Capital is an important and critical resource for all companies. The capital resources can be divided into two main categories, namely equity and debt. Equity arises when companies sell some of its ownership rights to gain funds for operation and investing activities. Debt is a contractual agreement, whereby companies borrow an amount of money and repay it with interest within a stipulated time frame.
There are many definitions given to capital structure of companies. Osborn (1959) defined capital structure as term used to mean the financial plan according to which all assets of a corporation are furnished. This capital is supplied by long and short term borrowings, the sale of preferred and common stock and the reinvestment earnings. He further said that in analyzing the capital structure of an enterprise short term debt is excluded from consideration. Guthmann and Dougall (1955) stated that "Phrase 'capital structure' may be used to cover the total combined investment of the bondholders, including any long term debt such as mortgages and long term longs as well as total stockholders' investment including retained earnings as well as original investment." Brealey and Myers (1991) defined capital structure as comprising of debt, equity or hybrid securities issued by the firm. Schlosser (1989) defined capital structure as the proportion of debt to the total capital of the firms. Haugen and Senbet (1988) defined capital structure as a choice of firms between internal and external financial instruments. Bos and Fetherston (1993) pointed out that capital structure, being total debt to total asset at book value, influences both profitability and riskiness of the firm.
From the definitions given by many previous researchers, capital structure can be referred as combination of owned funds and borrowed funds. The owned funds include the share capital and free reserve and the surplus and the borrowed funds represent debentures, long term and short term loans provided by various financial institutions. The amount of debt that a firm uses to finance its assets is called leverage. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said to be unlevered.
One of the many objectives of financial managers is to maximize the wealth of shareholders. When financial leverage increases, it may bring better returns to some existing shareholders but its risk also increases as it causes financial distress and agency costs (Jensen and Meckling, 1976).
The bankruptcy cost is an example of direct financial distress cost while extraordinary administrative costs, loss of trade credit, loss of sales and key personnel are examples of indirect financial distress costs. Therefore, optimal capital structure is determined by the trade-off between benefits and costs of debt financing. The benefits are typically tax savings and the costs are financial distress and agency costs (Titman and Tsyplakov, 2004).
An optimum capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to the shareholders, but it is also important because of the impact of such decision on an organization's ability to deal with its competitive environment (Simerly and Li, 2002). Every firm strives to ensure the optimal mix of debt and equity in the firm's capital structure. Whether such optimal capital structure exists in reality or not? What are the potential factors those affect capital structure? These questions are very important for any firm and researcher. In other words, it is important to identify the potential determinants of capital structure in a given macro environment.
Prior to 1958, the traditional capital structure theory ( the Naïve Theory ) was based on the idea of weighted average cost of capital (WACC) principle, which states that companies issue debt in order to reduce their WACC as debt is considered less costly than equity (Prace, 2004).
The capital structure theory was later developed since the publication of seminal paper of capital structure irrelevancy framework by Modigliani and Miller (American Economic Review, 1958). They argued that a firm couldn't change the value of its outstanding securities by changing the proportions of its capital structure. Modigliani and Miller concluded that in a world without taxes, the value of the firm and also its overall costs of capital were independent of its choice of capital structure. A later study in 1963 by Modigliani and Miller concluded that by incorporating corporate tax, the market value of a firm is increased and the overall cost of capital is reduced to the point of interest being tax deductible.
Since Modigliani and Miller's publication in 1958, many financial economists studied a number of leverage relevant theories to explain the variation in debt ratios across firms. The trade-off theory explained the relevance of debt with the existence of taxes and bankruptcy costs (DeAngelo and Masulis, 1980 and Harjeet et al., 2004). The general result from this theory is that the combination of leverage costs and tax advantages of debt produces an optimal capital structure below 100% debt financing, as the tax advantage of debt is traded against the likelihood of incurring bankruptcy costs.
Pecking order model is another important theory in the study of corporate capital structure that explains the relevance of the debt and optimum capital structure. This theory was developed by Steward Myers in 1984 in his paper, "Capital Structure Puzzle". Myers (1984) presented two sides of the capital structure issue, which are called static trade-off theory and pecking order hypothesis. The static trade-off theory holds that the capital structure choices may be explained by the trade-off between benefits and costs of debt versus equity. A firm is regarded as setting a target debt level and gradually moving towards it.
The pecking order hypothesis contends, on the other hand, that there is no well defined target debt ratio, and firm have an ordered preference for financing. According to Myers, firms prefer retained earnings as their main source of funds for investment followed by debt. The last resort sought by a firm would be external equity financing. The reason for this ranking was that internal funds were regarded as 'cheap' and not subject to any outside interference. External debt was ranked next as it was cheaper and has fewer restrictions compared to issuing equity. The issuance of external equity is seen as the most expensive and dangerous as it can lead to potential loss of control of the enterprise by the original owner and manager; hence, it was ranked the last.
Another important theory is called the agency theory and this was developed by Jensen and Meckling in their 1976 publications. This theory considered debt to be a necessary factor in creating the conflict between equity holders and the managers. Jensen and Meckling recommended that, due to increasing agency costs with both the equity holders and debt-holders, there would be an optimum combination of outside debt and equity to reduce total agency costs.
Ross (1977) popularized the signaling theory of capital structure that states the managers of the firm posses inside information and they only reveal it by the method of financing. The managers will issue more debt if the future prospect is positive as they are willing to incur higher risk of bankruptcy and other relevant costs of higher debt.
Ever since Myers article on the determinants of corporate borrowing in 1977, the literature on capital structure has grown steadily with different theories trying to explain factors affecting capital structure. Many studies have concentrated their empirical research on the determinants of the level of debt or observed debt ratios of firms and explain the cross-sectional regularities in the level of debt. Titman and Wessels (1988) have studied the theoretical determinants of capital structure by examining them empirically. The theoretical attributes namely; asset structure, non-debt tax shields, growth, uniqueness, industry classification, firm size, earnings volatility and profitability are tested to see how they affect the firm's debt-equity choice. From that study, they found that debt-levels are related negatively to the uniqueness of a firm's business. Short-term debt ratios were shown to be negatively related to firm size and past profitability. In their research, Titman and Wessels, could not find any effect on debt ratios for volatility, collateral value, future growth and non-debt shield. However, Harris and Raviv (1991) in their seminal work on capital structure determinants found some relationship of those factors with leverage. They pointed out that leverage positively relates to fixed costs, non-debt tax shields, investment opportunities and firm size. In another classical study, Homaifar et al. (1994) examined the effect of profitability, firm size, future growth, non-debt tax shield, operating risk, dividend policy and uniqueness on the firm's leverage ratios. Their results showed a positive effect of firm size and future growth of earnings on the capital structure decision. The capital structure study revealed both consistent and contradictory results of the factors affecting capital structure choice of US firms.
In the beginning, the research on the determinants of capital structure was directed mainly on firms in the United States. It is a well-known fact that studies based on the experience of a single country may not represent the effect of diversity of economic tradition and financial environment on corporate capital structure (Antoniou et al, 2002). However, in the mid-1980s, research coverage widened to Europe and Japan (Nagano, 2003). To broaden the understanding of determinants of capital structure, Rajan and Zingales (1995) have attempted to find out whether capital structure choices in other G7 countries are based on the similar factors of that influencing capital structure of U.S firms. It showed clearly that there are many similarities than differences in the underlying factors of firm's debt to equity choices of the US with other countries. They noted that across the countries, asset tangibility is positively correlated with leverage for all the countries as theory supports the notion that firms having more fixed assets in their assets mix will use it as collateral to get more loans or debt. The market to book ratio, the proxy for growth seemed to be negatively correlated with leverage except for Italy. Having high market value of the stocks will enable firms to issue more stocks and not seek debt. Firm size is positively correlated, while profitability is negatively correlated with leverage in all countries except Germany. Apart from this, several other studies have focused on the developed nations, Chen and Jiang (2001) on Dutch firms, Devic and Krstic (2001) on Poland and Hungarian firms, Antoniou et al. (2002) on the UK, France and German firms, Drobetz and Fix (2003) on Switzerland firms and Padron et al. (2005) on Spanish firms.
Even though the theoretical framework for the capital structure decision is founded upon larger firms, research on capital structure for SMEs trying to explain the applicability of the theoretical framework also on SMEs does exist. Van der Wijst (1989) studied the Netherlands and Germany, Holmes and Kent (1991) studies the Australia, Sogorb-Mira (2005) studied Spain, Tran Dinh Khoi Nguyen and Neelakantan Ramachandran (2006) study of Vietnam. Hutchinson et al. (1998) studied the small firms in the United Kingdom. Almost all the studies on capital structure were examined using secondary data. However, there were few interesting studies conducted by interviewing CFO and financial managers to find out the preferences for capital structure and the factors influencing them (Graham and Harvey, 2001, Winter et al., 2004 and Beattie et al., 2004). There are also some recent studies on capital structure focused on certain industries (Tang and Jang, 2005 for lodging and software firms, Upneja and Dalbor, 2001 for restaurant firms and Guzhva and Pagiavlas, 2003 for airline business).
According to the literature, the empirical studies on the determinants of capitals structure are largely focused on the United States and other developed nations with similar institutions. The issue of determinants of capital structure in developing countries however received little attention. Lately, there were only few studies on the determinants of capital structure conducted in the developing countries. One of the recent empirical studies on determining the factors affecting capital structure in developing countries have been attempted by Booth et al. (2001). In their studies, a sample consisting of 10 developing countries were analyzed. From their analysis, the authors have concluded that the variables that explain the capital structures in developed nations are also relevant in the developing countries irrespective of differences in institutional factors across these developing nations.
Bhaduri (2002) did an empirical study of the determinants of corporate borrowing from the Indian perspective. He concluded that the optimal capital structure choice is influenced by factors such as growth of earnings, cash flow of the firm, size of the firm, and product and industry characteristics.
It is noted that many research were directed towards finding the leverage levels and the determinants of leverage. The theoretical determinants of capital structure and the models had been tested by many scholars mainly in large companies of the developed nations. However, there were not many studies done to prove the models and the theoretical determinants of capital structure in the developing countries, especially the countries in the ASEAN region. To add to the literature of capital structure, this dissertation is an attempt to study the determinants of capital structure choice of firms in selected ASEAN countries. In this study, public listed companies in the main board of Malaysia, Thailand, Indonesia, Singapore and Philippines are analyzed separately to see the level of leverage and the factors affecting the capital structure choice.
The sources of data for this study are Balance sheets and Income Statements of companies over 14 years period from 1992 till 2005 which are mainly extracted from the Bloomberg. A total of 243 listed companies from Malaysia are analyzed by industry classification for the purpose of this study. The number of other ASEAN companies selected as sample for this study includes Indonesia, 132; Philippines, 79; Thailand, 25 and Singapore, 111.
In the earlier studies, cross sectional regression was dominantly employed to analyze the factors affecting the capital structure choices of firms. However, lately the use of panel data regression became popular in analyzing the determinants of corporate capital structure. Therefore, this study adopted the panel data regression model similar to what had already been used by Arellano and Bover (1990), Antoniou et al. (2002) and Abor (2007) in their study of capital structure determinants. Panel data is actually the pooling of observations on a cross-section of units over the prescribed time periods. According to Antoniou et al. (2002), panel data approach has several advantages than the cross sectional data as the former gives higher degrees of freedom, larger number of observations, reduces the multicollinearity among the explanatory variables and gives more efficient estimates. The generalized least square (GLS) regression methods had been used to run the analysis of the panel data with white heteroscedasticity-corrected standard errors and covariance.
