Determinants of debt to equity ratio (financial leverage) vietnamese firms case study

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES
HO CHI MINH CITY THE HAGUE
VIETNAM THE NETHERLANDS
VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS
DETERMINANTS OF DEBT-TO-EQUITY RATIO
(FINANCIAL LEVERAGE)-VIETNAMESE
FIRMS CASE STUDY
BY
NGUYEN THANH BIEN
MASTER OF ARTS IN DEVELOPMENT ECONOMICS
HO CHI MINH CITY, September 2012
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UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES
HO CHI MINH CITY THE HAGUE
VIETNAM THE NETHERLANDS
VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS
DETERMINANTS OF DEBT-TO-EQUITY RATIO
(FINANCIAL LEVERAGE)-VIETNAMESE
FIRMS CASE STUDY
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS
By
NGUYEN THANH BIEN
Academic Supervisor:
LE ANH TUAN
HO CHI MINH CITY, September 2012
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Table of Contents
List of Tables………………………………………………………………………......6
List of Figure………………………………………………………………………......7
Abstract……………………………………………………………………………......8
Chapter 1 Introduction……............................................................................................9
1.1 Problem Statement……………………………………………………...................9
1.2 Research Objectives………………………………………………………...........10
1.3 Research Questions………………………………………………………............11
1.4 Research Scope…………………………………………………………...............11
1.5 Research Contribution...........................................................................................12
1.6 Research Structure………………………………………………………..............12
Chapter 2 Literature Review........................................................................................13
2.1 Theoretical Review.................................................................................................13
2.1.1 Static Trade Off Theory......................................................................................13
2.1.2 Pecking Order Theory …....................................................................................15
2.1.3 Agency Cost Theory ….......................................................................................16
2.2 Empirical Studies..................................................................................................17
2.2.1 Bevan, A. and Danbolt, J., 2002..........................................................................17
2.2.2 Deesomsak, R., Paudyal, K., and Pescetto, G. (2004)........................................18
2.2.3 Buferna, F., Bangassa, K., and Hodgkinson, L. (2005)......................................19
2.2.4 Um, T. (2010), Capital structure determinants of Thai listed companies...........20
Chapter 3 Research Methodology................................................................................22
3.1 An Overview - Vietnamese Firm...........................................................................22
3.2 Conceptual Framework..........................................................................................23
3.2.1 Dependent Variable.............................................................................................23
3.2.2 Explanatory Variable...........................................................................................23
3.2.2.1 Tangibility of firm............................................................................................23
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3.2.2.2 Size of firm.......................................................................................................24
3.2.2.3 Profitability of firm..........................................................................................24
3.2.2.4 Growth of firm..................................................................................................25
3.2.3 The Regression Model.........................................................................................25
3.3 Data Collection.......................................................................................................26
Chapter 4 Data Analysis..................................................................................28
4.1 Data Description.....................................................................................................28
4.1.1 Variable Descriptive Statistic..............................................................................28
4.1.2 Correlation Matrix ….........................................................................................29
4.2 Regression Result …..............................................................................................30
4.2.1 Fixed-effects and Random-effects Regression Result.........................................30
4.2.2 Hausman Test ….................................................................................................30
4.3 Regression Result Discussion................................................................................31
4.3.1 Regression Equation............................................................................................31
4.3.2 Coefficients Significance....................................................................................32
4.3.3 Coefficients Sign.................................................................................................32
4.3.4 Multicollinearity and Auto Correlation …..........................................................33
4.3.5 Heteroscedasticity …..........................................................................................34
4.3.6 Industrial Groups Effect......................................................................................34
4.3.7 Public and Private Firm Comparison …........................................................... 35
4.3.7.1 Financial Leverage Degree ….........................................................................35
4.3.7.2 Determinants of Financial Leverage................................................................35
Chapter 5 Conclusion and Recommendation....................................................37
5.1 Conclusion.............................................................................................................37
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5.2 Recommendation....................................................................................................38
5.3 Research Limitation...............................................................................................39
REFERENCE...............................................................................................................41
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List of Tables
Table 1 Descriptive Statistics of Leverage and Explanatory Variables …..................28
Table 2 Correlation Matrix of Leverage and Explanatory Variables …......................29
Table 3 Fixed-effects and Random-effects Regression Result....................................30
Table 4 Hausman Test..................................................................................................31
Table 5 Coefficients of Variables -FEM Model...........................................................32
Table 6 Sign of Variables-FEM Model........................................................................32
Table 7 VIF Value of Variables...................................................................................34
Table 8 Wald Test for Heteroscedasticity....................................................................34
Table 9 Descriptive Statistics of Public and Private Firms..........................................35
Table 10 Regression Result of Public and Private Firms …........................................35
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List of Figures
Figure 1 Market Value of Firm – Debt Relation..........................................................14
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Abstract
This study points out determinants of debt-equity ratio (financial leverage) of 396
Vietnamese firms listed on Stock Exchange (HOSE and HNX) during 2006-2010. The
result of regression indicates consistence of Vietnamese case with capital structure
theories including trade-off, pecking order and agency. The study also investigates
differences between public and private companies related to tangibility.
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Chapter 1 Introduction
1.1 Problem Statement
Financial leverage and operating leverage are two popular ways of getting leverage to
improve profitability of companies. However, operating leverage is only applied for
several specific industries, such as metallurgical, pharmaceutical industry, and is not
suitable for tourism or services industries. Thus, operating leverage is limited in
reality when firms want to improve their profit. On the contrary, financial leverage
can be applied for every types of firms due to its alternative characteristics and
therefore, it is preferred than operating leverage. In fact, financial leverage appears in
every capital structures of firms with different degrees.
Depending on the degree of financial leverage, the firm decides the level of debt
equivalent to the degree and thus, debt-to-equity ratio is also named as financial
leverage. When a firm decides to issue debt, the firm has to refer to several internal
elements, for example, how much fixed assets the firm has, how much revenue the
firm gets. And the firm must consider some external conditions at the same time, for
example, government policies and macroeconomic conditions. It means that there are
several factors that influence the degree of financial leverage of each firm and
therefore, determinants of financial leverage are needed to understand and estimate
the difference in the degree of financial leverage. These determinants may be different
depending on each industry.
When Vietnam joined the WTO in 2007, it seemed that new East Asian export
powerhouse was on the scene. The country’s mix of young demographics with 27-
year-old average age and political, macroeconomic stability was a perfect set-up for
manufacturing exports. Credit growth during 2006-2010 was 35% on average, which
almost doubled the country’s nominal GDP growth. As a result, thousands of
enterprises have been established and these firms have been operating under market
economy disciplines. Therefore, capital structure of Vietnamese companies has
changed in the trend similar to capital structure of companies in developed countries
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or even more aggressively. Private and joint-stock companies have substituted public-
owned companies thanks to having better and effect operation.. Consequently,
financial leverage is used frequently as a main financial instrument to lift profit
especially as Vietnam economy has had symptoms indicating overheat in recent years.
Thus, it is necessary to study financial leverage and its determinants in Vietnamese
company cases.
In summary, Vietnamese firms are using debt as a major instrument to invest and
increase its capital. Financial leverage has become an important issue in Vietnam
economy and thus, determinants of financial leverage and their relationship need to be
clarified. The correlation between financial leverage and determinants is also
estimated to predict the trend of capital structure of Vietnamese firms. The difference
among degree of leverage of different industries is also considered.
1.2 Research Objectives
The research is implemented to study and identify both internal and external factors
that affect debt-to-equity ratio, or financial leverage of firms, including both public
and private. In addition to identifying the determinants of financial leverage, the
relationship between leverage and its determinants will also be clarified in this study.
These relationships will be explained in details to assess the significance of these
determinants on financial leverage.
In addition, the difference between financial leverage degree of public and private
firms, and the leverage level of different industries need to observed and compared, to
understand why the difference exists. Moreover, macro elements are also considered
to answer how external factors impact the leverage of firm. Assessing external aspects
is important because firms are controlled not only by internal factors but also external
ones.
As part of globalization process, the Vietnamese government has conducted open
policies to develop economy and improve living standard. As a result, Vietnamese
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firms
has approached and learned many innovative things in term of knowledge,
technologies and managements. Consequently, capital structures of Vietnamese firms
also changes to be suitable with globalization conditions. This study shows
Vietnamese firms are similar to others in developed countries in terms of financial
leverage and its determinants.
1.3 Research Questions
In overall, in order to clarify important issues associated to financial leverage of firm,
it is necessary for the research to answer several critical questions below.
Question1: Which determinants impact on financial leverage of firm?
Question2: Are there any differences between public firms and private firms?
Question3: What is the difference of financial leverage among industrial groups?
Question4: How do macro factors influence leverage of firm?
The answers to four questions above will support various parties, including the
government in making policies, financial institutions in assessing financial ability of
firms and investors in making investment decisions.
1.4 Research Scope
The research investigates determinants of financial leverage of 369 firms listed on
HOSE and HNX, which are categorized into four industrial groups during 2007-2010
periods. The relationship between leverage and its determinants will be identified,
examined and explained in specific details. In addition, the difference of leverage
degree between private and public companies, and among industries are also
considered in this research. However, financial firms and unlisted firms are excluded
in the research due to specific features in their capital structure. The research utilize
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panel data and thus, fixed effects model and random effects model regression are
implemented and compared to choose the better model for the dataset.
1.5 Research Contribution
The contribution of this research is to provide an empirical evidence to test the
financial theory involving trade-off theory, pecking order theory and agency cost
theory. In Vietnamese firms circumstance, the research proves the consistency
between capital structure theory and actual financial leverage of firms on HOSE and
HNX. The research provides useful financial information for government agencies,
financial institutions and individual investors in considering financial status of firms
on the stock exchanges, and reference documentary for further studies about
Vietnamese enterprises’ financing.
1.6 Research Structure
The content of this research is divided into five chapters and this item belongs to the
beginning chapter. The first chapter introduces overall issues of the research and
presents several critical questions that related to the nature of research purposes. The
second chapter reviews major theoretical studies and empirical studies associated to
capital structure of a firm. The third chapter presents research methodology from
theory framework to data collection method. The next chapter shows how to analyze
data and result of econometric regressions. The final chapter is conclusions and
implications of the research
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Chapter 2 Literature Review
2.1 Theoretical review
Based on the theory of Modigliani and Miller (1958) on capital structure, there are
three popular theories on capital structure that have been developed including static
trade-off, pecking order and agency cost theories. These theories have the same
objective, that is maximizing firm value, but their financial leverage levels are totally
different. Consequently, a firm leverage targets and capital structure are different by
adopting those theories.
2.1.1 Static trade-off theory
The static trade-off theory of capital structure states that a firm considers between
debt finance and equity finance in order to optimize capital structure by balancing the
cost and benefit. According to the static trade-off theory, firm managers believe to set
up an optimal debt-to-equity ratio to maximize firm value. The costs include the
financial distress cost and bankruptcy cost, and the benefits are the tax saving benefits
of debt, the interest tax shield. It is a trade off of costs and benefits of borrowing,
holding the firm’s assets and investment plans constant. The firm is guessed to
substitute debt for equity or equity for debt until its firm value is maximized. As
shown in figure 1, at the optimal capital structure, optimal financial leverage, the
benefit of tax shield offsets the cost.
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Figure 1 Market Value of Firm – Debt Relation
Market value of firm
PV costs of financial distress
PV Interest tax shields Firm value under all equity financing
Optimal Debt
As random events happen to either debt or equity of the firm, the optimal structure
capital will move away. Hence, managers try to bring the capital structure back to its
optimal level. Therefore, leverage ratio is static as the target of the firm.
Myers (1984) debates that three factors including costs of adjustment, debt and taxes,
and cost of financial distress would impact financial behavior of firms under static
trade-off theory. First, adjustment cost always exists following modification of firms
in order to optimize leverage target. Second, interest tax shield is an advantage for
firms when issuing debt compared with issuing equity and that explains why several
firms are awash in debt. Finally, associated with financial distress cost, risky firms
and tangible asset were concerned in Myers’s study. Risky firms ought to borrow less
because cost of financial distress would threaten the safety of firms. Firms holding
tangible assets will borrow less than other firms with intangible assets or valuable
growth opportunities. In case firms encounter financial distress, intangible assets and
growth opportunities may lose expected value.
In the study of Myers (1984),’the capital structure puzzle’, firms following the static
trade-off theory should set a target debt-to-equity ratio and try to achieve it step by
step. However, according to Myers, managers do not want to issue equity if they
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predict that it is undervalued in the market. As a result, investors should be aware that
issuing equity will happen if equity is over-priced. Consequently, investors appear to
have a negative opinion of new equity issue of firms and thus board of managers
should limit new equity issue as much as possible.
2.1.2 Pecking order theory
On the contrary to static trade-off theory, Pecking order theory was first studied by
Donaldson in 1961 and it was modified by Myers in 1984. According to the states of
the theory, firms prefer financing from internal as retained earnings to financing from
external funds as debt and finally from an issue of new equity. At the top of the
model, internal finance is chosen even with sticky dividend policies. If internally
generated cash flow is less than investment outlays, firms would move away from
marketable securities portfolio. At the bottom, external finance is required in the
following order from debt, hybrid securities to issuing equity at last. Myers debates
that it is difficult for a firm to achieve an optimal capital structure with its equity at
the top and the bottom of the ‘pecking order’. Moreover, the leverage target of firms
is difficult to approach if the firms have two types of equity as internal and external.
There are several advantages including no flotation costs and no disclosure of the
firm’s proprietary financial information when the firm follows internal funds. In
addition, using internal funds may make new potential investment chances for the
firms and increase profitability as a result of undertaking such investments.
Firms with reliance on internal finance want to avoid the separation of ownership and
control. If firms rely on external finance, they have to follow strict discipline of
financial market. Over the decade 1973-1982, most of capital expenditures of non-
financial firm came from internal finance. However, it is not so obvious that firms
following the pecking order model do not direct towards maximizing shareholders
interests. The basic reason is to avoid issue costs and effects of requirements of
external financial market on the firms.
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According to pecking order theory of capital structure, firm managers are reluctant to
disclose private information about the attributes of the firm’s return stream. In
addition, insiders may hide good investment opportunities to take advantages
comparing to common investors. That is the asymmetric information between insiders
(managers of firms) and common investors (outside of firms) as external financing.
On the contrary to the prediction of static trade-off theory, internal funds and external
funds are used orderly following the criteria as first internally with retained earnings,
debt, and finally with an issue of new equity.
Following the pecking order theory, profitable firms prefer internal finance than
external finance and thus, these firms were predicted to hold less debt than less
profitable firms. As a result, there is a negative relation between profitability and
financial leverage.
However, the relationship between financial leverage and tangible assets is the same
to that in trade-off theory. According to Myers (1984), a high tangible assets level
may mitigate the asymmetric information associated to financing cost thanks to being
secured by collateral. As a result, a positive relationship is expected between financial
leverage ratio and tangible assets level.
2.1.3 The agency cost theory
According Jensen and Meckling (1976), conflicts between benefit of lenders on one
side and benefit of shareholders and managers on the other side lead to an increase of
debt agency cost including the monitoring expenditures by the principal, the bonding
expenditures by the agent and the residual loss. Normally, managers are willing to
invest funds in risky business for shareholders’ gains. If the business fails, the lenders
are able to incur the cost while the shareholders only have limited liability.
The agency cost theory of capital structure is an economic concept associated to the
costs arising from conflicts between the parties involved. According to this theory, the
firm will obtain its optimal capital structure by minimizing this cost, Jensen and
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Meckling (1976) show that agency costs influence strongly financing decisions via
the conflicts between shareholders and debtholders. Therefore, while companies are
confronting financial distress, shareholders can prefer managers to take decisions to
capitalize more funds from debtholders to equityholders. Debtholders that have a
good understanding of financial markets will require a higher return for their money if
there is a potential gain of wealth, debt issue with interest payments may decrease the
agency conflict between shareholders and managers. Debtholders are compensated
legally, if risks happen, by getting interest payments. Managers of the firm will be
able to operate the firm as well as possible in order to maximize wealth of
shareholders.
The debt agency cost may be reflected by the firm size according to the approach of
agency theory. Therefore, the financial leverage of larger firms with higher debt
agency costs will be higher than smaller firms with lower debt agency costs. It means
that there is a positive relationship between firm size and financial leverage of firms.
2.2 Empirical studies
2.2.1 Bevan, A. and Danbolt, J., 2002. Capital structure and its determinants in
the UK- a decompositional analysis, Applied Financial Economics 12, 159-170.
The research of Alan A. Bevan and Jo Danbolt in 2002 studied capital structure and
its determinants. The data in this study comes from 822 UK companies. Authors
interpreted factors that impact the financial leverage of firms in both short-term and
long-term debts. The OLS result of regression gives a different correlation between
leverage and determinants of capital structure. However, in terms of long-term debts,
the relationships are similar to the predictions of static trade-off theory and agency
cost theory.
In details, the study determines four elements that influence the leverage of firms
including tangibility, firm size (logarithm of sales), profitability and growth (market-
to-book). According to the regression result, correlation between leverage and
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tangibility is significantly positive and the same for relation between leverage and
size. These relationships are consistent with description of trade-off theory and
agency cost theory. In contrarst, correlations between leverage and profitability,
leverage and growth are negative. These relationships are similar to pecking order
theory. The finding of Bevan and Danbolt is in line with the prior empirical studies
and theory of capital structure as applied data of UK companies.
This study utilizes data of firms at a developed country to examine determinants of
capital structure and firm financial behavior, and how that behavior affects financial
leverage of firm. As a result, four basic determinants are admitted including
tangibility, firm size, profitability and growth opportunities of firms. Although,
business environment and financial institutions between Vietnam, a developing
country, and United Kingdom, a developed country, are definitely different but factors
that affect on the capital structure are still same. However, relationships among capital
structure and its determinants are likely to be not similar to UK firms.
2.2.2 Deesomsak, R., Paudyal, K., and Pescetto, G. (2004), The determinants of
capital structure: evidence from the Asia Pacific region. Journal of Multinational
Financial Management, 14, 387-405.
This study was conducted in 2004 to investigate determinants of capital structure,
meaning financial leverage level of firms. Authors of the study used data from 4
countries in the Asia Pacific region, namely Thailand, Malaysia, Singapore and
Australia in 1993-2001 periods. It shows that financial leverage (debt-to-equity ratio)
of firms depends on firm-specific characteristics, meaning inside factors of firms.
However, severe events as the financial crisis of 1997 have had a significant influence
on capital structure decisions of firms. The study provides significant evidence about
relationship between financial leverage and its determinants and consistency with
capital structure theories including trade-off, pecking order and agency cost theory.
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The determinants of capital structure are identified in this study as tangibility, firm
size, profitability, growth opportunity and volatility of earnings. Firstly, the
relationship between leverage and tangibility is positive and statistically significant in
Thailand, Malaysia and Singapore. This result is definitely consistent with the
prediction of capital structure theories. Secondly, the negative relation between
profitability and leverage also is found as predicted of the pecking order theory in this
study and this relationship is statistically significant in Thailand, Singapore and
Australia. Thirdly, there is a positive relation between firm size and leverage for all
countries involving Thailand, Malaysia and Australia. This finding is consistent with
trade-off and agency cost theories. Fourthly, growth opportunity has a negative
impact on financial leverage and this influence is statistically significant for Thailand.
It is consistent with the results of the trade-off and agency theories. Finally, volatility
of earnings is found that have no significant impact on leverage for all countries.
According to the result of this study, capital structure of Thai firms is mostly
consistent with static trade-off theory and pecking order theory. Vietnam has
conditions in term of business environment, social and culture similar to those of
Thailand. Therefore, the study of Thai company capital structure is a lesson for
Vietnam situation and can be applied for Vietnam companies. Consequently, five
determinants above also are chosen to examine the relationship between the leverage
and firms attributes involving tangibility, firm size, profitability, growth and volatility
of earnings.
2.2.3 Buferna, F., Bangassa, K., and Hodgkinson, L. (2005), Determinants of
capital structure: evidence from Libya, Research Paper Series, 8, University of
Liverpool.
The empirical study provided further understanding related to capital structure or
financial leverage in a developing country. In details, the study conducted analyzing
data of Libyan firms in the lack of a secondary market. As a result, authors recognized
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the relevancy between capital structures of Libyan companies and the capital structure
theories including static trade-off and agency cost theories.
In this study, four determinants of capital structure are identified in both private
companies and public companies and they are similar to previous empirical studies as
Rajan and Zingales (1995) and Bevan and Danbolt (2000). These determinants
involve tangibility, firm size, profitability and growth. In addition, relationships
among them and leverage of firm are pointed out by the result of cross-sectional OLS
regressions. First of all, tangibility influences positively on leverage of firms with
significant positive slope coefficient in both private and public firms. Second of all,
size and profitability also affect positive impacts on leverage of firms.
Lastly, there is a negative relation between growth and leverage in both private and
public firms, implying that growing firms prefer internal finance to external finance
like debts. Relationships observed in this study are in line with predictions of capital
structure theories.
Vietnam is a developing country like Libya and opened market from 1986. However,
financial market of Vietnam has had a secondary market while Libya still lacks this
market.
Consequently, firm capital structure of Vietnam is a little different from Libya,
meaning the result of this study can be used for reference only in Vietnam
circumstance. The factors that impact on capital structure in Libya are same as prior
empirical studies and thus can definitely be utilized to observe capital structure of
Vietnamese companies.
2.2.4 Um, T. (2010), Capital structure determinants of Thai listed companies
The study of Um (2010) concentrates on companies listed on the Stock Exchange of
Thailand over period from 2004 to 2008 to examine the determinants of capital
structure. The study shows the effects of internal independent variables on firm
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