Capital structure and law around the world

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Abstract

In this research paper we examine the determinants of capital structure using a large panel of firms from 31 countries, all with different legal systems and different levels of investor protection. Our results confirm that institutional variables play an important role in a firm's capital structure, although firm-level determinants seem to be similar around the world. The most important conclusion of this research concerns the negative impact of the interaction between shareholder rights and profitability on market leverage. It suggests that the more shareholder rights there are, the fewer asymmetric problems occur.

Introduction

Capital structure has been a perennial subject of study since Modigliani and Miller (1958). In the 1960s and 1970s a considerable amount of research was concentrated on the analysis of the benefits and costs of debt, always assuming the hypothesis of market efficiency and symmetric information. The main objective was to study how firms balance bankruptcy costs with the benefits of tax shields (Kraus and Litzenberger, 1973, Scott, 1976, Kim, 1978). This field of investigation is called static trade-off theory. It is characterised by the idea that firms set a target for a leverage ratio and move towards it.

In the mid 70s, Jensen and Meckling (1976) and Myers (1977) focused on agency costs. Jensen and Meckling (1976) gave more emphasis to the conflicts between management and shareholders (or between control and ownership) and to the conflicts of interest between bondholders and stockholders. The first conflict is characterised by managements’ resource to perquisites or aberrant investments, destroying the wealth of the firms’ owners. Jensen (1986) argued that one way to solve this problem was by issuing debt, avoiding the use of free cash flows in inadequate decisions. The latter conflict can be seen in two different angles: the underinvestment problem (Myers, 1977), when firms – even in the presence of projects with NPV > 0 – reject their execution wherein stockholders refuse to invest in low-risk assets to avoid shifting wealth from themselves to the debtholders; and the asset substitution problem (Jensen and Meckling, 1976), a problem that arises when a company exchanges its low-risk assets for high-risk investments. This substitution transfers value from a firm's bondholders to its shareholders. Corporate finance in the 1980s placed more emphasis on information asymmetries among investors and firms. This microeconomic problem was called Pecking order theory by Myers (1984) and Myers and Majluf (1984). In its purest version, managers cannot issue equity under any circumstance, resulting in the assumption that there is no optimal capital structure. It posits that firms, in consequence of information asymmetries, prefer to use internal rather than external resources, and secured securities rather than unsecured ones. That is, investors would require an incentive to invest in risky securities because they would know less about a firm than its management did. Thus, equity, considering its risk, would be the last alternative a firm would choose for investment, and on the contrary, funds internally generated would be the best financing choice. In fact, according to the Pecking order theory and in opposition to the static trade-off theory, a firm does not have a well-defined target for leverage. Baker and Wurgler (2002) introduced a new theory based on the idea that capital structure is a persistent result of past decisions. Market timing assumes that there are changes in market-to-book values that will produce permanent changes on leverage, contradicting the static trade-off theory point of view. A firm tends to issue (repurchase) equity instead of debt when market value is high (low) in comparison to book value and past market values. The foundations of their theory stem from the results obtained, among others, by: Ritter (1991), who diagnosed the underperformance, particularly of small growth firms after they had gone public, taking advantage of the optimism of investors concerning potential earnings; Pagano et al. (1998), who studied whether the positive relationship between initial public offerings and market valuation resulted from higher investments in industries with growth opportunities or, on the other hand, was an attempt by the owners to misprice those firms excessively, concluding that the latter alternative was the most plausible; and Hovakimian et al. (2001), who suggested that stock prices have an important role on the firm's financing choice, issuing (repurchasing) equity and repurchasing (issuing) debt when a firm experiences stock price increases (decreases), suggesting that managers do not issue equity for reasons related to optimal capital structure, but rather as a way to avoid sharing earnings per share.

The determinants of firm capital structure decisions are typically examined in terms of firm-level characteristics, despite the fact that capital structure choices are also likely to be determined by a firm's institutional environment or a country's infrastructure.1 Institutional variables and market imperfections influence corporate financing choices. A firm is more likely to raise equity or debt depending, respectively, on whether the country has an efficient capital market or a developed banking system. In an illiquid capital market, investors will demand higher stock returns, increasing the cost of equity of the firms. Under these circumstances a firm has incentives to raise funds using either the banking system or internally generated funds. This is the typical reason, among many others, why research on capital structure, more recently, has focused on the interaction between firm determinants and country infrastructures, namely legal environment, shareholder and creditor rights, capital market development, banking development, and other variables. Variables related to a national financial environment, such as legal system and financial development, are plausible reasons to enlighten why France, Germany, and Japan, for example, have banking-based systems and also why capital markets play an important role in financial choices and in corporate control methods in the US and the UK. Financial environments explain the involvement of German banks in firm decisions, why French firms are controlled by the State, as well as why Turkish firms are owned by families. Anglo-Saxon countries, on the other hand, present a different environment, namely concerning the legal structure, whereby shareholders and creditholders are well protected, the quality of enforcement and the standards of accountability are generally higher than in Civil law-based countries, and as a result a developed local capital market is expected, motivating firms to issue equity (La Porta et al., 1997, La Porta et al., 1998, Demirgüç-Kunt and Levine, 1999).2 However, the impact of the law on different legal regimes must be analysed with caution because there are several Civil regimes: the French, the German, and the Scandinavian; and the level of creditors’ and shareholders’ protection differs among them. French Civil law countries present the weakest level of investor protection, whereas countries inspired by the German and Scandinavian Civil law regimes offer greater protection to investors (La Porta et al., 1998).

Rajan and Zingales (1995) were, probably, the first to refer to the importance of studying country specificities in firms’ capital structure. Although their research had taken into account some institutional variables such as the size of capital markets, the bankruptcy law, and the relation between ownership and control of firms, they found that these did not interact simultaneously with firm-specific determinants of capital structure. Demirgüç-Kunt and Maksimovic (1996) expanded this research field, analysing the impact of stock market development on firms’ financing choices, showing that there is, as would be expected, a negative relationship between long-term and short-term debt and the size of capital market. Booth et al. (2001), following previous studies, examined capital structures in ten developing countries, concluding that determinants of capital structure are not different between developed and developing countries, although maintaining that much has to be done to understand the impact of countries’ infrastructures on financing choices. Claessens et al. (2001) examined how corporate finance patterns and risk-taking behaviours are influenced by the legal and financial development of a particular country, and concluded that companies in Common law environments present less risk (for example, in terms of cash flow risk and financial leverage). Fan et al. (2011) debated the impact of some institutional variables such as corruption, taxes, inflation, and legal and political institutions on capital structure and debt maturity choices, suggesting that public policies and institutional environment are more influential on firms’ financing choices than industry affiliation. Giannetti (2003) analysed, within a sample of unlisted firms, the impact of firm characteristics, legal rules, and financial development on corporate finance decisions, and concluded that, among other aspects, countries with higher creditor rights standards were particularly interesting for firms characterised by investing in intangible assets since they needed less collateral instruments than they would if they were located in a country with weaker creditor rights. De Jong et al. (2006), on the other hand, evaluated the role of firm- and country-specific determinants of capital structure in 42 countries, concluding, contrary to some literature, that the impact of specific determinants was not equal around the world because they depended on country specific factors.

Our main objective is to evaluate the influence of institutional variables on the determinants of financing choices, namely how they fit into very different theories of capital structure.

We have examined a sample of firms from 31 countries with different features: Australia, Belgium, Brazil, Canada, Chile, Denmark, Finland, France, Germany, Hong Kong, Indonesia, Ireland, Italy, Japan, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Philippines, Portugal, Singapore, South Africa, South Korea, Spain, Sweden, Switzerland, Thailand, Turkey, the UK, and the US.

This sample includes firms in countries with different legal systems as well as different institutional environments. Some firms come from countries that have adopted Common law – such as Malaysia, the UK, and the US –, and as a result of such policy represent a market-based system. Other firms are from countries that use bank-based systems, such as France and Japan, whose legal systems are Civil law-oriented.

Capital structure determinants include both institutional and firm-level variables. We have used five internal exogenous variables: profitability, tangibility, market-to-book, and size (suggested by Rajan and Zingales, 1995) and external finance weighted average (suggested by Baker and Wurgler, 2002). Legal system origin, banking development, capital market development, and investor protections are the institutional variables examined.

Our contributions reveal that: (1) we consider the origin of the legal system and investor protection as determinants of leverage; (2) we study how firm-level variables interact with the institutional variables in determining capital structure; and (3) we analyse market timing in an international context.

Our results can be summarised as follows. First, we show that shareholder rights, in general, are an important determinant of capital structure even when controlling other institutional variables, e.g., creditor rights, legal systems, capital market development, banking development, corruption index, average number of analysts, and inflation. Second, size seems to be a common determinant of capital structure around the world. We can confirm its importance in 21 countries (see Appendix A) as a determinant of market leverage. Leverage is less sensitive to size (as a proxy for bankruptcy costs) on Scandinavian Civil law based countries. Third, profitability, more than any other firm characteristic, seems to be a common determinant around the world. In 25 countries (see Appendix A) of the sample this variable plays an important role as a determinant of leverage. The relationship between asymmetric information costs and leverage is more pronounced in countries where shareholders are well protected. It means the more shareholder rights there are, the fewer asymmetric problems occur. The Pecking order theory of Myers (1984) and Myers and Majluf (1984) and its relationship with the protection of shareholders is strengthened in this research, regardless of the countries or the size of the firms analysed. Fourth, tangibility seems to be more related with short and long-term debt to assets than with book and market leverage. The greater the shareholder rights are, the lower is the impact of collateral assets on long-term (and short-term) debt to assets. This occurs because either creditor rights or shareholder rights are positively related, and the conflict of interests between shareholders and creditholders is reduced in those circumstances. Fifth, market-to-book and external finance weighted average market-to-book are observable respectively in 22 and 23 countries (see Appendix A). It is not suggested that both variables explain different theories, namely market timing, but as Hovakimian (2006) refers, EFWA contains information about the firm's growth opportunities not observed by current market-to-book. Sixth, our results confirm that firm-level variables are influenced by the institutional environment, namely by shareholder rights, although the impact of country-level variables is not the same in all countries. Seventh, it seems that the results concerning firm-level variables are more constant around the world than country-level variables. Eighth, when firms’ size and profitability are controlled, the impact of country-level variables is not similar on all firms. For example, the average number of analysts is only important for small firms, and such is expected. In general, there is less information about small firms. The larger the number of analysts following a small firm the higher is the probability that such firm issues equity.

This paper is organised as follows. Section 2 discusses the determinants of capital structure. Section 3 describes the data and presents descriptive statistics. Section 4 details the results of using a panel data, with industry effects. Section 5 contains considerable robustness and a number of additional tests. Section 6 concludes the paper.

Section snippets

Determinants of capital structure

This section debates the factors that determine a firm's capital structure. The underlying theories and previous empirical evidence are also reviewed. First, we present the firm-level variables previously mentioned. Second, we present country-level variables, pertaining to legal and institutional environments, which may influence financing decisions.

Data and descriptive statistics

The data extracted from Worldscope include firms from the 31 countries, as shown in Table 1. We have excluded financial institutions because they are subject to specific regulations that influence their leverage. We have also excluded utilities, namely in Table 6, since in the United States and many other countries, utilities are faced with significant regulations that may directly affect their leverage ratios and profitability. The industries include Basic Industries, Cyclical Consumer Goods,

Empirical results

First, we have estimated a regression equation, which includes time and industry-fixed effects:LEVi,t=α+b1LAWi,t1+b2SRi,t1+b3CRi,t1+b4PCi,t1+b5LRi,t1+b6TANGi,t1+b7PROFi,t1+b8LN(Salesi,t1)+b9MBi,t1+b10EFWAi,t1+ui,twhere LEVi,t is one of the four different measures of leverage for firm i in period t; LAW (legal dummy variable), SR (shareholder rights), CR (creditor rights), PC (private credit), and LR (liquidity ratio) are institutional variables; TANG is tangibility; PROF is

Robustness and additional tests

Table 7, Panel A analyses the impact of firm and institutional variables on market leverage, controlling firms’ sales (by quartiles) and considering the panel data with year and industry-fixed effects. The corruption perception index reveals a positive influence on market leverage. Investors do not like to buy shares in countries where the relationship between firms, government agencies, and justice is not very clear. On the other hand, creditor rights influence negatively market leverage when

Conclusion

Our analysis of the determinants of the capital structure of firms considers different institutional environments. We have used a panel of firms from 31 countries with different legal systems, shareholder and creditor rights and banking and capital market development. Our main objective has been to see how the institutional environment is related to internal variables—tangibility, profitability, size, market-to-book, and external finance weighted average. Our particular contribution is our

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