Download Determinants of Firm`s Financial Leverage: A Critical

Determinants of Firm’s Financial Leverage:
A Critical Review
Rahul Kumar1
Abstract
The purpose of this review paper is to critically investigate the underlying factors that
affect firm’s financial leverage from the perspective of theoretical underpinnings. We reviewed
107 papers published from 1991 to 2005 in the core, non-core and other academic journals.
On the basis of critical review, this research has identified a number of determinants of
financial leverage based upon logical arguments identified in the literatures. Major findings
show that various frameworks like leverage irrelevance, static trade off, pecking order,
asymmetric information signaling framework have partly helped us in understanding the
underlying factors determining the firm’s financial leverage, there is no consensus and there
is no universal factor determining financial leverage. The paper sets out two challenges for
future research: one, how to integrate different factors determining firm’s financial leverage
into a common framework and second, what are the explanatory factors determining firm’s
financial leverage in a network phenomena.
Introduction
In general, companies may raise
money from internal and external sources.
They can raise money from internal
sources by plowing back part of their profits,
wh ich woul d otherwise have be en
distributed as dividend to shareholders. Or,
they can raise money from external
sources by an issue of debt or equity. When
a company issues shares, shareholders
hope to receive dividen d on the ir
investment. However, the company is not
obliged to pay any dividend. Because
di vide nd i s di scre tion ary, it is n ot
considered to be a business expense. When
a company borrows money by way of debt,
it promises to make regular interest
payment and to repay the principal (i.e. the
original amount borrowed). If profits rise,
the debt holders continue to receive a fixed
interest payment, so that all the gains go
to the shareholders. On the contrary, when
the reverse happens and profits fall,
shareholders bear all the pain. If times are
sufficiently hard, a company that has
borrowed heavily may not be able to repay
its debt. The company then becomes
bankrupt and shareholders loose their
entire investment. Because debt positively
affects returns to shareholders in good
times and adversely affects to them in bad
times, it creates “financial leverage”
(leverage). An “unlevered firm1” uses only
equity capital whereas a “levered firm”
uses a mix of equity and various forms of
1. The author is a member of The Institute of Chartered Accountant of India and a Doctoral Scholar,
Management Development Institute, Gurgaon (India). He can be reached at fpm05 rahul_k @mdi.ac.in
Journal of Contemporary Research in Management, January - March 2008
57
debt. Common ratios such as debt-to-total
capital or debt-to-equity quantify this
relationship. The importance of leverage
in the capital structure 2 of the company is
that its efficient use reduces the weighted
average cost of capital (WACC) of the
company. Lowering the cost of capital
increases the net economic returns which,
ultimately increases firm’s value. In sum,
the guiding principle of leverage is to
ch oose the cou rse of actio n th at
maximizes the firm’s value and value of
the firm is maximized when the WACC is
minimized.
The firm’s leverage decision centers
on the allocation between debt and equity
in financing the company. However, how
the leverage of a firm is determined in a
world in which cash flows are uncertain
and in which capital can be obtained by
many different media ranging from pure
de bt i nstrumen ts to pure equi ty
instruments is an unsettled issue. A
number of researchers have attempted to
understand financing choices of the firm
and to identify the effect of changes in
financial structure on the WACC of the firm
and its value. A survey on capital structure
theories by Harris and Raviv (1991) provide
a summary of determinant of financial
leverage of the firm, as identified and
discovered by the researchers up to the
time. However, in the absence of any
review of published papers in the area since
then, a need was felt to do this type of
review and objective was decided. The
literature review is done to understand the
progress of research on the subject and to
identify the future direction of research.
The present study reviews the literatures
from January, 1991 to December, 2005, and
summari zes
vari ous
hypo theses
determin ing the le verage of firm as
discovered by the researchers. The review
work follows from the perspective of
theoretical underpinnings developed by the
researchers during this time.
This paper is organized as follows. In
Section 2, we present methodology of
review. Section 3 presents classification,
discussion, and summary of hypothesis
brought forth in the published papers
during January, 1991 to December, 2005
from different theoretical underpinnings
propounded in the subject area, though the
divide line is oblique. Section 4 is the last
section devoted to conclusions and future
directions of the research.
Section: 2
For the purpose of our study, we
systematically exclude certain topics,
which are related to the leverage structure
of the firm, but do no t ke ep the
determinants of the leverage as its central
focus. These include literatures dealing
with call or conversion of securities,
dividend, bond covenants and maturity,
bankruptcy law, pricing and method of
issuance of new securities, common and
preferred stock. Second, we briefly discuss
the theories on leverage under various
1
For the purpose of the paper the terms firm, company, and corporate are used interchangeably and
implies the same meaning.
2
The term “capital structure” refers to the proportion of capital from long term sources.
58
Journal of Contemporary Research in Management, January - March 2008
subsection of section 3. Though such
theories are undoubtedly of great empirical
importance, we found that such theories
have extensively been surveyed by Harris
and Raviv (1991), Bradley et. al. (1984) and
for the purpose of convenience we referred
the authors for detailed explanation on the
theories.
Gro upin g th e variables driving
leverage, allows discussion of the variables
in one place, and facilitates examination
of the relation ship amo ng simil ar
variables. The researchers in the past have
looked into the capital structure from
various theoretical perspectives and
brought forth a number of theories on
capital structure. Accordingl y, the
determination of firm’s leverage was
postulated to fall under various theoretical
model/framework. These are:1.
Irrelevance theory: Research in this
area was initiated by Modigliani and
Miller (1958);
2.
Static trade-off theory: Research in
this area was initiated by Myers and
Majluf (1984);
3.
Asymmetric information signaling
framework : This stream of research
began with the work of Ross (1977) and
Leland and Pyle (1977);
4.
Models base d on Age ncy cost :
Research in this area was initiated
by Jensen and Meckling (1976)
building on earlier work of Fama and
Miller (1972);
5.
Pecking order Frame work: Th is
stream of research began with the
work of Myers and Majluf (1984) and
Myers (1984);
6.
The legal environment Framework of
capital structure: Research in this
direction was initiated by La Porta et.
al.(1997);
7.
Target leverage Framework (Mean
reversion theory): Research in this
direction was initiated by Fischer et
al. (1989);
8.
Transactio n co st Framework:
Research from this perspective was
initiated by Williamson (1988).
For the purpose of our study, we
followed the above distinct categories as
have been brought forth by the researchers.
Over and above the above theoretical
framework, we found that there is some
variables not fitting into any of the given
categories, which we have put into “others”
category. For the purpose of our study,
Papers published in the Journals listed in
Table-I in the last fifteen years (from 1991
to 2005) are re view ed. Zivn ey and
Reichenstein (1994) categorized academic
finance journals as “core” and “noncore.”
Based on their definition, we categorized
the journals into three categories: (i) Core,
(i i) Non Core, and (i ii) Othe rs. We
understand that our sample is the true
representative of the population to reflect
the state of research in determining the
variables affecting the firm’s leverage. We
reviewed articles in the journals through
the EBSCO research database, Proquest
database, Emerald full text database,
Elsevier’s Business management and
accounti ng colle cti on, and JSTOR
database.
Journal of Contemporary Research in Management, January - March 2008
59
Table I : Classified list of Journals Reviewed : Core, Non-Core and Others
(Figures in bracket represent the number of papers reviewed from respective journal)
Core
Non Core
1.
Review of Financial
Studies (11)
1. Journal of Financial 1. The Journal of the Financial
Economics (7)
Management Association (2)
2.
Journal of Business (7)
2. Review of Quantitative and
Accounting (1) Finance
3.
Journal of Finance (17)
3. Bank of England Quarterly
Bulletin (3)
4.
Financial Management (4)
5.
Journal of Business
Finance & Accounting (3)
Journal of Financial &
Quantitative Analysis (5)
Journal of Financial
Research (1)
6.
7.
Others
4. Journal of International
Business Studies (1)
5. European Journal of
Finance (3)
6. Small Business Economics (2)
7. The American Economic
Review (2)
8. Accounting and Finance (2)
9. Management Science (3)
10. International Journal of the
Economics of Business (2)
11. The Journal of the American
Taxation Association (1)
12. The Journal of Risk Finance (1)
13. Journal of Accounting
Research (1)
14. Journal of Political
Economy (1)
15. Journal of Economic
Perspectives (2)
16. Journal of Property
Research (1)
17. Applied Financial Economics(1)
18. European Financial
Management (1)
19. Journal of Economics and
Finance (1)
20. Venture Capital (1)
21. Corporate Governance:
An International Review (2)
22. The Bell Journal of
economics (1)
Table I: Table showing classified list of Journals reviewed: Core, Non-Core and Others
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Journal of Contemporary Research in Management, January - March 2008
Section 3
3.
Classification, Discussion, and
Summary of Hypothesis
The researchers have captured a
number of factors determining firm’s
leverage. In this section, we report the
factors identi fied in the publish ed
literature under different theoretical
framework propounded over the period by
the researchers.
3.1.
The leverage “irrelevance”
framework
The genesis of research in the area
started with th e se minal paper of
Modigliani and Miller (1958). Modigliani
and Miller (1958) in their seminal paper
“The cost of capital, corporation finance,
and the the ory of i nvestmen t”
demonstrated that in the absence of
transaction cost, no tax subsidies on the
payment of interest, and the same rate of
interest of borrowing by individuals and
corporations, firm value is independent of
its leverage and is given by capitalizing the
expected return at the rate appropriate to
that asset class.
Mathematically,
Vj (S j  Dj ) 
k 
xj
Vj
xj
k
                         (1)
Where,
Xj
:
Expected return on assets
owned by the firm j
Dj
:
Market value of debt of the
firm j
Sj
:
Market value of common
shares of the firm j
Vj
:
Market value of firm j
Pk
:
Cost of capital appropriate to
the asset class k.
Modigliani and Miller (1958) concluded
that a firm cannot increase its value by
using leverage as part of its capital
structure. The traditional belief was that
th e capital structure of the firm is
determined by the rate of interest on bonds,
so the firm will push the investment to the
point where the marginal rate of yield on
physical assets equals the market rate of
interest. Hence a firm can increase its
market value by generating yield on assets
that exceeds the market rate of interest.
Modigliani and Miller (1958) challenged the
traditional notion that a firm can increase
its value by using debt4 as part of its capital
structure. Ghosh et. al. (1996) investigated
the valuation effects of exchangeable debt
calls and indicated that the shareholders
of firms calling exchangeable debt do not
experience any significant changes in
wealth. They found that the negative effect
of a decrease in leverage due to the call is
offset by the calling firm’s change in asset
composition.Current empirical researches
documented significant decline in equity
prices both around the announcement of a
new equity issue and for the immediately
subsequent years and validated Modigliani
and Miller argument.
Journal of Contemporary Research in Management, January - March 2008
61
3.2. Static trade-off framework: tax
benefit and bankruptcy costs
As we have discussed above, payment
of interest on debt is a mandatory charge
on the business of the firm, which is
allowed as expenses for tax purpose. As a
result, the presence of bankruptcy cost5 and
favorable tax treatment of interest payment
led to the development of static trade off
framework. The framework was first
propounded in 1984 (Myers and Majluf,
1984). The proponents of static trade-off
model argues that firms balance debt and
equity positions by making trade-offs
between the value of tax shields on
interest, and the cost of bankruptcy or
financial distress. In other words, keeping
other things constant, higher the cost of
bankruptcy, lower the debt and vice versa.
Secondly, keeping other things constant,
higher the maximum marginal rate of tax,
higher the debt and vice versa.
Graham (1996) found evidence that
changes in debt are positively and
significantly related to the firm’s effective
marginal tax rate. Graham (2003) did an
extensive review on how taxes can affect
domestic and multinational corporate
capital structure and found evidence that
high tax rate firms in order to take
advantage of tax shie ld o n in tere st
expenses use debt more intensively than
do low tax rate firms. Bancel and Mittoo
(2004) on the basis of survey of managers
in 16 European countries found that in
determining the debt policy of firms,
financial flexibility of the firm, tax shield
on interest, and volatility of earning are
important concerns of the managers. Kaye
J. Newberry (1998) investigated the impact
of foreign tax credit (FTC) limitation on
firm’s capital structure decisions and found
evidence that FTC limitation influences
firms to decrease their domestic debt by
substituting both common and preferred
stock. Bhaduri (2002) argued that non-debt
tax shields are substitutes for tax benefit
of debt financing, and thus a firm with
large non-debt tax-shield is likely to be less
leveraged. The author further contended
that large firms tend to be more diversified
and hence likely to be less susceptible to
financial distress, and so a positive
association is expected between firm’s size
and leverage, on the other hand, firm
characterized by unique products are likely
to be less leveraged because their specific
use of capital reduces the probability of an
alternative use in the event of bankruptcy.
Graham et. al. (2004) found that employee
stock option deductions lead to large
aggregate tax savings for Nasdaq 100 and
S&P 100 firms and also affect corporate
marginal tax rates. They suggested that
option deductions are important non-debt
tax shields and that option deductions
substitute for interest deductions in
corporate capital structure decisions,
explaining in part why some firms use so
little debt. Kahle et. al.(2005) analyzed the
relation between the capital structure of a
firm and the tax benefits realized from the
exercise of stock options and found that
debt ratios are negatively related to the size
4
The term debt and leverage is used interchangeably.
5
Bankruptcy costs are the cost directly incurred when the perceived probability, that the firm will
default on financing, is greater than zero.
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Journal of Contemporary Research in Management, January - March 2008
of tax benefits from option exercise. They
concluded that firms with option-related tax
benefits tend to issue equity, with the net
amount of equity issued an increasing
function of these tax benefits. Pittman
(2002) found evidence that the younger
firms at an earlier stage i n th eir
developments rely more on investment tax
shields and less on debt tax shields.
Brierley and Bunn (2005) argued that the
corporate gearing at the aggregate level is
based on the trade off model in which a
company targets a long run equilibrium
gearing ratio, which is determined by the
tax benefit of gearing6 relative to the risk
of financial di stre ss. The auth ors
contended that larger firms tend to enjoy
more diversified income streams and a
lower volatility of earnings, which point to
a positive relationship between gearing and
size. Nengjiu Ju, et. al. (2005) suggested
that the trade-off model performs reasonably
well in predicting capital structures for
firms with typical levels of debt. They
indicated that, in addition to the tax
shields, important determinants of capital
structure include the underlying risk of
the firm’s assets, the maturity of the debt,
the ability of debt-holders to force default
for a given level of firm value, and the
incremental bankruptcy costs conditional
on default. MacKay (2003) investigated
whether the real flexibility in firm’s
technology affect its financial structure
and found that the result is consistent with
static trade off theory in that the finance
leverage is negatively related to production
fle xibi lity but positively related to
investment flexibility. In this context, the
author argued that production flexibility can
increase debt capacity by allowing a firm
to adjust its factor intensity, product mix,
or production level to changing market
conditions, thus lowering the risk of
default; whereas investment flexibility can
increase debt capacity by allowing a firm
to expand or contract its capital stocks,
thus lowering distress cost by making its
collateral assets more liquid. Akhtar (2005)
on the basis of empirical analysis of
Australian multinational and domestic
corporations from 1992 to 2001 found that
collateral value of assets is a significant
determinant of debt equity ratio. Jaggi and
Gul (1999) argued that because large firms
are generally more diversified and less
prone to bankruptcy and financial distress,
which enable them to have an easier
access to bond markets, hence it allows
them to issue a higher level of debt. Frank
and Goyal (2003) argued that according to
the trade off theory the profitable firms
should be more highly levered to offset
corporate taxes. Gaud et. al. (2005) on the
basis of empirical study of 104 Swiss
companies found that that the trade-off
model works in explaining the capital
structure of Swiss companies. Thornhill et.
al. (2004) argued that firms with high
collateral assets should have greater
access to bank funding compared to those
with more ephemeral intellectual assets.
This follows from the reduced riskiness of
investment and transactions involving
assets that have low specificity and well
developed factor market. Consequently,
they proposed that firms in goods producing
industries will have a higher debt to equity
mix than will firms in service industries.
Rajan and Zingales (1995) proposed that one
cannot easily dismiss the possibility that
taxe s influ ence ag gregate corpo rate
leverage. Other results that support the
static trade off model include Farrino &
Weisbach (1999), Cassar & Holmes (2003),
Morellec & Smith (2003). Morellec (2004),
and Parrino & Weisbach (2005).
6. The word “gearing or leverage” refers to the same meaning.
Journal of Contemporary Research in Management, January - March 2008
63
The researchers have also observed
result inconsistent with the prediction of
static trade off theory. Fama and French
(1998), despite an extensive statistical
research, could find no indication that debt
has net tax benefit. Bagley et. al. (1998)
critiqued the static tradeoff theory for it does
not explicitly treat the impact of transaction
costs; does not explain the policy of
asymmetry between frequent small debt
transactions and infrequent large equity
transactions; does not explain why the debt
ratio is allowed to wander a considerable
distance from its alleged static optimum,
or how much of a distance should be
tolerated.
In short, static trade off theory offers
a partial expl anation of the facto rs
determining firm’s choice of leverage.
Table IIa : Determinants of leverage under Static trade off framework Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
(Impact on
leverage)
Author (Year of publication)
Effective marginal tax
rate on firm
Positive
Graham (1996); Graham (2003); Bancel and
Mittoo (2004)
Personal tax on
interest income relative
to personal tax on
equity income
Negative
Graham (2003)
Accumulated
foreign tax credit
Negative
Graham (2003)
Limitation on Foreign
tax credit for firm
Negative
Kaye J. Newberry (1998)
Non Debt tax Shield
e.g. Tax Allowable
employee stock option
Negative
Bhaduri (2002); Graham et. al. (2004); Kahle et.
al.(2005)
Firm size
Positive
Jaggi and Gul (1999); Bhaduri (2002); Brierley and
Bunn (2005)
Earning Volatility /
Operating risk
Negative
Bayless and Chaplinsky (1991); Bhaduri (2002);
Frank and Goyal (2003); Bancel and Mittoo (2004);
Brierley and Bunn (2005)
Bankruptcy cost
Negative
Nengjiu Ju et. al. (2005)
Production Flexibility
Negative
MacKay (2003)
Investment Flexibility
Positive
MacKay (2003); Bancel and Mittoo (2004)
Age
Positive
Pittman (2002)
Product uniqueness
Negative
Bhaduri (2002)
Profitability
Positive
Frank
Net operating loss carry
forwards
Negative
Graham (2003)
Collateral value of assets
Positive
Thornhill et. al. (2004); Akhtar (2005)
and Goyal (2003)
Table IIa : Determinants of leverage under Static trade off framework -Summary of Variables, Hypothesis,
and Author (year of publication)
64
Journal of Contemporary Research in Management, January - March 2008
3.3.
Asymmetric Information
Signaling Framework
The proponen ts of Informati on
signaling model argue that the existence
of information asymmetry between the
firm and the likely finance providers
causes the relative cost of finance to vary
between the different sources of finance.
For instance, an internal source of finance,
where the funds provider is the firm, will
have more information about the firm than
new equity holders; thus new equity holders
will expect a higher rate of return on their
investments meaning that it will cost the
firm more to issue fresh equity shares than
using internal funds. The conclusion
drawn from the asymmetric information
theories is that there is a hierarchy of firm
preference with respect to the financing of
their investments (Myers and Majluf,
1984). Ooi (1999) investigated the corporate
debt matu rity structure of prope rty
companies quoted in the UK over the period
1989-95 and showed that, in order to
distinguish themselves from firms in other
ri sk classes and to mi tigate the
information asymmetry effects, property
companies with potential good news employ
more debt in their capital structure, which
is con sistent with the sig nali ng
hypothesis. Bayless and Chaplinsky (1996)
found that when there are low levels of
in formatio n asymme try (i.e., in h ot
markets) the annou ncement-peri od
returns are significantly higher than in
cold markets. They concluded that firms
try to take advantage of these “windows of
opportunity 7” as they decide when to
schedule a new equity or debt issue. Frank
and Goyal (2003) argued that large firms
are usually more diversified, have better
reputations in debt markets, and face lower
information costs w hen borrowin g,
therefore, large firms are predicted to have
more debt in their capital structures. Hall
et. al. (2004) argued that because much of
the data which small firms will supply to
banks, in their applications for loans, will
not be readily verifiable, hence, the problem
of information asymmetry that they face
will be particularly acute, so debt would be
positively related to firm size. Bhaduri
(2002) proposed that young firms are more
vulnerable to the problem of asymmetric
information, and hence they are likely to
use debt and avoid the equity market.
Further, the author argued that a firm with
a reputation of dividend payment faces less
asymmetric information in accessing the
equity market, therefore, an inverse
relationship is predicted to exist between
leverage and dividend payment. Bancel and
Mittoo (2004) found in their sample survey
of managers from 16 European countries
that over 40% of the managers issue debt
when interest rates are low or when the
firm’s equity is undervalued by the market.
These findings suggest the managers use
windows of opportunity to raise capital. The
authors further reasoned that managers
issue convertible debt because it is less
expensive than straight debt, or to attract
investors who are unsure about the
riskiness of the firm. Habib and Johnsen
(2000) showed that debt and outside equity
can be used to elicit accurate information
about the value of an enterprise in
alternative uses. They argued that the firm
issue securities to reveal outside investors
knowledge of the expected return through
the size of the stake they acquire and the
price they pay for it assuming that the
outside investors observe a signal and
communicate it to the firm. Devis (1996)
explained that preference financing is
1. Firms use “window of opportunity” by selling shares when their equity is overvalued.
Journal of Contemporary Research in Management, January - March 2008
65
chosen when significant information
asymmetries exist between management
and outside investors. Mark Garmaise
(2001) showed that firms attempt to
maximize diversity of opinion by issuing
risky securities such as equity. The author
suggested that the researching the state
of investor beliefs and choosing an optimal
design in the light of these beliefs can
create substantial value for the firm’s
original owners. McLaughlin et. al. (1998)
examined the information content of
offerings of debt and equity by public
corporations by analyzing the relationship
between information asymmetry and long
run changes in firm operating performance
around the offerings. Their results were
consistent with the information model of
decision to issue securities. Dittmar (2000)
examine d an d fo und that the firms
repurchase stock to take advantage of
potential undervaluation. Michaelas et al.
(1999) empiricall y ex amin ed the
implication of theory of capital structure
in the U.K. small business sector and
suggested that the asymmetric information
costs have an effect on the level of debt in
small firms.
The researchers have also observed
inadequacy in asymmetric information
signaling model to explain the capital
structure decisions. Byrd et. al. (1996)
examine d stock price re acti ons to
conversion forcing calls of convertible bonds
and preferred stocks and found that
analysts earning forecast, both short term
and long term, were revised upward
fol lowi ng the call anno unce ment of
convertible bonds and preferred stocks.
Their findings cast doubt on the established
belief that such capital structure decisions
signal negative information about firm
value. Bhabra et. al. (1996) examined
whether all firms that issue convertible
bonds truthfully reveal firm quality at the
offer announcement and found that some
low-quality firms issue convertible bonds
with contract terms that suggest higher
quality, however market reacts more
positively to announcements of these low
quality firms. In short, the researchers
have derived a number of hypotheses with
reference to the determinant of firm’s
leverage following asymmetric information
framework.
Table IIb : Determinants of leverage under Asymmetric Information Signaling
Framework - Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
(Impact on
leverage)
Author (Year of publication)
Potential good news
Positive
Ooi
(1999)
Levels of information asymmetry Negative
Bayless and Chaplinsky (1996)
Firm size
Positive
Frank
Positive to long term debt
Hall et. al. (2004)
and Goyal (2003)
Negative to short term debt
Dividend Payment
Negative
Bhaduri (2002)
Age
Negative
Bhaduri (2002)
Interest rate
Positive
Bancel and Mittoo (2004)
Firm’s valuation of
equity in the market
Negative
Bancel and Mittoo (2004)
Table IIb : Determinants of leverage under Asymmetric Information
Summary of Variables, Hypothesis, and Author (year of publication)
66
Signaling Framework -
Journal of Contemporary Research in Management, January - March 2008
3.4. Agency cost Framework
Conflict between principal (share
holders) and their agents (managers) can
also affect capital structure choice. Jensen
and Meckling (1976) defined agency costs
as the sum of (1) monitoring expenditures
of the prin cipal, ( 2) the bondi ng
expenditures by the agent, and (3) the
re sidu al l oss arising out of agen cy
relationship8. The agency model relies on
the argument that managers sometimes
pursue their own objectives at the expense
of shareholders. Jensen (1986) argued that
the optimal capital structure can be
obtained by trading off the agency cost of
different types, thus influencing firm value.
He argued that managers of low growth
high free cash flow (FCF)9 firms are likely
to waste cash resources by investing in
uneconomic projects. Since the debt has
to be paid back in cash, therefore, the
amount of free cash flow that could be
diverted by the manager is reduced by
assuming more debt. Thus, the debt serves
as a monitoring device to discipline the
manager from engaging in self serving
activities, e.g., perquisite consumption,
empire building, etc. Grossman and Hart
(1982) argued that short term debt can serve
as a mechanism to align managerial
incentive with that of shareholders since
bankruptcy is costly for management. Short
et. al. (2002) argued that as management
ownership increases, the interests of
management are likely to become more
aligned with those of debtholders and hence
the agency costs of debt are likely to be
reduced, therefore, a positive relationship
will exist between debt and management
ownership. Furthermore, they contended
th at the prese nce of larg e ex tern al
shareholders with incentives to monitor
and control management will reduce the
ability of managers to consume excess
perquisites and hence reduce the agency
costs o f equity . Th erefore, firms
characterized by the presence of large
external shareholders would be expected to
be associated with higher agency costs of
debt and lower agency costs of equity than
firms w itho ut such larg e ex tern al
shareholders. Hence, due to the effect of
large external shareholders on the relative
agency costs of debt and equity, a negative
relationship is predicted to exist between
debt and the presence of large external
shareholders. Suto (2003) found that since
the bank acts as information suppliers,
which work to mitigate the agency conflict
between the len ders and corporate
managers, hence the commitment of the
banks to finance corporate debt as well as
lending create increase debt ratios. Zwiebel
(1996) deve lope d a mode l in whi ch
managers voluntarily choose a debt level
to credibly constrain their empire-building
desire. In the model, using debt as a
committing device to constrain the ability
of managers to undertake inefficient
investments, a dynamically consistent
capital structure is derived through
trading-off managers’ empire-building
desires with the need to insure sufficient
efficiency to avert takeover threats and
challenges. Jaggi and Gul (1999), based on
a sample of 1869 observations from 1989
to 1993 for non regulated U.S. firms, found
that since the debt reduces the agency cost
of free cash fl ow by re duci ng the
discretionary resources, the firm’s debt
level is higher when it has high free cash
8. Jensen and Meckling (1976) define the agency relationship as a contract under which one party
(the principal) engages another party (the agent) to perform some service on their behalf. As part of
this, the principal will delegate some decision-making authority to the agent.
9. FCF is a “cash flow in excess of that required to fund all projects that have positive net present
value when discounted at the opportunity cost of capital”.
Journal of Contemporary Research in Management, January - March 2008
67
flow and low investment opportunity set.
They further found that there is a positive
association between debt and free cash flow
for low growth firm, especially when they
are large. Fama and French (2002) argued
that debt helps to align managers’ personal
interest with those of security holders by
forcing managers to pay out more of the
firm’s excess cash (the excess of cash
earning over profitable investments) and
further predicted that firm with more
investment relative to earning have less
need for debt. Rajan and Zingales (1995),
argued that if a large fraction of a firm’s
assets are tangible, then asset should serve
as collateral, diminishing the risk of the
lender suffering the agency cost of debt
(like risk shifting), and leverage should be
higher. They, further, argued that firms
with high future growth opportunities are
likely to use a greater amount of equity
finance. Frank and Goyal (2003) argued that
firms with high growth opportunities keep
th e de bt l evel low to seize su ch
opportunities when they appear. Bhaduri
(2002) argued that for growing firms, the
agency problems are likely to be more
severe since they are more flexible in their
choice of future investments and indicated
a negative association between long-term
debt and future growth of a firm. Further,
the author suggested that growing firms
can use short-term debt instead of longterm debt to avoid agency costs. Noe et. al.
(2003) examined corporate security choice
by simulating an economy populated by
adaptive agents who learn about the
structure of the security returns and prices
through experience and found that despite
the fact that markets are perfect and agents
maximize value, a financing hierarchy
emerges in which straight debt dominates
other financing choices. Jung et. al. (1996)
found strong support for the agency model.
They argued that as predicted by the
agency model firms that do not have
68
valuable investment opportunity when offer
equity signal a bad news for shareholders,
since it enhances managerial discretion
and lead to higher agency cost as compared
to issue of debt. Chesney and Asner (1999)
examined the notion that the shareholders
tend to invest in riskier projects as the
probability of default increases and
suggested that in an unlevered firm a
boundary level on the firm’s asset value
imposed by agents other than bondholders,
induces shareholders to adopt riskless
in vestment pro jects. Lee (1997)
investigated whether or not managers of
issuing firms knowingly sell overvalued
equity and found that insiders intentionally
selling overvalued equity and suggested
that increased free cash flow problems after
issue play an important role in explaining
the underperformance of issuing firms. .
Smith and watts (1992) provide empirical
evidence, using US data that supports the
negative relation between leverage and
gro wth oppo rtun itie s. Lins (2003)
investigated whether management stock
ownership and large non-management
share ownership are related to firm value
across a sample of 1433 firms from 18
emerging markets, and found that when a
management group’s control rights exceed
its cash flow rights, firm values are lower,
and that large non management control
rights blockholdings are positively related
to firm value. The author interpreted that
ex tern al
share hol der
protecti on
mechanisms play a role in restraining
managerial agency costs and add value to
the firm. Burgman (1996) argued that
Multinational companies face higher
auditing costs, language differences,
sovereignty uncertainties, and varying
legal and accounting systems. In addition,
their investors are confronted with wider
informational gaps and higher costs of
in vestigation. Hen ce, mul tination al
co mpan ies are pre dicted to face
Journal of Contemporary Research in Management, January - March 2008
significantly higher monitoring costs than
domesti c co mpan ies resulting in
multinational corporations to have lower
debt ratios than purely domestic firms.
Kanatas and Qi (2004) examined the case
when firm’s liquidation decision is left to
len ders
and
len ders
beh ave
opportunistically, and suggested that in
such a scenario an optimal mix of debt and
dividend can mitigate the twin moral
hazard problem of the manager, and the
lender. Fluck (1999) investigated the
distribution of equity ownership between
entrenched management and dispersed
outsiders when the management has the
ability to manipulate the cash flow and
when it is costly for equity holders to prove
managerial wrong doing in court. They
found that when shareholders are long
term oriented, then outside shares trade
at a premi um o ver thei r value to
management, and management is inclined
to sell off its equity stake to dispersed
outsiders; when shareholders are short
term oriented, then outside shares trade
at a di scou nt below the ir value to
management, and disciplinary pressure
can be substantially reduced via strategic
share purchase. Mao (2003) argued that,
contrary to conventional views, the total
agency cost of debt does not uniformly
increase with leverage. Winton (2003)
showed that a financial institution that
finances and monitors firms learn private
information about these firms, and when
the institution seeks fund to meet its own
liquidity needs, it faces adverse selection
(“liquidity”) costs that increase with the
risk of its claim on these firms. The author
suggested that the institution can reduce
its liquidity costs by holding debt rather
than equity.
Table IIc : Determinants of leverage under Agency cost Framework Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
(Impact on
leverage)
Author (Year of publication)
Percentage of shares held by Management
Positive
Short et. al. (2002)
Ownership by large external shareholders
Negative
Short et. al. (2002)
Bank Commitment to finance debt
Positive
Suto (2003)
Ownership concentration
Negative
Suto (2003)
Free Cash Flow
Positive
Zwiebel (1996); Jaggi and Gul (1999); Fama and
French (2002)
Growth Opportunities
Negative
Rajan and Zingales (1995); Fama and French
(2002); Frank and Goyal (2003)
Growth
Negative to
long term debt
Bhaduri (2002); Hall et. al. (2004)
Positive to
Short term debt
Asset structure
Negative to
Hall et. al. (2004)
Short term debt
Positive to
Long term debt
Top management Experience
Positive
Noe et. al. (2003)
No Growth opportunity
Positive
Jung et. al. (1996)
Collateral value of assets
Positive
Rajan and Zingales (1995)
Table IIc : Determinants of leverage under Agency cost Framework - Summary of Variables, Hypothesis, and Author
(year of publication)
Journal of Contemporary Research in Management, January - March 2008
69
3.5. The pecking order Framework
The pecking order framework lays out
th e li nkag es betwe en firm’s capital
structu re, divi dend and investment
policies. The model suggests that firms
prefer to use internal equity to pay
dividends and finance new investment. It
ranks internal equity at the top of the
pecking order, followed by debt and then
hybrids of debt-equity, with external
finance at the bottom of the pecking order.
In summary, the pecking order theory
states that businesses adhe re to a
hierarchy of financing sources and prefer
internal financing when available; and, if
external financing is required, debt is
pre ferred o ver equity. M yers (1984)
contrasted two ways of thinking about
capital structure, one is the static trade off
framework and another is pecking order
framework. He argued that the pecking order
framework performs at least as well as the
static trade off theory in explaining what we
know about actual financing choices and
their average impact on stock prices.
The pecking order hypothesis suggests
that firms prefer to use internal equity to
pay dividends and implement growth
opportunities; and if external finance is
needed, firms prefer to raise debt before
external equity (Donaldson, 1961; Myers,
1984; and Myers and Majluf, 1984). There
are two divergent views in the literature
about why firms prefer internal equity to
external fi nance. D onal dson (1961)
suggests that internal equity is preferred
because firms want to avoid flotation costs
which usually accompany external finance.
He also suggests that firms prefer debt to
external equity, if external finance is
needed, because the flotation cost of debt
is usually less than that of external equity.
Myers (1984) and Myers and Majluf (1984)
70
disagree with the view that firms prefer
internal equity to debt because of flotation
costs. They argue that the net benefits of
debt financing, in terms of tax shield and
risk of financial distress, are likely to
outweigh flotation costs. Pecking order
hypothesis suggest that the firms are
willing to sell equities when the market
overvalues it. (Chittenden et. al.(1996).
Empirical evidence tends to support the
pecking order model’s prediction of a
negative relationship between corporate
gearing and profitability [Rajan and
Zingales (1995) and Fama and French
(2002)]. Hall et. al. (2000) examined 3500
unquoted, UK small and medium sized
enterprises (SM Es) to test vari ous
hypotheses concerning the determinants
of SME capital structure and found the
result consistent with pecking order theory
in that profits are negatively related to
short-term debt and since the older a firm
is, the more it is able to accumulate funds
and the less it will need to borrow either
short term or long term, hence age is
negatively related to both long- and shortterm debt. Hall et. al. (2004) reasserted that
the firm which can generate more earning
will borrow less, all things being equal.
Brierley and Bunn (2005) argued that the
pecking order model clearly suggest that
there should be a negative relationship
between gearing and profitability. Akhtar
(2005) argued that because multinational
companies have better opportunities than
domestic companies to earn profits due to
having access to more than one source of
earning and better chances to have
favorable business conditions in particular
countries, multinational companies are
predicted to have relatively lower debt level
than domestic companies. Frank and Goyal
(2003) argued that from the perspective of
testing the pecking order, since tangible
assets serve as collateral, hence, collateral
Journal of Contemporary Research in Management, January - March 2008
is associated with increased leverage.
Bagley et. al. (1998) offered a class of
diffusion model that augments the pecking
order theory and provides a flexible
quantifiabl e
framew ork
for
its
implementation as a decision tool. ShyamSunder and Myers (1999) tested static trade
off model against the pecking order model
of corporate finance and expressed greater
confidence in the pecking order model than
the static trade off theory. Cassar and
Ho lmes (2003) empi rically tested
hypothesis utilizing pecking order and
static trade off theory in small and medium
size Australian firms and found the result
in consistent with the pecking order and
static trade off arguments proposed by the
theoretical models. Jamie W. Munro (1996)
studied the use of convertible debt in the
finance choice in the UK and indicated that
the type of convertible debt issue made (i.e.
debt-equity likeness) is consistent with
Mye rs’ unde rinvestment hypo thesis
relating growth opportunities and finance
choice.
Attempts to empirically test the
pecking-order hypothesis have been
extensive, though results have been
mixed. Fama and French (2002) noted that
the negative relationship between profits
and leverage is consistent with the pecking
order theory. But the pecking order is not
the only possible interpretation of the
relationship. There are at least two issues.
First, current profitability can also serve
as a signal of investment opportunities.
The second issue is that firms may face
fixed costs of adjustment. When a firm
earns profits, debt gets paid off and leverage
falls automatically. Only periodically will
large readjustments be made in order to
capture the tax benefits of leverage.
Empirically, most of the data reflects the
process of paying off the debt by using
profits. Thus, profitable firms will be less
levered even if the tradeoff theory is at work
and the adjustment costs are taken into
account. Fama and French (2005) found, in
their empirical examination during 19732002 of samples of listed non-financial,
non-utility firms of an average of 2,951 for
1973 to 1982, to 4,417 for 1993 to 2002, that
financing decisions of more than half of
the sample firms violate the central
prediction of the pecking order model about
how often and under what circumstances
firms issue equity. Frank and Goyal (2003)
tested the pecking order theory on a broad
cross-section of publicly traded American
firms over the period 1971–1998 and found
that in contrast to what is often suggested,
internal financing is not sufficient to cover
investment spending on average, external
financing is heavily used, debt financing
does not dominate equity financing in
magnitude. These facts are surprising
from the perspective of the pecking order
the ory. Abo r (2005) evaluated the
relationship between capital structure and
profitability of listed firms in Ghana stock
exchange during a five year period (19982002) and found that profitable firms use
more short term debt to finance their
operation. In short, Myers (1984) presents
the pecking order model as a theory both
about how firms finance themselves and
about the capital structures that result
from pecking order financing. Subsequent
tests of the model follow these two routes.
For example, Chittenden et. al.(1996),
Bagley et. al. (1998), Shyam-Sunder and
Myers (1999), Fama and French (2002), and
Frank and Goyal (2003) test the model’s
predictions about the securities firms
issue to cover financing deficits, while
Rajan and Zingales (1995), Shyam-Sunder
and Myers (1999), Fama and French (2002),
Fama and French (2005), test the model’s
predictions about capital structures
Journal of Contemporary Research in Management, January - March 2008
71
Table IId : Determinants of leverage under Pecking order Framework Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
Author (Year of publication)
Profitability
Negative
Rajan and Zingales (1995); Hall et. al.(2000);
Fama and French (2002); Hall et. al.(2004);
Brierley and Bunn (2005); Akhtar (2005)
Level of tangible
assets
Negative
Frank and Goyal (2003)
Age
Negative
Hall et. al. (2000)
Table IId : Determinants of leverage under Pecking order Framework - Summary of
Variables, Hypothesis, and Author (year of publication)
3.6. The legal environment Framework
The researchers have also studied the
impact of l egal environ ment in the
determination of capital structure of the
fi rm and found that diffe rent leg al
environments influence firms’ financing
decisions. The influence of the legal
environment on the firm’s capital structure
has been analyzed by La Porta et. al.(1997)
and many of their papers that followed (La
Porta, et al., 1999). In La Porta, et al., (1997)
stressed that legal system is the primary
determinant of the availability of external
financing in a country. They argued that
the common-law system provides better
quality of investor protection than civil-law
systems, and among the civil-law systems
German and Scandinavian systems provide
better protection than the French system.
They showed that the size and breadth of
capital markets vary systematically and
positively associated with the quality of
legal systems across countries. They
concluded that if the capital markets are
smaller and narrower, this affects the costs
1
72
of external finance and firms may rely more
on internal finance or inter-firm credit. La
Porta, et al., (1999) found evidence of higher
valuations of firms in countries with better
protection of minority shareholders, which
do affect the choice between debt and
equity. They found that in countries with
less protection of minority shareholders,
the costs of equity finance are higher than
in coun trie s wi th bette r mi nori ty
shareholder protection. Garvey et. al. (1999)
examined the impact of anti-takeover
statutes on firm’s capital structure and
argued that because the anti takeover laws
raise the cost of hostile takeover, firms
protected by anti takeove r laws
substantially reduce their use of debt, and
unprotected firms do the reverse. Hall et.
al. (2004) examined the extent to which the
financial behavior of the small and medium
firms10 (SMEs) are affected by the country
specific factors and found that there are
variations in both SME capital structure
and the determinants of capital structure
SME was defined as having fewer than 200 employees.
Journal of Contemporary Research in Management, January - March 2008
between the countries surveyed. They
attributed that variations could be due to
differences in attitudes to borrowing,
disclosure requirements, and relationships
with banks, taxation, and other national
economic, social and cultural differences.
Their result was based on the survey of
fin anci al data for four tho usan d,
incorporated SMEs, five hundred each from
eight countries: Belgium, Germany, Spain,
Ireland, Italy, Netherlands, Portugal and the
UK. Desai et. al. (2004) empirically analysed
the capital structures of foreign affiliates
an d in tern al capi tal markets of
multinational corporations and found that
multinational affiliates are financed with
less external debt in countries with
underdeveloped capital markets or weak
creditor rights, reflecting significantly
higher borrowing cost.
Burgman, Todd A. (1996) examined
whether there are systematic differences
in the traditi onal capital structu re
determinants between multinational
companies and domestic companies, and
if there are additi onal , un ique ly
international factors to explain the capital
structu re choice of mul tination al
corporation s. The autho r’s resu lts
suggested that specific international
factors such as political risk and exchange
rate risk are relevant to the multinational
capital structure deci sion , th at
multinationals have higher agency costs
than purely domestic firms, and that
international diversification does not lower
earnings volatility for multinational
corporations.
Bancel and Mittoo (2004) did a cross
country comparison of managerial views on
determi nant of capital structure by
surveying managers from 16 European
countries, viz., Austria, Belgium, Greece,
Denmark, Finland, Ireland, Italy. France,
Germany, Netherlands, Norway, Portugal,
Spain, Switzerland, Sweden, and the UK,
and argued that quality of a country’s legal
system is an important determinant in
determination of debt policy. The authors’
finding supported their prediction. Brounen
et. al. (2004) analysed corporate financial
management practices in UK, Netherlands,
Germany, and France and found that
corporate financial management practices
are predominantly determined by firm size,
to a le sser extent by share holder
orientation, and least by country of origin.
Th ey concl uded th at share holder
orientation prevails in the UK and in the
Netherlands, but in the German and
Fre nch firms sh areh olde rs are l ess
important. Rivaud-Danset et al. (1998)
found that the bankruptcy regulations, the
accounting and financing practices of a
cou ntry , as wel l as the ban k–fi rm
relationship are among the determinants
of a firm’s capital structure. They found
that national financial features differ from
country to country, and these features have
a greater influence on small firms. Wald
(1999) con ducted a cro ss country
compari son of five countries, using
empirical data from France, Germany,
Japan, the United Kingdom, and the United
States to find out the impact of the cross
country variation in legal and institutional
differences on capital structure and
observed that some variables, such as those
associated with moral h azard, tax
deductions, R&D, and profitability are
consistent effect across countries, other
variables, such as those associated with
risk, growth, firm size show different effect
in different countries. The author argued
that institutions may be a significant
determinant of capital structure.
Journal of Contemporary Research in Management, January - March 2008
73
Table IIe : Determinants of leverage under legal environment Framework Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
Author (Year of publication)
Countries with poorer
investor protection
Positive
La Porta, et al., (1997)
Countries with less protection
of minority shareholders
Positive
La Porta, et al., (1999)
Firms protected by anti takeover laws
Negative
Garvey et. al. (1999)
Countries with weak creditor’s right
Negative
Desai et. al. (2004)
Table IIe : Determinants of leverage under legal environment Framework - Summary
of Variables, Hypothesis, and Author (year of publication)
3.7. Target leverage Model (Mean reversion Framework)
Target-adjustment theory follows from
the dynamic capital structure models, such
as those proposed by Fischer et al. (1989),
Leland (1994), and Goldstein et al. (2001).
The models imply that firms let their
leverage fluctuate over time as long as it
stays within an endogenously determined
range. Only when the range boundaries are
crossed, do firms adjust their leverage
ratios toward a target within the range.
Such behavior arises as a result of a
dynamic optimal capital structure policy
that balances the benefits of debt financing
with its costs in an environment where
capital structure adjustments are costly.
Empirically, such behavior implies that
security issues and repurchases either
offset the deviation from the target
accumulated prior to the transaction or
respond to shifts in target leverage. The
proponents of target leverage theory propose
that firm adjust outstanding debt in
74
response to the changes in firm value, thus
generating mean reverting leverage ratio.
This framework generates stationary
(me an reverting ) le verage ratio s.
Hovakimian et. al. (2001) examined how
firm characteristics affect the issuing firm
debt/equity cho ice and foun d th at
co nsistent with th e targe t le verage
hypothesis, the possibility of issuing debt
rather than equity is inversely related to
the amount of excess (relative to the target)
leverage. Shyam-Sunder and Myers (1999)
argued that even if firms follow the pecking
order theory, we might as well find a mean
reversion of leverage ratios. Dufresne and
Goldstein (2001) contended that most
structural model of default preclude the
firm from altering its capital structure. In
practice, firm adjust outstanding debt in
response to the changes in firm value, thus
generating mean reverting leverage ratio.
Chen and Zhao, (2005) showed, both
Journal of Contemporary Research in Management, January - March 2008
theoretically and empirically, that leverage
ratios can revert to mean mechanically
regardless of which theory better describes
financing decisions; and that opposite
inferences can be drawn depending on
whether financing decisions or leverage
ratio changes are studied. Goldstein et. al.
(2001) argued that most capital structure
models assume that decision of how much
debt to issue is a static choice. They
contended that in practice, however, firms
adjust outstanding debt levels in response
to changes in firm value. Hovakimian
(2004) examined empirically whether the
corporate financing behavior is consistent
with target leverage hypothesis and found
that firms do not initiate equity transaction
to offset the accumulated deviation from
the target leverage ratio and argued that
the debt issuers respond to an increase in
their target leverage. However, Lie (2002),
using a sample of 286 tender offers that
were announced from the 1980 to 1997 in
the Wall Street Journal (WSJ) and the Dow
Jones News Retrieval (DJNR) service,
found that firms conduct non-defensive self
tender offers to move debt ratios to more
optimal levels and defensive self tender
offers to move debt ratios beyond optimal
levels, where defensive self-tender offers
are un dertaken to defe nd again st
takeovers. Bunn and Young (2003 and
2004) argued that companies adjust their
balance sheets when gearing deviates
from the implied long run equilibrium level
and strengthen the empirical support for
the mean reversion model, because it
shows that the firms adjust their behavior
in response to the deviation from the target.
Gaud et. al. (2005) based on the empirical
analysis of Swiss firms showed that they
adjust toward a target debt ratio. Aydin
Ozkan (2002) argued that the firms have
long-term target leverage ratios and they
adjust to the target ratio relatively fast.
Hovakimian (2004) examined whether the
corporate financing behavior is consistent
with the target leverage hypothesis and
argued that it is possible that firms issue
(retire) debt primarily when they want to
adjust their leverage toward a higher
(lower) target, but they issue (repurchase)
equity primarily to take advantage of
favorable market conditions. In this
connection the author proposed that only
debt reductions offset the deviation from
target leverage accumulated prior to the
transaction and debt reductions follow
periods of rising excess leverage, which
drops as a result of the transaction.
Table IIf : Determinants of leverage under Target leverage Framework Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
Author (Year of publication)
Amount of excess (relative to the
target leverage)
Inversely
related to debt
Hovakimian et. al. (2001);
Hovakimian (2004)
Table IIf: Determinants of leverage under Target leverage Framework - Summary of
Variables, Hypothesis, and Author (year of publication)
Journal of Contemporary Research in Management, January - March 2008
75
3.7.1. Transaction cost Framework
Transaction cost framework assumes
that the human agents are subject to
bounded rationality and are given to
opportunism. These two behavioral
assumption support the following statement
of the purposes of economic organization:
Craft governance structure that economizes
on bounded rationality while simul
taneously safeguarding the transaction in
question against the hazard of opportunism.
Transaction costs emphasizes ex post costs
and include: - (1) maladaptation costs
incurred when transactions drift out of
alignment, (2) the haggling cost incurred if
bilateral efforts are made to correct ex post
misalignments, (3) the set up and running
cost associated with the governance
structures (often not the courts) to which
the disputes are referred, and (4) bonding
costs of effecting secure commitments. The
research from this perspective started with
the work of Williamson (1988), who argued
that rather than regard debt and equity as
“financial instruments” they are better
regarded as different governance structures.
Ever since pioneering work of Williamson
(1988) several capital structure studies
have focused on testing the hypothesis of
association between capital structure and
the main characteristics of corporate
governance, which include board size, board
composition, management compensation,
the tenure of directors and managers,
managerial equity proportion etc. Wen et.
al. (2002) argued that larger board size
translates into strong pressure from the
corporate board to make managers pursue
lower leverage to get good performance
result and hence leverage is negatively
related to debt. On Board composition, the
authors argued that the outside directors
monitor managers more actively, causing
these managers to adopt lower leverage to
avoid the performance pressures associated
with commitments to disgorge large
amounts of cash. In so far as the tenure of
the CEO is concerned, the authors
contended that CEO’s control over internal
monitoring mechanisms increases as the
tenure lengthens and hence the tenure of
CEOs is negatively related to the leverage.
The authors stressed that the entrenched
CEOs and directors prefer low leverage to
reduce the performance pressures
accompanying high debt. Further, the
authors argued that fixed compensation of
CEOs encourage them to pursue lower
leverage to reduce the financial risk. John
and John (1993) studied the interrelation
ship between top-management compen
sation and design and the mix of external
claims issued by a firm and found a negative
relationship between pay-performance
sensitivity and leverage. Berger et al. (1997)
indicated that leverage is lower when the
CEO has a long tenure in office. The authors
studied associations between managerial
entrenchment and firms’ capital structures,
with results suggesting that entrenched
CEOs seek to avoid debt.
Table IIg : Determinants of leverage under Corporate Governance Framework Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
Author (Year of publication)
Board Size
Inversely related to debt
Wen et. al. (2002)
Top Management’s
fixed compensation
Inversely related to debt
Wen et. al. (2002); John and John (1993)
Tenure of the Directors
and Managers
Inversely related to debt
Berger et al. (1997); Berger et. al. (1997) ; Wen
et. al. (2002) Percentage of Outside
Directors on the Board
Inversely related to debt
Wen et. al. (2002)
Table IIg : Determinants of leverage under Corporate Governance Framework - Summary of
Variables, Hypothesis, and Author (year of publication)
76
Journal of Contemporary Research in Management, January - March 2008
3.8. Others
Other than the above theoretical
framew orks, th e re searchers have
identified frameworks to explain the capital
structure of the firm which for the purpose
of this paper has been categorized under
“others” category. Bancel and Mittoo (2004)
in a survey of managers from 16 European
co untries
foun d
th at
h edgi ng
considerations is the most important
factors for firms raising capital in foreign
market. The authors further argued that
that between short term and long term debt
firm’s chooses short-term debt when
managers expect the long-term interest
rates to decline, and chooses long term debt
to minimize the risk of financing in bad
times. Burgman. (1996) indicated that,
co ntrary to co mmo n ex pectatio n,
multinational corporations have lower
target ratio than purely domestic firms.
The author argued that this is so because
although international diversification can
lower the volatility of earnings, firms
operating multinationally are also exposed
to exchange rate risk and political risk, and
it may manage these risks by keeping the
debt at lower levels. Allayannis et. al. (2003)
examined why firms make currency
domination of debt (foreign and local debt)
in their capital structure decision and
argued that firms are likely to make a trade
off between the benefits of lower foreign
borrowing costs and a probable increase in
fin anci al risk due to ex chan ge rate
uncertainty. They further argued that
firms are likely to borrow in foreign
currency in an attempt to exploit lower
interest rates and hence the higher the
difference in interest rate, the higher
(lower) the level of foreign (local) currency
debt. Second they argued that the choice
between domestic currency debt and
foreign currency debt is also influenced by
the firms foreign earning before interest
and tax, and foreign cash flows. Thornhill
et. al. (2004) argued that firms competing
in more uncertain domai ns, with a
relatively greater knowledge component to
their value-added processes, may have less
access to debt financing because both
knowledge assets and R&D-intensive
physical assets are highly firm- and
industry-specific, thus lowering liquidity
value. Consequently, they argued that,
firms in high-knowledge industries will
have a lower debt-to-equity mix than will
firms i n lo w-kn owle dge indu stri es.
Stenbacka and Tombak (2002) argued that
both capital structure and investments are
endogenous and that they both depend on
more basic ingredient such as the nature
of the capital markets, the characteristics
of investment opportunities available to
the firm, and the internal funds. They
showed that the optimal combination of debt
and equity depends on a trade off between
the bankruptcy risk associated with debt
and the dil utio n co st o f in cumbent
shareholders of new equity. McClure et al.
(1999) found that companies’ capital
structures are still significantly different
by nationality for the G7 countries (Canada,
France, Italy, US, Germany, Japan, UK),
and suggested that macroeconomic factors,
including economic growth, interest rates
an d in flation, may be important
co nsiderations in capital structu re
decisions and cause of difference.
Journal of Contemporary Research in Management, January - March 2008
77
Booth et. al. (2001) examined the
capital structure of 10 developing countries
to assess country’s effect on firm’s capital
structure decision and found that there are
significant differences in the ways in which
the decision is affected by country factors
such as GDP, growth rate, inflation rate,
and the development of capital market. The
countries examined were India, Pakistan,
Thailand, Malaysia, Turkey, Zimbawe,
Mexico, Brazil, Zordon, and Korea. Baker
and Jeffrey (2002), found that low leverage
firms are those that raised funds when
their market valuations were high, as
measured by the market-to-book ratio,
while high leverage firms are those that
raised funds when their market valuations
were low.
Table IIh : Determinants of leverage “others”Summary of Variables, Hypothesis, and Author (year of publication)
Variable
Hypothesis
Author (Year of publication)
Exchange rate risk
Positively related to
foreign currency debt
Bancel and Mittoo (2004)
Interest rate
Inversely related
to debt
Bancel and Mittoo (2004)
Exchange rate risk
Inversely related to
foreign currency debt
Burgman (1996);
Allayannis et. al. (2003)
Political risk
Inversely related to debt
Burgman (1996)
Knowledge intensity
Negatively related to debt
Thornhill et. al. (2004)
Table IIh: Determinants of leverage “others”- Summary of Variables, Hypothesis, and
Author (year of publication)
Section 4
Gaps Identified and Future Research
Direction
In the last five de cade s, the
researchers have attempted to identify What determines the firm’s financial
leverage. Thereby all perspectives like
leverage irrelevance, static trade off,
pecking order, asymmetric information
signaling framework evolved towards
answering the question. Though these
78
frameworks have partly helped us in
understanding the underlying factors
determining the firm’s financial leverage,
there is no consensus and there is no
universal factor determining financial
leverage and this creates a vital gap to
understand the phenomena. A prudent way
to address this gap is to integrate different
factors de terminin g fi rm’s fin anci al
leverag e in to a strateg ic resou rce
framework Furthermore, across these
Journal of Contemporary Research in Management, January - March 2008
frameworks; we notice on e common
assumption about the architecture of the
firm is that the firm is as an isolated,
indepen dent
entity.
Today,
the
phenomenon of business network and
interdependence of firms has become so
common that firm cannot be looked at in
isolation to understand the financial
structure. Instead, it is the networks of
firms, which aims to understand and
explain this question. As a result, the
relevance of these frameworks is restricted
in the ir relevance. Thoug h th is
phenomenon is the focus of the study in
strategic management literatures and has
been accepted conceptually therein, the
academic field of finance is devoid of any
stu dy focusing the dete rmin ants of
financial leverage in the case of business
network. Hence, the two challenges for
future rese arch in this reg ard are
identified: one, how to integrate different
factors de terminin g fi rm’s fin anci al
leverage into a common framework and
second, what are the explanatory factors
determining firm’s financial leverage in a
network phenomena.
3.
Allayannis George, Gregory W. Brown,
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Evidence From Foreign Debt Use in
East Asia”, Journal of Finance, Vol. 58,
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4.
Andrew Winton (2003), “Institutional
Liquidity Needs and the Structure of
Monitored Finance”, The Review of
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5.
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Baker,
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7.
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“Cross-Country Determinants of
Capital Structure Choice: A Survey of
European
Fi rms”,
Fi nancial
Management (2000), Vol. 33, No.4,
pp.103-132.
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