Choice of Short-Term and Long-Term Debt in Five Eastern European Countries Anoop Rai

Journal of International Business and Law

Volume 4 | Issue 1 Article 2

2005 Choice of Short-Term and Long-Term Debt in Five Eastern European Countries Anoop Rai

Victoria Danilevskaia

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Recommended Citation Rai, Anoop and Danilevskaia, Victoria (2005) "Choice of Short-Term and Long-Term Debt in Five Eastern European Countries," Journal of International Business and Law: Vol. 4: Iss. 1, Article 2. Available at: http://scholarlycommons.law.hofstra.edu/jibl/vol4/iss1/2

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CHOICE OF SHORT-TERM AND LONG-TERM DEBT IN FIVE EASTERN EUROPEAN COUNTRIES

By: Dr. Anoop Rai & Victoria Danilevskaial

I. Introduction

The capital structure of a firm refers to the proportion of debt and equity maintained by a firm. In 1958, Nobel laureates Franco Modigliani and Merton Miller published a paper theorizing that in a perfectly competitive market with no taxes, asymmetric information or bankruptcy costs, the debt- equity level of a firm is irrelevant in the valuation of a firm. Financial economists thereafter have studied this issue extensively, proving the existence of an optimal capital, but only by relaxing one of the assumptions. The choice between debt and equity creates a problem because of the different risk return characteristics associated with each type of financing. In debt financing, the interest payments are tax-deductible offering significant savings to the shareholders. However, too much debt increases the likelihood of bankruptcy. requiring shareholders to demand a higher rate of return. The use of debt also leads to conflicts between shareholders and creditors. At high levels of debt, shareholders may opt for riskier projects than desired by creditors. An equilibrium capital structure is attained at the point where the risk and return of the two competing groups are satisfied. Another area of interest in capital structure is the choice between short- and long-term debt. Short-term debt is less expensive than long-term debt but is riskier because they need to be renewed periodically. A firm may find itself in a crisis if they are unable to renew their debt. usually because of some negative news, real or otherwise. Most failures of large corporations are precipitated by the unavailability of short term funding, as was the case for Drexel Burnham Lambert. Enron and WorldCom. Long-term debt offers more stability but is more expensive than short-term debt. The ability to borrow short-term debt also depends on the maturity and depth of the market. In the U.S., the market for short-term instruments like commercial paper and repos (repurchase agreements) are well developed. Consequently, large firms can access these funds quickly and efficiently. In other countries, the lack of an efficient short-term capital market may limit their choices of debt. When comparing the capital structure of firms in different countries: not only does the cultural, social and institutional factors make an impact but also the level of development of capital markets. The focus of this paper is to examine the choice of short- and long- term debt by firms in five countries that moved from a centrally planned economy to a market based system. These five countries, Russian Federation

The article is hascl on the Honor's ssy "xrittcnb \Victoria l)anilexskaia at Hofstra Univ(rsit. undLr the surxnision of Profc.,cr Anoop Rai.

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(RU) Poland (PO), Hungary (HU), the Czech Republic (CZ) and Slovakia (SL), have yet to develop a well functioning capital market that is fully conducive for private industries to operate competitively. Reforms have been slow to implement and rules on corporate governance are not as transparent as those in other major markets. Due to the limited choice of capital instruments, firms are forced to optimize under constraints that include a lack of liquidity, legal protection and transparency. Different factors will therefore play a role in determining the choice of debt in each country. We first examine whether the choice of debt is similar in the five countries. We next attempt to identify some factors that can explain the differences.

II. Literature Review

A substantial volume of research has examined capital structure of firms globally, with significant differences observed in different parts of the world. We however focus our literature review on the capital structure of European and Eastern European firms. Wanzenried (2002) found that there are considerable differences between the capital structure of the continental European countries and the UK. In using financial data from 167 firms over a time period from 1989 to 1998, Wanzenried found that British and continental companies finance an average of 16% of their assets with external long-term capital and both have higher leverage as the firm size increases. European firms, however, raise most of their funds through banks. which may also hold a large stake in the company. In a time-series study, Bevan & Danbolt (2000) analyzed the determinants of capital structure of 1,054 UK companies from 1991 to 1997. Companies with high levels of growth opportunities are found to utilize more long-term and short-term debt, although over time there is a shift towards equity finance. Antoniou, et. al. (2002) researched the capital structure of firms in the UK, France, and Germany during the years 1969, 1983, 1987 and 2000. The research indicates that the market interest rate plays a role in determining levels of long-term debt. They conclude that companies preferred not to borrow long-term when the market interest rates were high. France and Germany had higher leverage than UK. which confirms the traditional belief that European companies take on more debt, while UK firms prefer to use more equity. In a more comprehensive study, Rajan and Zingales (1995) analyzed leverage of 8.000 companies from G-7 countries for the years of 1987-1991. They did not find significant differences in leverage between bank-oriented and market-oriented countries. Tangibility was found to be an important determinant of debt. Size had a positive correlation to leverage in all countries except Germany while profitability was negatively correlated in all countries except Germany. All the countries utilized public financing more heavily then private financing based on the percentage of GDP. The US had by far the highest utilization of private financing. but it was still small compared to public capitalization. Japan and the UK., after the US, had the highest private financing capitalization. while France and Italy had the lowest.

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The capital structure of a company is also affected by the legal system of a country due to the laws that regulate the corporate governance of firms. For example. the depth of legal protection affects investor protection, which in turn can influence the choice of debt or equity. La Porta et al. (2000) analyzed the effects of investor protection on dividends paid to shareholders in 33 countries around the world. They found that firms operating in protective legal environments paid lower dividends. Fast growing companies in those countries tended to pay smaller dividends than slow growing companies. In poorly protected countries, shareholders opted to take any dividends they could get, regardless of the investment quality. Aussenegg and Jelic (2002) studied the effects of privatization in Poland, Hungary, and the Czech Republic. The study focused on 154 companies listed on the National Stock Exchanges in Poland on April 16. 1991, Hungary on June 21, 1990 and the Czech Republic on April 6, 1993 and found a decline in profitability, output, employment, efficiency, and sales per employee. These results have not been experienced in industrial countries, suggesting that the market economies have not fully matured. They also report that leverage has remained constant except for slight increases in dividend payout ratios. Csermely and Vincze (2000) conducted a detailed research on the privatization of firms in Hungary through 1996. Their study finds that firms in Hungary have capital structures that resemble those of a transitional economy. Foreign investment was found to be an important indicator of a firm's creditworthiness. Koke and Schroder (2003) analyzed the security exchanges in Central and Eastern Europe (CEE). They found that the markets were significantly smaller than that of Western Europe. Further, the CEE markets had a capitalization of approximately 18% compared to the above 50% capitalization rates in Western Europe. The Czech Republic. Hungary. and Poland had the most developed stock exchanges. with the largest stock exchange in Poland. The Warsaw exchange showed a continuous increase in listed companies while the Czech Republic, Hungary and Slovakian exchanges exhibited stagnant or decreasing growth. The corporate bond markets were found to be insignificant in all these countries, the largest being in the Czech Republic, Hungary, and Poland. There is not much literature on the use of short- and long-term debt by firms in these countries. The few existing works on the analysis of capital structure in Eastern European Countries have focused mostly on one or two countries at a time. We focus on five countries at a time and test the significance of four variables on the choice between short- and long-term debt. The variables are size. tangibility, profitability and growth. The scope of the paper is similar to Bevan & Danbolt (2000) who also focused on the choice between short- and long-term debt.

III. Hypothesis

Four hypotheses are tested in this study. Since long-term debt and short-term debt do not show high correlation, we are able test the variables

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together. Unlike in developed countries, large companies in these five countries are expected to prefer long-term debt because of the lack of a well-developed equity market. Smaller banks may have no option but to opt for short-term bank debt.

Hypothesis 1: Company size is positively related to Long-term Debt and negatively related to Short-term Debt.

Company size is hypothesized to be positively related to long-term debt. Since the equity markets in Eastern European countries are not yet fully developed, companies may be forced to rely on long-term debt. Large companies have the ability to borrow long-term debt because they have a lower possibility of bankruptcy than smaller companies. Smaller companies are likely to be considered riskier by investors for lending long-term. As Wanzenried (2002) pointed out, larger firms are also less likely to face bankruptcy than smaller firms because they usually have diversified portfolios. Further, we expect to see changes between 1997 and 2000. If long- term equity markets are developing, then size and long-term debt may decrease in 2000 relative to 1997. If equity markets continue to be under-developed, it is likely that size and long-term debt will increase in 2000.

Hypothesis 2: Tangibility is positively related to Long-term Debt and negatively related to Short-term Debt.

The relationship between tangibility and debt levels should be positive because tangible assets can serve as collateral for loans. In the literature, fixed costs are often used as proxies for tangibility. The larger the tangible assets, the higher the probability that the company will repay the loans. since tangible or fixed assets such as machinery can be liquidated. We therefore hypothesize that tangibility is positively related to long- term debt and negatively related to short-term debt.

Hypothesis 3: Growth opportunities are negatively related to Long-term Debt and positively related to Short-term Debt.

Wanzenried (2002) and Bevan and Danbolt (2000) both hypothesize that high growth companies have lower long-term debt. Wanzenried bases her argument on the costs of long-term debt, which she believes are higher while Bevan and Danbolt base their hypothesis on the empirical findings of other studies. However, both studies are based on firms in developed markets. Companies that exhibit higher growth rates are not necessarily more profitable, since they need to invest a significant amount of money into achieving further growth. If the equity markets in Eastern Europe are still underdeveloped, then companies may seek to finance their growth through debt. In terms of the choice between short- and long-term debt. it is likely that growth companies are perceived to be riskier. Under such circumstances. banks may be the only lenders willing to lend to risky companies through short-

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term loans. However, it is also likely that growth companies will have the capacity to borrow directly, domestically or internationally. This would result in a positive relationship between growth and long-term debt.

Hypothesis 4: Profitability is positively related to Long-term Debt and negatively related to Short-term Debt.

Profitability and leverage may have a negative or positive relationship. If companies are profitable, they may take on debt to increase their tax shields in line with the Modiglianni and Miller proposition. However, empirically Rajan and Zingales (1995) find debt to be negatively related to profitability. As for the relationship between short and long-term debt, profitable companies are more likely to have greater access to equity and long-term debt. However, profitable companies may also have excessive risk that may make it difficult for them to raise debt capital. Since debt and equity markets are still not fully developed in the five countries, firms may have to rely more on bank debt. Thus, the relationship between profitability and short- and long-term debt is an empirical question.

V. Data:

The data consists of firms operating in Hungary, Poland, Russian Federation. the Czech Republic, and Slovakia. Income statement and balance sheet data are available for the years 1992 to 2001 for a total of 259 companies, with 46 in Russia, 93 in Poland. 44 in Hungary, 57 in Czech Republic, and 19 in Slovakia. Of them. 142 companies had data from five to nine years and 117 had data for less than five years. Russia and Slovakia had the least available historical data. while Poland and Hungary had the most. There was not a significant amount of data reported for years 1992 through 1994 except for Poland and Hungary. We selected the years 1997 and 2000 for our study since they had the most data. All data was obtained from Worldscope. Exhibit A shows the breakdown of companies in each country by industry groups. There are 5 transportation firms. 181 industrial firms, 24 banking firms, 41 utilities firms, and 8 insurance and financial firms. Industrial firms dominated the sample with Poland having the largest number (67) and Slovakia the lowest (17). Exhibits B and C show the summary statistics of the data for the years 1997 and 2000, respectively. The data is broken down by country. A detailed description of these variables, provided by Thomson Data, is shown in Exhibit D. The 1997 data in Exhibit B shows that Russia has the largest average assets followed by Poland. Poland had the largest long-term debt ratio while Slovakia had the largest short-term debt ratio. Poland also had the highest profit ratio followed by Hungary while Russia had the lowest. The Czech Republic had the highest tangibility ratio.

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The 2000 data in Exhibit C demonstrates that the Russian Federation continues to have the largest firms in the sample by total assets. Although the total assets for firms in all countries increased in local currencies, they declined in dollar terms because of the exchange rates. Hungary and the Czech Republic saw an increase in the use of long-term debt while they declined in other countries. Hungary and Slovakia saw some increases in the use of short-term debt while they declined for other countries.

VI. Tests and Results:

A standard regression is used to test the four hypotheses. We used SAS to compute the following four equations.

SIZE = a + 3, (LTDi) + 32(STDi) + ri TANGIBILITY, = a + 31 (LTD) + 032 (STD) + ci GROWTHi = a + 3, (LTDi~n) + f2 (STD) + Fi PROFITABILITY = a + 031(LTD) + P32(STD) + ei Where i = ith firm. LTD = long-term debt and STD = short-term debt.

The regressions were run separately for each country and separately for the years 1997 and 2000. We used LTD and STD as independent variables instead of dependent variables to be consistent with Bevan and Danbolt (2000). The results of the tests are given in Exhibit E for 1997 and Exhibit F for 2000 and are discussed below.

A. Size

Hypothesis I was tested by running a regression with long-term debt (LTD) and short-term debt (STD) as the independent variables and Size as the dependent variable. Our proxy for Size was the log of net sales. The relationship between short-term debt (STD) and Size was positive for all countries in 1997, but the result was significant only for Poland at the 1% significance level. In 2000 the positive relationship remained the same for all countries except Slovakia. but was significant again only for Poland at the 5% level of significance. The results therefore do not indicate that the large firms prefer to carry more short-term debt. The relationship between long-term debt (LTD) and Size is also not significant or consistent. In 1997 CZ. PO. and SL had a negative relationship between LTD and Size. while HU and RU both had a positive relationship between LTD and Size. However, since none of the results are significant. we summarize that long-term debt is unrelated to size for the 1997 sample. In 2000 there was a positive correlation between LTD and Size for all countries, but only the results for CZ were significant at a 5% level. The changes in the relationships from negative to positive are likely to be the result of developments in the long-term debt markets. In sum. it appears that no clear relationship between short-term and long-term borrowing and company size can be established. Our results are

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consistent with Bevan & Danbolt who also find no clear positive relationship between debt and size.

B. Tangibility

The second hypothesis, that tangibility is positively related to long- term debt, is tested by regressing LTD and STD against Tangibility as the dependent variable. The ratio of fixed assets to total assets served as a proxy for tangibility. There is a clear and significant negative relationship for all countries between STD and Tangibility in 1997. The significance level is 10% for HU and 1% for all others. The negative and significant relationship remains the same for CZ and PO in 2000, but becomes insignificant for the other countries. The tests indicate that there is a positive correlation between LTD and Tangibility for HU at a 1% significance level in 1997. The results for other countries are mostly positive, but insignificant. In 2000 there is a significant and positive correlation between LTD and Tangibility for CZ at a 5% level of significance and for PO at a 1% level of significance. The remaining countries have a positive relationship but are statistically insignificant. Our findings are consistent with our hypothesis that tangibility is negatively related to short- term debt and positively related to long-term debt. These results are robust and suggest that firms with large fixed assets are more likely to have longer-tem debt, most likely because fixed assets serve as collateral against bankruptcy.

C. Growth

The third hypothesis tests the relationships between LTD and STD as the independent variables, while maintaining Growth as the dependent variable. We estimate Growth only for year 2000, by estimating the difference between log sales of 2000 and 1997. The growth for 1997 was not estimated because the data prior to 1997 is scattered and incomplete. The results indicate that there is a significant positive relationship between Growth and LTD for HU and PO. Hungary has a 10% level of significance, while Poland has a 5% level of significance. The outcomes for STD and Growth are mixed and mostly insignificant. CZ, HU. and SL had a negative relationship, while RU and PO had a positive relationship. The t-value was only significant for CZ and HU, at a 5% level of significance, providing no support for our hypothesis. Thus it appears that growth firms are more likely to borrow long-term debt than short-term debt.

D. Profitability

The final hypothesis tests the relationship between profitability and debt by regressing the dependent variable Profitability against independent variables Long-term Debt (LTD) and Short-term Debt (STD). Our proxy for profitability is net sales divided by total assets.

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The relationship was mostly negative between STD and Profitability in 1997. but only significant at a 1% level for Poland. In 2000, the negative correlation changed to positive for Poland but insignificant. Only Slovakia had significant negative results, at a 10% level of significance. The results in 1997 for LTD and Profitability were also mostly negative and only significant at a 5% level for the Czech Republic. In 2000, the results remained mostly negative, but were significant for Poland and Slovakia at 5% and 10% levels of significance, respectively. The findings suggest that profitability is negatively related to both short- and long-term debt for both periods. A likely explanation is that profitable companies may be using their own internal funds to finance their capital requirements. The tables also report estimates of the variance inflation factor from the regressions. The results indicate that multicollinearity is not a factor in the tests. Similarly, the estimates of the Durbin-Watson tests are also provided. They too indicate no significant serial correlation. Thus, the regression estimates should be considered as robust and reliable.

VII. Conclusion:

The focus of this study is to determine the factors that affect the choice of short- and long-term debt of firms in the five Eastern European countries of Russian Federation, Poland. Hungary, Slovakia and the Czech Republic. These countries are in various stages of economic development, specifically in the development of their capital markets. As these countries move from a centrally planned system. firms have to finance their own capital. If debt markets are underdeveloped, the firms are often forced to rely on bank financing. As the capital markets develop, firms have the option of not only obtaining equity financing but also choosing between short- and long-term debt. We specify four hypotheses related to the choice between short- and long-term debt. First, large firms are hypothesized to prefer long-term over short-term debt. Second. firms with more tangible assets are expected to have more long-term debts, with tangible assets serving as collateral for lenders. Third. we specify that growth may have a positive or negative relationship to long-term debt. This is because even though growing firms may have the ability to borrow long-term, they may be viewed as being too risky for long- term commitments. Fourth, similar to growth, profitable firms are also hypothesized to have a positive or negative relationship with long-term debt. A total of 259 firms from the five countries were obtained and tested for two periods, 1997 and 2000. The overall results support some of the hypotheses. Size does not appear to be an important factor and is not related to either short- term or long-term debt. Tangible assets are a significant factor in the choice of debt. The results indicate that firms with more tangible assets are more likely to borrow long-term than short-term debt, consistent with expectations. Similarly, high growth firms also show a positive relationship to long-term debt. Although high growth firm may be considered riskier and are more likely candidates for venture capital, the lack of such capital may explain

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the positive relationship with long-term debt. Finally, profitability is shown to have a negative relationship with both short- and long-term debt suggesting that these firms are probably using their internal funds to meet their financing needs.

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REFERENCES

Antoniou, Antonios. Guney, Yilmaz and Paudyal, Krishna. 2002. Detenninants of Corporate Capital Structure: Evidence from European Countries, Working Papers, Centre for Empirical Research in Finance, University of Durham.

Aussenegg, Wolfgang and Jelic. Ranko, 2002, Operating Performance of Privatized Companies in Transition Economies- The Case of Poland, Hungar, and the Czech Republic, Working Papers, Vienna University of Technology, The University of Birmingham.

Bevan, Alan A. and Danbolt. Jo, 2000, DYnamics in the Detenninants of Capital Structure in the UK, Department of Accounting and Finance. University of Glasgow.

Csermely. Agnes and Vincze, Janos. 2000, Leverage and Foreign Ownership in Hungay, Russian and East European Finance and Trade, vol. 36. no. 3. pp. 6- 30.

Koke, Jens and Schroder, Michael, 2003, The Prospects of Capital Markets in Central and Eastern Europe, Eastern European Economics, vol. 41, no. 4. pp. 5-37.

La Porta, Rafael., Lopez-De-Silantes, Florencio., Shleifer, Andrei and Vishny. Robert. 2000, Agency Problems and Dividend Policies around the World, The Journal of Finance, Vol. LV, No. 1, pp. 1-33.

F. Modigilani and M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment." American Economic Review (June 1958)

Rajan, Raghuram G. and Zingales, Luigi. 1995. What Do We Know about Capital Structure? Some Evidence from International Data, The Journal of Finance, Vol, L, No. 5, pp. 1421-1460.

Wanzenried, Gabrielle, 2002, Capital Structure Dynamics in UK and Continental Europe, Working Papers, University of California Berkeley, Haas School of Business and Institute of Economics, University of Bern.

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Exhibit A

COMPANIES IN SAMPLE BY INDUSTRY GROUP Countries: Russian Federation. Poland, Hungary, Czech Republic, and Slovakia

Country Industry Group Total Transportation hIdustrial Banking Utilities Insurance Financial Russian 2 24 1 19 0 46 Federation Poland 1 67 17 4 4 93 Hungary 1 32 2 7 2 44 Czech 1 41 3 11 1 57 Republic Slovakia 0 17 1 0 1 19 Total 5 181 24 41 8 259

Notes for Exhibits B and C * All data is stated in millions * Exhibit B: o The exchange rates used in conversions: " $0.00491/HUF- Hungary " $0.02874/SKK - Slovakia " $0.17/RUB - Russian Federation " $0.02898/CZK - Czech Republic " $0.28490/PLN - Poland " Source: http://www.oanda.com/convert/fxhistorv " Exhibit C: o The exchange rates used in conversions: " $0.003562/HUF - Hungary " $0.02139/SKK - Slovakia * $0.035050/RUB - Russian Federation * $0. 02659/CZK - Czech Republic * $0. 24213 1/PLN - Poland * Source: http://www.oanda.com/convert/fxhistori " LDEBT = Long-term debt over Total Assets " SIZE = Log of Sales " SDEBT + Total Liabilities - Long-term debt over Total Assets * PROF = Net Income over Total Assets * TANG = Fixed Assets over Total Assets * GROWTH = Log of 2000 Sales - Log of 1997 Sales

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