Table of Contents
1.1. Background of the Study
1.2. Statement of Problem
1.4. Objectives of the Study
1.4.1 General objective
1.4.2 Specific objective
1.6. Significance of the Study
1.7. Scope and Limitation of the Study
2. LITERATURES REVIEW
2.1. Definition of Capital Structure and Small Scale Manufacturing Industries
2.2. Theories of Capital Structure
2.2.1. Trade-off Theory
2.2.2. Pecking Order Theory
2.2.3. Agency Theory
2.3. The Determinants of Capital Structure
2.3.4. Earnings Volatility
2.3.7. External Determinants of Capital Structure
2.4. Empirical literature Review of study
2.5. General result of the empirical study
2.6. Conceptual Framework
3. RESEARCH METHODOLOGY
3.2. Research Approach
3.3. Sampling Design
3.4. Variables in the Study
3.4.1. Dependent Variable
3.4.2. Independent Variables
3.6. Data Analysis Technique
3.7. Model Specification Test
3.7. Classical Linear Regression Assumptions and tests
4. ANALYSIS RESULTS AND DISCUSSION
4.1 Descriptive analysis
4.3 Model Specification Test
4.3.1 Test of Data stationary or non-stationary
4.4 CLRM Assumptions and Diagnostic Tests
4.4.1 Normality Test
4.4.2 Multicollinearity Test
4.4.3 Correlation Analysis
4.4.4 Autocorrelation Test
4.4.5 Heteroscedasticity Test
4.5 Regression Analysis and Discussion of Results
4.5.1 Regression Analysis
4.5.2 Discussion of Results
5. Conclusions and Recommendations
On the onset, my heart-felt gratitude and respect goes towards my thesis advisor Ato soloman fiseha (PhD candidate) and Ato soloman assefa (MSc.) for their patience in repeatedly reading the draft manuscript of this study and for making constructive comments and suggestions from which I have immeasurably benefited in sharpening my understanding, predominantly, on the area I study. It is palpable fact that without his closer follow-up and continuous encouragement with valuable comments this thesis would not have been finalized in its present structure. However, all the imperfections and shortcomings that may be inherent in this thesis are entirely mine. Second, I would like to extend grateful acknowledgement specifically to Addis Ababa as well as Hawassa SSMFs themselves for providing me with all the necessary information and documents required to carry out this study.
Third, I would like to thank Ato Biruk (FBE dean) and Ato tesfaye E (head of economics dep.) for their support in statistical software application. I am also indebted for many friends and to all those who helped me one way or another for the accomplishment of my study.
The purpose of the study is investigating the determinants of capital structure for Small Scale Manufacturing Firms (SSMFs) in Ethiopia. Hypotheses utilizing trade-off, pecking order and agency theories are empirically examined using a series of firm characteristics: size, tangibility, profitability, earning volatility, age and macroeconomic variable (GDP growth rate, inflation rate and interest rate). A structured record review was made to collect a panel data, which include 20 SSMFs year observations of 11 years over the period 1998 – 2008 E.C. The findings suggest that profitability, earning volatility, age, growth, GDP, inflation rate and interest rate variables are the most important determinants of capital structure of SSMFs in Ethiopia. The findings also reveal that the dominant capital structure theories (trade-off, pecking order, and agency theories) appear indeed to be valid for Ethiopian SSMFs’ capital structure; in fact, trade-off theory best explains Ethiopian SSMFs’ capital structure. All firm specific variables except Size, tangibility and growth variables seem to have an effect on the level of leverage in Ethiopian SSMFs.
Key word: capital structure, profit, firms
List of table and figures
Figure 2.1: conceptual framework
Table 1: Summary of Description of Independent Variables and their Expected sign
Table 4.1 descriptive statistics
Table 4.2 Correlated Random Effects - Hausman Test
Table 4.2 Data stationary or not checkup by unit root test
Figure 4.1 Normality Test- BJ
Table 4.3 Multicollinearity test (correlation with in independent variables)
Table 4.5 Breusch-Godfrey Serial Correlation LM Test
Table 4.6 Heteroskedasticity Test: White
Table 4.7 Random effect regression result
Abbildung in dieser Leseprobe nicht enthalten
1.1. Background of the Study
Manufacturing is critical and is probably the most important engine of long-term growth and development. As countries transform from primary agricultural-based economies to Manufacturing based ones, more sustainable revenue for growth is obtained. Manufacturing industry in Ethiopia started in 1920s with a simple processing technology that produces agriculture-based products; but still the sector is infant -even by African standards, dominantly focusing on semi-processing. According to CSA(central statistical agency) census report of 1994 the vast majority of countries rely on the dynamism, resourcefulness and risk-taking of private enterprises (to which most small scale manufacturing enterprises belong) to trigger, sustain the process, and form the base for private sector led of economic growth. In this regard, small scale manufacturing industries are playing an ever-increasing role in the manufacturing industrial structure of the country. Expansion and development of the sector increases agricultural productivity through providing agricultural inputs and creating demand for agricultural outputs. Furthermore, small scale manufacturing industries play a key role in stimulating other sectors of the economy such as trade, construction and services and in reducing unemployment CSA census (1994). Basic data on manufacturing output, input, employment, fixed assets, investment and capacity are of paramount importance for designing and formulating industrial development programs, strategies and policies. Capital structure represents a firm's financial framework which consists of the debt and equity used to finance the firm CSA (1994). Firms’ ability to carry out their stakeholders’ requirements is closely related to capital structure. Therefore, this foundation is an imperative piece of information that should not be disregarded. Capital structure in financial term means the way firms finance their assets through the mixture of equity, debt, or hybrid securities (Saad, 2010). In a nutshell, capital structure is a mixture of a company's debts (long-term and short- term), common equity and preferred equity (Akintoye, 2008). Capital structure is fundamentally on how a firm finances its overall operations and growth by using diverse sources of funds (Tsuji, 2011)
In overall economic development, a critically important role is played by micro, small and medium enterprises in Ethiopia. The country relies on these enterprises (to which small scale manufacturing Firms belong) to insure the sustainability of the economic growth. SSMFs’ contribution to the growth and sustainability of the country’s economy both in terms of GDP and employment creation is responsible for over 15% of GDP and over 30% of employment CSA (2004). However, they are still facing difficulty in accessing capital to finance their operation. Thus, this needs to raise a question as to what factors determine their capital structure (important concern to improve financial policies).
Macro and Small Enterprises Agency of Ethiopia defines SSMFs as: “establishments with a paid up capital of more than Birr 20,000 but not exceeding Birr 500,000.” Manufacturing is defined here according to, International Standard Industrial Classification of All Economic Activities (2002) as: “the physical or chemical transformation of materials or components into new products, whether the work is performed by power - driven machines or by hand, whether it is done in a factory or in the worker’s home, and whether the products are sold at wholesale or retail. The assembly of the component parts of manufactured products is also considered as manufacturing activities. Firms, as economic enterprises and as self-help organizations, play a meaningful role in uplifting the socio-economic conditions of their members and their local communities. They are member-owned businesses. The simplest way to understand them is that they aggregate the market power of people who on their own could achieve little or nothing, and in so doing they provide ways out of poverty and powerlessness.
According to CSA (2007/8) there were 43,338 small scale manufacturing establishments in Ethiopian fiscal year (E.F.Y) 2000 (2007). Out of the total, the largest in number, or slightly more than 23 thousand or 53.2 %, were grain mills, 8.6 thousand (19.8 %) furniture manufacturers and metal manufacturing establishments numbered 4.4 thousand or 10.1 % of the total, respectively. On the other end, very few small scale establishments were engaged in chemical, leather and footwear manufacturing, while there were none in the machinery and parts manufacturing in SSMFs, a possible area of focus for policy makers.
During the stated year all the establishments are combined and 138,951 peoples are engaged in it, which are roughly a ratio of 1 to 3.2, i.e., on average in 10 small scale manufacturing establishments 32 people are engaged. A further look reveals that in absolute terms, grain mills employed the most: 70,023 (50.4 %), followed by furniture manufacturers, 34,718 (25.0 %) and metal manufacturers, 15, 031 (11.0 %), in that order. Gross value of production (GVP) in the stated period amounted to birr 2.79 billion, out of which grain mills contributed 1.1 billion, which is 40.0 % of the total. Furniture manufacturers’ GVP reached 635.9 million, which is ahead of metal manufacturers’ GVP (419.6 million). The other notable GVP was, that of food manufacturers amounting to 308.3 million birr or 11.0 %, trailed by non-metallic mineral products manufacturing 116.9 million birr (4.2 %) and wearing apparel manufacturing 115.7 million or 4.1 % of total gross value of production by small scale manufacturing establishments during the year.
According to central statistical industrial census report of 2015 total number functional small scale manufacturing industry was 118000 and around 13% was in Addis Ababa and around 7.9% was in Hawassa. The Federal Negarit Gazeta (1998) defines a cooperative Society as: “an autonomous association established by individuals on voluntary basis to collectively solve their economic and social problems and to democratically manage same. According to Abor (2005), capital structure of a firm is a mix of different securities issued by firms to finance their operations. In general, firms can choose among many alternative capital structures. They can arrange lease financing, issue a large or small amount of debt, sign forward contracts or trade bond swaps. They can issue dozens of distinct securities in combinations; however, they attempt to find the particular combination that minimizes the firm’s cost of capital and thus maximizes firm value (optimal capital structure).
Capital structure decisions are crucial for the financial well-being of any firm. Financial distress, liquidation and bankruptcy are the ultimate consequences lay ahead if any major misjudgment occurred following financing decision of firms. Thus, firms with high leverage need to allocate an efficient mixture of capital that will finally reduce its cost (Kila and Mahmood, 2008). Literatures show that the determination of capital structure appeared to existence since Modigliani and Miller (1958) introduced their capital structure irrelevance preposition in their seminal paper. Since then the determination of capital structure has been one of the most controversial issues in the finance literature. Following the path-breaking work of Modigliani and Miller (1958, 1963), several theories have been advanced to explain capital structure, though studies in the area of capital structure are dominated by three theories: trade-off, pecking order and agency theories. Trade-off theory suggests that firms balance tax savings resulted from debt against bankruptcy costs associated with debt (Myers, 1984). Pecking order theory suggests that firms follow a financing hierarchy: internal finance, where information asymmetry does not exist is preferred first, then, the safest security (debt), and equity as a last option (Myers, 1984).
1.2. Statement of Problem
Capital structure theories, such as trade-off theory, pecking order theory, and agency theory have been developed to explain capital structure. These theories were initially developed referring to the characteristics of large firms (Daskalakis and Thanou, 2010). Most of studies on capital structure theories are conducted using the data set of large firms. According to Jensen and Meckling (1976), agency theory suggests that equity-holders of levered firms can potentially extract value from debt-holders by increasing investment risk to maximize equity value after debt is in place; this leads to conflict of interest between debt-holder sand equity-holders, thereby causes agency costs. Several studies have been conducted in the field of capital structure, though no one could found the optimal capital structure. Myers (2001) states that there is no universal theory of debt-equity choice, and there is no reason to expect. In fact there are several useful conditional theories. Moreover, Kila and Mahmood (2008) suggest that the key to choose appropriate and acceptable level of financial leverage is still debatable, i.e., there are no specific guidelines to assist the attainment of efficient mixture of debt and equity.
These studies have contributed a lot to these theories, i.e., evidence based up on these firms tends to support these theories. However, the validity of these theories in the small firms’ context has been given little attention. The little evidence obtained through empirical investigation of small firms in developed nation (such as Michaelas et al., 1999 who investigated Financial Policy and Capital Structure Choice in U.K. Small and Medium Enterprises (SMEs); and Cassar and Holmes, 2003 who investigated Capital Structure and Financing of Australian SMEs) suggest that most of the determinants of capital structure presented by the aforementioned theories appear to be valid for the small firms. The validity of these theories to small firms in Ethiopia had been checked by Daniel, Kebed (2011),the Determinants of Capital Structure in Ethiopian Small Scale Manufacturing Co-operatives) almost six of determinants of capital structure mentioned in theory are valid , however, has received a very limited attention; there was study conducted on determinants of capital structure in Ethiopian small firms but the study is conducted only on cooperative manufacturing industry firm and short period of time of only five year and also only in one city (Addis Ababa) small sample of 13 firms. This fact reveals a great need for studies to update the existing evidence. This study, therefore, attempts to test the validity of these theories to Ethiopian SSMFs by including private manufacturing industry firm and extending time of data 5 year to 11 year also by increasing sample size and sample area with their data set. And also only focused on internal factors of firms’ capital structure but external variables (macroeconomic) like GDP, Inflation rate and interest rate was not considered in pervious conducted study. These all may cause firms unwanted risk on their capital structure and financial management system of Ethiopian SSMFs, so the researcher was needs to include such variables in the study.
Empirical studies on capital structure have identified various firm level characteristics that influence firms’ capital structure. This section attempts to apply some of these characteristics in the small firms, and develops testable hypotheses that examine the determinants of capital structure of Ethiopian SSMFs. The firm specific variables considered in this study are size, tangibility, profitability, earning volatility, growth and age.
Trade-off theory states that large firms will have more debt since they are more diversified and have lower default risk; as a result, they tend to have higher leverage (Frank and Goyal, 2007). According to pecking order theory by Myers (1984) and Myers and Majluf (1984), in imperfect market firms rely on less information-sensitive securities (such as internal funds and riskless debts) when insiders and outsiders suffer from asymmetric information. Thus, firms tend to issue debt than equity. Based on these theories, the researcher hypothesizes that:
Hypothesis 1: There is a positive relationship between size of the firm and debt ratio.
Titman and Wessels (1988), referring to trade-off theory, suggest that the extent to which the firms’ assets are tangible results in the firm having a greater liquidation value. This reduces the degree of financial loss that financiers may suffer if the firm defaults. Consequently, firms with assets that have greater liquidation value tend to have relatively easier access to debt financing with lower costs by pledging their fixed assets as collateral. Agency theory suggests that equity-holders of leveraged firms have an incentive to invest in risky investment to expropriate wealth from the firm's debtor. However, if the debt can be collateralized, the borrower is restricted to use the funds for a specified project. This indicates positive relation between leverage and the capacity of firms to collateralize their debt (Myers, 1977). Based on these theories, the researcher hypothesizes that:
Hypothesis 2: There is a positive relationship between tangibility of the firm’s assets and debt ratio.
Pecking order theory suggests that firms prefer internal finance first, and then, if external financing is required, they issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last option (Myers 1984). Thus, according to this theory, firms that are profitable and therefore generate high earnings are expected to use less debt capital than those generate low earnings. Consistent with this theory, Titman and Wessels (1988) also suggest that firms with high profit tend to maintain relatively lower debt ratios since they generate funds from internal sources (retained earnings). Benchmarking this theory, the researcher hypothesizes that:
Hypothesis 3: There is a negative relationship between profitability of the firm and debt ratio.
Earnings volatility is considered to be either the inherent business risk in the operations of a firms or a result of inefficient management practices. In either case earnings volatility is proxy for the probability of financial distress and the firm will have to pay risk premium to outside fund providers. To reduce the costs of capital, firms will first use internally generated funds and then outside funds. This suggests that earnings volatility is negatively related with leverage. This is simply represented by internally generated fund before tax. This is the combined prediction of trade-off theory and pecking order theory. Following the prediction of these theories, the researcher hypothesizes that:
Hypothesis 4: There is a negative relationship between earnings volatility of the firm and debt ratio.
According to agency theory, equity-controlled firms have a tendency to invest in risky investments to extract wealth from the firm's debt-holders. The cost associated with this agency problem is likely to be higher for firms in growing industries, which have more flexibility in their choice of future investments. In addition, growth opportunities are capital assets that add value to a firm but cannot be collateralized and do not generate current taxable income (Titman and Wessels, 1988). According to Daskalakis and Thanou (2010), high-growth firms are most likely to exhaust internal funds and use debt as a good alternative in their search for additional capital, as raising equity may be difficult and time-consuming for smaller firms. Basing on these arguments, the researcher hypothesizes that:
Hypothesis 5: There is a negative relationship between growth of the firm and debt ratio.
According to agency theory of Jensen and Meckling (1976), financiers use reputation of the firms as a measure of their creditworthiness. Managers concerned with a firm’s 31 reputation tend to avoid riskier investments in favor of safer investments, even when equity-holders do not approve the safer investment, thus reducing debt agency cost. Given this, the firm’s reputation become a valuable asset in the management of relations between equity-holders and debt-holders. Thus, benchmarking this theory, the researcher hypothesizes that:
Hypothesis 6: There is a positive relationship between age of the firm and debt ratio.
GDP Growth Rate
GDP growth factor as measured by annual real gross domestic product growth rate reflects how much a country’s overall economy is growing as compared to its own one year lagged value. As noted in Frank and Goyal (2004), Trade off theory predicts a positive impact of GDP growth rate of a country on leverage of firms operate within that country. This positive prediction implies that firms will have more debt level in the period of higher economic growth than did in lower economic growth. Results of empirical studies including Cekrezi (2013) and Bas et al. (2009), confirmed positive relationship of GDP growth rate and leverage. Consequently, in this study GDP factor represented by annual real gross domestic product of an economy and hypothesized to have a direct impact on leverage.
Hypothesis 7: There is a significant positive relationship between GDP growth rate of Ethiopian economy and leverage of SSMFs in the country.
In studies pertaining to capital structure determinants, most commonly interest rate factor is measured with lending rate of commercial banks within a country. Interchangeably, lending rate represents a cost that firms incur in order to raise debt. Under pecking order theory, there is no effect, or else an increase in the interest rate will tend to reduce debt level (Frank and Goyal, 2004). On the other hand, trade off theory predicts a positive relationship between interest rate and leverage of firms, in that firms will prefer more debt because an increase in interest rate would highly increase the cost of equity (Frank and Goyal, 2004). Researchers including Bas et al. (2009) and Cekrezi (2013) confirmed such a positive prediction of trade off theory for the relationship between interest rate and leverage. Thus, in the present study, interest rate measured as an average lending rate of commercial banks in Ethiopia and expected to have a positive relation with the dependent variable.
Hypothesis 8: There is a significant positive relationship between interest rate and firms’ leverage in Ethiopian SSMFs.
The third and the last macroeconomic variables employed for this study’s purpose was inflation rate and measured by annual general inflation rate in Ethiopia. Trade-off theory postulates a positive relationship between leverage and expected inflation. As cited in Frank and Goyal(2005), Taggart (1985) explained that such a positive relation of inflation and leverage is mainly due to features of the tax code, implying that the real value of tax deductions on debt is higher when inflation is anticipated to be high. Empirical studies including Frank and Goyal (2004) and Tesfaye and Minga (2012) confirmed such a positive relation of inflation rate and debt level. In line with the tradeoff prediction and empirical findings, the researcher of this study hypothesized annual inflation rate variable to have a positive impact on debt level.
Hypothesis 9: There exists a significant positive relationship between inflation rate and SSMFs firms’ leverage in Ethiopia.
1.4. Objectives of the Study
1.4.1 General objective
Generally objective of the study aims at investigating the determinants of capital structure of SSMFs in Ethiopia, there by attempts to test the validity of dominant capital structure theories to the manufacturing industry in both co-operatives and private firms.
1.4.2 Specific objective
Specifically, the study attempts to address the following objectives:
- To investigate the variability of capital structure with the size of the firms;
- To investigate The influence of tangibility of firms’ assets on capital structure;
- To investigate The extent to which profitability influences the capital structure of the firms;
- The influence of earnings volatility on firms’ capital structure;
- To investigate the variability of capital structure with the growth of the firms;
- To investigate the influence of firms’ age on its capital structure ;
- To investigate the influence of macroeconomic variables(GDP, Inflation rate and interest rate) on firms capital structure;
1.5. Research questions
The researcher wants to explore the current study with reference to the following research questions:
What are the most important firm specific determinants of capital structure of SSMFs in Ethiopia?
What are the most important macroeconomic determinants of capital structure of SSMFs in Ethiopia?
1.6. Significance of the Study
SSMFs play a vital role in Ethiopian economy both in terms of contribution to GDP and employment creation. And also study will have significance for various parties Such as:-
- The study alerts the government to strive to set up a financial infrastructure to support these firms.
- Thus, in explaining the determinants of capital structure of Ethiopian SSMFs, the findings turn out to be relevant to add knowledge to the existing literature.
- Moreover, for further studies in the area of capital structure determinants.
- The study will be important for management bodies of Firms by suggesting major factors those will influence their financing decision and the most prominent theory they have to care of as well.
- This study will be significant for current business of Ethiopian current manufacturing firms and
- For new firms of SSMFs in Ethiopia by giving an ample knowledge and direction about influential factors those can affect capital structure and their implication for firms in Ethiopian industry sector and it will also enable firms to know how they have to treat such factors in order to achieve an optimal capital structure decision there by enabling to minimize a cost of capital and maximizing their firm’s value..
- This study will be serves as a benchmark and a good reference for other researchers in the future those will conduct their research in relation with capital structure determinants in general and in case of Ethiopian manufacturing industry sector in particular.
1.7. Scope and Limitation of the Study
The scope of the study is limited to investigating the firm specific determinants of capital structure of SSMFs. In addition, it is limited to the SSMFs located in Addis Ababa and Hawassa city. Addis Ababa city and Hawassa are chosen as a population sample area because of that most SSMFs are located in it. As our country consideration annual financial statement and auditing system of SSMFs is not fully available for all firms. So audited financial data has led the researcher to limit the number of sample of 20 firms and 11 years audited report in both cities of Ethiopia. Almost all of SSMFs maintain only two financial statements: balance sheet and income statement. In addition, they do not maintain separate account for short-term and long-term rather they report their debt as total debt. There are also no figures that show dividend account at all, and most of them do not have interest expense account in their financial statements. All these facts led the researcher to minimize the potential determinants of capital structure to nine. Not only that the data handling and management system is too poor this affect researcher CLRM assumption test of normality and the degree of dependent explained by explanatory variable.
1.8. Organization of the Paper
The body of this paper structured with five chapters and different sub sections with in. Chapter 1 deals with Introduction parts starting with background of the study then followed by problem statement, study objectives, hypothesis, , significance, scope, and finally limitations of the study. Chapter 2 presents Review of Literature which includes a discussion of theoretical as well as empirical works then end with conclusion and conceptual frame. Chapter 3 discusses about data and methodologies used by the researcher to conduct multiple linear regression analysis. Chapter 4 is all about data analysis and discussion of results; whereas chapter 5 present conclusions and recommendations of the study.
2. LITERATURES REVIEW
2.1. Definition of Capital Structure and Small Scale Manufacturing Industries
Capital structure represents a firm's financial framework which consists of the debt and equity used to finance the firm. Firms’ ability to carry out their stakeholders’ requirements is closely related to capital structure. Therefore, this foundation is an imperative piece of information that should not be disregarded. Capital structure in financial term means the way firms finance their assets through the mixture of equity, debt, or hybrid securities (Saad, 2010). In a nutshell, capital structure is a mixture of a company's debts (long-term and shortterm), common equity and preferred equity (Akintoye, 2008). Capital structure is fundamentally on how a firm finances its overall operations and growth by using diverse sources of funds (Tsuji, 2011). The foremost contemporary theory of capital structure started with the article of Modigliani and Miller (1958). Since, then, various studies have been carried out to investigate the optimal capital structure in the absence of Modigliani-Miller’s assumption. According to MM Theorem, capital structure theories function under perfect market condition.
2.2. Theories of Capital Structure
In corporate finance, as the literature indicated, one of the most important questions about capital structure today is whether firms have target debt ratios or not (Graham and Harvey, 2001). To examine such issues, the path-breaking works of Modigliani and Miller (1958; 1963) has paved the way for the development of capital structure theories. The seminal work of Franco Modigliani and Merton Miller (1958, 1963) made a significant contribution to the understanding of the corporate debt policy. Modigliani and Miller (1958) initiate the theory of capital structure in their path-breaking work on the effects of capital structure on the firm’s value. They demonstrated that in a world of no income taxes, the capital structure is irrelevant for determining the value of firms, rather the value of firms depends on their operating income; thus levered and unlevered firms should have similar value. Their next paper, Modigliani and Miller (1963) demonstrated that the introduction of corporate taxes allowed firms to deduct interest on debt in computing taxable profit. This is the tax benefit created as the interest payments associated with debt are tax deductible. Thus, firms maximize their values by maximizing the use of debt. This suggests that tax advantages derived from debt leads firms to be completely financed through debt. However, the fact that this proposition is not in accordance with reality, led the authors themselves to argue for the relevance for bankruptcy costs. Pettit and Singer (1985) cited in Abor (2008) also argue that increasing debt results in an increased probability of bankruptcy. Hence, the optimal capital structure represents a level of leverage that balances bankruptcy costs and benefits of debt finance. Moreover, Jensen and Meckling (1976) argue that bankruptcy costs are not the only costs; agency costs are also relevant to a firm’s capital structure. Accordingly, because of the unrealistic assumptions in Modigliani and Miller irrelevance theory, researches on capital structure gave birth to other theories. Following the path-breaking work of Modigliani and Miller (1958, 1963) on capital structure, the following three conflicting theories of capital structure have been developed: trade-off, pecking order, and agency theories.
2.2.1. Trade-off Theory
The theoretical foundation for the trade-off theory comes from Modigliani and Miller (1963), which suggests that the optimal capital structure is all debt because of the tax deductibility of interest expense. Castanias (1983) extends the Modigliani and Miller (1963) theorem by including the possibility of financial distress costs. Thus, the idea of the trade-off theory is that an optimal capital structure at which the firm maximizes its value and minimizes its cost of capital exists; it can be attained when the benefits and costs of debt exactly offsets (Myers, 1984). Miller (1977), however, argues that bankruptcy costs are too small to affect optimal capital structure; he also argues that taxes are irrelevant to the firms’ debt to equity choice. Pettit and Singer (1985) cited in Kashefi-Pour and Lasfer (2010) argue that for small firms, the tax advantages of debt may be negligible. They argue that small firms tend to operate in less concentrated markets. Greater competitive pressures and lower profits margins would result in lower tax rates. Therefore, they may not take the tax benefits of debt. While large firms are those firms with diversified business lines and higher profits margins resulting in greater tax advantages.
2.2.2. Pecking Order Theory
Pecking order theory is from Myers (1984) and Myers and Majluf (1984). The pecking (preference) order theory of capital structure is among the most influential theories of capital structure. Its concept is that firms follow a certain hierarchy of preferences for different types of finance, reflecting their relative costs with the ranking being: internal finance is preferred first, then, the safest security (debt), and equity as a last option. Internal financing is preferred first because it incurs no flotation costs and requires no disclosure of the firms’ financial information that may include firms’ potential investment opportunities and gains that are expected to accrue as a result of undertaking such investments. Thus, this theory suggests that profitable firms, firms with significant amount of retained earnings, tend to maintain low level of debt in their capital structure. Myers and Majluf (1984) and Myers (1984) consider the asymmetric information to observe the pecking order theory under which leverage increases with the extent of information asymmetry. They argue that in imperfect capital markets, there are information asymmetries between firm insiders and outsiders (investors). Insiders might have more information about the firms’ assets in place and its future investment opportunities. This is not reflected in the stock price since outside investors have only access to public information. Thus, according to the pecking order theory, external sources of capital are subject to adverse selection. Outsiders are aware of their relative ignorance and demand a premium on their investment returns. For this reason, firms prefer to finance their investments with the least information sensitive securities, such as internal funds or riskless debts. In contrast, Rajan and Zingales (1995) argue that informational asymmetries between firm insiders and the capital markets are lower for large firms. So large firms should be more capable of issuing informational sensitive securities like equity, and should have lower debt. In small firms context, Pettit and Singer (1985) cited in Kashefi-Pour and Lasfer (2010), argue that asymmetric information is typically significant for smaller firms. It is more costly for small firms to provide audited information, and thus outsiders do not have sufficient information about firms' value. Thus, small firms follow pecking order theory.
2.2.3. Agency Theory
Agency theory initiated by Jensen and Meckling (1976) suggests that agency costs arise from the conflict of interest between debt-holders and equity-holders. Commonly, managers, being part of the owners, tend to collaborate with equity-holders, thus if the firm is approaching financial distress, equity-holders may encourage managers to pass decisions, which, in effect, extract wealth from debt-holders to equity-holders (Buferna etal., 2005). If managers pass the decision to invest the raised fund in the risky investment in an intention to extract wealth from debt-holders, then the conflict of interest arises. According to Myers (1977), if the investment is successful, the benefits are enjoyed solely by equity-holders, i.e., debt-holders receive only the fixed interest on the capital they invested. In contrast, if the investment fails, the firm may default on debt, and then debt-holders suffer a lot since they cannot look beyond the assets of the corporation for satisfaction of their claims. This is because the liability is limited to the corporation. Thus, sophisticated debt-holders tend to monitor the firms’ behavior. Consequently, costly monitoring devices are included into debt agreements, thereby increasing the cost of capital offered to the firm. Thus, firms with relatively higher agency costs tend to maintain lower level of debt. However, the agency problem can be mitigated if the debt is secured with collateralize able tangible assets (Esperanca, 2003). This indicates that financiers may not be the losers, if the borrower firm goes bankrupt, i.e., at least the principal amount can be compensated by selling the collateralized tangible asset.
2.3. The Determinants of Capital Structure
According to Harris and Raviv (1991), theories of capital structure have identified a large number of potential determinants that might have an impact on debt levels. Among these factors, which have been found by a large number of studies to influence the firms’ capital structure are size, tangibility, profitability, risk, non-debt tax shield, growth, uniqueness, dividends, free cash flow, liquidity, age, and regulation. This section briefly discusses what theories of capital structure suggest about the relationship between capital structure determinants considered in this study (size, tangibility, profitability, earning volatility, growth, and age) and leverage. It also discusses both theoretical and empirical evidence related to the determinants of capital structure.
Trade-off theory states that large firms will have more debt since larger firms are more diversified and have lower default risk; as a result, they tend to have higher leverage (Frank and Goyal, 2008). On the other hand, smaller firms tend to have lower debt ratio when the relative bankruptcy costs are an inverse function of the firms’ size (Titman and Wessels, 1988).According to pecking order theory by Myers (1984) and Myers and Majluf (1984), in imperfect market firms rely on less information-sensitive securities (such as internal funds and riskless debts) when insiders and outsiders suffer from asymmetric information. Thus, firms tend to issue debt than equity.
In contrast, Frank and Goyal (2008) suggest that the pecking order theory is usually interpreted as predicting an inverse relation between leverage and firm size. The argument is that large firms have been around longer and are better known. Thus, they face lower adverse selection and can more easily issue equity compared to small firms where adverse selection problems are severe. Referring to agency theory, they also suggest that large firms have a reputation in debt markets and consequently face lower agency costs of debt. Titman and Wessels (1988) find a negative relation between size and long-term debt and positive relation between size and short term debt. They argue that cost of issuing debt and equity securities is also related to firm size. In particular, small firms pay much more than large firms to issue new equity and also somewhat more to issue long-term debt. This suggests that small firms may be more leveraged than large firms and may prefer to borrow short term rather than long-term debt because of the lower fixed costs associated with this alternative. The impact of size on leverage is ambiguous. Several empirical studies, however, reveal a positive relationship between size and leverage of the firms, i.e., support the trade-off and agency theories (Hovakimian et al., 2004; Buferna et al., 2005; Nguyen and Ramachandran, 2006; Eriotis et al., 2007; Saeed, 2007; Abor, 2008; Salawu and Agboola, 2008; Smith, 2010; Yazdanfar, (2013); Bhaird and Lucey, (2006); and Munyo, (2011).Their results suggest that smaller firms are more likely to use equity finance, while larger firms are more likely to issue debt. In contrast, Kila and Mahmood, 2008; and Ramlall, 2009, suggest a negative relationship between size and leverage of the firm, i.e., support the pecking order theory. Amidu (2007), found profitability, corporate tax, growth opportunity, asset tangibility, and size factors to influence banks capital structure in Ghana. In more specific manner, he emphasized that size factors to have significant and positive influence on total debt as well as short term debt ratios; whereas profitability and tangibility appeared a significant negative relationship with short term as well as total leverage of Ghanaian banks. Amidu (2007) also found that firm growth, and size variables to affect long term leverage negatively and significantly; whereas profitability and tangibility established a positive link with long term debt level of banks.
Cardone-Riportella and Cazorla-Papis (2001) measuring size by the number of employees, volume of sales and volume of assets found a negative relationship between size and total borrowing ratio. Gidey (2005) suggests that size of average income measured in logarithmic function indicates a negative relationship with debt financing. Thus, he concluded that Micro and Small Enterprises finance their capital requirements from equity sources and later on may raise debt finance when they grow. Shah and Khan (2007) also by studying the determinants of capital structure of Karachi Stock Exchange listed non-financial firms for the period 1994-2002 based on Pakistani panel data, found a negative relationship between size and leverage. Then, they suggest that as debt increases the chances of bankruptcy, hence smaller firms should have lower debt ratio. Cassar and Holmes (2003), Esperança et al. (2003), Hutchinson (2003) and Hall et al.(2004) found a positive association between firm size and long-term debt ratio, but a negative relationship between size and short-term debt ratio. This indicates that large sized firms use long-term debt rather than short-term debt to finance their operation. Beyene (2005) by studying the determinants of capital structure decision of Medium Enterprises in Ethiopia based on a panel data over the period 1991 - 1996 EC, found a positive relationship between size and leverage. Thus, he suggests that as firms grow in size, they tend to become a candidate for debt. Kashefi-Pour and Lasfer (2010) basing on the panel data they found size being positively related to leverage across firms’ sizes (small, medium, and large firms). Thus, they concluded that large firms use more debt in their capital structure compared to small companies. Bas et al. (2009) also by examining the differences in the determinants of capital structure decisions of private and listed firms, and small and large firms in developing countries, found size being positively related to leverage. Thus, they concluded that as firms get larger, their debt increases. This conclusion indicates that large firms have positive association with leverage, while small firms have negative association. Morri and Cristanziani (2009) found a positive relationship between size and leverage. Thus, they suggest that bigger firms can borrow at more favorable rates because they are perceived as less risky. Moreover, the economies of scale reached in case of debt issues by bigger firms by smoothing the amount of fix costs over a larger mass, represent a considerable cost advantage that can redirect financing choices. Daskalakis and Thanou (2010) by examining a number of hypotheses relating to the capital structure decision in relation to the firms’ size, i.e., distinguishing among micro, small and medium firms they found size of the firm being positively related to leverage .And, concluded that larger firms are associated with higher debt, as found by other studies and supported by theoretical considerations.
Agency theory suggests that equity-holders of leveraged firms have an incentive to invest in risky investment to expropriate wealth from the firm's debt-holders. If debt can be collateralized, the borrowers are restricted to use the funds for a specified project. Since no such guarantee can be used for projects that cannot be collateralized, creditors may require more favorable terms. This reveals a positive relation between debt ratios and the capacity of firms to collateralize their debt (Jensen and Meckling, 1976).
Titman and Wessels, (1988) referring to the trade-off theory suggest that the extent to which the firm’s assets are tangible results in the firm having a greater liquidation value. This reduces the degree of financial loss incurred by financiers if the firm defaults. Consequently, firms with assets that have greater liquidation value tend to have relatively easier access to finance with lower costs of financing. Under the pecking order theory, Harris and Raviv (1991) argue that the low information asymmetry associated with tangible assets makes equity financing less costly, resulting in a negative relation between leverage and tangibility. According to Nguyen and Ramachandran (2006), firms with high collateralize able tangible assets tend to have easier access to debt by pledging those assets as collateral .Shah and Khan (2007) suggest that firms with large amount of fixed assets tend to incur debt at relatively lower rate of interest by providing these assets to creditors as an assurance. Thus, firms with higher percentage of fixed asset tend to borrow more as compared to firms whose cost of borrowing is higher because of having less fixed assets. Bradley et al. (1984) also suggest that firms that invest a lot in tangible assets have higher financial leverage since they borrow at lower interest rates if their debt is secured with such assets. Most of empirical studies suggest a positive relationship consistent with theoretical argument between tangibility and leverage of the firms, i.e., support the trade-off and agency theories (Bradley et al., 1984; Esperança et al., 2003; Hovakimian et al., 2004; Shah and Khan, 2007; Salawu and Agboola, 2008; Ramlall, 2009; Teker et al., 2009; and Smith, 2010). In contrary, Buferna et al. (2005) and Nguyen and Ramachandran (2006) suggest a negative relationship between tangibility and leverage, i.e., support the pecking order theory. Beyene (2005) by studying the determinants of capital structure decision of Medium Enterprises in Ethiopia based on a cross sectional data over 1991 to 1996 EC, found a negative relationship between tangibility and leverage. Thus, he suggests that as Ethiopian Medium firms kept more and more fixed assets, they become attractive to debt. Daskalakis and Thanou (2010) in examining a number of hypotheses relating to the capital structure decision in relation to the firms’ size, i.e., distinguishing among micro, small and medium firms they found tangibility being negatively correlated with leverage. This result leads them to the conclusion that firms view tangible assets as a stable source of return which provides more internally generated funds and leads firms to use less debt, following the pecking order theory. Kashefi-Pour and Lasfer (2010), in contrast, found that consistent with the trade-off theory, strong evidence concerning the significant positive relationship between debt ratio and tangibility across firms’ sizes listed in the U.K Main and AIM markets. Hutchinson (2003), Cassar and Holmes (2003), Hall et al. (2004), Yazdanfar (2013) and Bas et al. (2009) specifically suggest a positive relationship between tangibility and long-term debt, and a negative relationship between tangibility and short-term debt. The conclusion of their finding is that firms with a large proportion of fixed assets tend to maintain a higher long-debt than other firms. Esperança et al. (2003), however, suggest a positive relationship between tangibility and both long-term and short-term debt. Marsh (1982) agrees that firms with few fixed assets are more likely to issue equity, thus, positive relationship between tangibility and leverage. Munyo, I (2011) also found tangibility of assets being positively related to long-term debt, thus, suggests that firms with a bigger proportion of tangible assets are more likely to be finance through debt.
The pecking order theory explains the relationship between firm profitability and capital structure. It suggests that firms prefer internal finance first, and then, if external financing is required, they issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort Myers (1984). According to this theory, firms that are profitable and therefore generate high earnings use less debt capital than those generate low earnings, thus it suggests an inverse relationship between profitability and leverage. Consistent to this theory, Titman and Wessels (1988) suggest that firms with high profit end to maintain relatively lower debt ratios since they generate funds from internal sources (retained earnings).In contrast, trade-off theory predicts that profitable firms have more debt since bankruptcy costs are lower and interest tax shields are more valuable for profitable firms, Frank and Goyal(2008). Profitable firms are more attractive to financial institutions as lending prospects; therefore they can always take on more debt capital Ooi(1999). This theory suggests a positive relationship between profitability and debt. Empirical studies typically seem to be consistent with the pecking order theory, i.e., several studies found a negative relationship between profitability and leverage (Cassarand Holmes (2003); Esperança et al.,(2003); Hutchinson, (2003); Hall et al., (2004); Frielinghaus et al., (2005); Buferna (2007); Morri and Cristanziani, (2009); Bas et al., (2009); Ramlall,(2009); Smith, (2010); Yazdanfar, (2013).; and Munyo, (2006). In contrast, the findings of Salawuand Agboola (2008), Teker et al. (2009), and Kashefi-Pour and Lasfer (2010) are consistent with trade-off theory suggesting a positive association between Profitability and leverage. Daskalakis and Thanou (2010) by examining a number of hypotheses relating to the capital structure decision in relation to the firms’ size, i.e., by distinguishing among micro, small and medium firms they found profitability being negatively related to leverage. Having this result, they concluded that firms that generate relatively high internal funds tend to avoid debt financing. Beyene (2005) in examining the determinants of capital structure decision in Medium Enterprises in Ethiopia using a cross sectional data over 1991 to 1996 EC, found a strong negative relationship between profitability and leverage because of the accessibility of internal funds. Abor (2005) evaluated the relationship between capital structure and profitability of listed firms on the Ghana Stock Exchange (GSE) during a five-year period (1998-2002). His results revealed a positive association between short-term debt and profitability, suggesting that profitable firms use more short-term debt to finance their operation. His results also revealed a negative association between long-term debt and profitability. Regarding the relationship between total debt and profitability, his regression results revealed a positive association between total debt and profitability. This suggests that profitable firms depend more on debt as their main financing option.
2.3.4. Earnings Volatility
Tradeoff theory suggests that earnings volatility is a proxy for the probability of financial distress and firms are expected to pay risk premium to outside fund providers. Thus, it predicts an inverse relationship between earnings volatility and leverage. The pecking order theory also predicts the same and it suggests that to reduce costs of capital caused by earnings volatility, firms tend to use internally generated funds first and then outside funds. According to Cassar and Holmes (2003), if firms are likely to be exposed to agency and bankruptcy costs, they tend to reduce the level of debt within their capital structure. One factor that impacts such exposure is firms operating risk, i.e., the more volatile firms earnings streams, the greater the chance of the firms defaulting and being exposed to such costs. Consequently, these firms with relatively higher operating risk will have incentives to have lower leverage than firms with more stable earnings. Shah and Khan (2007) also suggest that the magnitude of earnings volatility is a sign of expected bankruptcy. Firms with higher volatility are considered risky because they can go bankrupt. The cost of debt for such firms should be more and thus these firms tend to employ low level of debt within their capital structure. Kim and Sorensen (1986) state that it is sometimes argued that firms with high degrees of business risk have less capacity to sustain high financial risk, and thus will use less debt. In contrast Myers (1977) states that “We have an interesting, perhaps surprising, conclusion. The impact of risky debt on the market value of the firm is less for firms holding investment options on assets that are risky relative to the firms’ present assets. In this sense we may observe risky firms borrowing more than safe ones”. In addition, Michaelas et al. (1999) pointed out that bankruptcy costs are not significant enough to ensure a negative relationship between risk and leverage. Thus, suggest positive relationship between risk and leverage. Empirical studies seem to be contradictory. Some studies have indicated an inverse relationship between risk and leverage, i.e., support both the tradeoff and the pecking order theories (Bradley et al., 1984; Titman and Wessels, 1988; Cassar and Holmes2003). In contrary, Kim and Sorensen (1986), Jordan et al. (1998), Michaelas et al.(1999) and Esperança et al. (2003) suggest a positive relationship. Abor (2008), by comparing the capital structures of publicly quoted firms, large unquoted firms, and small and medium enterprises (SMEs) in Ghana, found an inverse relationship between risk and long-term debt ratio in all the sample groups, implying that firms with high risk levels exhibit low long-term debt ratios. And he suggests that such firms avoid accommodating more financial risk by employing less long-term debt. For SMEs and the quoted firms’ samples, however, his results indicate a positive relationship between risk and short-term debt ratio. And he suggests that higher risk may force firms to demand short-term debt.
The pecking order theory suggests that firms with higher growth opportunities need external finance to cover their investments when they do not generate enough internal funds (Myers and Majluf, 1984). Moreover, this theory predicts that firms with more investments should accumulate more debt over time (Frank and Goyal, 2008). Thus, according to this theory, growth and leverage are expected to be positively related. In contrast, both the trade-off and agency theories predict a negative relation between leverage and growth. The former suggests growth firms lose more of their value when they go into distress, and the later suggests as growth options increase, asset substitution problems also become more severe. In high growth firms, it is easier for equity-holders to increase project risk and it is harder for debt-holders to detect such changes. Thus, debt is more costly for firms with high growth opportunities. Myers (1977), referring to agency theory, holds the view that firms with growth opportunities will have a smaller proportion of debt in their capital structure. This is because conflicts of interest between debt and equity holders are especially serious for assets that give the firm the option to undertake such growth opportunities in the future. The benefits of this growth, if realized, will not be enjoyed by lenders who will only recover the amount of their loans, resulting in a clear agency problem. This will be reflected in increased costs of debt that leads firms to maintain low level of debt in their capital structure. Titman and Wessels (1988) also suggest that equity-controlled firms have a tendency to invest borrowed funds in risky investments to transfer wealth from the firm's debt-holders to equity-holders. The costs associated with this agency problem are likely to be higher for firms in growing industries, which have more flexibility in their choice of future investments. In addition, growth opportunities are capital assets that add value to a firm but cannot be collateralized and do not generate current taxable income. These arguments suggest a negative relationship between growth and leverage. Empirical evidence seems inconclusive. Most of studies found negative relationships between growth and leverage, i.e., support the trade-off and agency theories (Buferna etal., (2005); Eriotis et al., (2007); Shah and Khan, (2007); Kila and Mahmood, (2008); Salawu and Agboola, (2008); Morri and Cristanziani, (2009); Ramlall, (2009); and Yazdanfar, (2013).In contrast, Michaelas et al. (1999), Hutchinson (2003), Cassar and Holmes (2003) Hallet al. (2004), Nguyen and Ramachandran (2006), Saeed (2007) and Smith (2010) suggest positive relationship between growth and leverage, i.e., support the pecking order theory. Bas et al. (2009) found growth being positively related to long-term debt ratio, while negatively related to short-term debt ratio. Hall et al. (2004) suggest that growth tends to place a greater demand on internally generated funds and push the firm into borrowing. Marsh (1982) also suggests that firms with high growth tend to maintain relatively higher debt ratios. Daskalakis and Thanou (2010) in examining a number of hypotheses relating to the capital structure decision in relation to the firms’ size, i.e., distinguishing among micro, small and medium firms they found growth being positively related to debt for all groups of firms. The result leads them to the conclusion that high-growth firms are most likely to exhaust internal funds and use debt as a good alternative in their search for additional capital, as raising equity may be difficult and time-consuming for smaller firms. Beyene (2005) in examining the determinants of capital structure decision of medium enterprises in Ethiopia based on a panel data over 1991 to 1996 EC, found a negative relationship between growth and leverage. Thus, suggests that as Ethiopian Medium Enterprises desire to expand their operation increases, their desire to use debt declines. Kashefi-Pour and Lasfer (2010) with respect to the agency conflict between share-holders and debt-holders, also found a negative relationship between leverage and growth opportunities in large companies, whereas, positive relationship in small companies.