This research aims to employ longterm leverage and total leverage to investigate the capital structure determination of 200 sample FTSEL Allshare firms in manufacturing and service sector in the UK and to conduct a comparative research of capital structure determination across those two sectors. Such sectors have its own business environments as well as characteristics. Thus, the capital results from such sectors might vary. The study variables are developed based on prior literature and empirical evidence. Financial data are collected from FAME and annual reports. Statistical tests include correlation analysis, descriptive statistics and pooled OLS regression analysis.
Determinants of non-financial firms capital structure Abstracts This research aims to employ long-term leverage and total leverage to investigate the capital structure determination of 200 sample FTSEL All-share firms in manufacturing and service sector in the UK and to conduct a comparative research of capital structure determination across those two sectors Such sectors have its own business environments as well as characteristics Thus, the capital results from such sectors might vary The study variables are developed based on prior literature and empirical evidence Financial data are collected from FAME and annual reports Statistical tests include correlation analysis, descriptive statistics and pooled OLS regression analysis Based on the empirical results, it can be seen that manufacturing sector normally borrow more debt than their counterparts in two other sectors The descriptive analysis suggested that for longterm debt to equity ratio during year-period from 2011 to 2015, manufacturing companies prefer to use more long-term debt to finance for their investments which implies that manufacturing firms rely on more long-term debt than the companies in service sectors since they are capital-intensive companies Since manufacturing companies use more long-term debts, the service firms are concluded to have higher short-term leverage, suggesting that the capital structure of service firms in the UK tend to have higher level of short-term debt which are suitable for the roll over of their expenditure and current investments for the working capital for a year Higher asset tangibility and the size of the firm imply that manufacturing companies have higher investments on non-current assets Since firms in manufacturing industry rely largely on long-term financing, this leads to lower liquidity position as compared to the service companies This empirical observation is in line with the trade off and agency argument for capital structure relevancy Dividend payment in manufacturing firms tends to be lower than that of the service companies, which can be explained by higher growth opportunities and large investment in fixed assets in manufacturing sector Result by performing pooled OLS multiple regression with panel data, the model was free from the problem of multicollinearity and proved that this model is econometrical robustness The trade-off theory (TOT) and pecking-order theory (POT) are the two main strands of theories and the testable hypotheses are built and tested based on them In terms of dividend, it can be easily seen that there is a positive correlation between dividend and debt levels in all two sectors, which provide strong evidence support for the POT and suggesting that TOT had no effect on such variable No-debt tax shield and firm growth also support for POT Nevertheless, in term of firm size and profitability, there is strong evidence for inverse relationships with long-term and total leverage ratio, supportive for POT With respect to tangibility, the result was found to support for TOT in all proxies and for two sectors The result from liquidity variable is complicated while long-term debt to equity support for TOT while total debt-to-equity support POT in two sectors Acknowledgements Foremost, I would like to express my sincere thanks to my advisor Prof … for the continuous support of my Bachelor study and research, for his patience, motivation, enthusiasm, and massive knowledge His guidance helped me a lot for this dissertation Besides my advisor, I would like to express my sincere gratitude the rest of my lecturers and tutors at University, for their encouragement, guidance, dedication during my academic courses Last but not the least; I would like to to convey my sincere thanks to my family: my parents, for giving birth to me at the first place and supporting me spiritually throughout the term year Table of Contents List of figures List of tables INTRODUCTION 1.1 Background Financing choices are major decisions of firm’s capital structure, which play an important role in the firm performance and market value From the technical perspective, the firm capital structure balances the levels of equity and debt used to finance the firm’s daily operations, assets and future performance Under tactical view, capital structure has an effect on all the firm performance in terms of risk management, funding method and cost, required rate of return and resilience to macroeconomic downturns (Vatavu, 2015) Recent studies of the issues of corporate financing or capital structure in the Eurozone have raised concerned about the impact of capital structure choice to the whole performance and stability of the zone (Inderst and Mueller, 2008) The UK economy, which play a leading role in the Eurozone, would strongly affect the performance of the whole zone The purpose of this study is to investigate the determinants of capital structure in the non-financial firms in the UK Although capital structure decision has a strong impact on an economy, the theory of Modigliani and Miller (1958) finds that the firm capital structure is independent of the company market value It is noticeable that this theory is only valid under the assumption of a perfect capital market, which is not exist in the world economy However, the Modigliani and Miller theory has been a cornerstone for the corporate management and decision The capital structure theory was introduced by Modigliani and Miller (1963) While most empirical studies argue that companies could benefit from tax deduction of using debt to finance their operations which may positive affect firm value, no consensus study investigating the factors affecting firm capital structure Literature review section provides conflicting findings of the determinants of firm capital structure In addition to this, few studies have examined the factors influencing capital structure in the UK market One of the main purpose of this paper is to contribute to the literature on the decision of the UK firm capital structure With respect to the capital structure decision, a wide range of factors may influence the leverage level of a firm such as shareholder, board characteristics, and firm-specific factors This paper focuses on investigating the impact of firm-specific factors including firm size, profitability, liquidity, nondebt tax shield, growth and tangibility on the UK firm capital structure proxied by firm leverage level Unfortunately, the majority of empirical studies investigate determinants of capital structure in the US market, only few studies test the capital structure theories on worldwide market For example, the worldwide empirical study of Wald (1999) provide evidence that the impact of firm-specific factors on capital structure is different across countries and industries This means that each country may have different characteristic leading to the difference firm capital structure decision Using empirical data of the UK non-financial firms, this paper will feedback the literature on the impact of firm-specific factors on level of leverage When it comes to the capital structure theory (irrelevance proposition) of Modigliani and Miller (1958, 1963), some modern capital structure theories based on the MM theory are given under the relaxation of some unrealistic assumption of the MM theory The static trade-off and pecking order are two main theories that incorporate some improvements on the original capital structure theory This paper takes into account both trade-off theory and pecking order theory to develop research hypotheses Further details of these theories are given in the literature review section 1.2 Research Objectives The main purpose of this study is to examine the determinants of the all UK non-financial companies over the period between 2000 and 2011 Based on the major theories relating to the determinants of firm capital structure, the study aim to contribute to the literature of capital structure in the UK economy The research objectives are detailed in the following bullet points • • • To identify the factors affecting the capital structure decision of the UK firms To identify the strongest factors affecting the capital structure To give the feedbacks to the literature of capital structure studies 1.3 Research Questions The paper aim is to answer the following questions • What are the statistically significant factors having an impact on the non-financial firms • in the United Kingdom? Which are the strongest factors affecting the capital structure decision of the UK non- • financial companies? Whether the findings of this paper are consistent with the recent studies of the determinants of capital structure? 1.4 Research methods overview The purpose of this paper is to examine the impact of the UK non-financial firm’s characteristics on the level of leverage In particular, firm characteristics include firm size, growth, profitability, non-debt tax shield, dividend and tangibility This paper uses non-financial companies in the FTSE All Share Index as the representation of the UK non-financial firms To reflect the current trend of the determinants of firm capital structure, this papers only examined firms during the period between 2011 and 2015 The main methodology of this paper is the Pool Ordinary Least Square (OLS), which could provide reliable results of the impact of firm-specific factors on the level of leverage 1.5 Research structure This section provides details of each main section of this paper including introduction, literature review, methodology, results and findings, and conclusion Introduction: This section introduces the background, purposes, and summarizes the main regression results of this paper The research methodology used to carry out regression tests is also mentioned in the introduction section Literature review: this section focuses on reviewing recent findings of the determinants of capital structure and two main capital structure theories, namely trade-off theory and pecking theory Based on the review of empirical studies on the impact of firm-specific factors on capital structure, hypotheses are also developed in this section Methodology: This section provides the research method used for testing developed hypotheses in section (Literature review), and the model of this paper Data collection method and analysis is also given in this section Results: This section summarizes the finding of OLS regression models to determine the impact of firm-specific factors on capital structure Results section also gives the comparative analysis in three different sectors in terms of decision of capital structure Conclusion: This section summarizes the main findings and contributions of this paper Also, some limitations and recommendation for future researches on the determinants of capital structure will briefly given in this section LITERATURE REVIEW This section provides a short review of major theories relating to the capital structure and potential variables that are expected to have an impact on the firm capital structure The hypotheses are given based on given theories 2.1 Modigliani and Miller capital structure theory Under the perfect markets where taxes, bankruptcy costs and transactions costs not exist and all information are disclosure, the level of debt in the firm capital structure does not affect the firm’s market value (Modigliani and Miller, 1958) Because of the existence of taxes is inevitable in every economy in the world, a new theory by Modigliani and Miller (1963) called incorporates taxes and relaxes the assumption of no tax This leads to the realistic of the investigation of the impact of tax on the firm capital structure There are different capital structure decisions that a company can make to finance their business operations Most companies tend to use both debt and equity to finance their operations On the other hand, many companies solely use equity for their operations and not get involve in debt There are different reasons that could explain the conflicting trends of capital structure The trend of using debt is first developed by the capital structure theory of Modigliani and Millers (1958) which states that using debt does not affect firm market value This study has created a fundamental background of capital structure theory However, the main weakness of this MM theory is its unrealistic assumptions that the theory is only valid in perfect market where tax, brokerage fees, asymmetric information, transaction cost, bankruptcy cost are not existed, and all investors have rational behavior Moreover, no investor or security issuer is large enough to influence the market in the perfect market Although these assumptions are unrealistic, the contribution of the theory has been a cornerstone of capital structure theory Due to the unrealistic assumptions, many studies have relaxed some assumptions of MM theory to update the irrelevance theory The most significant update of Modigliani and Miller (1958) theory is the Modigliani and Miller (1963) theory which relaxes the tax assumption, which means that the MM (1963) theory takes into account the influence of tax on firm market value This updated theory has significantly contributed to the capital structure theory as tax is always existent and inevitable However, there are some incorporated assumption of the MM theory with tax In particular, no transaction costs exist and both individuals and corporates can borrow at the same rate The proposition II of MM theory suggests that as the firm’s level of leverage increases, the estimated return on equity will increase in linear due to the tax reduction of using leverage If a firm spends interests for their loans, the tax obligation will be lower, which in turn improves firm’s return on equity To support the MM capital structure theory, the study of Miller (1977) investigates the impact of private tax and corporate tax on capital structure However, the finding of Miller (1977) is conflicting with the finding of Modigliani and Miller as he argued that corporate tax could be trade off by the associated tax benefit of private taxes resulting in the irrelevance of tax on capital structure decision In addition to this, the study of Fama and French (1998) finds that the advantage of tax could lower firm market value, which is inconsistent with the previous capital structure theories of Modigliani and Miller (1963) and Miller (1977) The inconclusive of the impact of tax on firm market value and capital structure decision would encourage future studies on capital structure and irrelevant theory with more relaxation on unrealistic assumptions on brokerage fees, transaction costs, bankruptcy costs and asymmetric information The following subsections will provide details about some major capital structure theories 2.2 Static trade off theory The trade-off theory considers both bankruptcy costs and taxes based on the Modigliani and Model models, which products a benefit for company holding a high level of debt due to the tax shield In other words, this theory encourages firms to balance the level of debt and equity because these can play lower taxes due the tax deductible from debt (Jong, Verbeek and Verwijmeren, 2011) Using both equity and debt is a common trend of firms in the world as they can benefit from tax deduction and allow them to control the risk of using leverage However, determining the optimal ratio of equity to debt is the most important question The main purpose of capital structure decision is to find the optimal ratio of debt and equity which enhances firm market value and shareholder value Kjellam and Hansen (1995) argue that a proper capital structure decision allows a company to effectively combine financing sources to maximize firm market value and minimize the cost of capital Unfortunately, it would be impossible to find an optimal point based on capital structure theories due to the unrealistic of their assumptions of a perfect market where transaction, agency, brokerage and bankruptcy costs not exist To apply the capital structure theory into the practice, it is essence to relax some assumptions of a perfect market In reality, there is a link between debt and the insolvency risk that could associate with bankruptcy costs The trade-off theory takes into account bankruptcy costs in determining the optimal capital structure The theory was introduced by Myers (1977) and argues that there are benefits of using leverage within a capital structure up until the optimal capital structure is reached Using the mix structure of debt and equity to balance the costs and benefits is the main purpose of the trade-off capital structure theory The trade-off theory also takes into account the benefit from interest payments, financial distress costs, agency costs of debt and agency benefits of debt Welch (2004) introduced the following model of trade-off capital structure theory: Where VL stands for the market value of leveraged firm, V U stands for unleveraged firm value, PV stands for the interest tax shield, which indicates the benefit of tax deduction of using leverage, PV (Agency Benefits of Debt) is the present value of agency benefits of debt, PV(Financial Distress Costs) is the present value of financial distress costs arising when a company employ excessive the optimal level, PV (Agency Costs of Debt) and PV (Agency Costs of Debt) refer the present value of agency issues 2.3 Agency theory Freedom of agency cost is an assumption of the Modigliani and Miller irrelevance theory in a perfect market Jensen and Meckling (1976) developed agency theory that relaxes the agency cost assumption of MM theory The agency cost arises when the interests of a company’s shareholders conflict with interests of its managers as the objectives of the two parties might be different On the one hand, firm’s managers with their deep understanding on business operation and capital structure could improperly use their power to get involve in potential projects with negative NPV to maximize their wealth and power In addition to this, On the other hand, shareholders require firm’s managers to run the company in a way that maximizes shareholder value Jensen and Meckling (1976) argue that the managers and agents can exploit their power to generate personal benefit which negatively affect firm market value and shareholders’ interests This leads to the high separation in a firm operation and high agency costs Agency issues tend to arise in listed companies where shareholders have rights to influence company’s operations The conflict of interests between managers and shareholders would result in high agency costs to control the managers With respect to the relationship between agency costs and capital structure, Kjellam and Hansen (1995), Fama and French (2002) and Berger and Patti (2006) find a statistically and negatively relationship between these factors For example, these authors argue that the relatively high level of free cash that are available for managers would induce them to overinvest in negative NPV projects that could increases their wealth and power which negative influence shareholder value and firm market value In other words, there is a negative association between firm leverage proxied by the ratio of debt to asset ratio and the agency costs proxied by the ratio of general administration costs to firm total assets This indicates that using debt to finance firm operation is a method to lower agency cost or conflict of interest To support this argument, Frank and Goyal (2007) find that using leverage would allow firms to lower their free cash flows due to the interest payments Lowering available cash flow would obstruct firms’ managers to overinvest or exploit to generate personal benefits Furthermore, using leverage could also improve private monitoring as creditors have strong incentives to observe and create pressure on firms’ managers to increase firm profitability (Huang and Song, 2006) 2.4 Pecking order theory Although the trade-off theory has been a cornerstone of the capital structure theory, it has failed to explain the trends that the yield of stock price tends to increase and decrease with the leverage-increasing and leverage-decreasing volumes, respectively (Chen, 2004) Pecking order -(1.455) -(0.745) 2.488*** 1.544 Asset tangibility (2.634) (0.789) 0.665 0.983 Firm growth (0.318) (1.340) 0.899 0.593 Firm liquidity (0.065) (0.309) 0.971 0.232 Non-debt tax shield (0.656) (0.323) 3.402*** 2.032* Dividend payout (3.910) (2.518) Year dummy Included Included Industry yummy Included Included Number of observation 100 100 R squared 0.453 0.389 Adjusted R-squared 0.376 0.299 F-statistics 2.203 2.005 p-value 0.001 0.019 The regression finding reports that the first model has F-statistics=2.203, p-value=0.001