This paper is conducted subject to an empirical investigation of the determinants of capital structure and capital structure behavior by Malaysian Companies across three different industries which are Food and Beverages Industry, Plantation Industry and Hospitality Industry for the period form Year 2005 to Year 2009.Capital structure decisions which can be a very crucial and critical for the financial wellbeing of a particular firm. For most firms main objective, they want to choose the capital structures that best suited to their current conditions which can results in maximizing stockholder wealth and minimizing their cost of capital. Damodaran (2001) proposed that the three most important decisions which are investment, dividend and financing have a great impact to a firm's value. A company only able to gain insight of what would be the optimal capital structure with proper understandings of the variables which can affect the capital structures. The critical consequences which may happen such as bankruptcy and financial distress if there is any major misjudgment occurred the firm's financing decision. Thus, management would have a critical task in hand for choosing between the debt and equity in their firm's activity which in turn may affect the firm's value and its stock price. They can choose any capital structure that they wish. A firm can adjust their debt to equity ratio either choose by issue more debt to buy back stock or else by issue stock to pay debt. The purpose of this study is to figure out what are the determinants that a firm would consider which can helps to achieve the optimal capital structure. The optimal capital structure is a situation where the most appropriate mix of financial sources (Ross et. al., 2005) either from internal or external of the firm (Haugen &Senbet, 1988). Also, this study also helps to explain to what extent that a firm will choose the optimal debt and equity in their financing policy and see how the firms decide their financing decisions based on trend analysis.
Literature Review
The Modigliani and Miller (M&M) model (1958) provides us a basis perception on the capital structure and they claimed that the firm's value is stand independently from changes in capital structure in a perfect capital market where there is no transaction and bankruptcy cost incurred and assuming that there is costless information available to all investors. This model provides that the total investment value of a firm is depend on its profitability and risk and invariant respect to changes in firm's financial capitalization. Thus, no matter how a firm divides the capital structure in terms of financing mixing of debt or equity, the firm's total value stays the same. This also implies that the changes in debt to equity ratio do not give any effect in its cost of capital. Therefore, this model often shows irrelevance of capital structure principle. Subsequently, Modigliani and Miller (1963) have reviewed their first argument and implied that the interest payment and corporate taxes are tax deductable, and full debt financing will gives the optimal results. And surprisingly this M&M model is supported by Hatfield, Cheng and Davidson (1994).
However, there are many researches and empirical works have been done and these lead the way to the development of different alternatives theories to capture the concept of capital structure. The alternatives theories that mentioned are include trade off theory, pecking order theory, agency theory, information asymmetry, and others relevant theory. For the trade off theory, this is where it concerned about how much proportion of debt financing and equity financing a firm may hold in balancing their cost and benefits. This theory stated that there will be advantageous to the firm as it can gain tax shield with the usage of debt financing. The firm value will be varied upon the debt ratio (Myers, 1984). This is where the higher interest payment of debt a firm, the lower taxes the firm will pay. Mackie-Mason (1990) provides evidence for this theory by his empirical work. However, the significance of this theory has been questioned by few researchers (Frank& Goyal, 2003). When a firm holding large proportion of debt, these will caused the firm in the high probability to financial distress, firm with low debt ratio, subject to bankruptcy and non bankruptcy cost (Miller, 1977). Overall, trade-off theory suggests that a firm can attain to optimal capital structure with the rules that it must appropriately decide in balancing the tax benefits and usage of debt. The firm's leverage has a negative relationship with the expected bankruptcy cost and non debt tax shield (Bradley et al., 1984). Also, Titman and Wessels (1988) proposed that there is a inverse relation between debt ratio and profitability of a firm.
The Pecking Order theory which was first investigated by Myers (1984) and it capture that internal financing is cheaper than external debt or equity financing due to asymmetric information (Ross, 1977). This theory basically giving ideas that the hierarchy use of funds in a firm, they will first use internal funds when available and only acquired external funds through debt over equity when it is needed. This is where assume that the management knows more about the future prospects of the firm than the outsider. It implied a way of providing signaling effect when they make announcement of issuing debt or equity. If the firm starts to buy back their shares, these provide a good indication towards outsiders and it brings good reaction to the firm. Conversely, when a firm decides to issue new equity, these will bring signal towards outsiders that the firm lack of confident to their future prospect. However, Byoun and Rhim (2003) argued that this theory is more applicable to small firms where they do not pay dividends and complexity for them to acquired external financing.
Agency theory which is another issue we may concerned in determining the capital structure of a particular firm. This theory is generally about the agency cost that may incurred when there is conflict of interest between the managers and the shareholders. This conflict happened as managers are given authority to run the firms and they will act based on their own interest and benefits which is totally opposing the basic goals to maximize the firm's welfare and shareholder's wealth (Jensen & Meckling, 1976). Managers may put the firms at risk by high borrowing and invest in risky investments whereas they think that the firm will pay for their loses when predictions go wrong. Therefore, owners should take periodic monitoring and supervising towards all the workers and managers to avoid conflict happened. Also, growths in a firm lead increase the manager's control power in the firm. As growths in sales increased, the compensation for managers will increase as well ((Murphy, 1985). These will caused the firm tend to keep more resources to payout for managers. However, debt is considered one of the instruments used to minimize the agency cost by balance off the cost of debt and the benefits of debt.
Besides these theories, the sizes of a firm will gives effect to its capital structure where there will be economies of scale for large firm when there is large amount of fixed issuant costs for the public issues. Also, those bigger firms are mostly more diversified, they may have overseas investment and they may use foreign debt to manage the currency exposure (Barclay &Smith, 1995). Finally, those large firm will expected to have more debt compare to small firms.
Additional, there is also empirical work proves the evidence that the profitability will have a negative relationship with the capital structure which is against the M&M theory (Kester, 1986). These can be explained through those more profitable firm tend not to issue external equity as the firms holding amount of cash flow in order to avoid dilution of ownership.
Data, Methodology and Variable Identification
The sample data for this study include 12 firms which are across three different industries in Malaysia for five years period, from Year 2005 to Year 2009. The three different industries that mentioned include Food and Beverages Industry, Plantation Industry, and Resort Industry. And each of the industry consists of four different firms which is public listed companies. The data that used in the study are collected from the financial statements of every listed firm from their respective official website and some relevant ratios are computed.
In order to assess the determinants of capital structure based on the sample, some of the relevant ratios are computed based on every individuals firm. Our estimation model uses panel data with the combination of time series and cross sectional data and the subsequent result is generated by Gretl. The expected model will as follow:
DCRi,t = α0 + β1TANG + β2PRO + β3SIZE + β4LiQ + β5NDTS + ε
Where DCR= Debt to Capital ratio, TANG= Tangibility Ratio, Size= Firm Size, LIQ= Liquidity
NDTS= Non-debt Tax Shield
Total Debt + Shareholder's equity
DCR =
=
Total DebtThe debt to capital ratio (DCR) is commonly used by managers in deciding the firm's capital structure. This ratio is also used as dependent variable in the model and it is measured as:
The total debt contains long term and short terms liabilities in the firm while the total capital consists of total debt and the shareholder's equity. This ratio used to explain the level of leverage that being used by the company. High percentage in the ratio indicates the company is using too much debt instead of equity in financing the firm's activity and vice versa. The higher the ratio, it indicates that the firm is more risky as it used large amount of debt which can lead them to higher default risk and financial distress.
Total Fixed AssetsGenerally, there are many factors that will affect the capital structures of a firm. However, this paper only discussed some of the identified factors and they are considered as independent variables in the model. Tangibility ratio is measured as:
Total Assets
Tangibility =
The higher the tangibility ratio, it means that the company has large amount of assets and has the incentives to borrow more debt at cheaper rates. With large amount of fixed assets, firms can easily raise debt as the debt can collaterized by the tangible assets. Scott (1977) proposed that firms which are unable to provide collateral to their debt, they are required to pay higher interest and forced to issue equity instead of debt. Thus, the tangibility is expected have a negative relationship with debt.
Earnings before interest, tax and depreciationProfitability ratio is also calculated by:
Total Assets
Profitability =
The profitability is expected have a inverse relationship with debt as these can explained where a firm with high profitability, they will tend first to finance firm's activity with internal funds without go for debt. They can choose to cover their financial deficit using their retained earnings where they have gained from profits.
Current Liabilities
Current Assets
Liquidity =Firm size is also one of the determinants in this paper. The firm size is normally measured by natural log on total assets. Wald (1999) proposed that the larger the firms will tend to have more debt as large firm has lower probability of bankruptcy risk. Also, large firms will tend to acquire more debt which brings beneficial from tax shield. The liquidity which is defined as:
Non- Debt Tax Shield =The higher the liquidity ratio, it means that the firm considers more secured as it is able to pay off its short term debts. Pecking order theory predicted that the high liquidity firms will tend to borrow less. Also, firms will high current ratios are able to generate internal inflow to finance its operations. Thus, it is expected to have an inverse relationship with debt. Non-debt tax shield is defined as:
Total Assets Annual Depreciations
DeAngelo and Masulis (1980) implied that the non-debt tax shield is the substitutions of interest or debt tax shield. The firms will use the debt instead of equity for tax shield purpose which is consistent with the trade off theory. Therefore, with a high non debt tax shield it will lower the effect of tax shield and finally it showed inversed relation to debt.
Results and Discussions
Figure 1 showed the trend and movement of mean leverage of each industry in the sample period.
Among five years, the both Figure 1 and Table 1 showed that the food and beverages standing at the highest leverage ratios and it is dramatically increased its debt during Year 2008. This is affected by one of the firm which increased their debt financing due to their business expansion and these required them to increase their borrowing dramatically. Conversely, the debt ratio for resort industry and the plantation industry are regularly decreasing from Year 2006 onwards. However, the resort industry achieved the highest leverage ratio in the Year 2006. Among the firms in the industry, the Country Height Resort showed the highest debt ratio. This is due to the firm acquired borrowings through issue bond and bank borrowings for the purpose of acquiring qualifying fixed assets in their business. While for the plantation industry, it showed the highest ratio during Year 2005 and steadily decreasing after all.
Figure 1: Average leverage ratios in sample industries from Year 2005 to Year 2009
The summaries of descriptive statistics of all variables are reported in Table 1. All the means of each variable are calculated. The debt ratio which is also used as dependent variable in reviewing the capital structure across the firms in three industries in this study. The mean of debt ratio is varied based on different industry and this is consistent with Harris and Raviv (1991) who implied that firms within industry have similar leverage ratios while it will vary across industries. Within the three industries in the study, the food and beverage is considered highly levered with the ratio of 0.53527. However, these considered as opposition to Talberg et al. (2008) who argued that the food and beverage industry will tend to have a stable condition as they are classified as homogenous products. Every industry will possessed their individual set of economic condition. For industry which has high volatile earnings, their leverage ratio will tend to be higher as they holding more equity as a defense against possible event of insolvency. Secondly, the resort industry is classified as the second highest in leverage ratio. This industry is considered more sensitive to the market conditions. These can be explained that there are more people will tend to expense for their vacation during good economy. Also, the resort industry will required a large amount of capital as they normally have to employ various types of equipment such as swimming pool, fitness center and others facilities to satisfy customer needs during their vacation.
Table 1: Summary of Descriptive Statistics
DEBT
TANG
PROFIT
SIZE
LIQ
NDTS
Food & Beverage
Mean
S.D
0.53527
0.49579
0.09646
19.37216
1.77902
0.04187
0.27098
0.12290
0.15345
1.28313
0.97530
0.00919
Plantation
Mean
S.D
0.24596
0.78367
0.11772
21.52338
3.22119
0.01308
0.13786
0.15000
0.05015
1.80553
2.27391
0.00804
Resort
Mean
S.D
0.36115
0.73309
0.05315
21.57233
1.80542
0.01892
0.18550
0.22677
0.07238
0.82546
1.99915
0.01357
DEBT is the debt to capital ratio, TANG (tangibility) is the ratio of total fixed assets to total assets, PROFIT (profitability) is the ratio of total earnings before interest, taxes, and depreciations to total assets, SIZE is the natural logarithm of total assets of the firm, LIQ (liquidity) is the ratio of current assets to current liabilities, NDTS (non debt tax shield) is the ratio of depreciation to total assets.
The lowest leverage ratio, 0.24596, goes to plantation industry. The plantation industry which referring here consists of those firms which planting palm oil tree. Conversely, there are studies showed that the palm oil industry have a high volatility according to the market condition.
While for the tangibility ratio, it showed how much a firm holds tangible assets. The plantation industry possessed the highest tangibility ratio with 0.78367 with the lowest ratio of 0.49579 for food and beverages industry. These are consistent with theory saying that the debt and the tangibility which are inversely related. For the profitability ratio, table showed the plantation industry earned the highest profitability among the three industries during the sample period. High profitability firms will less outsource their financing and the low debt ratio in the study provides the evidence. These also supported by the pecking order theory. In terms of liquidity, the plantation industry shows highly liquid with the ratio of 3.22119. High liquid firm will tend to borrow less as they manage to finance activities with internal funds. Thus, plantation industry shows the lowest leverage ratio among the three.
Table 2 below reports the panel regression result which is using fixed effect model. The result signifies that the tangibility and the debt to capital ratio have a positive relationship and it is statistically significant. This is where the firms used their tangible assets act as collateral to the debt issued. And this finding is found to be consistent with Prasad et al. (2003). Subsequently, the relationship between profitability and the leverage ratio is found to be inversely as expected and it is statistically significant. It provides evidence that the result is consistent with the pecking order theory and showing that the firms prefer to employ their internal funds rather than external financing when they are able to generate high profits. These also help the firm to minimize their cost of financing. Also, there also evidence provides that those firms with low profitability will not have sufficient incentives to issue debt.
Table 2: Fixed Effect Regression Result
Coefficient
Std. Error
t-ratio
p-value
Const
-0.134547
0.450445
-0.2987
0.7666
Tangibility
0.289264
0.159712
1.811
0.0771*
Profitability
-0.320374
0.348447
0.9194
0.3630*
Firm_size
0.0166193
0.0203051
0.8185
0.4176
Liquidity
0.000182370
0.00656970
0.02776
0.9780
Non_debt_tax_shield
0.0484938
0.660917
0.07337
0.9418
Notes: Dependent Variable= Debt to Capital Ratio (DCR). *Significant at 10%
