Capital Structure in Developing Countries - Essay Example

Capital structure in developing countries By + Top of Form Bottom of Form This study uses current data set to evaluate whether capital structure theory is applicable across countries having different company structures. The paper analyses capital structure choices of firms in a developing country, Saudi Arabia, and provides evidence that these decisions are affected by the same variables as in developed countries (Bierman, 2003). However, there are determined variations across countries, showing that given country factors are being used (DeMarzo & Sannikov, 2004). Our findings suggest that though some of the perceptions from recent finance theory are applicable across countries, much is still to be done to bring out the effect of different institutional features on capital structure choices. Our knowledge of capital structures has mostly been derived from data from developed economies that have many institutional similarities. The purpose of this paper is to analyse the capital structure choices made by companies from developing countries that have different institutional structures (Artikis, 2007). The study also is to examine the determinants that can be used in capital structure choices of firms. This is mainly for small and private firms. In the study, there was use of data obtained from World Bank to determine the differences that exist in capital structure in the countries (DeMarzo & Sannikov, 2004). Introduction In accordance with the capital structure theory, the importance of firm level elements of capital structure, tangibility in terms of assets, and profitability of firms and size of companies are brought out. Results are healthy to the different descriptions of size. Large and listed firms can have easy access to finance in developing countries, thus they have higher leverage and higher debt maturities (Bierman, 2003). For small and private firms, access to finance is depended on the conditions of economic environment. Leverage and debt maturities are sensitive to macroeconomic factors. The knowledge on the capital structure in the essay was also used to analyse the choices that are made by institutions, mainly from developing countries that have different structures in their institutions. As in Gordon and Li (2005), profitability is measured using the return on sales (ROS), return on assets (ROA) and return on equity (ROE). With respect to leverage, there are several measures in the literature. Following Gordon and Li (2005), the paper considers the following ratios: Total Debt to Total Assets ratio and total debt to equity ratio. Findings From analysis, it was found out that financial decisions that are made on finances are different in developing countries. In the approach, there was use of aggregate flow of funds to bring out the difference between financial system of Anglo Saxon model and those from Continental-Germany Japanese banking model (Bierman, 2003). The problem that came out from this approach is that the data obtained comes from aggregate flow of funds without considering individual firms. The differences between private, public, and foreign ownership structures have a profound influence on such data. The weakness is that it does not indicate how groups that are profit oriented make their individual financial decisions (Blouin, 2014). In studies that have been conducted, there are key independent variables that have been used to compare and determine capital structure in developed countries. The elements that have been used include measure of profitability, tangibility of asserts and market to book ratio (Blouin, 2014). The other consideration that was made in capital structure was difference in debt and capital structures according to size. The coefficient estimate for asset tangibility is positive, suggesting that small firms borrow more long-term debt as their tangible assets increase. The coefficient estimate for profitability is negative (Comin, 2009). As profitability increases, small firms prefer to use internal sources. Macroeconomic variables have significant impact on the long-term debt of small firms. The coefficient estimate for GDP per capita, growth and inflation are positive. As GDP per capita, growth, and inflation increase, long-term debt increases (Comin, 2009). The coefficient estimate for interest and tax are negative, indicating that increases in interest and tax cause long-term debt to decrease. As asset tangibility increases, small firms borrow less. The coefficient estimate for profitability is negative, indicating that profitable small firms borrow less. The macroeconomic factors have also effect on leverage decisions of small firms. The impact of GDP per capita is positive, suggesting that as countries become richer, more funds become available and small firms borrow more (Cummins & Mahul, 2009). The coefficient estimate for growth is positive. As economy grows, leverage increases. Inflation has negative coefficient approximation suggesting that an increase in inflation significantly decreases leverage. Interest has no effect on leverage decisions of small firms. The coefficient approximation for tax is positive, implying that as tax increases, small firms borrow more (Cummins & Mahul, 2009). For small firms, firm level variables have an inverse impact on leverage of medium firms. The coefficient estimate for tangibility is negative, indicating that medium firms with more collateral borrow less. The coefficient estimate for profitability is negative, implying that medium firms with more profits prefer internal sources to debt financing. GDP per capita and tax have no impact on the leverage decisions of medium size firms (DeMarzo & Sannikov, 2004). The coefficient estimate for growth is positive, indicating that as economy grows, and medium firms borrow more. The coefficient estimate for inflation is negative. Capital structure of Saudi Arabia The data used in the study was mainly obtained from one of the developing countries, Saudi Arabia. The data used in the analysis of capital structure of the country was obtained from Finance Department, College of Business Administration, King Saud University, Saudi Arabia. Finance Department, College of Business Administration, King Saud University, Saudi Arabia got involved in determination of short-term ratio, debt ratio and long-term ratio. Influence of capital on firms in Saudi Arabia was also determined. There are many theories that came out in the analysis, which was thought to apply in many developing countries. The theories, which were brought out to determine the effect of capital structure, were trade-off theory and perking order theory where different variables are thought to contribute to decisions that are made on capital structures in companies (DeMarzo & Sannikov, 2004). According to trade-off theory, a firm’s best debt ratio is brought out by a trade-off between the bankruptcy total and tax benefit of borrowing (Froot, 2003). Higher profitability leads to reduction in the predictable costs of suffering and enable firms raising their tax profits by increasing leverage. Firms would opt for debt more than equity up to the point where the chance of financial suffering starts to be significant (DeMarzo & Sannikov, 2004). The type of assets that a firm has determines the cost of financial distress (Froot, 2003). For instance, if a firm invests largely in land, equipment and other tangible assets, it will have smaller costs of financial risk than firms relying on intangible assets will. Therefore, for debt financing, both small and large firms must provide some kind of guarantees materialized in collateral (DeMarzo & Sannikov, 2004). However, small firms are seen as risky because they have higher probability of insolvency than large firms do. On the other hand, tax advantage of borrowing can be applied to large firms, which are more likely able to generate high profits. However, for small firms, since they are less likely to have high profits, the tax advantage may not be the option to choose debt financing for the tax shields advantage. Tax system in the country was brought out as a unit code referred to as Zakat (Gordon & Li, 2005). According to pecking order theory, capital structure is driven by a firms desire to finance new investments. Therefore, the firms prefer internal financing to external financing. This theory is applicable for large firms as well as small firms (DeMarzo & Sannikov, 2004). Since small firms are opaque and have important adverse selection problems that are explained by credit rationing; they bear high information costs. Also since the quality of small firms financial statements vary, small firms usually have higher levels of asymmetric information. Even though investors may prefer audited financial statements, small firms may want to avoid these costs (Bierman, 2003). Therefore, when issuing new capital, those costs are very high, but for internal funds, costs can be considered as none. For debt, the costs are in an intermediate position between equity and internal funds. As a result, firms prefer first internal financing through retained earnings, then debt and they choose equity as a last resort. According to the theories, there are determinants in Saudi Arabia that has led to the structure that they hold. Company size is a factor that has been considered in Saudi Arabia for its structure. Large organizations are thought to be prone to bankruptcy and they are expected to incur costs that are low in giving out debt or equity. Through this, large firms are expected to hold more debt in their structure as compared to small firms. In Saudi Arabia, it was also found out that small size firms tend to have less long-term debt due to conflicts between lenders and shareholders (Bierman, 2003). Most of the evidences that were obtained from companies showed that there are positive relationships that occur between the sizes of companies and leverages and other evidences also bringing out a positive relationship between debt maturity structure and size of companies. In determination of capital structure through profitability, it was found that companies with more profits tend to have high levels of debt because of tax deductibility of interest payments. As brought out in trade-off theory, higher profitability reduces the expected costs of suffering. Because of this, firms increase their leverage to take advantage from tax profits. Consequently, asymmetric information, most companies like internal financial sources (Bierman, 2003). Companies that make high profits tend to have low levels of debt and higher retained earnings. This brings out that leverages are negatively related to the level of profits of companies in Saudi Arabia. In Saudi Arabia, managers of market-oriented companies tend to prefer internal liquidity. This is through the fact that when companies have close ties with their banks, there is reduction in information asymmetry to its minimal level thus the need for internal liquidity tends to be less important. Tangibility was also found to be a major determinant in capital structure in Saudi Arabia. Consequently, fixed assets to total assets value is found to be a major determinant of the degree of debt finance However, it can be conclude that the relationship between tangibility and leverage depends on the type of debt. While a positive relationship between tangibility and long-term debt is found, a negative relationship between tangibility and short-term debt is reported. Capital structures are also determined by growth opportunities in Saudi Arabia. Due to information irregularities, companies that have a high level of leverage ratios are seen in Saudi Arabia to have the tendency of undertaking activities that are contrary to the interests of debt holders. Through this, it is evident that companies in the country with growth opportunities have low level of leverage ratios. The evidence that occur between growth opportunities and leverage are mixed. Effective tax rate has been used as a possible determinant of the capital structure choice in Saudi Arabia. As interest payments on debt are tax-deductible, firms with enough taxable income have an incentive to issue more debt. It must also be pointed out that higher corporate tax rates reduce firms’ internal funds and increase their cost of capital. Through analysis of firms in Saudi Arabia, higher taxes might decrease the formation of fixed capital and demand for external funds. Based on this argument, we expect a negative relationship between the level of debt and the effective tax rate in the country through companies. Asset tangibility is used as a substitution for activity costs or collateral. Due to the use of tangible assets as collateral, the large amount of them decreases the risk of lender suffering the agency costs of debt, like risk shifting. Therefore, firms with a high ratio of fixed assets should have greater borrowing capacity. So the higher the tangible assets, the more willing should lenders be to supply loans and leverage should be higher. Most studies have found positive relationship. In the study of capital structure in Saudi Arabia by Finance Department, College of Business Administration, King Saud University, Saudi Arabia, there was consideration of medium, large, and small firms. Medium firms employ 51 to 500 employees; large firms are defined as those with more than 500 employees. There were findings that only 9.5 percent of the firms in the sample are publicly listed while 90.5 percent are private companies. 27.5 percent of listed firms are large companies, 46.5 percent are medium, and 26 percent are small firms. On the other hand, 50.7 percent of unlisted firms are small, 39.7 percent are medium, and 9.6 percent are large companies. The model that was used by Finance Department, College of Business Administration, King Saud University, Saudi Arabia in assessing companies was: Leverage= t+ 1Tangibilityit + 2Profitabilityit + 3ASmalli + 3BLargei + 4GDP/Capt. + 5Growtht + 6Inflationt + 7Interestt + 8Taxt + it Comparison of Saudi Arabia and United States and United Kingdom The results obtained were compared to those of Unites states and United Kingdom. The mean of leverage is 39.10 percent while the median is 37.74 percent. Leverage is low in the sample taken from companies in the past three years. This is per the data that was brought out by Finance Department, College of Business Administration, King Saud University, Saudi Arabia. In the US, the mean of leverage is around 58 percent, while in the UK leverage is around 54 percent. As brought out by the study of firms in Saudi Arabia, firms in developed countries are highly levered compared to firms in emerging markets. The reason for this might be the limited availability of funds in emerging markets to finance companies. The available funds are generally allocated to publicly listed companies or large firms. The leverage of listed firms is 44.23 percent, while the leverage of private companies is 36.81 percent. The leverage for small, medium, and large firms is 30.65, 46, and 50.49 percent, respectively. Small firms have limited access to finance compared to medium and large size companies. On the other hand, listed firms borrow more than private firms do. The reason for this high leverage among listed firms could be the lack of well-developed stock markets. In addition, lenders may prefer to fund listed companies because the quality of information provided by them is more reliable than that of private firms (DeMarzo & Sannikov, 2004). Therefore, in developing countries, it is difficult to access to finance for small and private companies. According to Finance Department, College of Business Administration, King Saud University, Saudi Arabia, on average 45.21 percent of the firm’s assets are fixed assets which can be used as collateral. Therefore, firms with high asset tangibility should have greater borrowing capacity. Listed firms have 44.44 percent tangible assets, while private companies have 46.64 percent. The mean of asset tangibility for small, medium, and large companies is 48.16, 42.80, and 41.44 percent, respectively. The mean of asset tangibility for listed companies in the UK is 35.6 percent while tangibility in the US is 39.5 percent. Stock markets in Saudi Arabia and other developing countries are not as efficient and liquid as in developed countries; therefore, equity financing may not be available. Therefore, listed firms in developing countries rely on high asset tangibility for debt financing. From data obtained from Finance Department, College of Business Administration, King Saud University, Saudi Arabia, the mean of profitability in the sample for three years is 33.96 percent. Listed firms have 30.87, while private firms have 35.89 percent. The mean of profitability for small, medium, and large firms is 30.48, 35.25, and 44.60 percent, respectively. The profitability in the UK is 11.6 percent: whereas, it is 16 percent in the US. The firms in Saudi Arabia have higher profitability than that of firms in the UK and US. Since funding options are limited in developing countries, firms prefer to keep their profits in the company as an internal funding source. In the study of companies in Saudi Arabia, there was use of dummy variables for large and small firms from Finance Department, College of Business Administration, King Saud University, Saudi Arabia, which mainly considered the number of employees in the firm. In the country, a firm is classified to be large when it has a number of employees adding to more than 500 with small companies being less than 50 employees. In data which was collected, large companies were few having a percentage of 10.82 while small companies are more in the country with a percentage of 48.2. Medium sized companies were found to be 41.1 percent. According to Finance Department, College of Business Administration, King Saud University, Saudi Arabia, the average GDP of Saudi Arabia was estimated at 120.80 dollars. In the same period, the GDP per capita in the UK is 25,359 dollars while in the US it is 34,852 dollars. Asset tangibility is negatively correlated with leverage in contrast to what we expected. According to the theory, since fixed assets can be used as collateral, debt level should increase with higher fixed assets. We find this positive relation, when we look at the correlations between asset tangibility and long-term debt. Nevertheless, asset tangibility is negatively correlated with short-term debt. The correlation between leverage, debt maturities, and macro variables are not so high. GDP per capita is positively related with leverage and short-term debt, while it is negatively related with long-term debt. Growth is positively correlated with leverage and long-term debt, while it is inversely related with short-term debt. Inflation is negatively correlated with leverage and debt maturities. Interest is not significantly correlated with leverage. However, it is positively related with short-term leverage, while, it is negatively related with long-term debt. Tax is positively correlated with leverage and short-term debt: whereas, it is negatively related with long-term leverage. . In the UK, Artikis (2007) concludes that profitability, liquidity and growth opportunities have a negative effect on the leverage ratios. Likewise, Litan, Pomerleano and Sundararajan (2003) compare the determining factors of capital structure in Saudi Arabia and US firms, finding that transaction costs in Saudi Arabia are lower compared to US due to the higher percentage of private debt in Saudi Arabia. Comparison with Europe Profitability is positively correlated with leverage, because highly profitable companies tend to use more debt because of tax incentives. Another factor that may affect the firm’s debt equity choice is the tangibility of assets. As brought out by bankruptcy costs theory, tangible assets keep their value even in bankruptcy, so firms with more tangible assets can support higher levels of debt at lower costs because of the ability of firms to collateralize their debt. By contrast, Litan, Pomerleano and Sundararajan (2003) assert that firms with fewer intangibles may choose higher debt levels to limit their manager’s consumption of perquisites because bondholders or bankers will carefully supervise such firms. Furthermore, according to Gordon and Li (2005) size is positively correlated with leverage; nevertheless, very large firms pay less than small firms do to issue equity, so they prefer to issue equity in the capital markets. Leverage is also related to growth opportunities. Finally, institutional and legal characteristics determine capital structure because the legal environment has a significant effect on the ability of firms to raise external finance. Artikis (2007) carried out a comparative study of the capital structure of the firms from the G7 countries and found that, at aggregate level, differences between the leverage of firms are not explained by institutional differences. Also at the international level, Artikis (2007) points out that variables associated with risk, growth, firm size and inventories show different effects across countries. In Europe, Gordon and Li (2005) carry out an analysis of small and medium-sized enterprises. In Europe, it was conclude that variations in the determinants of capital structure between countries are due to the financing requirements of firms, their relationship with banks, taxation and other national economic, social and cultural differences. Methodology Firstly, we compare the economic-financial characteristics of private firms and those that are privatized or in the process of privatization by carrying out the Wilcoxon, two-sample paired signed rank test, which does not require normality. In accordance with the previous section, the factors to be compared are profitability, leverage and efficiency. Conclusion Our findings suggest that though some of the perceptions from recent finance theory are applicable across countries, much is still to be done to bring out the effect of different institutional features on capital structure choices. Our knowledge of capital structures has mostly been derived from data from developed economies that have many institutional similarities. In Saudi Arabia, managers of market-oriented companies tend to prefer internal liquidity. Bibliography Artikis, G. (2007). Capital structure. [Bradford, England]: Emerald. Austin, J. (2000). Managing in developing countries. New York: Free Press. Bierman, H. (2003). The capital structure decision. Boston: Kluwer Academic Publishers. Bird, R., & Oldman, O. (2007). Readings on taxation in developing countries. Baltimore, MD: Johns Hopkins Press. Blouin, J. (2014). Thin capitalization rules and multinational firm capital structure. [Washington, D.C.]: International Monetary Fund. Comin, D. (2009). 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