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ERASMUS UNIVERSITY ROTTERDAM
ERASMUS SCHOOL OF ECONOMICS
Department of Business Economics
Bachelor Thesis Entrepreneurship
DETERMINANTS OF CAPITAL STRUCTURE OF SMEs
Author: K.M.A. Romijn
Student number: 328622kr
Thesis supervisor: A. van Stel
Finish date: July 2016
ABSTRACT
This paper analyzes how country- and aggregated firm-specific variables affect the capital structure of
European small and medium sized enterprises. 11,720 firms across 11 European countries are studied
using data from the year 2009 to 2014. Data from a survey done by the European Central Bank and
European Commission are used. Country specific variables are examined to find out to what extent they
affect capital structure of SMEs. The determinants of capital structure namely GDP per capita, GDP
growth, inflation and interest rate are tested. The aggregated firm specific variables are Turnover, General
Economic View and Profitability. Two theories are used to examine how these variables affect the capital
structure. The two theories used are the pecking order theory and the trade-off theory. The results show
that macroeconomic and aggregated firm specific variables are an important aspect in explaining SME’s
capital structure and cannot be neglected.
Keywords: Capital Structure, Trade-off Theory, Pecking Order Theory, SME, Cross Country Data
ii
TABLE OF CONTENTS
ABSTRACT .............................................................................................................................................. ii
TABLE OF CONTENTS............................................................................................................................. iii
CHAPTER 1. Introduction ....................................................................................................................... 1
CHAPTER 2. Literature Review................................................................................................................3
2.1 Pecking Order theory....................................................................................................................... 3
2.2 Tradeoff theory ............................................................................................................................... 4
2.3 Determinants.................................................................................................................................... 5
CHAPTER 3. Research Question & Hypotheses...................................................................................... 8
CHAPTER 4. Data & Methodology........................................................................................................ 12
CHAPTER 5. Results...............................................................................................................................17
CHAPTER. 6 Conclusion…………………………………………………………………………………………………………………….21
CHAPTER 7. Bibliography...................................................................................................................... 23
iii
1 Introduction
Small and Medium Sized enterprises, hereinafter SMEs, are central to economic prosperity of almost every
developed country. They boost competition and entrepreneurship. They provide efficiency, innovation
and aggregate productivity growth (Grossman & Helpman, 1993), (Bhaskaran,2006). According to the
Organisation for Economic Co-operation and Development, SMEs in OECD countries stand for more than
60% in the economy. This illustrates the importance of SMEs. Different cross country studies have shown
that there are multiple factors which are capable of explaining SMEs capital structure. Decisions relating
to financing the assets of a firm are very crucial in every business. By determining a proper mix of fund
sources, a firm can keep the overall cost of capital to the lowest as well as maximizing its market value.
There are some variables which have an influence on how firms determine their capital structure.
Identifying to what extend country- and aggregated firm specific variables affect it was one of the major
reasons for writing this research paper.
There are large numbers of research papers with the focus on determinants which affects a firm’s capital
structure. However, most of the research done on capital structure has been carried out on large listed
companies in the US. The most prominent theories that came out of all this research were the trade-off
theory and pecking order theory. There has been a large number of empirical work done in order to test
both theories, and some have favored one theory over the other. Yet, there still is no clear answer on
which theory explains capital structure best. Rather, it seems like both theories are only partly capable of
explaining capital structure of companies. This research paper will focus on the capital structure of SME’s
in Europe and try to provide new insight on how these two theories explain capital structure.
The first authors who developed a capital structure theory were Modigliani and Miller in 1958. The
proposal of this theorem, under certain assumptions, is that the market value of the firm is independent
of its capital structure composition (Modigliani & Miller, 1958). Since then, numerous economists
presented their financial leverage theories to try and explain the different compositions of debt ratios
maintained by firms. Some theories suggest that debt is relevant due to the existence of information
asymmetry (Myers & Majluf, 1984). Other theories mention that the existence of bankruptcy and taxes
are what make debt relevant (DeAngelo & Masulis, 1980). However, the empirical evidence regarding the
alternative theories lead to different results and conclusions.
This paper contributes to the literature by examining which country specific variables as well as
aggregated firm specific variable influence the capital structure of SMEs in Western Europe. In particular,
1
we address the following question: ‘To what extent do macroeconomic variables and aggregated firmspecific variables help in explaining the capital structure in small and medium sized businesses in Western
Europe’
The remainder of this paper is organized as follows. In chapter 2 a literature review will be conducted,
starting with the paper of Myers and Majluf. In this chapter earlier studies on capital structure will be
explained. In chapter 3 the research question and hypotheses will be explained. Chapter 4 will present
the data gathered for this research, as well as the theories and methods which were used to conduct
this study. Chapter 5 is where the results of the research will be presented. In the last chapter a short
summary will be provided along with a conclusion.
2
2 Literature Review
2.1 Pecking Order theory
The Pecking Order Model developed by Myers and Majluf (1984), suggests that firms prefer internal
funding over external funding. Capital structure is driven by a firm’s desire to finance new investments,
first internally, then with debt, and if all else fails equity is generated as a last resort. So the firms don’t
have an optimum debt to equity ratio. This theory is applicable for large firms as well as small firms. When
it comes to pecking order theory it has been supported by many academics. Merton Miller and his
colleague Franco Modigliani published their paper on capital structure in 1958. In this paper they
presented what is nowadays often referred to as M&M’s proposition I, also known as ‘The Irrelevance
Proposition’, which is considered to be the first real theory on capital structure. M&M stated that the
value of a leveraged firm is equal to the value of an unleveraged firm (Modigliani & Miller, 1958,).
The logic behind the proposition was that the value of a pizza does not depend on how it is sliced (Myers,
2001). The composition of assets on the left hand side of a balance sheet will generate expected cash flow
for a company. Depending on the operating risk of the company the cash flows are discounted to find the
value of the company. According to the proposition, the amount of debt relative to equity only serves to
determine the split of cash flows between equity holders and debt holders, and does not affect the value
of the company. This statement however, only holds in the fabricated world of M&M, where capital
structures are perfect.
While this theory is based on a perfect world, it triggered something very valuable, namely emphasizing
the importance of the capital structure theory. “The Irrelevance Proposition” brought a stream of research
trying to disprove M&M’s proposition, in other words that financing actually matters. Several research
has shown that the Modigliani-Miller theorem fails under a variety of circumstances (Frank & Goyal, 2005).
The most commonly used factors include bankruptcy costs, consideration of taxes, transaction costs, and
agency costs.
Referring to the pizza again, Myers argues that the value of a pizza actually depends on how it is sliced,
since consumers rather pay more for more slices, than for a whole pizza (Myers, 2001). One of the aspects
of the pecking order theory is that when it comes to profitable firms, they would always prefer internal
financing if available. Retained earnings have no adverse selection as compared to equity and debt. This
argument is supported by Fama and French (2000) who found that profitable firms were less leveraged as
compared to non- profitable firms.
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2.1.1 SME’s & Pecking Order theory
The structure of SMEs and their availability to capital is very different to that of large firms. It is therefore
essential to verify if the pecking order theory is also valid for SMEs. When testing the pecking order theory
for SMEs, it is important to identify the reason why SMEs behave according to this theory, since the reason
can be very different compared to large firms. There are some clear explanations why the pecking order
theory should be able to explain the behavior of SMEs regarding their capital structure.
One of these reasons is that SMEs are often owned by one shareholder, who at the same time, are the
founder of the firm. Issuing equity can lead to a loss of control over the company and is therefore not the
first choice of the owner. The avoid issuing equity, the owner may turn to debt for financing his business
(Lopez- Garcia & Mestre-Barbera, 2011). This is in line with the pecking order theory where financing with
debt is preferred over financing with equity.
2.2 Trade-off Theory
Probably due to the many critics that the irrelevance proposition was based on a perfect world, M&M
decided to add taxes, in a later paper (Modigliani & Miller, 1963). By taking into account that interests are
tax deductible, which leads to tax benefits, their model introduced an interest tax shield. Internal financing
is generally thought to be less expensive than external financing, because there are no transaction costs
and there is no need to pay taxes associated with paying dividends. Yet, when debt is assumed to be riskfree and there is no drawback in increasing one’s leverage then an optimum capital structure consists only
of debt. This induced an increase in the popularity of the tradeoff theory.
The tradeoff theory suggests that the optimal capital structure of a company is based on a tradeoff
between the value of the interest tax shield and the leverage cost. The optimal capital structure is where
the marginal increase in the additional leverage costs negates the marginal benefits of the increase in the
interest tax shield from additional leverage. Leverage costs are direct costs of bankruptcy, lawyers’ fees,
administration expenses etc. Bankruptcy cost is a cost directly incurred when the perceived probability
that the firm will default on financing is greater than zero. One of the bankruptcy cost is liquidation cost,
which represents the loss of value as a result of liquidating the net assets of the firm. Another bankruptcy
cost is distress cost, which is the cost a firm incurs if stakeholders believe that the firm will discontinue. A
study however, showed that bankruptcy cost is negligible, and therefor do not rationalize the borrowing
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among most firms (Warner & Gruber, 1977). According to the tradeoff theory, firms are expected to look
for a target debt ratio (Jalilvand & Harris, 1984).
2.2.2 SME’s & Trade-off Theory
Normally, research on capital structure including the trade-off theory has been performed on large listed
US companies, due to the better availability of data. However, in this paper we will focus on SME’s and
therefore it is felt necessary to elaborate whether one can expect SME’s to behave in a similar way as
large companies in terms of the trade-off theory. Several papers have been published with arguments
that support financial decisions by managers of SME’s, indicating that they can be explained by the same
theories used for large firms i.e. pecking order theory and trade-off theory (Sogorb-Mira, 2005). However,
SME’s might face certain problems that large firms do not face to the same degree.
One possible example in which SME’s might not follow the trade-off theory as compared to large firms is
the lack of knowledge among managers. These managers should be aware that having a higher leverage
may be advantageous. Many small firms led by entrepreneurs will have skills that are not in the field of
finance, and therefore might not have the knowledge to take advantage of this (Jensen & Uhl, 2008).
Managers who do not possess this knowledge tend to operate at a lower debt level than is optimal.
Another important issue is the potential financial constraint SMEs have compared to large firms. This
implies that SMEs might not be able to acquire debt as easily as large firms, due to information asymmetry.
This doesn’t have to be a big issue, but it becomes a serious problem if the lack of debt financing results
in SME’s having to pass up on profitable investment opportunities which may restrict growth.
2.3 Determinants
There have been a lot of theories to explain the capital structure choices which firms make. Most of these
theories were mainly developed and tested in advanced countries like the US. Some studies have been
conducted for the G7 countries which show that the capital structure choices in these countries are similar
to one and other (Rajan & Zingalas, 1995). The authors did a firm level research with size, asset tangibility,
growth rate and profitability as independent variables. They found that 19% of the variation in the firms’
leverage in the G7 countries is explained by these factors. The findings in these paper was also supported
by the author Wald (1999), who continued Rajan and Zingales’ paper to study the capital structure
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determinants including Germany, Japan, France, US and the United Kingdom. Other authors like Fama and
French (2002) reached a similar conclusion about companies financing behavior, where the pecking order
theory couldn’t be rejected.
As previously mentioned, most research on capital structure has been performed on datasets consisting
of large listed companies mainly located in the US. Even though attention on SMEs has been increasing
lately, research on capital structure has primarily been based on US firms (Sulla, Sarria- Allende & Klapper,
2002). Earlier studies that highlight the importance of country specific variables are e.g. (Booth et al,
2001), (Jõeveer, 2005) and several others. The importance of country level variables is emphasized in
these studies. Jõeveer makes an important statement in her paper in connection with the country level
variables. She argues that country level variables have a larger impact on the capital structure of SMEs.
Small firms are more likely to operate under borrowing constraints, so they will face non- firm- specific
determinants of capital structure. Her paper points out the importance of country level variables in the
context of this study since it only deals with SMEs. This might suggest that when a company reaches a
certain size, the importance of country level variables is reduced because the company might obtain
access to other capital markets.
Studies on the capital structure of firms, have attempted to identify country specific determinants of
capital structure choices as function of the factors that build the theories such as the pecking order theory.
There have been some country specific determinants of capital structure identified, based on the most
accepted theoretical models of capital structure. The country specific determinants many previous studies
have used to determine their impact on the capital structure decisions include the Gross Domestic Product
(GDP), growth rate, inflation, interest and taxes. A paper written by Bas, Muradoglu and Phylaktis (2009)
show that most of the macroeconomic variables are significant. The coefficient estimates of GDP per
capita and growth were positively correlated, while inflation and taxes had a negative effect on leverage.
These results are not shared by all. Authors Jensen and Uhl (2008) have contradicting results in their
paper. The different views suggest that the study on determinants of capital structure is not yet complete
and gives room for further studying.
This paper will take both theories into account while examining the factors which may influence a firms’
capital structure. Many studies have been published about these two theories, but most of them have
been focused on only one. Therefore, it is hard to conclude if one is better than the other. A paper by De
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Jong, Verbeek and Verwijmeren (2011), studies how these two theories do against each other. The
authors wanted to study if the pecking order theory was better than the tradeoff theory. The important
difference in the prediction is that the tradeoff theory argues that a firm increases its leverage until it
reaches its target debt ratio, while the pecking order theory yields debt issuance until the debt capacity is
reached. For example, the research did on 6000 US firms between 1985 to 2005 shows that pecking order
theory captures the issue decisions of firms better than the tradeoff theory. On the other hand, a
company’s capital structure decisions are better explained by the tradeoff theory if focused on the
repurchase decisions. Therefore, it was concluded that neither was better than the other. By testing the
firm- and country specific variables on capital structure, an expected outcome can be made by using either
the tradeoff theory or the pecking order theory.
The following section will explain the research question and hypotheses that will be used to conduct this
study.
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3 Research question and hypotheses
In the literature review, the most important capital structure theories were reviewed together with some
empirical evidence. It was also shown how the focus on macro- and firm specific variables in explaining
capital structure choices has increased in the past few years. In this study it is expected that the capital
structure of firms is influenced by the macroeconomic variables as well as aggregated firm specific
variables. This expectation can be summarized by the following research question:
‘To what extent do macroeconomic variables and aggregated firm-specific variables help in explaining the
capital structure in small and medium sized businesses in Western Europe’
The results that will be obtained by this study may produce valuable information to policy makers on
which factors affect the capital structure of SMEs. Traditional capital structure theories do not take
macroeconomic variables into account that influence SMEs access to debt and therefore only illustrate an
incomplete picture. This paper controls for the following macroeconomic variables: GDP per capita,
growth rate of GDP, inflation rate and the interest rate. These will be further explained and the expected
outcomes are shown in table 1.
Gross Domestic Product per capita
Gross Domestic Product (GDP) is the expenditure on final goods and services minus imports: final
consumption expenditures, gross capital formation and exports less imports. Intuition behind this is that
the higher the GDP per capita is the richer a country is. A wealthy country may indicate that firms have
more retained earnings compared to poorer countries and are more capable of financing themselves with
internal finance. According to the pecking order theory this means that GDP and leverage are negatively
associated with each other. On the other hand, a well-developed capital market makes it easier for SMEs
to borrow money. If debt is considered to be risk-free there is no drawback in increasing one’s leverage,
then firms will most likely borrow more. Therefore, the first hypothesis is as follows: ‘The GDP per capita
is positively correlated with the capital structure of SMEs’.
Gross Domestic Product Growth
GDP growth (GDPGROWTH) is used as a macroeconomic variable to proxy for the overall state of the
economy in a country. A growing GDP signals that firms have better investment opportunities and are
expected to create more profits. The pecking order theory suggests that these improved economic
8
conditions lead to a higher free cash- flow. This means that firms have more internal funds, which
decreases their need for external funding. Earlier studies show that pecking order theory is applicable for
SMEs, which means that SMEs will prefer internal funding over external funding if there is a GDP growth.
According to the pecking order theory, GDP growth is positively related with capital structure in the short
term, but negatively related in the long run. However, as the firm grows, their requirement of finance
increases. Growth is likely to push SMEs into borrowing if their internal finance is not enough to finance
the increasing demand. Therefore, the trade-off theory suggests a positive association between GDP
growth and capital structure in the long run. The second hypothesis is ‘the growth rate of GDP is positively
correlated with the capital structure of SMEs’.
Inflation
This variable is represented in the regression as (INFLATION). Inflation provides evidence on the stability
of the local currency and is measured based on the GDP deflator. If this increases, the cost of equity as
well as the cost of debt should increase. However, this might not be the case in real terms, due to the
deterioration of the real value. Furthermore, when part of the interest paid on a loan is actually
compensation for deterioration of the principal, then also the value of the tax shield is increased, because
part of the principal repayment is then tax-deductible (Jensen & Uhl, 2008). Therefore, a positive relation
between inflation and leverage can be expected. Countries with high inflation are associated with high
uncertainty (Demirgyc- Kunt & Maksimovic, 1996). The rate of inflation may influence the riskiness of debt
financing so that lenders are more likely to avoid providing debt. The trade-off theory puts the emphasis
on using more debt, but an increase of inflation will most likely lead do less lending. Therefore, we expect
inflation to be negatively correlated with capital structures of SMEs. According to the pecking order
theory, inflation would have no effect on capital structure (Houwen, 2011). The third hypothesis is
‘Inflation is negatively correlated with the capital structure of SMEs’.
Interest
If interest rate increases firms will be less willing to finance new investment with debt. According to the
pecking order theory, additional debt will be less attractive due to the increase cost of borrowing
(Bartholdy & Mateus, 2008). This indicates a negative relation between the interest rate and leverage.
The trade-off theory states that interest are tax deductible, which leads to tax benefits. This is the reason
9
why a positive relationship is expected with capital structure. The fourth hypothesis is as follows: ‘The
change in interest rate is negatively correlated with the capital structure of SMEs’.
VARIABLE
DEFINITION
GDP
Gross Domestic Product
GDPGROWTH
INFLATION
Growth rate of the Gross
Domestic Product
Inflation rate
INTEREST
Interest rate
Trade-off theory
Pecking Order Theory
+
+
+
+/+
-
Table. 1 Macro-Economic Variables.
The availability of reliable data is scarce due to the fact that most studies which focus on capital structure
of SMEs are researched with firm level variables. However, with the Doing Business initiative of the World
Bank, the available data has increased. Most of the country specific variables will be obtained through this
database. Using this source of data and researching several countries to create variation in the country
specific variables, it is expected to see a relationship between these variables and the capital structure of
SMEs. This may provide additional insight into capital structure theories and the importance of country
specific variables. Knowing which specific variables influence capital structure, it is possible for policy
makers to use this information to change certain government policies in order to provide SMEs with
additional support. This does not mean that unexpected findings will not be elaborated on. If possible,
further interesting findings will be analyzed and concluded on, or otherwise suggested for further
research.
The second part of this study will investigate the relationship between aggregated firm specific variables
and capital structure. There has been previous study done on this topic, but none which uses the Survey
on Access to Finance of Enterprises as a database. The three aggregated firm specific variables obtained
from this data source are the Turnover rate, the General Economic Outlook, and the Profitability. These
variables will be further explained and their expected effect on capital structure will be shown in table 2.
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Turnover
The variable turnover will be used as a proxy for the size of a company and will be denoted as TURNOVER.
Small firms are often managed by very few people whose main objective is to keep the majority of the
firm. That is why internal financing is preferred over external financing, in order to lower the risk of losing
control. Therefore, following the pecking order theory a positively relation is expected. Moreover, small
firms have a higher risk of default compared to larger firms. Reason for this is that larger firms tend to be
more diversified and should lead to a lower debt to assets ratio for smaller firms. The trade-off theory
suggests that more debt financing is weighted against the potential cost of bankruptcy which is affected
by de probability of default (Rajan & Zingales, 1995). According to this theory, size is positively related to
the capital structure (Jõeveer, 2006). The fifth hypothesis is that ‘Turnover is positively correlated with the
capital structure of SMEs’.
General Economic Outlook
This variable is represented in the regression as (GVIEW). This variable will be used as a proxy for future
growth opportunities. High future growth opportunities will lead firms to finance themselves more with
equity than with debt, because less leveraged firms are more likely to maximize profitable investment
opportunities (Myers, 1977). This is also in accordance with the trade-off theory. It is however expected
that retained earnings are not enough to finance all projects, meaning that debt financing has to be
sought. This indicates a positive relation between debt and growth opportunities, and is in line with the
trade-off theory. The sixth hypothesis can be denoted as ‘General Economic View is negatively correlated
with the capital structure of SMEs’.
Profitability
Profitably of SMEs is used as an aggregated firm specific variable to test the amount of debt in a firm and
is denoted as PROFIT in the regression. According to the trade-off theory profitable firms have a lower
probability of financial distress and find interest tax shields more valuable (Houwen, 2011). Therefore,
firms should seek more debt instead of equity. Yet, according to the pecking order theory firms prefer
using internal financing over external financing, so profitable firms will use more equity. It is expected that
profitability and capital structure is negatively correlated. Therefore, the seventh hypothesis is that
‘Profitability is negatively correlated with the capital structure of SMEs’.
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VARIABLE
DEFINITION
TURNOVER
Turnover
GVIEW
General Economic Outlook
PROFIT
Profitability
Trade-off theory
Pecking Order Theory
+
+
+
-
Table. 2 Aggregated Firm Specific Variables.
In the following section named Data I will describe how this particular data was obtained and from which
sources they were gathered. Any change done with the obtained data will also be explained. Further, the
methodology will also be described in the next part.
4 Data & Methodology
To conduct this research various kinds of data is needed. These are collected from a couple of different
sources. Some of these sources are well known databases, for example the World Bank database. Below
follows a description of the different types of data and some attributes of these data.
Our main dataset is a country-level survey data for 11,720 firms from Survey on Access to Finance of
Enterprises (SAFE) conducted in the euro area. This is an investigation performed by the European Central
Bank (ECB) and European Commission (EC) to study the general characteristics of the euro area. The
results in the SAFE database is an aggregated data source of SMEs across 12 European countries. This
signifies that these variables refer to the average results obtained within a country and year of the
enterprises that participated on the survey. The countries included in this survey are the four largest euro
area countries namely Germany, France, Italy, Spain and 8 other countries (Belgium, Ireland, Greece, the
Netherlands, Austria, Portugal, Finland and Slovakia). The smallest countries in the euro area (Estonia,
Cyprus, Latvia, Lithuania, Luxembourg, Malta and Slovenia) are excluded, since they represent less than
3% of the total number of employees in the euro area and excluding them only has a very marginal impact
on the results for the euro area as a whole. In this paper we will focus on the data gathered for eleven
European countries. Slovakia is excluded, because not enough data was available.
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SME
Turnover
Total Assets
Number of Employees
Medium companies
< 50 million EUR
≤ 43 million EUR
≤ 250
Small Companies
< 10 million EUR
≤ 10 million EUR
≤ 50
Micro companies
< 2 million EUR
≤ 2 million EUR
≤ 10
Table 3. Source:http://ec.europa.eu/enterprise/enterprise_policy/sme_definition/index_en.htm
Firms can be divided in different size classes. They are defined as small and medium if they meet the
criteria stated in table 3. The data provided by SAFE was collected to construct a comparable precision for
micro, small and medium-sized firms, taking into account total employment in these size classes. In this
study we will target the small and medium size companies and not the micro companies. The reason for
this is that not much data is available for micro firms due to the fact that this group is not required to
make annual reports public.
This research is based on firms from 11 European countries. Here the capital structure of SMEs for all
countries is gathered with the exception of Slovakia. This country is excluded from the paper because
there is not enough data to study. Our sample period covers the years 2009 to 2014. A reason for this
particular period is that the data is gathered after the financial crisis of 2007-2008. Looking at the data
there seems to be no irregularities.
Using the Safe database, the dependent variable is obtained, namely the debt-to-assets ratio. A country
level variable is obtained from this database as well, namely the change in interest rate. After gathering
the data from the SAFE survey, three other macroeconomic variables are then gathered. These are
obtained from the World Bank database. The three country specific variables gathered here are the Gross
Domestic Product per capita, Gross Domestic Product growth rate and the inflation rate. However,
because the data obtained from the World Bank are annual percentage, the data obtained from the SAFE
survey also need to be generated into annual percentage data. Following mathematics ruling semi- annual
data was converted to annual data. The chosen independent variables were chosen, because it’s well
accepted that these are macroeconomic variables which may influence a firm’s capital structure. This is
also consistent with earlier research on country level basis for capital structure (Bas, Muradoglu and
Phylaktis, 2009).
After gathering macroeconomic variables, aggregated firm specific variables were then gathered. The
aggregated firm specific variables gathered were Turnover, General Economic View and Profitability. All
13
these variables were gathered from the SAFE survey. The data gathered here are changes in percentage
on a semi- annual basis, which were converted to annual data.
After the data is gathered and structured; the regression model is built and tested. One of the most
commonly used ways of assessing the relationship between debt and its determinants is the OLS
regression. Considering the previously defined determinants of debt used in this study, the evaluation of
an OLS regression can be presented in the following way:
The relationship between a continuous response variable (Y) and a continuous explanatory variable (X) is
presented. Here α indicates the value of Y when all values of the explanatory variables are zero. The β
parameter indicates the average change in Y that is correlated with a unit change in X, while taking the
other explanatory variables into account. OLS regression is particularly powerful as it relatively easy to
also check the model assumption such as constant variance, linearity and the effect of outliers using
simple graphical methods (Hutcheson and Sofroniou, 1999).
The variable that we intend to explain is SMEs capital structure. Capital structure is defined as the way a
corporation finances its assets through some combination of equity, debt, or a combination of both. The
composition, the ‘structure’ of how a firm is being financed is then called capital structure (Jensen & Uhl,
2008). Here, capital structure is defined as the total debt ratio. This is obtained by dividing total debt with
total assets;
There are a lot of papers where total debt is separated in long-term debt and short- term debt. However,
other studies show that using the total debt ratio show similar results to the long-term (Wald, 1999).
Therefore, using the total debt ratio is sufficient and reliable and is in accordance with similar papers
(Rajan & Zingales, 1995; Deesomsak et al, 2004).
The relationship of the independent variables with the dependent variable will be studied with the
following regression:
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TDR= β0+ β1*GDPCAPITA+ β2*GDPGROWTH+ β3*INFLATION+ β4*INTEREST+ β5*TURNOVER+
β6*GVIEW+ β7*PROFITABILITY
The countries included in this paper will be tested with these regression models. The independent
variables will be accepted if they have a significant effect on the dependent variable or rejected if this is
not the case. For this research a 5% significance level and 10% significance level will be maintained. When
using a 5% significance level, it is accepted that there is a 5% probability that the null hypothesis is wrongly
rejected (and 10% when using a 10% significance level); this is called the type 1 error. The type 2 error is
the probability that the null hypothesis is not rejected when it should have been. Choosing a higher
significance level gives a greater chance of accepting the null hypothesis, however this also increases the
chance of a type 1 error. A higher level of significance lowers the security of the test result. Rejecting the
null hypothesis can only be done with a certain amount of certainty, a relationship between two variables
can never be completely ruled out.
4.2 Descriptive Statistics
In this part the descriptive statistics of this study will be briefly mentioned and are represented in table 4.
This table shows the descriptive statistics of 11 European countries during the period 2009 until 2014.
These observations are measured in percentage change (∆%). An important descriptive statistic is the
standard deviation, which is in some cases higher than the mean of the sample. This signifies that there
are high deviations within the 11 countries tested. There seems to be no irregularities.
Table 4. Descriptive Statistics
∆%
TDR
GDP
GDPGROWTH
INFLATION
INTEREST
GVIEW
TURNOVER
PROFIT
Valid N (listwise)
N
Minimum Maximum
66
66
66
66
66
66
66
66
66
-63
-8.885
-9.132
-67.200
-68
-92.646
-87.777
-94.676
45
4.870
5.199
107.000
222
108.107
107.012
52.265
Mean
-13.24
-.904
-.632
42.758
49.92
-44.211
.804
-33.431
Std. Deviation
19.987
2.952
2.976
27.281
78.583
40.538
50.464
38.572
15
Table 5 provides the Pearson correlation for the variables in the regression and is used to examine the
possible degree of collinearity among these variables. As can be seen from the data in table 5, the
correlation coefficients are not large enough to cause collinearity problems in the regression and are
statistically significant. Most of the independent variables co-vary at a significance level of 1% with the
exception of GVIEW & INTEREST, which co-vary on a significance of 5%. Another interesting observation
can be found by looking at the first column. It can be noticed that most independent variables seem to be
negatively correlated with TDR, with the exception of INTEREST.
Table 5. Correlations
TDR
GDP
GDPGR INFLATIO
OWTH
N
INTEREST
GEO
TURNOVER
TDR
1
GDP
-.425**
1
GDPGROWTH
-.414**
.985**
1
INFLATION
-.069
.064
.063
1
INTEREST
.424**
-.158
-.174
.027
1
GVIEW
-.436**
.596**
.572**
-.013
-.306*
1
TURNOVER
-.691**
.742**
.746**
.105
-.477**
.711**
1
PROFIT
-.763**
.644**
.656**
.055
-.511**
.728**
.955**
PROFIT
1
*P<0.05, **p<0.01
16
In the next section named Results, the results obtained from these test will be described. It will be
examined if these were the findings which were expected. Implication of different coefficients will also be
deliberated on.
5 Results
5.1 Country Specific Variables
The empirical results from the regression analysis on the country specific determinants are denoted in
table (4). These findings are for the period 2009 to 2014. Yearly dummies have also been included in the
regression to control for any differences across time, with 2009 as the basis. The relation between capital
structure and the Gross Domestic Product per capita (GDP) was expected to be positive, but shows a
negative relationship at a 5% significance level. Earlier studies done on the relationship between GDP per
capita and capital structure show a positive significant relation (Jensen & Uhl, 2008). Due to the negative
coefficient results from GDP, the first hypothesis is rejected. GDP and capital structure are not positively
associated with each other. Therefore, this variable does not follow the trade-off theory and the
assumption that SME’s would borrow more in a country with increasing GDP finds no support. A wealthy
country may indicate that these firms have more retained earnings and thus need less debt to finance
themselves. Most of the countries used in this data belong to the top 30 wealthiest countries in the world
(cia.gov, 2015). This may be an explanation why the GDP is consistent with the pecking order theory rather
than the trade-off theory.
The relation between the growth rate of GDP (GDPGROWTH) and capital structure is found to be
significant at a 5% significance level. This finding is consistent with earlier studies done on the relationship
of the GDP’s growth rate and capital structure (De Jong, Kabir & Nguyen, 2008). The second hypothesis is
not rejected. The results show a positive association between the growth rate of GPD and capital
structure. This variable follows the pecking order theory as well as the trade-off theory. SMEs will use
more internal funds as the GDP grows. However, as the firms grows they will start to use more debt if
their internal finance is not enough to finance the increasing costs of investment (Bas, Muradoglu &
Phylaktis, 2009).
17
The change in inflation was measured with the change in the GDP deflator and shown in the table as
INFLATION. The results show an insignificant effect on capital structure of SME’s while maintaining a 5%
significance level. This is consistent with earlier studies where inflation also had an insignificant effect on
capital structure (Noguera, 2001). Inflation was expected to be negatively associated with capital
structures of SMEs, but the results show that they are positively associated with each other. This finding
is consistent with earlier studies where it was shown that firms use more debt in inflationary periods
(Modigliani, 1983). The deterioration of the real value may explain the positive association between these
variables. Deterioration of the real value leads to repayments being tax-deductible, which makes
borrowing more attractive (Jensen & Uhl, 2008). Therefore, we can reject the third hypothesis. The
variable inflation has a positive association with capital structure and is consistent with the trade-off
theory.
The relationship between capital structure and the change in interest rate is shown to be significant at a
5% significance level. The results show that the interest rate and capital structure are positively associated
with each other. Therefore, this variable does not follow the pecking order theory but follows the tradeoff theory, which suggest that as the interest rate increases they will use more external funds. Firms
should aim towards more debt financing due to the tax deductions associated with the interest payments
on debt (Modigliani & Miller, 1963). This encourages the use of more external finance as more debt
increases the after- tax earnings when the interest rate goes up. The fourth hypothesis is therefore
rejected and is consistent with the trade-off theory and not the pecking order theory, which was originally
believed.
5.2 Aggregated Firm Specific Variables
The empirical results from the regression analysis on the aggregated firm specific determinants are also
denoted in table (6). These findings are for the period 2009 to 2014, measured on an annual basis. The
relation between capital structure and turnover (TURNOVER) reveals a positive coefficient, indicating that
the two variables are positively associated with each other. This result is consistent with other empirical
research done on the relationship between size and capital structure (Jõeveer, 2006; Rajan & Zingales,
1995). The trade-off theory suggests that more debt financing is weighted against the potential cost of
bankruptcy which is affected by de probability of default (Rajan & Zingales, 1995). According to this
theory, size is positively related to the capital structure (Jõeveer, 2006). Myers and Majluf (1984) state
that the bigger the firm, the lower the information asymmetry. Because information is an obstacle for
18
firms to borrow money, larger firms can get loans easier than smaller firms. The fifth hypothesis finds
support and cannot be rejected.
The relation between profitability (PROFIT) and capital structure is found to be negative as expected with
a significant probability. Previous studies which analysis the relationship between profitability and capital
structure also report a significant effect (Rajan & Zingales, 1995; Cassar & Holmes, 2003). However, they
only use a limited set of variables to test their hypothesis. In comparison to these earlier studies, this
paper includes additional aggregated firm specific variables to overcome a possible omitted variable
problem. The negative and significant result is consistent with the pecking order theory, demonstrating
that firms prefer to use internal sources of financing over external when profits are high. Profitable firms
generate enough internal funds to finance new projects, and therefore do not depend as much on raising
funds via an issue of debt. The sixth hypothesis is not rejected.
The general economic outlook variable (GVIEW) is also shown in table (6). According to the trade-off
theory, a negative relationship is to be expected. The results are significant, but show a positive
coefficient. The result is consistent with an earlier study carried out in Europe by Jensen and Uhl (2008),
but in contrast with other empirical findings (Devesa & Esteban, 2008). The sixth hypothesis is rejected
and it can be concluded that future growth opportunities cannot be explained by the trade-off theory.
Following the pecking order theory, firms who see growth opportunities will use retained earnings first to
finance new projects. However, it can be expected that these internal funds are not enough to entirely
finance these new projects. Therefore, SMEs will have to borrow additional capital.
The adjusted R-squared compares the explanatory power of regression models that contain different
number of predictors. It can be observed in table 7 that the adjusted R-squared for this regression is above
50% (76%). This indicates that the model captures a good part of the variations in this regression. Countryand aggregated firm specific variables should therefore not be neglected in capital structure studies since
they have a large explanatory power.
19
N=66
GDP
GDPGROWTH
INFLATION
INTEREST
TURNOVER
PROFIT
GVIEW
DUMMY2010
DUMMY2011
DUMMY2012
DUMMY2013
DUMMY2014
Coefficient
t-Statistic
p-value
-7.243
-2.17
0.034
7.315
2.3
0.025
0.00003942
0.1
0.921
0.078
2.11
0.04
0.391
3.19
0.002
-0.913
-6.92
0
0.142
2.58
0.013
-16.212
-2.6
0.012
-21.583
-2.9
0.005
-15.919
-2.97
0.004
-24.681
-3.94
0
-4.991
-1.04
0.303
Table.6 Regression Results
Adjusted RSquared
0.761
Table.7
20
6 Conclusion
The aim of this paper was to find how certain variables may influence the capital structure of SME’s in
Europe. Through the course of the years much research has been conducted on this subject, yet most
studies were focused on firms in the United States. This study focuses only on the Small and Medium firms
mentioned in table 3. The aggregated data for the 11,720 firms in Europe is used for the period 2009 until
2014. The research on European countries is very limited. This paper is an attempt to add to the existing
pool of literature by analyzing how macro- and aggregated firm specific variables explain capital structure
changes using different theories. To answer the research question, 7 hypotheses were formulated. To test
these hypotheses data was gathered from the World Databank and from the Survey on Access to Finance
of Enterprises.
With the results obtained from testing the hypotheses the research question ‘To what extent do
macroeconomic variables and aggregated firm specific variables help in explaining the capital structure in
small and medium sized businesses in Western Europe’ can be answered.
The 7 variables which were studied in order to answer the research question were the 4 country specific
variables GDP per capita, GDP growth rate, inflation rate, interest rate and the 3 aggregated firm specific
variables Turnover, General Economic View and Profitability. The hypotheses constructed were based on
theories which were most commonly used to explain the variable in question.
The trade-off theory makes it possible to explain part of the capital structure of SMEs. Turnover is
significant positively related to the total debt ratio, as expected from theory. Interest rate is found to be
significant negatively related to the total debt ratio, which was not expected. SMEs use more debt
financing, because they receive tax deductions when the interest goes up. This makes it very attractive to
pursue more external financing. The last variable which can be explained by the trade-off theory is the
inflation rate. A negative relation was expected between inflation rate and capital structure, but the
results showed a positive relation instead. This variable can be explained by the trade-off theory, even
though it was not significant. Deterioration of the real value leads to repayments being tax deductible,
which makes debt more attractive than internal financing.
The pecking order theory also explains the debt policy in SMEs quite well. According to this theory SMEs
would prefer internal funds over external funds. Consistent with this theory, GDP growth leads to more
borrowing by SMEs. In the short run firms will use internal funds to finance new projects, but will switch
to external financing in the long run. This is explained by the fact that SMEs don’t have enough internal
21
funds to keep financing new project long term and therefore have to switch to external financing. Another
variable which is consistent with the pecking order theory is the variable Profitability. This variable is
significant negatively related to capital structure. Profitable firms generate enough internal funds to
finance new projects, and therefore do not depend as much on raising funds via an issue of debt. The
variables GDP and General Economic View were expected to be consistent with the trade-off theory, but
are explained by the pecking order theory instead. Most countries used in this study belong to the richest
countries in the world and may therefore indicate that firms inside these countries have more retained
earnings to finance themselves. More retained earnings will lead to SMEs having less need for debt
finance. The significant positive relation between General Economic View and capital structure can be
explained by the fact that most SMEs don’t have enough internal resources to fund themselves. Therefore,
they must seek additional capital to be able to invest in new projects.
Most of the variables did not show the relationship which was expected, based on the chosen theories.
Nevertheless, all but one was strongly significant. Most of the earlier studies only take one theory into
account while examining a firms’ capital structure, but this study has shown that both the pecking order
theory as well as the trade-off theory needs to be to be taken into account while studying a firms’ capital
structure. Furthermore, the results obtained in this study have shown that macroeconomic and
aggregated firm specific variables are an important aspect in explaining SME’s capital structure and cannot
be neglected.
The main downfall of this study is the narrow timeframe which was used. Further research could benefit
from choosing a longer period of time in order to study these determinants, and their effect on capital
structure, better. This study was also not sufficient enough to make a statement on which of the two used
theories are better in explaining the capital structure of SME’s. It is an attempt to identify relationships
between certain determinants and leverage. Future studies may want to use both theories to examine
the variables which affect the capital structure of SMEs.
22
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