This chapter provides a general introduction of the study about two major capital structure theories: trade-off theory and pecking theory. The first section introduces the background of this research. Section 1.3 describes the research problem followed by the objective of this study in section 1.4. Next section: section 1.5 explains the contribution of this study. Finally, section 1.6 states the organization of this proposal.
1.2 BACKGROUND OF STUDY
Capital structure refers to the composition of a firm's liabilities and owners' equity (Karadeniz, Kandir, Balcilar and Onal, 2009). It attempts to explain the mix of securities and financing sources that used by corporation to finance real investment (Myers, 2001). Capital structure decision is one of the financing decision which managers have to make when they want to raise money from different sources (Karadeniz et.al., 2009). It is also a critical decision.
Capital structure is very important because it may cause the ability of the firms to meet the needs of its stakeholders (Shubiri, 2010). Shubiri ( 2010) stated that the capital structure of firms may able to maximize return to its stakeholders by establishing optimal capital structure which is referred to the cost of debt is offset by the benefits of debt. Besides that, capital structure is vital to companies growth (Abor, 2008). According to Abor (2008), businesses fail to start or progress due to issueance of finance. Hence, capital structure is very important to a firm.
To understand the capital structure decision, there is four important theories are used (Gajurel, 2005). They focus on how taxation, bankruptcy costs, agency cost and information asymmetries influence the relationship between capital structure and firm value (Manos and Hen, 2001). Tax benefist associate with debt, bankruptcy cost and agency cost can be explained based on the trade-off order theory, while the pecking order theory explains about information asymmetries which may influence capital structure. Hence, the major models of capital structure, trade-off theory and pecking order theory, are selected in this study.
Trade-off theory suggests that, given total assests and investment plans, the optimal debt ratio for a firm could be determined if marginal benefit and marginal cost of debt are equal (Hong, Yong, Li, Lin and Lee, 2012). According to Myers (1984), a firm that follows the trade-off theory sets a target debt-to-value ratio and then moves toward the target gradually which is determined by balancing the benefits and costs.
Pecking order theory states that companies prefer internal to external financing and debt to equity, if they issue securities (Karadeniz et.al., 2009). The companies prefer to issue debt rather than equity if internal finance is insufficient. If external funds are required, the companies will issue the safe security first and finally to equity as a last resort (Myers,2001).
1.3 PROBLEM STATEMENT
Over the past four decades, there are many companies have struggled with wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions (Milken, 2009). These companies will face a trouble of unable to pay for its debt. Then, this may lead company towards bankruptcy. That is why the capital structure is matter.
Besides that, capital structure may also affect the interest of company's shareholders. For example, dilution control of shareholders may occur when issuing addition shares to obtain funds (Ganor, 2011; Graham et. al., 2001). The more addition shares are issued; the control of shareholders over the companies is decreased. Their voting right may also be affected as dilution of control. Hence, the shareholders' wealth is affected. Apart from that, dividend is useful tools that managers can employ to create value for shareholders (Asquith and Mullins, 1986). Dividend paid to shareholders is part of company earnings which had deducted for retains and reinvest in business (Baker, 2009). Therefore, if the company prefer to use internal financing, the small amounts of dividends will be paid out. As the result, shareholders' interests are affected.
In the other hand, capital structure decision may affect the growth of company. Credit ratings are vital to determinant of debt policy (Graham et. al., 2001). Hence, managers need to maintain a good credit rating when obtain debt (Berk, Stanton and Zechner, 2010). A good credit rating reflects the creditworthiness of firms. Robb and Robinson (2009) discovered that high credit worthiness firms able to have more funds. Once the company is having more funds, the greater chance that company will have towards the growth of company. Besides that, the company may able to deal with its competitive environment with the greater funds (Abor, 2008).
1.4 RESEARCH OBJECTIVE
The general objective of this study is to examine the factors affecting capital structure decisions of public listed companies in Malaysia with pecking order theory and trade-off theory. Therefore, the following specific objective are :
RO1: To investigate the relationship between profitability of companies and capital structure.
RO2: To investigate the relationship between growth oppurtunities and capital structure.
RO3: To investigate the relationship between the size of firms and capital structure.
RO4: To investigate the relatioship between the age of firms and capital structure
RO5: To investigate the relatioship between the tax rate and capital structure.
RO6: To investigate the relationship between the fixed asset structure of companies and capital structure.
RO7: To investigate the relatioship between the liquidity of companies and capital structure.
1.5 CONTRIBUTION OF STUDY
As research problem, there are fewer studies of the capital structure practise conduct in Malaysia such as Nor, Ibrahim, Haron, Ibrahim and Alias (2012), Wahab, Amin and Yusop (2012) and Siam (2002). This study contributes to the investors more information about the variable that affect the capital structure practise in Malaysia. By this findings, the investors will know how the firm is financing and is that the firm able to handle the risks associated. Low level ofdebt of companies reflects that the companies have a healthy capital structure and it is less expose to risk. Therefore, It is a positive signal of invesment quality. Lastly, the investor will based on the capital structure of that company to make decision whether should invest in such firms and may expect the return from that investment.
Apart from that, this findings of study will also contribute to firm managers who will decide on capital structure decision. Based on the determinant of capital structure, they are guided to make the capital structure decision which is suitable for their companies. They must also consider which capital structure theory is adopted by their company. Hence, they must think of their the target debt ratio and also the cost and the benefit of debt financing before make the capital structure decision. They may choose the financing when the benefit is exceed the cost.
1.6 ORGANIZATION OF STUDY
The rest of the study is organized as follow: Chapter 2 presents a review of literature and relevant research. Chapter 3 presents the methodology and procedures used for data collection and analysis.
CAPITAL STRUCTURE:
PECKING ORDER THEORY VERSUS TRADE -OFF THEORY
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
In this chapter is aimed to provide a better understanding of this study. Section 2.2 discusses about capital structure. Section 2.3 indicates the theories of capital structure. Next, section 2.4 discusses the determinant of capital structure. Lastly, section 2.5 will summarize the chapter 2.
2.2 Capital Structure
Kuang and Ching (2011) state that the capital structure are referred to the way that a firm finances its assets through some combination of financing sources. It focuses on mix between securities (equity) and financing sources (debt). Therefore, it is concerned on the right-hand sides of corporations' balance sheets (Myers, 2011).
The capital structure decision is tougher. The firms have to make financing decision on the mix of different securities issued by the firms from either internal or external sources. They also have to consider about the firm value whether the combination is maximizes the firms' value (Siam, 2002). However, there is no universal theory of the debt-equity choice, and no reason to expect one. Therefore, several theories had been introduced for example the trade-off theory, pecking order theory and market timing theory (Myers, 2011).
2.3 Theories of Capital Structure
Although there are a lot of theories for capital structure, only the two major theories will be discussed for this study. Trade-off order and pecking order is chosen to be discussed because they are powerful theoretical models which have been tested for the last 20 years (Miglo, 2010). He also finds that trade-off theory does not have many weaknesses and can explain a lot of facts about capital structure, while pecking order theory provides direct explanation for capital structure.
2.3.1 Trade-off theory
The study of trade-off theory is focus on firms' target leverage which is driven by three competing forces: taxes, cost of financial distress and the agency conflict (Gajurel, 2005). The trade-off theory states that a firm's debt ratio is based on a between the benefits and the cost of debt (Hong et. al, 2012).
The benefit of debt is the tax-shelter effect, which arises when interest paid is deductible at the corporate tax level (Manos, 2002). The interest payments of debt will reduce the tax base, thus the cost of debt is less than the cost of equity. Hence, the tax advantage of debt motivates the optimal capital theory (Karadeniz et. al., 2009). Meanwhile, the cost of debt mainly is the possible of financial distress such as bankruptcy cost (Frydenberg, 2004). The probability of financial distress increase rapidly with additional borrowing and the potential costs of distress begin to affect the firm value (Brealey, Myers and Marcus, 1999).
Therefore, the firm has to seek the optimal debt ratio by substituting debt for equity, or equity for debt until the value of the firm is maximized (Frydeberg, 2004). Then, the firm moves toward the target debt ratio which had been set (Myers, 1984).
2.3.2 Pecking order theory
The pecking order theory is based on two realistic assumptions. One of the assumptions is the presence of information asymmetry between insiders (managers) and outsiders (investors). It implied that the managers have a better knowledge about the true value of firm than the outsiders (Gajurel, 2005). Another assumption is that managers are acting in the interest of the existing shareholders. The first assumption implies that the managers have a better knowledge about the true value of firm than the outsiders (Cotei and Farhat, 2009). The second assumptions implied that the managers refuse to issue undervalued shares (Myers, 2001). Due to managers know more information about the firm, the stock price will fall. Assume that the managers are acting in the shareholders' interest; the firm will issue the safe debt to avoid the falling price of stock price (Myers and Majluf, 1984).
Apart from that, the costs of raising external finance become higher (Baker and Wurgler, 2002). The cost of external finance not only those administrative and underwriting costs but may also the possibility of the firms to sell the securities for less than they are really worth (Myers, 1984). Besides that, the pecking order theory predicts that there is no target capital structure which is also known as target debt ratio. The firms will choose their capital that used to finance their businesses according to the preference order: internal finance, debt, equity (Chen and Chen, 2009). Internal finance is placed at first because it can avoid those risks that may occur. Meanwhile debt is preferred than equity because it is less risky than equity financing (Myers, 1984).
2.4 The determinant of capital structure
2.4.1 Profitability
There are different impacts on the financing decision between the trade off theory and the pecking order theory. Rajan and Zingales (1995) explain that the dominant source of external finance for United Kingdom is equity. So the firms with high profitability and have few investment opportunities will reduce equity issues drastically. Therefore, these firms will have more positive correlation between leverage and profitability. Gajurel (2005) state that initially the profitability is positively correlated to leverage, but after the certain level the relationship is negatively correlated. He increase in debt ratio initially increases the profitability through debt tax shield at moderate level. But because of increasing bankruptcy, financial distress and agency cost due to increase in leverage ratio, and the benefits of tax shield unable to cover the cost. Hence, the firm will reluctant to have debt finance which in line with trade-off theory. Frank and Goyal (2003) also show that the profitability is fairly reliably positive.
However, according to Chen et. al. (2009), there is negatively correlation between capital structure and profitability which is in compliance with the pecking order theory. She argues that a more profitable firm has more internal financing available. Hence, it is more likely to use internal finance rather than external finance. Furthermore, Dreyer (2010) also argue that, due to costly external debt, the firm will prefer to make use of internal finance over external finance. Huang and Song (2006) also discover that the profitability is negatively correlated with leverage which is in line with the pecking order theory. They claim that the firms will use their retained earnings first as the source of investment fund and then move to bonds and new equity only if necessary. The managers prefer to finance projects internally because of the informational asymmetry between managers and outsider Deesomsak, Paudyal and Pescetto (2004). There are numerous researchers (Banchuenvijit, 2011; Rajan et. al.,1995) also find negative relationship between profitability and debt levels.
Apart from that, Mira and Gracia (2003) find that there is non-significance relationship between profitability and leverage among the small medium enterprises (SMEs). Chang, Lee and Lee (2009) state that different measurement for profitability may get different results. When the profitability is measured as operating income divided by total assets, it has negative effect on leverage. But when use operating income divided by total assets, the effect on leverage is positive.
2.4.2 Growth opportunity
Under the trade-off order theory, the firm considers the cost and the benefit of debt. Hence, growth opportunity has negative relationship with leverage (Rajan and et. al.,1995; Frank and et. al., 2003; Deesomsak et. al., 2004; Huang et.al., 2006 ). Rajan and et. al. (1995) discuss that firms that have high market-to-book-ratios have higher cost of financial distress. That why the negative relationship exists between growth opportunities and leverage. Frank et. al. (2003) state that indicator of future growth is 'value'. Hence, the higher market-to-book ratio is associated with less leverage. Bamchuenbijit (2011) also claims that firms with high intangible growth opportunity do not want to commit themselves to debt servicing as their revenue may not available when needed. Besides that, Bancel and Mittoo (2002) find that more high growth view equity as a less risky and cheapest source of funds and as a signal of better impression than debt. Therefore, growth is negative correlated with leverage.
In the other hand, growth opportunity is likely to use out retained earnings and force the firm into borrowings (Chen and et.al, 2009). The firm will need more debt as the opportunity of growth arises. Thus, under the pecking order theory, growth opportunity and leverage are positively correlated which consistent with Chen and et. al. (2009), Frank and Goyal (2005), and Mouamer (2011). Chen (2004) also find a positive relationship between growth opportunities and debt in China. Serrasqueiro and Nunes (2010) find that for the companies in Portugal with high growth opportunities and low cash flow turn more to debt to take advantage of those opportunities and fulfill the need to pay dividends.
Growth is the most influential determinant on capital structure when growth is measured by market-to-book assets ratio or the market-to-book equity ratio. It is because the different measurement will come out different results. The growth has negative impact on leverage when using market-to-assets ratio, while positive if using market-to-equity ratio (Chang et. al., 2009).
However, Karadeniz et. al., (2009) find that there is no significant relationship between growth opportunities and debt neither in trade-off order and pecking oerder theory.
2.4.3 Size of companies
Most studies find that size is positively related to debt level. Omran (2009) discovers that size is positively associated with long term capital structure. Frank and et. al. (2003) also states that larger firms tend to have greater leverage. They argue that mature firms are often larger and more creditworthy; thus, those mature firms have more debt. The positive relationship between size and debt ratio also has shown by Banchuenvijit (2011), Huang et. al. (2006), Deesomsak et.al (2004) and Kayo and Kimura (2011). Deesomsak et. al. (2006) argue that bigger companies tend to have better borrowing capacity than smaller companies. Kayo et. al (2011) assume that larger firms are more transparent and able to reduce the bankruptcy risk which is also in line with Wiwattanakantang (1999). Wiwattanakantang (1999) also state that those larger firms are well-known firms, so they obtain loans without providing collateral. Chen (2004) finds that the relationship of firm size between total debts in Chinese firms is positive.
Apart from that, Gracia and Mira (2008) find that under pecking order theory, larger firms have greater ability to generate more internal funds. Therefore, less debt is needed and size of firms has a negative relationship between leverage. Graham et. al. (2001) state that most of the small firms use debt when face insufficient internal funds. Chen (2004) also finds that the coefficient of size to long-term debt is negative and highly significant. He argues that large firms have better access to capital markets for equity finance because of their reputation in markets. He also suggests that because of bankruptcy costs are low in China since legal system incomplete at that time. There is no protection of bondholders from default.
Nevertheless, Chen et, al. (2009) claims that the size is a moderator variable. It can be seen from the path of tax to capital structure. In large companies take advantage of the tax deductibility of debt when they raise funds from formal institutions.
2.4.4 Age of companies
The age of companies is referred to the time when the companies are incorporated until present. The age of companies is negatively correlated with the leverage (Mira et.al, 2003). Gracia et. al. (2008) and Zoppa and McMahon (2002) argue that older firms able to generate sufficient internal, so they do not need too much of debt and vice versa. This behavior is undoubtedly in line with the pecking order approach. Manos (2002) also argue that firms which follow pecking order theory are likely to have more retained earnings, then those firms do not rely more on external debt financing. Abor (2008) state that age of firm is a standard measure of reputation in capital structure model. Hence, older firms are often in the position of attracting more equity investors and then able to capture high equity finance.
Most of researches find negatively correlation between age of firms and leverage. However, Gracia and et. al. (2008) discover that age of firms influences firms' debt level positively. They also claim that age of companies has a positive relationship with the leverage under trade-off theory. They suggest that the older firms face less agency problem and default risk, therefore, they borrow more. Besides that, there is no significant results are found for age firm and leverage by Wiwattanakantang (1999).
2.4.5 Tax rate
Tax rate affects tax payable positively. Once the tax rate is high, then tax payable will be more. The tax rate affects positively leverage (Chen et. al. 2009). The higher tax rate associates with the higher leverage (Frank and et.al.,2003). They state that interest paid for debt is deductible expense for tax. Therefore, firms appear to take this advantage by raising funds from formal institutions.
However, Abor (2008) and Karadeniz et. al. (2009) discover that there is negative relationship between tax rate and leverage. Abor (2008) states that Ghana listed companies have a special tax rebate. Thus, increase in corporate tax would be associated with increasing equity capital. Karadeniz et. al. (2009) finds a weak negative relationship between these two variables for tourism companies and he state that it is contra with the predictions of both trade-off theory and pecking order theory. Shubiri (2010) state that tax advantage of leverage is decreased when other tax deduction for example is increased.
Besides that, Gracia et. al (2008) find that relationship between tax rate and leverage is non-significant. It means that the taxes of firms that have to pay do not influence their capital structure decision.
2.4.6 Fixed assets structure
Fixed assets structure is defined by the ratio of fixed to total assets which represents the degree of assets' tangibility (Manos and Hen, 2002). Tangibility shows positive and significant relation leverage (Kayo et. al., 2011; Huang et.al, 2006). It shows that asset tangibility is an important criteria in banks' credit policy (Chen, 2004). They suggest that the fixed assets of firms are collateral when borrowing debt. Hence, it is important leverage driver among the country which is selected as sample of their study which is in line with trade-off theory. Shubiri (2010) also finds a significant positive relationship between fixed assets structure and leverage of Jordanian firms. He suggests that firms with high tangibility assets may easily to obtain debt since their debt is secured with such assets. Rajan et. al (2003) also state that tangible assets are easy to collateralize, thus; the agency cost of debt may reduce.
Apart from that, Chen (2004) finds a positive correlation between these two variables which is consistent with both trade-off theory and pecking order theory. However, Banchuenvijit (2011) finds negative correlation between fixed assets structure which is collaborating and he assumes that tangible assets with lower information asymmetries, equity issue will be relatively less costly and will reduce leverage ratio. Manos et.al (2002) also discover that there is strong negative impact between fixed assets structure and leverage but it is not consistent with neither trade-off theory nor pecking order theory. Furthermore, there is no significant relationship between fixed assets structure and firms' leverage in Chen et. al. (2009) study.
2.4.7 Liquidity
As suggested by Gajurel (2005), the liquidity is defined as the ratio of current assets to current liabilities which he followed previous study (Ozkan, 2001). He states that liquidity is the major firm specific determinants of the capital structure decision. He finds that liquidity has a negative relationship with leverage where the liquidity is the decreasing function of leverage. He also shows that the increasing leverage leads to short-term insolvency, which may drive to bankruptcy. Lipson and Mortal (2005) state that the cost of issuing equity and the required return on equity is increased the liquidity; therefore, they assume that more liquid firms may issue equity rather than debt in capital structure. These results are consistent with trade-off theory which considers the costs and benefits of debt.
Furthermore, Deesomsak et. al (2004) find that liquidity has a negative and significant relationship with leverage which is predicted by pecking order theory. They argue that the firms tend to use their liquid assets as the source of finance their investment rather than obtain the external debt and equity. In contrast, Mouamer (2011) finds that there is positive correlation between liquidity and long term debt. He argues that the firms tend to use their liquid assets for investment rather than raising the external debt. He also states that there is a negative correlation between liquidity and short term debt and total debt meaning that the more liquid the company, the less resort to borrowing. The firms with higher liquidity use that liquidity to substitute the short term loans.
2.5 Summary
This chapter reviews the previous studies that had done by the researches. From the prior studies, few results can be drawn. For example, the relationship between two variables may positive, negative or even no-significant. Lastly, based on prior studies, a conceptual framework is generated (Figure 1).
Capture.JPG
Figure : Conceptual framework of capital structure.
CAPITAL STRUCTURE:
PECKING ORDER THEORY VERSUS TRADE-OFF THEORY
CHAPTER THREE
METHODOLOGY
3.1 Introduction
This chapter presents the research methodology which used to examine the factors affecting capital structure decisions of public listed companies in Malaysia with pecking order theory and trade-off theory. Section 3.2 shows the development of hypothesis of this study and section 3.3 indicates the sample selection. The following section: section 3.4 discusses about data collection method. Next in section 3.5 will show the data analysis method . In the end of this chapter, section 3.6 present the summary of this chapter.
3.2 Hypotheses Development
3.2.2.1 Profitability and capital structure
Profitability explains the efficiency and success of the firm and it focuses on the firm's earnings. In this study, profitability will be define as earnings before interest and tax (EBIT) scaled by total assets which refer from previous studies, such as, Huang et. al.(2006); Dreyer (2010); Mira et.al (2003) and Mouamer (2011).
The trade-off theory and the pecking order theory vary in their predictions on profitability and the amount leverage incurred by firms. According to the trade-off theory, profitable firms will borrow more since interest is tax deductible and they have greater needs to shield income from corporate tax (Huang et. al, 2006). Besides that, Gajurel (2005) suggests that the increasing in profitability, the expected bankruptcy cost will reduce. Therefore, the trade-off theory predicts has a positive relationship between profitability and leverage. This prediction is consistent with Gracia et. al. (2008), Rajan et. al. (1995) and Frank et. al. (2003).
In the pecking order theory, the profitability is estimated to have negative relationship with leverage. The profitable firms who have sufficient internal funds will prefer to use their retained earnings as their primary source of funding. If the internal fund is exhausted, then they will tend to have debt. The last alternative will be issue new equity. This prediction is in line with Chen and et. al. (2009), Wiwattanakantang (1999), Deesomsak et. al. (2004), Kayo et. al. (2011) and Huang et. al, (2006).
By the empirical result from previous studies, the hypothesis is set as below:
H1: There is a relationship between profitability and capital structure.
3.2.2.2 Growth opportunities and capital structure
There is a difference relationship between trade-off theory and pecking order theory. Based on trade-off theory, there is a negative relationship between growth opportunities and leverage. Titman and Wessels (1988) argue that growth opportunities add firm value, but the firm cannot use growth opportunities as security to support more debt. Besides that, the firms that have growth opportunities may expose to more risk because they have to bear the higher financial distress cost (Karadeniz et.al., 2009). Hence, growth opportunities negatively affect on leverage under trade-off theory. This prediction is same as Chen and Hammes (1997), Huang et. al. (2006), Kayo et.al. (2001), and Gracia et. al. (2008).
On the other hand, in line with pecking order theory, the growth opportunities affect leverage positively. Chen et. al. (2009) state that firms with high growth opportunities are more likely to require additional funds as retained earnings are exhausted. In other words, growth is likely to push the firms into borrowing. Mira et. al. (2003) also argue that those firms which have more investment opportunities will need more financing resources and forcing them to have debt financing. As the result, there is a positive relationship between growth opportunities and leverage.
Based on those prior studies, the hypothesis is set as below:
H2: There is relationship between growth opportunities and capital structure.
3.2.2.3 Size of firms and capital structure
The relationship between size of firms and leverage is different in the point view of trade-off theory and pecking order theory. In trade-off theory, the size of firms and leverage are positively correlated. Since, the larger firms are more diversified; hence, it is less risky and less likely to go bankrupt (Rajan et. al., 1995). The lower the cost of bankruptcy allows larger firms take advantage to issue debt. Therefore, the larger firms have higher debt capacity (Manos et.al., 2002). Besides that, Wiwattanakantang (1999) argues that the larger and well known firms have an advantage when accessing credit market. They may obtain loan without providing collateral. Therefore, the size of firms affects leverage positively. This prediction is consistent with Banchuenvijit (2011), Wiwattanakantang (1999), Deesomsak et. al. (2004) and Kayo et. al. (2011).
However, according to pecking order theory, the size of firms is negative affected leverage of firms. Banchuenvijit (2011) claims that the larger firms are expected to have lower information asymmetries making equity issue more attractive. It means that the chance of undervalue stock price of new equity is reduce, thus those firms are encourage to use equity financing. Furthermore, the larger firms are observed by analysts more closely; therefore, they are more capable issue more informational equity which means there is less asymmetrical information, and have lower debt (Gajurel, 2005). This implies that the larger firms tend to have equity financing rather than debt financing. Hence, the size of firms is correlated to the leverage of firms negatively.
Based on those studies, the hypothesis is set out as below.
H3: There are relationship between size of firms and capital structure.
3.2.2.4 Age of firms and capital structure
The age of firm is referred to the years that it is incorporated. There is different point view of trade-off theory and pecking order theory on the relationship between age of firms and leverage.
In the point view of trade-off theory, the older firms may face less agency problem and default risk. Therefore, they tend to have more debt. In other words, the age of firms is positively influence firms' leverage. Furthermore, Mouamer (2011) states that the age of firms is a standard measure of reputation in capital structure models. Before make a loans, banks will evaluate the creditworthiness of firms. As the age of firms becomes older, the firms' reputation may increase as well as the creditworthiness of firms. Therefore, those mature firms can borrow at better terms and conditions. As the result, the impact of age on leverage should be positive.
Based on the pecking order theory, Gracia et. al (2008) argue that the older firms may generate sufficient internal funds and not too depend on debt as much as those younger firms. In other words, those mature firms may have accumulated higher levels of past retained earnings, and then these firms do not rely on debt finance. In contrast, younger firms have less time to generate sufficient internal funds; therefore they tend to rely on external finance as debt finance is prioritized. Hence, the age of firms and leverage are negatively correlated.
The hypothesis below is set based on the prediction above:
H4: There is a relationship between age of firms and capital structure.
3.2.2.5 Tax rate and capital structure
When the tax rate is higher, the firms are bounded to be paid for tax is higher too. Most of studies believe that the tax rate is an important determinant of capital structure (Brounen, Jong, Koedijik, 2006; Huang and et. al., 2009; Karadeniz et. al., 2009). The relationship between tax rate and leverage is different between trade-off theory and pecking order theory.
The trade-off theory assumes that the tax rate has positive influence on leverage of firm. The interest payment plays the important role when calculating the tax burden as it is deductible expenses from corporate tax (Gracia et. al., 2008). The firms with a higher tax rate should obtain a tax shield gain. Thus, they should take the advantage by using debt as the source of financing through the interest payments. This effect of encourages the use of debt by firms increases the profit after tax to owner (Chen et. al., 2009). Consequently, the tax rate should affect positively leverage.
However, the pecking order theory does not establish a certain relationship between tax rates and leverage (Karadeniz et. al., 2009). Chen et. al. (2009) and Karadeniz et. al., 2009 discover that there is no correlation between the leverage and tax rate under pecking order theory. Hence, there is no significant relationship between tax rate and leverage of firms.
Therefore, the hypothesis is set as below:
H5: Tax rate and capital structure is positive correlated.
3.2.2.6 Fixed assets structure and capital structure
Fixed assets structure is also an important determinant of capital structure decision (Chen et. al., 2009). The ratio of fixed to total assets represents the degree of assets' tangibility (Manos et. al., 2002).
Based on trade-off theory, fixed assets structure is positively associated with leverage of firms. Saeedi and Mahmoodi (2012) state the fixed assets often use as collateral and they provides higher collateral value than intangible assets. It is because fixed assets with high collateral value give creditors a guarantee of repayment (Drobetz and Fix, 2003). It means that with collateralized assets, the debt fund is not restricted. Besides that, the intangible assets such as goodwill can lose market value rapidly in the event of financial distress or bankruptcy (Chen et. al., 2004). Thus, firm with more fixed assets tend to have more debt. Besides that, Manos et. al. (2002) also state that fixed assets often decrease the cost of financial distress for example bankruptcy cost because they tend to have higher liquidation value. Therefore, firms may obtain more debt as they have more fixed assets. This implies that the fixed asset structure is positively correlated with leverage (Chen et. al., 2004; Wiwattanakantang, 1999).
From the point view of pecking order theory, the firms that hold more fixed assets will be less prone to asymmetric information problems (Chen et. al., 2004). With existence of asymmetric information, the managers prefer to use internal funds or debt financing than equity issue. It is because the announcement of stock issue will immediately undervalued the stock price which may affect the interest of existing shareholders (Myers, 2001). Meanwhile, Wiwattanakantang (1999) assumes that firms that have more collateral may obtain debt with less strict condition. Therefore, equity financing is more costly than debt financing. As the result, the more fixed assets that firms have, the more likely those firms will have more debt.
Thus, the hypothesis is set as below:
H6: There is a relationship between fixed assets structure and capital structure.
3.2.2.7 Liquidity and capital structure
Liquidity is defined as the ability of an asset to be converted to cash quickly at low cost (Brealey et. al., 1999). As predicted by trade-off theory, high liquidity assets are easier to convert to cash easily than low liquidity assets. The cost of convert the assets may be lower. However, the sales of assets may reduce the size of firms as well as the value of firms and therefore are bad for creditors (Morellec, 2001). Apart from that, Lipson et. al. (2009) claim that the net cost of equity will reduce as increasing in liquidity; hence, more equity financing will relied on. Therefore, trade-off theory assumes that the liquidity and leverage are negatively correlated.
According to pecking order theory, the relationship between liquidity and leverage is estimated to be negatively correlation. Deesomsak et. al. (2004) state that firms with more liquidity will borrow less. They also state that the agency of debt is increasing when the managers manipulate liquid assets in favour of shareholders against the interest of debt holders. Besides that, Lipson et. al.(2009) argue that asymmetry between market participants is correlated with asymmetry between managers and the market. Thus, firms with more liquidity prefer to use equity as the lower adverse selection.
The hypothesis, therefore, is set as below:
H7: Liquidity is negatively correlated to capital structure.
The summary of determinant of capital structure and its expected results based on trade-off theory and pecking order theory is shown in Table 1.
Table 3.1: Summary of determinant of capital structure and its theoretical predicted signs based on two theories.
Determinants
Theoretical Predicted Signs
Trade-off theory
Pecking order theory
Profitability
+
-
Growth opportunities
-
+
Size of firms
+
-
Age of firms
+
-
Tax rate
+
n.s.
Fixed asset structure
+
+
Liquidity
-
-
Note: '+' means that there is positive relationship between determinant and capital structure.
"-" means that there is negative relationship between determinant and capital structure.
"n.s." means that there is no significant relationship between determinant and capital structure.
3.3 Sample Selection
The population of this study is all companies listed in the Bursa Malaysia. Since financial crisis occurred in Malaysia in year 2008, so that a sample is selected from year 2009 to year 2011. Hence, the result will more consistent. In Bursa Malaysia, there are average 913 listed companies in main market and ace market which has excluded financial sector. The financial sector was excluded since the financial firms and banks operate in a different way (Saeedi et.al, 2012). Finally, the sample consists 269 listed companies in Bursa Malaysia by using the Krejcie and Morgan table (Sekeran and Bougie, 2010).
3.4 Data Collection
Secondary data is used when conducting this study. Secondary data refer to information gathered by someone other than the researcher conducting the current study (Sekeran et. al., 2010). The sources of secondary data used including annual report of companies and the database.
Bursa Malaysia website has a list of all the companies in the main market and ace market. Besides that, they are can be sorted by sector industries. After the list is sorted out from financial sector, random sampling is used to choose the companies from the sorted list of companies. Then, the annual report will get from the chosen companies in the website of Bursa Malaysia. Meanwhile, the database is provided by library of University Putra Malaysia.
3.5 Data Analysis
The statistical analyses are analyzed by using Statistical Package for Social Science (SPSS) after collection of data.
3.5.1 Multicollinearity analysis
Multicollinearity occurs when two or more variables in the model are correlated and provide redundant information about the response. Multicollinearity analysis is conducted to examine the correlation between those variables.
3.5.2 Heteroscedasticity test
Heteroscedasticity occurs when the variance of errors has non-constant variance for all observations. Hence, heteroscedasticity test is used to examine the occurrence of heteroscedasticity.
3.5.3 Multiple regression analysis
Multiple regression analysis is used to test the relationship of independent variables on a single dependent variable. In this study, the dependent variable is capital structure (CAPSTR), while independent variables are profitability (PROFIT), growth opportunities (GO), size of firms (SIZE), age of firms (AGE), tax rate (TAX), fixed assets structure (TANG), and liquidity (LQ). Table 3.2 shows the summary of operationalisation of the variables.
The following model is designed to analyze the relationship between the determinants of capital structure and capital structure:
Where:
α - Intercept
x1 ï€ Profitability
x2 ï€ Growth opportunities
x3 ï€ Size of firms
x4 ï€ Age of firms
x5 - Tax rate
x6 - Fixed assets structure
x7 - Liquidity
Y - Capital structure
ï¥ - Error term
Table 3.1: Summary of operationalisation of variables.
Variable
Symbol
Operationalisation
Dependent Variable:
CAPSTR
y
The ratio of total debt to total assets (Chen et. al., 2004)
Independent Variables:
PROFIT
x1
The ratio of operating income to total assets (Banchuenvijit, 2011)
GO
x2
Change of sales over previous year sales (Gajurel ,2005)
SIZE
x3
Natural logarithm of total assets (Niu, 2008;)
AGE
x4
Number of years since the year of incorporation (Manos et.al., 2002)
TAX
x5
Effective tax rate (Niu, 2008)
TANG
x6
The ratio of fixed assets to total assets (Banchuenvijit, 2011)
LQ
x7
Current assets over current liabilities (Gajurel, 2005)
3.6 Summary
This chapter discusses about how the study conducted systematically. There is 269 listed companies in Bursa Malaysia will involve in this study. The data for this study will be collected through data base and annual report of companies over 3 years period. Lastly, the Statistical Package for Social Science (SPSS) is used as statistical tool to analyze the collected data and conducted multicollinearity analysis, heteroscedasticity test and multiple regression analysis.
