Does firm characteristic matter in capital structure decision an empirical study of listed food processing companies in vietnam

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS DO FIRM CHARACTERISTICS MATTER IN CAPITAL STRUCTURE DECISION? AN EMPIRICAL STUDY OF LISTED FOOD PROCESSING COMPANIES IN VIETNAM A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By DINH THI THU Academic Supervisors: Dr NGUYEN TRONG HOAI Mr NGUYEN XUAN THANH HO CHI MINH CITY, October 2014 ABSTRACT The aim of this paper is to explore the firm-specific factors that affect the capital structure of food processing companies listed in Vietnamese stock exchange The paper firstly reviews theories of capital structure: trade-off theory, pecking-order theory and other related empirical studies Seven factors are thereinafter concluded and discussed in the studied model in respect of correlations and the determinants of capital structure by using panel data procedures for a sample of 41 food processing companies listed on the Vietnamese Stock Exchange during the period of 2007-2012 Pecking order theory dominates in explaining financial decision of these firms There are differences between the determinants of long-term fund-raising and short-term fund-raising Profitability, size, tangibility, earnings volatility and liquidity are found statically significant to short-term leverage whereas tangibility and earnings volatility is the most important factors impacting the long-term leverage Empirical findings suggest some policy recommendations for sustainable development of the private sector in Vietnam Keywords: Capital structure; leverage; food processing; Vietnam listed companies; panel data ACKNOWLEDGEMENT Studying is a long and interesting journey It would be more interesting if you have a chance to get to know the talented people and learn from them This paper could not have been completed without support from my supervisors, friends and family I would like to convey profound appreciation to Dr Nguyen Trong Hoai, Mr Nguyen Xuan Thanh and Mr Truong Dang Thuy for their guidance in conducting this thesis My special thanks go to Mr Nguyen Xuan Thanh for his valuable guidance, critical comments and warm support which made this work possible at the crucial stages To my family and friends, my sincere gratitude for their unconditional love, support, and encouragement TABLE OF CONTENTS CHAPTER INTRODUCTION 1.1 Research background 1.2 Problem statement 1.3 Research objectives 1.4 Thesis structure CHAPTER LITERATURE REVIEW 2.1 Capital structure definition 2.2 Capital structure theory 2.2.1 The trade-off theory 10 2.2.2 Pecking Order theory 14 2.3 Comparative look on capital structure theories 15 2.4 Empirical evidence on determinants of capital structure 17 2.4.1 Empirical evidence around the world 17 2.4.2 Empirical studies in Vietnam 22 CHAPTER OVERVIEW OF FOOD PROCESSING SECTOR IN VIETNAM 27 CHAPTER CAPITAL STRUCTURE DETERMINANTS – HYPOTHESES 32 4.1 Profitability 32 4.2 Tangibility 33 4.3 Firm Size 34 4.4 Non-debt tax shields 34 4.5 Growth opportunities 35 4.6 Earnings volatility 36 4.7 Liquidity 36 CHAPTER Methodology AND DATA 39 5.1 Data 39 5.2 Methods of estimation 39 CHAPTER EMPIRICAL RESULTS 42 6.1 Descriptive statistics 42 ii 6.2 Analysis of the correlation among variables 43 6.3 Empirical results 46 CHAPTER CONCLUSION 53 7.1 Findings 53 7.2 Policy implications 54 7.3 Limitations 57 REFERENCES 59 iii LIST OF FIRGURES Figure Conceptual framework for firm-level determinants of capital structure………… 37 LIST OF TABLES Table Market capitalization of Vietnam’s stock exchange (2004 – 2012)……… …….… Table A summary of selected studies on determinants of capital structure in Vietnam… 26 Table Output and export contribution of food processing sector…………………… … 27 Table Number of enterprises manufacturing food and beverages by size of employees and capital resources ………………….… …………………… …………………………29 Table Some financial indicators of Vietnamese enterprises…………………… ……… 30 Table Summary of determinants of capital structure: theory and measurement …….… 38 Table Summary statistics of sample variables………….……………………………… 43 Table Correlation coefficients among variables and VIF coefficients… ………… … 45 Table Results of Hausman tests for Model 1, and 3…………………………… …… 47 Table 10 Estimation results of firm-level factors impacting on total leverage, short-term leverage and long-term leverage using FEM…………………… …………………………48 iv CHAPTER INTRODUCTION 1.1 Research background Vietnam is a developing country in Southeast Asian region with total area of 331,210 square kilometers and population of over 91 million Recovering from the war damage and the rigidities of a centrally-planned economy, the country has become among the fastest growing economies over the past decades thanks to the Doi Moi reforms in 1986 During this period, the private sector has emerged as one of the most important driving forces in Vietnam’s economic development The Enterprise Law in 2000 is conceived as a remarkable milestone for development of the private business in Vietnam This law mainstreams the registration and operation of private companies, implements a regime of property rights and guarantees equal treatment among economic sectors As a result, the period of 2000-2005 witnessed a boom in private sector development It is estimated that 160,672 private enterprises were registered with a total combined capital of US$20 billion during the period of 2000-2005, which is 3.2 times more than the total number of private enterprises registered during 19911999 The private sector has played an increasingly important role in job creation, poverty reduction and economic growth Vietnamese private enterprises annually contribute about 42% to overall GDP and provide 56.3% of the country's regular job supply Nevertheless, these private firms have been facing many challenges in their existence and competition One of the biggest challenges is financial capacity The majority of Vietnamese firms are small-sized in terms of labor and capital More than 90 percent of the local businesses are small and medium enterprises These firms have been facing tough competition from foreign companies in technology and financial capacity Vietnam joined the WTO in 2007 following a long negotiation process of more than ten years and became the member of Trans-Pacific Partnership trade agreement in 2010 These turning points have brought both opportunities and challenges to Vietnamese firms They have chances to compete in the international market and expand their markets via goods export On the other hand, they also face tough competition from foreign companies when these firms have a free access to the Vietnamese market To compete with foreign firms, the local ones need to keep high quality products and services with lower costs It is noticed that many Vietnamese firms have recently gone bankruptcy due to two important reasons First, firms could not sell their products Second, they faced capital shortage problem The first reason can be explained by the current global crisis in which the demand for products declines in attempts of cutting cost The second reason of capital shortage is identified as the top constraint in almost every survey on private small firms in the country Vietnam is characterized by a bank-based economy where banking sector is the main source to finance the economy activities Financial liberalization has progressed by several reform policies In 1998, Vietnam’s financial system was strengthened and readdressed toward a more market-oriented approach when the Law on the State Bank of Vietnam No.01/1997/QH10 and Law on Credit Institutions No.02/1997/QH10 came into force The reform has led to a significant increase in total credit granted to the domestic private sector by the state-owned commercial banks in the following decades (World Bank, 2005) However, the private sector still gets less preferential access to banking credit than state-owned enterprises (SOEs) Most small businesses continue to finance their operations through retained earnings or informal sources of credit The recent global financial crisis together with macroeconomic instability due to rapid credit growth has forced Vietnamese government to pursue a tighter monetary policy Vietnamese banks are required to adopt conservative credit policies in 2011 As the result, local firms have limited financing resources for their operation and investment and face with bankruptcy Several local firms have chosen alternative channels for capital mobilization such as bond market or stock market Vietnam bond market: Vietnam bond market is in a nascent stage even though its formation dated in the early 1990s Local currency bonds are mainly issued by the government or government sponsored institutions such as Vietnam Development Bank, Vietnam Bank for Social Policy and Vietnam Expressway Corporation According to Vuong and Tran (2010), the overall bond market accounts for about 15% of the total GDP in comparison with the average percentage of 65% in East Asian region The corporate bonds, 92% of which have maturities of 1-3 years, are traded on both HOSE and HNX and account for 1.4% of GDP Currently, primary market for corporate bond is weak while the secondary market is virtually nonexistent Vietnamese companies, most of which are small- and medium- sized, would hardly raise fund for their operations through the bond market Vietnamese stock market: The historical development of Vietnamese stock market can be traced back with the establishment of Ho Chi Minh Stock Exchange (HOSE) in July 2000 and Hanoi Stock Market (HNX) in March 2005 Starting with five listed companies in 2000 with market capitalization of 0.2% of GDP, the number of listed companies increases to 311 in the year of 2012 with market capitalization of more than 21% of the country's GDP Even though Vietnamese stock market has nowadays become an increasingly important channel for medium and long term capital, it is still far from international standards in terms of market size and market capitalization Table Market capitalization of Vietnam’s stock market (2004 – 2012) Total of listed Year domestic companies Market capitalization of Market capitalization of listed listed companies (US$) companies (% of GDP) 2004 26 248.012.350,01 0,50 2005 33 461.326.003,81 0,80 2006 102 9.092.539.058,79 13,70 2007 121 19.541.780.000,00 25,24 2008 171 9.589.377.646,86 9,67 2009 196 21.198.623.760,20 20,00 2010 275 20.385.102.198,90 17,58 2011 301 18.316.217.136,95 13,51 2012 311 32.933.061.036,47 21,14 (Source: World Bank) The Vietnamese stock market has been facing fundamental weaknesses that need to be resolved properly During its development, Vietnamese stock market experienced high volatility For example, in the period 2006-2007 there was a boom in this market due to over-expectation of the country’s economy growth and WTO accession Market capitalization in 2007 reached 25,24% of GDP Affected by the global financial crisis, Vietnamese stock market took a deep plunge in 2008: VN-Index fell down sharply and market lost around two-third of its value when foreign investors withdrew their investment from Vietnamese stock market The root weakness relates to dismal transparency, predictability and information clarity for investment decisions Many listed companies frequently adjust their business results Annual reports not provide much useful information for investors and the discrepancy before and after auditing are large With high information asymmetry, investors have to bear the brunt when punishment for these practices is not strong enough Moreover, information on the macro-economy is unpredictable and uncertain Consequently, the Vietnamese stock market can only attracts short-term and unstable funds instead of long-term players such as retirement funds, public savings funds and becomes a playground for day traders or hit-and-run investors Despite the above-mentioned weaknesses, Vietnamese stock market still plays an increasingly important role in the national economic development with the increasing numbers of listed companies and becomes the second important channel in capital mobilization Vietnamese firms can choose debt finance via the banking system or raise equity in the stock market Therefore, it is worthwhile to study the financing practices of the listed firms on Vietnamese Stock Market The general purpose of this paper is to extend our knowledge of how Vietnamese listed companies choose their capital structure and to what extent their financing behaviors are consistent with the theoretical explanations, namely the trade-off theory and pecking order theory 1.2 Problem statement There are three major motivations for the study First, being not a new research area, capital structure remains one of the most interesting and puzzling ones Capital structure refers how a firm uses different sources of funds to finance its operations and growth It is recognized that financial capital plays a crucially important role in the existence and growth of a firm Good capital structure decisions not only lead to higher profitability or lower risk but also help firms to allocate risk as well as control power among various groups of shareholders Since first paper of capital research by Miller and Modigliani in 1958, there has been a vast amount of research on firm capital structure However, empirical results are (2006); Biger et al (2008); Dzung et al (2012) find the positive relationship between growth and leverage However, Titman and Wessels (1988) and Deesomak et al (2004) also find the insignificant impact of growth on leverage Our results not support hypothesis “growth opportunities has significant impact on leverage” Earnings volatility is statistically significant on all measures of leverage: total leverage, short-term and long-term leverage However, it is positively associated with total leverage and short-term leverage and negative with long-term leverage This is because firms with higher earnings volatility tend to use more liabilities for their shortterm financial needs, usually the working capital However, firms with higher earnings volatility are more likely to face higher costs of financial distress, which really matters to their banks or their business partners in offering long-term finance As a result, firms with higher earnings volatility have less long-term leverage As mentioned in section 4.6, empirical results are found mixed for the relationship between earnings volatility and leverage We conclude that pecking order theory works well in prediction of shortterm leverage whereas the trade off theory explains long-term leverage The hypothesis “earnings volatility has a significant effect on leverage” is confirmed Liquidity is found to have negative and significant impact on total leverage and shortterm leverage whereas it remains negatively associated with long-term leverage with no significant The result is consistent with the finding of Dung et al (2012) in the same period The relationship also follows the prediction of the pecking order theory: firms with higher liquidity prefer to use internally generated funds, thus, less debt to finance their financial needs Therefore, the hypothesis “Liquidity has a significant effect on leverage” is partly supported In summary, we find that profitability, size, tangibility, earning volatility and liquidity are important firm-level determinants in the capital structure of Vietnamese listed food processing companies Non-debt tax shield and growth opportunities are found not to be statically significant determinants of leverage It is also noted that there are differences between the determinants of long-term fund-raising and short-term fundraising Profitability, size, tangibility, earnings volatility and liquidity are statically significant to short-term leverage whereas tangibility and earnings volatility is the most 51 important factors impacting the long-term leverage Some of these factors impact on short-term leverage and long-term leverage in the opposite direction, for example, tangibility is negatively related to short-term leverage and positive with long-term leverage whereas earnings volatility impacts positively on short-term leverage and negatively on long-term leverage It can be concluded that both the pecking order theory and the trade off theory help to explain the capital structure decisions of Vietnamese listed food processing companies 52 CHAPTER CONCLUSION This chapter presents the main conclusions and policy implications Finally, it ends with discussion of limitations of the study and recommendation for future research 7.1 Findings This paper has investigated the determinants of capital structure in food processing companies listed in Vietnam Stock market during period 2007-2012 Previous studies on capital structure using Vietnamese data focus on financial behaviors of SMEs (Nguyen and Ramachandran, 2006) or listed firms operating in all industries (Nguyen et al., 2012) Being among top manufacturing industry in Vietnam, food processing sector is deserved to be analyzed independently A sample of 241 firm-year observations for 41 food processing companies listed on VSM is analyzed using panel data analysis The data is extracted from the audited financial statements provided by FPT Securities Company The test of capital structure has revolved around the pecking order theory and the trade-off theory The paper in turn analyses how the firm-specific factors affect short-term and longterm leverage since firms often have separate policies for short-term debt and longterm debt The empirical analysis revealed the below findings: First, Vietnamese listed food processing companies averagely employ a debt ratio of about 46.57% of total assets Local food processing companies rely mostly on shortterm financing The average of short-term leverage is 40.99% while long-term leverage accounts for 5.6% on average Second, there are differences between the determinants of long-term and short-term financing Profitability, size, tangibility, earnings volatility and liquidity are found statically significant to short-term leverage whereas tangibility and earnings volatility are the most important factors impacting the long-term leverage Moreover, the impact of tangibility and earnings volatility diverges across different measures of leverage: tangibility is negatively associated with short-term leverage and positive with longterm one; earnings volatility impacts positively on short-term leverage and negatively 53 on long-term leverage The result also indicates that growth opportunity does not influence capital structure at any significant level The extent of influence on leverage is different among determinants, that is, earnings volatility has the largest impact on total leverage and short-term leverage while tangibility is the most important determinants on long-term leverage Third, the results suggest that the firm-specific factors impact leverage in a way supporting both pecking order theory and trade off theory Relationship between firm size and leverage is consistent with trade-off theory while profitability and liquidity follow the prediction of the pecking order The prediction of pecking order works well at prediction the influence of tangibility and earnings volatility on short-term leverage while the impact of these factors on long-term leverage is consistent with the trade-off theory The finding is consistent with some recent empirical studies such as Gaud et al (2005), Bharath et al (2009) and De Jong et al (2011) These studies document that the trade-off theory and pecking order theory are complementary because each theory alone cannot fully explain the capital structure behaviors of companies 7.2 Policy Implications From the results of this research, some policy implications are suggested as below First, there should be proper policies to encourage private sector’s growth in size Empirical result shows that firm size is positively associated to short-term leverage and total leverage, significant at 1% level This implies that enterprise with bigger size will have more access to credit Currently, firm-size is one of the biggest disadvantages that Vietnamese firms are facing and there has been an upward trend in firms going bankrupt In fact, the local firms become more vulnerable to external changes and have lower survival probability due to their limited financial capacity Therefore, it is suggested to have support programs, including but not limited to, such as credit guarantee funds, development of private sector’s internal and external networks and extension of non-collateralized finance for enterprises that have feasible business plans to meet their finance needs for investment 54 Second, information environment should be improved Even though the financial decisions of Vietnamese listed food processing companies follows both the pecking order theory and the trade-off theory, the pecking order theory appears to dominate in explaining the capital structure of these firm Therefore, it should be noted that asymmetric information has a significant impact on firm leverage For example, table shows that tangibility becomes the most significant factor among firm-level determinants of long-term capital structure, reflecting that asymmetric information discourages creditors from lending without collateral in the long term Therefore, managers in Vietnamese food processing companies should recognize this in order to improve their accessibility to debt or credit trade To reduce asymmetric information, it is advised that firm should maintain the proper and transparent financial records and involve in networks with clients It is a common phenomenon that Vietnamese firms tend to inflate data for the purpose of tax reduction It is time to have this changed and improve fair value measurement so that the financial statement becomes more trustworthy in firm evaluation The government should regulate the frequency and new channels through which firms have to update their financial information to the market such as investor conference, periodical dialogues between firms and financial analysts In addition, the government should reinforce the legal framework for publishing firm financial information and penalty for making false or misleading statements By doing so, business partners, banks and investors can have more reliable information for their financial decisions towards the firm Third, the government should have policies to improve the legal system for bond market development It is also noted that credit constraint, especially the long-term financing capital, is one of the biggest challenges that Vietnamese firms have to address The empirical results show that tangibility dominates the impact of other firmspecific determinants in explaining the long-term leverage It means that creditors are not willing to lend long-term capital if firms have no asset for secured loans no matter how well they operate Table shows that proportion of loans requiring collateral in Vietnam is 90.8% while the average ratio is 77.8% among all countries The value of collateral needed for a loan (% of the loan amount) is also higher than the average one of all the countries, 217.7% in comparison with 189.4% Therefore, it is suggested that 55 the legal system offers more protection to the lender so that long-term loan decision is based on not only firms’ collateral but also on the efficiency of firms The empirical results also show that long-term debt only accounts for a moderate proportion of total leverage among Vietnamese listed food processing companies Currently, these firms rely mostly on short-term leverage for financial needs, implying that these firms have low long-term investment, thus, low return in long run It shows that the Vietnamese listed food processing firms still have limited access to capital market This also demonstrates the need for improving the bond market in Vietnam to increase the availability of long-term financing source for sustainable growth of the local firms A well-developed bond market is important for financial development of a country This can be done through the improvement of legal framework, predictable inflation and stable macro policies Once firms have more alternative channel to mobilize fund, especially long-term fund, for their development, they get stronger in competition with the foreign ones, reduce the risk of being acquired and reduce businesses’ sensitivity to economic cycles Finally, the financial health of Vietnamese banking system needs to be improved The positive relationship between earnings volatility (representing for business risk) and total leverage would imply that firms with high business risk tend to get more debt This raises the concern that the lending interest rates applied for the high-risk firms are not high enough to cover the potential risk and to discourage these firms from lending The reason behind is the ceiling lending rate regulated by the State Bank of Vietnam The commercial banks are only allowed to offer lending interest rates lower than the ceiling lending rate As a result, firms with high business risk, thus higher possibility of bankruptcy, can have higher leverage This has negatively impacted the financial health of the country banking system It is true that Vietnamese commercial banks have been facing serious problems due to increasing level of non-performing loans and Vietnam is one of countries having the highest ratios of non-performing loans in Asia According to the report by the State Bank of Vietnam (SBV), the non-performing loan (NLP) ratio in the banking sector in Viet Nam reached 4.7% as of October 2013 while this rate is much higher at 15% as per estimation by some rating agencies such as Moody’s and Fitch With regards to risk of default, it is suggested that the government 56 should deregulate interest lending rates so that the lending interest applied would reflect the degree of business risk It is also suggested that the current bankruptcy law should be revised to simplify the bankruptcy procedure and better protect creditors in case firms are in financial distress By doing so, it would bring more safety in operations of banking system and also force firms to balance their financial needs relevant to their business risk 7.3 Limitations This study has provided a number of insights, yet, there are still some limitations First, the small sample size and the short time period might potentially lead small finite sample biases in some estimators used in the regression model Moreover, the study only covers listed food processing companies, which not represent the whole food processing sector in Vietnam Other empirical studies on capital structure in Vietnam show that state-owned factors really matters in firm decisions of capital structure However, our sample only has state-owned firms, thus we not examine this impact in the research model Future research can further investigate impact of state-owned factors, with longer studied period, covering unlisted food processing companies to have the overall picture of food processing industry in Vietnam Second, limitation can stem from the various proxy variables used in the paper Even though these proxy variables have been are strongly defended by theoretically and empirically argument, they might not perfectly represent the theoretical propositions The empirical result might vary with the change of proxy standing for one factor However, according to Graham and Leary (2011), the proxy variable issue is a common problem in empirical studies Third, there could be possible endogeneity problem in the studied paper Endogeneity refers to the fact that an independent variable in the research model is potentially correlated with the error term, which results in inconsistent estimators Even though the fixed effect models can be accountable for reducing endogeneity effects of the observed and unobserved time-constant variables, it cannot rule out time-varying 57 unobserved 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World Bank in 2009, Vietnamese firms tend to using banks to finance the working capital and the proportion of working capital financed by banks is higher than other countries in the regions and