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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 60 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. 62 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. 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