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The Effect of Firm and Country Specific Factors on the Capital Structure The effect of firm and country specific factors on the capital structure Abstract This paper takes into consideration the major theories about capital structures and evaluates these ideas to determine which of them relate to corporate financing choices. What unique is in this paper is that it examines the influence the financial crisis had on the capital structure several years after it occurred in 2008. The main results and conclusions are that the tax rate has a significantly negative relationship with the leverage level, however, this relationship was expected to be positive because of the tax benefits. This research finds that the size of firms is significantly positive related to the leverage ratio. Furthermore, this research finds that profit is significantly negative related to the leverage ratio. These results are matching with the theories. However, the relationship between the age and the leverage ratio does not yield a significant outcome, most likely owed to the large time frame of the data sample. The financial crisis had, as was expected, a significant positive relationship with the leverage ratio. In this research, the relation of debt maturity with leverage ratio remains unexplained. Student number: s2972298 Name: Maudy Nijhuis Study program: MSc Finance Date: June 6th, 2018 1. Introduction Corporate financing choices can be determined by different factors that are related to firm and country specific characteristics. Since the paper of Modigliani and Miller (1958), which will be taken a look at in the literature review, there has been a lot of research about corporate financing choices. Studies such as Rajan and Zingales (1995), Wald (1999), and De Jong, Kabir and Nguyen (2008) examined the corporate financing choices of firms. However, these papers are inconclusive concerning which firm and country specific factors influence the financing choices of companies. Furthermore, recent papers of Graham, Leary and Roberts (2015) and Turk Ariss (2016) suggest that further research about corporate financing choices is still needed. Besides the inconclusiveness that exists about the factors that influence the corporate financing choices in the papers mentioned above, the global financial crisis of 2008 could have an important influence on the corporate financing choice of firms. Reinhart and Rogoff (2009) state that the global financial crisis of 2008 was the biggest financial crisis since the Great Depression in the 1930s. Many financial institutions collapsed, while others survived solely because they were nationalized or received massive state support. The global financial crisis of 2008 affected major financial centers across the entire world. The paper of Demirgüc-Kunt, Martinez Peria and Tressel (2015) states that the global financial crisis of 2008 offers an important opportunity to study the effects that macroeconomic and financial instability might have. This research is adding to previous research, because it investigates the corporate financing choices of firms several years after the financial crisis. There has been little research about the influence of the financial crisis on the corporate financing choices and about what happened the years following the crisis. However, the paper of Demirgüc-Kunt et al. (2015) examined the effect of the financial crisis on the corporate financing choices through the year 2011 and the paper of Mouton and Smith (2016) investigated this effect through the year 2013. In this research, the effect of the financial crisis on the corporate financing choices through the year 2015 is investigated. One of the corporate financing choices that companies have, is that they can be financed with both internal and external financing. Internal financing is raised by retaining the earnings that are generated. External financing is generally sourced from capital markets and consists of debt and/or equity. The difference between debt and equity is that debt must be paid back to the debtholders and debt is senior to equity, which means that debt has to be paid back in full before the equity claims can be paid out. 1 The advantage of equity financing is that the firm does not have to pay interest, no negative cash drain, and there is no restriction on its assets. In the case of debt, a creditor might require a pledge of assets for collateral which can restrict the firms' operations. The disadvantage of equity financing is that it reduces the share of profit to existing stockholders. The capital structure of a company defines how the external financing of a firm in the capital market is built up. When a firm is only financed with equity it is called an ‘unlevered firm’, after adding debt to the company it is called a ‘levered firm’. The amount of debt that the company holds in comparison to the total amount of debt and equity the firm holds specifies the leverage ratio, which is debt/total assets. In this research, we want to look at the influences of different factors on the capital structure of firms. Specifically, to look at what the effect is of differences in country and firm specific factors on the capital structure of companies. Where the leverage ratio will be used as measurement for capital structure. Besides the global financial crisis of 2008, this paper also investigates the effect of the debt maturity. Debt can exist out of short-term debt that has to be paid back in one year and long-term debt that has to be paid back over a longer period than one year. Therefore, short- term debt carries more risk than long-term debt. Debt maturity refers to the point in time the principal is due to be paid. In this research, the leverage ratio looks at the total debt used divided by the market value of total assets. As mentioned, short-term debt is more risky than long-term debt. Therefore, the tests are also done for short-term debt divided by the market value of total assets, the short-term leverage ratio, and the long-term debt divided by the market value of total assets, the long-term leverage ratio. The results of the short-term leverage ratio are compared to the results of the long-term leverage ratio, to find the influence that debt maturity has. Furthermore, the level of development of a country may have an impact on the capital structure of companies. Countries with a low level of development may have less access to financing for their new investments. This may lead to lower leverage levels for a lower level of development in a country. The main question of this research will therefore be: “Which firm and country specific factors can explain the capital structure choice of companies?” 2 According to the theory of Modigliani and Miller (1958) which is explained further in the literature review it should, in perfect markets, not matter if the firm is financed with debt and/or equity, because in perfect markets the firm can always get new financing. However, when there are market imperfections, such as taxes, it is important to look at the choice for the capital structure. In the real world, there are market imperfects and firms can gain from using more debt, because debt has tax benefits. Besides the Modigliani and Miller theory, there are two theories that focus on the capital structure choice: The Static Trade-off Theory and the Pecking Order Theory. The Static Trade- off Theory suggest that companies should hold the optimal level of debt-to-equity that balances the cost and benefits of debt financing. There are tax benefits on debt, but debt is riskier and could bring costs of financial distress with it. Furthermore, the Pecking Order Theory suggests that firms should first finance with retained earnings before they should get external financing. When the firm gets external financing, the firm should first issue debt before equity is issued. This is should be done to prevent the firm from asymmetric information problems. In this research those three theories, are used to find firm specific factors that can explain the choice of companies for their leverage levels. Besides these theories, other firm and country specific factors will be taken into consideration. The data used in this research is gathered from the Compustat Global database and the Central Intelligence Agency. The data consists of panel data of 579 firms over a period of 12 years from 2004 till 2015. The total sample consists of 6925 observations. The main outcomes are that taxes are negatively related to the leverage ratio, which is contrary to what was expected according to the Modigliani and Miller theory. The size of the firm is positively related with the leverage ratio, which is what was expected. The relation of the age of the firm is not significant which can be explained by the large time period the sample has, therefore bankrupt firms and new firms are deleted from the sample. Leaving only older firms in the sample. Profit is negatively related to the leverage ratio, which is also what was expected. Taking the significant factors in consideration, it can be concluded that both the pecking order theory and static trade-off theory can explain the leverage level of firms. The financial crisis has a significant positive relationship with the leverage ratio and the rate of development also has a significant positive relationship with the leverage ratio. The relation that debt maturity has with the leverage remains unexplained in this research. 3 2. Literature review In this section, the different theories about the corporate financing choices of companies are taken into consideration. Based on these theories an econometric model is developed to test the hypotheses. As stated in the introduction there are several theoretical perspectives about corporate financing choices. However there still exists inconclusiveness about which firm and country specific factors influence the financing choices of companies.
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