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 Follow this and additional works at: http://scholarlycommons.law.hofstra.edu/jibl 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 This Article is brought to you for free and open access by Scholarly Commons at Hofstra Law. It has been accepted for inclusion in Journal of International Business and Law by an authorized administrator of Scholarly Commons at Hofstra Law. For more information, please contact [email protected]. Rai and Danilevskaia: Choice of Short-Term and Long-Term Debt in Five Eastern European THE JOURNAL OF INTERNATIONAL BUSINESS & LAW 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. Published by Scholarly Commons at Hofstra Law, 2005 1 Journal of International Business and Law, Vol. 4, Iss. 1 [2005], Art. 2 THE JOURNAL OF INTERNATIONAL BUSINESS & LAW (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. http://scholarlycommons.law.hofstra.edu/jibl/vol4/iss1/2 2 Rai and Danilevskaia: Choice of Short-Term and Long-Term Debt in Five Eastern European THE JOURNAL OF INTERNATIONAL BUSINESS & LAW 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.