiopian share companies (Usman, 2014) also found a negative relationship between profitability and leverage of non-financial firms. Generally, these studies provide evidences consistent with the predictions of pecking order theoretical model (Majluf & Myers, 1984; Myers, 1984). Similar evidences have also been documented by studies done on banks of developing countries (Kuo, 2000; Amidu, 2007; Octavia & Brown, 2008; Çağlayan & Sak, 2010; Mohammed et al., 2015). Octavia & Brown (2008), focusing on banks of ten selected developing countries¹⁹, found out a negative relationship between profitability and leverage. Similarly, significant negative relationship between profitability and leverage also documented by studies carried out on banks of Turkey (Çağlayan & Sak, 2010), Ghana (Amidu, 2007), Taiwan (Kuo, 2000) and Ethiopia (Mohammed et al., 2015). Further, surveying financial managers of Nigerian banks, Iwarere & Akinley (2010) also disclosed profitability or financial flexibility and size of free cash flows as two of the most important factors that influence their capital structure decisions. However, other studies done on firms found in Libya (Buferna et al., 2005) and Morocco (Achy, 2009) depicted profitability as positively related to leverage of firms. Further, Ramall (2009) found insignificant effect of profitability on capital structure decision of Mauritius firms.

Growth Opportunities

In tradeoff theoretical model, high growth opportunities of firms imply high probability of bankruptcy and agency cost in the form of asset substitution (Jenson&Meckling,1976) and underinvestment (Myers, 1977). In pecking order theory, however, high growth opportunities of firms imply high fund requirements that exceed internally generated funds (Majluf & Myers, 1984; Myers, 1984).
Various empirical studies examined growth opportunities as one of the factors to be heeded for capital structure decision of non-financial firms in developed countries (Kester, 1986; Titman & Wessels, 1988; Rajan & Zinglas, 1995; Jordan et al., 1998; Hirota, 1999; Bevan & Danbolt, 2004; Frank & Goyal, 2004). However, the documented evidences are found to be inconclusive. The studies conducted in US (Frank & Goyal, 2004), G-7 countries (Rajan & Zinglas, 1995 and Japan (Hirota, 1999) found a negative relationship between growth and leverage of non-financial firms. Bevan & Danbolt (2004) also found growth opportunities as negatively related with short term debt ratio of UK firms. Similar studies done on banks of US and 15 EU countries showed a negative relation between growth and bank leverage (Gropp & Heider, 2007). Survey studies carried out on capital structure decision of banks found in Portugal (Marques & Santo, 2003) and UK (Alfon et al., 2004) also documented that investment policy or growth opportunity of banks is one of the important or very important internal determinants. Banks also tend to use equity financing in funding growth opportunities (Marques & Santos, 2003; Alfon et al., 2004). Similar studies which  have been done in US (Titman & Wessels, 1988), Japan (Kester, 1986) and UK (Jordan et al., 1998), however, depicted a positive relationship between growth and leverage of non-financial firms. These findings are also consistent with the findings observed in US banks (Berger et al., 2008) and in Australian trading banks (Sharp, 1995). Berger et al. (2008) and Sharp (1995) also found that growth is negatively related with capital ratio of banks.
In the same fashion, some empirical studies (such as Booth et al., 2001; Chen, 2004; Huang & Song, 2005; Chen & Strange, 2006; Abor, 2008; Ramalla, 2009; Usman, 2014) also investigated the relationship between growth and capital structure choice of non-financial firms in developing countries. Consequently, the evidences identified are inconclusive. The studies carried out in ten selected developing countries (Booth et al., 2001), Pakistan (Shah & Khan, 2007) and Libya (Buferna et al., 2005) revealed the existing negative relationship between growth opportunities and leverage of non-financial firms. These evidences are also consistent with the results of the survey studies on banking firms (Wong et al., 2004; Iwarere & Akinley, 2010). The survey studies conducted on banks of Honk Kong (Wong et al, 2004) and Nigeria (Iwarere & Akinley, 2010) found that growth is one of the important determinants of financing decision. Moreover, banks choose to issue equity financing to finance growth opportunities (Wong et al., 2004; Iwarere & Akinley, 2010).
However, studies carried out on non-financial firms of Ghana (Abor, 2008), Moroccan non-listed manufacturing firms (Achy, 2009), and Chinese listed companies (Chen, 2004) found that growth opportunities of firms are significantly positively related to debt ratio. In the same market, Huang Song (2005) and Chen & Strange (2006), consistent with the finding of Chen (2004), found a positive relationship between growth and leverage of Chinese firms. Similar studies conducted on Turkish banks (Çağlayan & Sak, 2010) and Ghanian banks (Amidu, 2007) witnessed a positive relationship between growth and leverage. But, there are still some empirical studies that proved insignificant effect of growth opportunities on capital structure decision of firms. Of these studies, Ramlall (2009) and Usman (2014), focusing on non-listed nonfinancial firms of Mauritius and large tax payer share companies of Ethiopia, respectively, documented insignificant effect of growth opportunities on leverage. Octavia & Brown (2008) and Mohammed and his colleagues (2015), on banks of selected developing countries and Ethiopian banks, respectively, also found insignificant coefficient of growth in regressing against book leverage.

Tangibility/Collateral Value of Assets

According to Rajan & Zinglas (1995), tangibility of assets represents the effect of collateral value of assets on capital structure decision of firms (Prasad et al, 2001). From available theoretical literature, the expected relationship between tangibility/collateral value of assets and leverage is debatable (Prasad et al., 2001). In tradeoff theoretical model, high tangibility of assets of firms imply high liquidation value at the time of distress (Harris & Raviv, 1991) and low agency costs of debt in the form of asset substitution (Jenson & Meckling, 1976) and underinvestment (Myers, 1977). Grossman & Hart (1982), however, argued that agency cost of equity from conflict of interest between managers and shareholders will be higher for firms which have low level of assets to be used as collateral (Titman & Wessels, 1988; Prasad et al., 2001). Hence, in tradeoff theoretical model, the relationship between collateral value of assets and leverage could be either positive or negative. In pecking order theory, high tangibility of assets of firms entail low information asymmetry related costs in external financing (Majluf & Myers, 1984; Myers, 1984).

DECLARATION 
ABSTRACT
DEDICATION 
ACKNOWLEDGEMENT 
CHAPTER ONE: ORIENTATIONS 
1.1.Introduction
1.2.Statement of the Problem
1.3.Aim and Objectives
1.4.Rationales and/or Importance of the Study
1.5.Delimitation/Scope of the Study
1.6.Outline of the Study
CHAPTER TWO: THEORETICAL FOUNDATION OF THE STUDY 
2.1. Introduction
2.2.Tradeoff Theory
2.3.Pecking Order Theory
2.4.Theory of Bank Capital Regulation
2.5.Summary
CHAPTER THREE: EMPIRICAL LITERATURE
3.1. Introduction
3.2.Evidences on Determinants of Capital Structure
3.3.Evidences on the Dynamics of Capital Structure Adjustment
3.4.Conclusion
CHAPTER FOUR: HYPOTHESES FORMULATION
CHAPTER FIVE: RESEARCH METHODOLOGY 
5.1. Research Approach and Paradigm
5.2. Research Design
5.3.Research Ethics
5.4.Methodological Limitations
CHAPTER SIX: RESULTS AND DISCUSSIONS
6.1. Introduction
6.2.Results
6.3.Discussions
CHAPTER SEVEN: CONCLUSION AND RECOMMENDATIONS
7.1. Introduction
7.2. Conclusion
7.4. Recommendations for Further Research
REFERENCES 
ANNEXES
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