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Dissertation_Capital Structure final

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Dissertation_Capital Structure final

  1. 1. 0 DE MONTFORT UNIVERSITY LEICESTER BUSINESS SCHOOL A critical analysis of the determinants of capital structure in non-financial public listed firms during periods of economic instability versus economic stable periods: A study of the 2007/2008 global financial crisis. JASMIN TAYLOR BA (Hons) Business and Management A dissertation submitted in part requirement for the award of MASTERIN INTERNATIONAL BUSINESS AND FINANCE (MSc) 15/09/2015 September 2015
  2. 2. 1 ABSTRACT The 2007/2008 global financial crisis presents the opportunity to critically evaluate the effect of the crisis on the determinants of capital structure. However, previous research on this subject matter has retuned inconclusive results suggesting that a gap exists in capital structure literature. Therefore, this dissertation attempts to add to current literature and narrow the gap in the literature. In order to achieve this, a correlation analysis is employed to analyse data on 10 non-financial public listed firms from 2004-2009. This dissertation defines 2007 as the start of the financial crisis thus, a comparative platform is employed to analyse and compare data over two sub periods that is; the pre-crisis period (2004-2006) and the crisis period (2007- 2009). Furthermore, the capital structure determinants selected for this research are; tangibility, profitability, size, liquidly and growth. Theses determinants are used to formulate several hypotheses based on the logic of the Trade-Off Theory and the Pecking Order Theory. The results of the correlation analysis revel, that each capital structure determinant altered as a result of the financial crisis. The coefficient for tangibility, size and liquidity exert a strong influence on capital structure choices during the financial crisis compared to the period before the crisis. The researcher also found that the coefficient for profitability exerts less influence on capital structure choices during the financial crisis in comparison to the pre-crisis period. Growth is the only variable that did not significantly alter as a result of the financial crisis. Furthermore, the results of the correlation analysis indicate that during the 2007/2008 global financial crisis, the Trade-Off Theory has more explanatory power than the Pecking Order-Theory.
  3. 3. 2 ACKNOWLEDGEMENTS The completion of this dissertation would not have been possible without the support and guidance of several people. Firstly, I would like to express my deepest gratitude to my dissertation supervisor, Alexandra Charles, for taking time out of her busy schedule in order to guide and support me throughout the whole dissertation process. This dissertation would not have been possible without her invaluable advice, her critical and constructive comments, her helpful suggestions and her patience throughout this process. Secondly, I would like to thank all my module lecturers that I have had the privilege to learn from throughout my MSc course. The knowledge and skills that I gained from their lectures have majorly contributed to this dissertation. Lastly, I would like to thank my family and friends for their constant support and encouragement during this dissertation period as well as throughout my whole MSc course.
  4. 4. 3 CONTENTS CHAPTER ONE: INTRODUCTION .....................................................................................6 1.1BACKGROUND....................................................................................................................6 1.2 PURPOSE AND MOTIVATION OF THIS DISSERTATION ........................................................8 1.3 RESEARCH OBJECTIVES...................................................................................................8 1.4 RESEARCH QUESTIONS ....................................................................................................9 1.5 OUTCOMES.......................................................................................................................9 1.6 METHOD OF RESEARCH................................................................................................. 10 1.7 LIMITATIONS................................................................................................................... 10 1.8 DISSERTATION OUTLINE ................................................................................................ 10 CHAPTER TWO: LITERATURE REVIEW...................................................................... 12 2.1 OVERVIEW OF CAPITAL STRUCTURE.............................................................................. 12 2.2 THEORIES OF CAPITAL STRUCTURE .............................................................................. 13 2.3 DETERMINANTS OF CAPITAL STRUCTURE...................................................................... 22 2.4 CAPITAL STRUCTURE DURING FINANCIAL CRISES ......................................................... 27 2.5 SUMMARY...................................................................................................................... 29 CHAPTER THREE: METHODOLOGY ............................................................................ 31 3.1 QUANTITATIVE RESEARCH............................................................................................. 32 3.2 QUALITATIVE RESEARCH ............................................................................................... 32 3.3 DATA.............................................................................................................................. 33 3.4 VARIABLES..................................................................................................................... 34 3.5 RESEARCH SAMPLE....................................................................................................... 35 3.6 HYPOTHESES................................................................................................................. 37 3.7 METHOD OF ANALYSIS................................................................................................... 38 3.8 LIMITATIONS................................................................................................................... 39 3.9 ETHICS........................................................................................................................... 40 CHAPTER FOUR: EMPIRICAL ANALYSIS ................................................................... 41 4.1 ANALYSIS OF THE WHOLE SAMPLE PERIOD (2004-2009) ............................................ 41 4.2 ANALYSIS OF THE PRE-CRISIS PERIOD (2004-2006) ................................................... 45 4.3 ANALYSIS OF THE CRISIS PERIOD (2007-2009)........................................................... 47 4.4 SUMMARY...................................................................................................................... 49 CHAPTER FIVE: COMPARITIVE ANALYSIS................................................................ 49 5.1 PRE-CRISIS PERIOD AND THE CRISIS PERIOD COMPARED............................................. 50 5.2 SUMMARY...................................................................................................................... 53 CHAPTER SIX: CONCLUDING REMARKS................................................................... 54 6.1 OVERVIEW ..................................................................................................................... 55
  5. 5. 4 6.2 ANSWERS TO RESEARCH QUESTIONS ........................................................................... 55 6.3 SUMMARY...................................................................................................................... 58 CHAPTER SEVEN: LIMITATIONS AND RECOMMENDATIONS.............................. 59 7.1 SUMMARY...................................................................................................................... 61 CHAPTER EIGHT: REFERENCES.................................................................................. 64 CHAPTER NINE: APPENDICIES..................................................................................... 73
  6. 6. 5 TABLES AND FIGURES LIST OF TABLES TABLE 3.1: VARIABLES AND THEIR MEASUREMENTS.............................................................. 35 TABLE 3.2: RESEARCH SAMPLE (SIMPLE RANDOM SAMPLE OF FIRMS)................................. 36 TABLE 3.3: HYPOTHESES AND PREDICTIONS......................................................................... 38 TABLE 4.1: CORRELATION ANALYSIS FOR THE WHOLE SAMPLE PERIOD (2004-2009)......... 42 TABLE 4.2: CORRELATION ANALYSIS FOR THE PRE- CRISIS PERIOD (2004-2006)............... 46 TABLE 4.3: CORRELATION ANALYSIS FOR THE CRISIS PERIOD (2007-2009)........................ 47 TABLE 5.1: CORRELATION RESULTS ACROSS SUB-PERIODS................................................. 50 LIST OF FIGURES FIGURE 2.1: THE TRADITIONAL VIEW OF CAPITAL STRUCTURE ............................................. 14 FIGURE 2.2: MODIGLIANI AND MILLER NO TAX MODEL........................................................... 16 FIGURE 2.3: MODIGLIANI AND MILLER WITH TAX MODEL........................................................ 17
  7. 7. 6 CHAPTER ONE: INTRODUCTION In the introductory chapter of this dissertation, the background of the subject is first presented, which involves a brief discussion about capital structure. This is then followed by a discussion outlining the purpose and importance of this dissertation. Following on from this, the researcher will present the research objectives, the research questions, the research outcomes, the research method and the research limitations. Finally, the researcher will outline the structure and organisation of each chapter to give an overview to the reader. 1.1 BACKGROUND “In pursuit of maximising firm value, financial managers are charged with two main responsibilities; investment decisions and capital structure decisions” (Harrison and Widjaja, 2014, p55). A firm’s capital structure is of great importance, because it signifies the ability of the firm to pursue investments. Hence, the capital structure of a firm can be described as; the manner in which the firm generates the capital required to fund its business ventures (Niu, 2008). These business ventures can be financed by either debt capital or equity capital. Therefore, a firm’s capital structure is made up of a mixture of debt and equity (Pike et al., 2012). The concept of capital structure was originally established by Modigliani and Miller (1958). According to Modigliani and Miller (1958), in a perfect capital market, the value of a firm is not affected by its capital structure. Modigliani and Miller’s (1958) model on capital structure has significantly contributed to the field of finance and it has built a solid foundation under which contemporary financial theories are developed (Danso and Adomako, 2014). However, many scholars have criticised the works of Modigliani and Miller (1958), arguing that their work is unrealistic and instead suggested conditions which were more realistic that is; relaxed perfect capital markets (Myers and Majluf, 1984; Miller 1988; Myers 2001; Frank & Goyal,
  8. 8. 7 2005) Furthermore, these scholars argue that the capital structure of a firm does in fact have an effect on its value and they also argue that an optimal leverage ratio exists. However, despite countless years of theoretical and empirical research, there is no universal accepted theory to determine where this optimum lies (Myers, 2001). This is due to the fact that research relating to capital structure has returned inconclusive results (Sheikh and Wang, 2011). Consequently, capital structure is one of the most controversial and debated topics in the field of finance. Following the works of Modigliani and Miller (1958), two prominent theories on capital structure were established; the Trade-Off Theory and the Pecking Order Theory. The Trade-Off Theory argues that a firm’s capital structure is dependent on a balance between the cost and benefits of debt (Niu, 2008). On the other hand, the Pecking Order Theory argues that firms use a hierarchical system to finance their investment projects whereby, firms give preference to internal financing over external financing (Niu, 2008). These two theories provide more realistic explanations on capital structure under certain conditions however, from an individual standpoint these theories are unable to explain everything as they fail to determine the optimal capital structure at which firm value is maximum (Myers 2001). Despite this, the logic of the Trade-Off Theory and the Pecking Order Theory provide a more comprehensive view on capital structure as they “help to understand the financing behaviour of firms and they help to identify the potential factors that affect capital structure” (Sheikh and Wang, 2011, p118). Consequently, various scholars including Titman and Wessels (1988), Harris and Raviv (1991) and Rajan and Zingles (1995), have used the framework of the Trade-Off Theory and the Pecking Order Theory to empirically explore the factors that influence decisions on capital structure. There are five factors that have been identified as the main capital structure determinants; tangibility, profitability, size, liquidity and growth. The influence of these determinants on capital structure have been extensively researched on both a theoretical platform and an empirical platform. However, the research has resulted in ambiguous results. For example, according to the logic of the Trade-Off Theory a positive correlation exits between profitability and leverage (Harrison and Widjaja, 2014). In other words, the more profitable a firm is, the higher its leverage ratio. However, previous empirical research presents a different conclusion. For example, Rajan and Zingales
  9. 9. 8 (1995) conclude that profitability and leverage are negatively correlated (the more profitable a firm is, the lower its leverage ratio). These contradictory results indicate that “capital structure theories might not be consistent as financial and /or economic conditions change” (Harrison and Widjaja, 2014, p56). The 2007/2008 global financial crisis presents an opportunity to explore how capital structure is affected by a financial shock. Although previous research on this subject matter is scare, some scholars offer some insight about the financial behaviour of firms. For instance, according to Bhamra et al (2010), in times of economic instability, firms tend to be extra cautious in their financial strategy. Arrif et.al (2008) conclude that in periods of economic instability a firm’s capital structure tends to adjust at a much slower rate compared to economic stable periods. Despite these findings however, as outlined earlier, there does not exist a universally accepted or a well-developed model to determine the financing choices of firms. 1.2 PURPOSE AND MOTIVATION OF THIS DISSERTATION Over the last 60 years, there has been countless research exploring the determinants of capital structure and the impact that theses determinants have on the capital structure of firms (Niu, 2008; Sheikh and Wang, 2011; Hossain and Ali, 2012). However, research exploring the determinants of capital structure during a financial crisis is limited. Hence, there is a gap that exists in capital structure literature. Consequently, the purpose of this dissertation is to narrow the gap in the literature by exploring the determinants of capital structure from a theoretical perspective and using an empirical platform to investigate how these determinants are affected by the 2007/2008 global financial crisis in various non-financial public listed firms. 1.3 RESEARCH OBJECTIVES  To critically analyse the relationship between capital structure determinants and leverage in non-financial public listed firms during stable economic periods (i.e. the pre-crisis period).
  10. 10. 9  To critically analyse the relationship between capital structure determinants and leverage in non-financial public listed firms during periods of economic instability (i.e. the 2007/2008 global financial crisis).  To compare and contrast differences in the relationship between capital structure determinants and leverage during the pre-crisis period and the crisis period. 1.4 RESEARCH QUESTIONS This dissertation aims to answer the following questions: 1) What are the main capital structure determinants and their effect on the capital structure of non-financial public listed firms? 2) How did the 2007/2008 global financial crisis affect the determinants of capital structure in non-financial public listed firms? 1.5 OUTCOMES The intended outcome of this dissertation is to produce findings that will shed more light on the role the determinants of capital structure have, in influencing the leverage of a firm, especially in times of economic instability, thereby, providing businesses with an enhanced understanding of their capital structure in order for them to make informed decisions about their leverage ratio. Furthermore, the researcher hopes to inform scholars of the importance of capital structure to any business and highlight areas for further research. Additionally, given the research questions identified, it is anticipated that the following many be concluded. The main capital structure determinants will be firm- specific factors and macro-economic factors and the financial crisis will alter the influence that these determinants have, on the debt/equity ratio of firms.
  11. 11. 10 1.6 METHOD OF RESEARCH This dissertation uses a quantitative research approach to analyse data collected from a sample of 10 non-financial public listed firms around the world. Furthermore, this dissertation involves a correlation analysis in which data is analysed over there periods; the whole sample period (2004-2009), the pre-crisis period (2004-2006) and the crisis period (2007-2009). 1.7 LIMITATIONS A significant limitation of this dissertation is the small sample size. The researcher originally intended to gather data from 100 sample firms. However, given the time consuming process of the data collection and the time allotted to complete this dissertation it is impossible to collect such vast amounts of data. Consequently, the sample is limited to 10 firms. Secondly, the correlation analysis is not conducted according to industry category/sector and this can potentially distort the results of the correlation analysis because industry patterns tend to affect the leverage ratio. Thirdly, the correlation analysis is based on five independent variables. It is not completely clear if more meaningful results could be generated by including more independent variables such as; macro-economic factors that affect the leverage ratio. 1.8 DISSERTATION OUTLINE This dissertation is structured as follows: Chapter two which is the literature review, beings by introducing the concept of capital structure. Then, the dominant capital structure theories are explored. Following on from this, the determinants of capital structure are explained under a theoretical framework which leads to the formularisation of various hypotheses. Lastly, the 2007/2008 global financial crisis is discussed in relation to capital structure and reference will be made to previous empirical research. Chapter three presents the research methodology whereby the research data and the research sample are explained. Furthermore, the variables which are used in the research process, the hypotheses and the method of analysis are outlined in this chapter.
  12. 12. 11 Chapter four is dedicated to discussing and analysing the results of the research. Chapter five compares the results obtained from the pre-crisis period and the crisis period, in in order to identify changes in capital structure determinants caused as a result of the 2007/2008 global financial crisis. Chapter six offers concluding remarks and presents the main research findings. Finally, chapter seven concludes the dissertation by outlining the research limitations which leads to a discussion on recommendations for future research.
  13. 13. 12 CHAPTER TWO: LITERATURE REVIEW This chapter presents a theoretical discussion on capital structure. First, a short description and definition of capital structure is presented. Following on from this, a detailed discussion of the major capital structure theories will be presented. Firstly, the Traditional View of capital structure will be explored which proposes that an optimal capital structure exits. This is then followed by a discussion on Modigliani and Miller’s (1958) model of capital structure, together with the developments and adjustments that they made to this model. All the contemporary capital structure theories originated from the ideologies of Modigliani and Miller (1958). Therefore, this chapter will then proceed to introduce the major theories that emerged after Modigliani and Miller’s Theorem. First, the core principles of the Trade-Off Theory are discussed and then the core principles of the Pecking Order Theory are discussed. The discussion of these two theories provides the foundation for a discussion on firm-specific determinants of capital structure. As a result, the researcher then proceeds to outline each firm-specific determinant of capital structure and they are analysed under the framework of the Trade-Off Theory and the Pecking Order Theory. This theoretical discussion allows for the development of several hypotheses. These hypotheses will be outlined in this chapter and they will be discussed later in the dissertation once the sample data has been processed. Lastly, this chapter will conclude by drawing upon previous empirical research in order to explore how capital structure determinants are affected by a financial crisis. 2.1 OVERVIEW OF CAPITAL STRUCTURE The concept of capital structure is centred on the financing sources adopted by firms and based on several theories, it attempts to explain the manner in which firm’s select their capital structure (Frank and Goyal, 2005). There are two main financing strategies that firms can employ. They can either borrow capital through debt instruments or issue new shares. Therefore, a firm’s capital structure is made up of a mixture of equity and debt (Pike and Neale, 2006). Making decisions regarding
  14. 14. 13 capital structure is a vital matter to all firms because it ultimately determines the value of a firm. In order to maximise firm value, a firm needs to adopt an optimal capital structure (Pilbeam, 2010). According to Baker and Martin (2012 cited in Jansen, 2014, p4) an optimal capital structure is a mixture of debt and equity that leads to the minimisation of the cost of capital which subsequently leads to the maximisation of firm value. Furthermore, capital structure is acknowledged as a controversial topic in the field of finance and the debate on capital structure consists of two spectrums that is; the relationship between firm value and capital structure decisions and the determinants of capital structure. As a result, the significance of these two factors has led to countless research examining both theoretical perspectives on capital structure as well as firm-level determinants of capital structure (Myers, 2001; DeJong, 2002; Gaud et al., 2005; Hossain and Ali, 2012). Therefore, the following sections will discuss the major theories and determinants of capital structure. 2.2 THEORIES OF CAPITAL STRUCTURE 2.2.1 The TraditionalView In order to fully appreciate the theories relating to capital structure, it is essential to first explore the Traditional View of capital structure. According to this view, there exists an optimal capital structure however, there is no actual formula to determine where exactly this optimum lies (Watson and Head, 2010). Due to this existence of an optimal capital structure, the Traditional View therefore proposes that a firm can increase its total value if it incorporates a sensible level of debt finance within its capital structure (Watson and Head, 2010). Hence, this view suggests that there is a correct debt to equity combination within the capital structure of firms, at which firm value is at its maximum level. Consequently, according to the Traditional View the capital structure of a firm should be composed of debt but only up to a particular point (which is unknown). If debt levels go beyond this point, firm value will decrease (Pike and Neale, 2006). Therefore, the existence of an optimum value of debt to equity ratio occurs when the market value of assets are maximised and the weighted average cost of capital (WACC) are minimised (Kaplan Financial, 2012). When a firm
  15. 15. 14 crosses this optimum value of debt to equity ratio, WACC will be affected because there will be a rise in the cost of equity. Exceeding the threshold, WACC increases and the market value of the firm begins a downward trend. The Traditional View is illustrated in figure 2.1. Figure 2.1: The Traditional View of capital structure Source: Kaplan Financial, Monday, 25 May 2015, [online] Where: Ke is the cost of equity Kd is the cost of debt Ko is the weighted average cost of capital X is the optimal level of gearing (leverage)
  16. 16. 15 2.2.2 Modiglianiand Miller’s Theorem The modern theory of capital and the importance of making decisions concerning capital structure was originally established in the 1950’s after the publication of Modigliani and Miller’s (MM’s) paper which outlined that firm value is unaffected by its capital structure (Modigliani and Miller, 1958). The ideas and principles outlined in MM’s (1958) research, overturned the ideologies of the Traditional View on capital structure and argued that the Traditional View was incorrect. According to MM’s (1958) research, there does not exist an optimal capital structure and “the value of a company and its cost of capital are independent of its capital structure” (Watson and Head, 2010, p284) under certain key assumptions. In other words, the total cash flow that a company can distribute to its debt and equity holders is unaffected by capital structure and the total value of the company’s debt and equity is not influenced by its capital structure (Grinblatt and Titman, 2002). This theory assumes that firms operate in a perfect capital market and perfect competition, where there is no existence of any taxes, bankruptcy costs, transaction costs, agency costs and arbitrage information (Berk and DeMarzo, 2007). Modigliani and Miller (1958) argue that under these perfect circumstances, capital structure is irrelevant in relation to firm value and there exists no optimal debt to equity ratio. Under this notion, only when these conditions are relaxed, will capital structure affect the value of a firm (DeJong, 2002). The implications of MM’s (1958) research is highlighted by Myers (2001) who suggests that firm value and the wealth of shareholders, regardless of the level of leverage, will remain constant and will not be improved by financing decisions. Furthermore, “debt has a prior claim on the firm's assets and earnings, so the cost of debt is always less than the cost of equity” (Myers, 2001, p84). However, attempting to use cheap debt over expensive equity will not lead to a reduction in the cost of capital because “it makes the remaining equity still more expensive-just enough more expensive to keep the overall cost of capital constant” (Myers, 2001, p85). Thus, the cost of equity of a firm rises with the debt to equity ratio and the WACC will only be dependent on the firm’s level of risk class (Neus and Walter, 2008). Consequently, this is the rational for MM’s (1958) argument that under perfect conditions, the financing structure of a firm does not affect its value and there does
  17. 17. 16 not exist an optimal capital structure that maximises the value of a firm. Modigliani and Miller’s Theory without tax is illustrated in figure 2.2. Figure 2.2: Modigliani and Miller no tax model Source: Kaplan Financial, Monday, 25 May 2015, [online] Where: Ke is the cost of equity Kd is the cost of debt This model implies that WACC and therefore firm value are not affected by changes in the level of gearing (leverage). Despite the pioneering works of MM in this field of study, numerous critical studies emerged concerning the assumptions made by these two scholars (Merton, 1974; Miller, 1988; Myers, 2001). Most of the critique was centred on the fact that MM’s (1958) research fails to explicitly validate the empirical findings on capital structure. Therefore, MM decided to revise their concept on capital structure in order to counter this criticism. They published a modified set of research on capital structure in 1963
  18. 18. 17 in which corporate tax was included in their model and dividends were excluded from their model (Watson and Head, 2010). Modigliani and Miller (1963) acknowledged that the existence of taxation was a key reason why capital structure does in fact influence firm value. “Their acknowledgement of the existence of corporate tax and the tax deductibility of interest payments implies that, as a company gears up by replacing equity with debt, it shields more and more of its profits from corporate tax” (Watson and Head, 2010, p287). Therefore, this saving on tax incurred from debt financing over equity financing means that a firm’s overall cost of capital (WACC) decreases as its leverage increases. This is illustrated in figure 2.3. Figure 2.3: Modigliani and Miller with tax model Source: Kaplan Financial, Monday, 25 May 2015, [online] Where: Ke is the cost of equity Kd is the cost of debt According to Arnold (2008, p809), while corporate value increases, “the WACC declines for each unit increase in debt so long as the firm has taxable profits.” In other words, when the capital structure of a firm is completely composed of debt, the value of the firm will be at its highest and WACC will be at its lowest.
  19. 19. 18 In addition to this, Miller (1988) further developed the model on capital structure by including corporate tax and individual income tax into the model. Therefore, according to Modigliani and Miller (1963) and Miller (1988), the capital structure of a firm should almost exclusively consist of debt since an optimal capital structure is subject to tax advantages of debt (Hossain and Ali, 2012). However, despite these modifications made by MM their concept was still surrounded with criticism. Miller (1988) for example, acknowledged the common critique that the inability of a firm to generate profits would instantly offset the tax shield effect. Despite the limitations and criticisms surrounding the practical relevance of MM’s research, their contribution and influence on the concept of capital structure is considered ground breaking. It can be argued that “while the Modigliani-Miller theorem does not provide a realistic description of how firms finance their operations, it provides a means of finding reasons why financing may matter” (Frank and Goyal, 2005, p7). Today, MM’s theory on capital structure is widely acknowledged and their theory acts as a benchmark under which contemporary financial theories are developed (Danso and Adomako, 2014). After MM’s theory, two prominent theories concerning capital structure emerged namely; the Trade-Off Theory and the Pecking Order Theory. 2.2.3 Trade-offTheory The Trade-Off Theory claims that companies are commonly financed to a certain degree with debt and to a certain degree with owner equity and they select how much equity finance and debt finance to use by creating a balance between benefits of debt (i.e. the tax shield effect) and the costs of debt (i.e. bankruptcy costs) (Myers 1997). “Under the Trade-Off Theory framework, a firm is viewed as setting a target debt to equity ratio and gradually moving towards it which indicates that some form of optimal capital exists that can maximise the firm value” (Sheik and Wang, 2011, p120). The Trade-Off Theory added to and advanced MM’s theory by incorporating additional vital factors such as bankruptcy costs. Therefore, costs of debt are characterised by indirect and direct costs of bankruptcy. Costs of bankruptcy include administrative and legal costs and more subtle costs such as monitoring and
  20. 20. 19 contacting costs (Myers 1984). However, Ju et al., (2005, p261) argue that “bankruptcy costs alone are too small to offset the value of tax shields and, thus, other factors, such as agency costs, must be introduced into the cost-benefit analysis to explain observed capital structure” As a result, the Trade-Off framework also embodies the Agency Cost Theory. The Agency Theory was established by Jensen and Meckling (1976) and they argue that a firm’s operations encompasses sets of contractual or agency relationships between shareholders and managers, whereby shareholders give managers the authority to manage the company in a manner that will result in the maximisation of shareholder wealth and firm value. However, in some instances managers ignore the interests of shareholders and instead pursue their own selfish interests and this conflict of interest between the two parties will result in agency problems and costs (Hossain and Ali, 2012). Furthermore, Jensen and Meckling (1976) claim that an optimal capital structure can be achieved by trading off the agency costs of debt against the benefits of debt. However, according to Frank and Goyal (2005), there is a lack of clarity concerning the influence of several agency costs on capital structure. “These costs include the costs of renegotiating the firm's debt contracts and the opportunity costs of non- optimal production/investment decisions” (Bradley et al., 1984, p860). According to Bradley et al. (1984), these costs tend to arise when a firm is unable to settle its debt commitments with lenders. Consequently, a broader term known as the ‘cost of financial distress’ is typically used when referring to both the costs of bankruptcy and the agency costs that arise when a firm is incapable of settling debt payments (Myers, 2001). Therefore, it is evident that the Trade-Off Theory is centred around MM’s (1958) model of capital structure, because the assumption regarding perfect capital markets are relaxed by incorporating bankruptcy costs, agency costs and taxes (Ozkan, 2001). However, in comparison to MM’s (1958) model, the Trade-Off Theory justifies the use of moderate levels of leverage. In addition, this framework also validates that
  21. 21. 20 an optimal capital structure exists and firms try to achieve and maintain it so they can increase the wealth of shareholders (Myers 1984). Therefore, based on the logic of the Trade-Off Theory, a value-maximising firm that is facing a reduced chance of going bankrupt should make complete use of debt. Consequently, one of the predictions of the Trade-Off Theory is that profitability and leverage are positively correlated because firms that possess a high level of profitability are capable enough to generate a larger saving on tax while simultaneously reducing the probability of bankruptcy (Hovakimian et. al., 2004). 2.2.4 Pecking Order Theory Myers and Majluf (1984) are the pioneers of the Pecking Order Theory and this theory is broadly used as a model to evaluate and explain the manner in which firms select their sources of finance. In contrast to the Trade-Off Theory, “the Pecking Order Theory goes against the idea of companies having a unique combination of debt and equity finance which minimises their cost of capital” (Watson and Head, 2010, p291). Instead, the Pecking Order Theory argues that firms appear to adhere to a hierarchical system of financing by considering their financing needs and then selecting their leverage ratio based on these needs (Watson and Head, 2010). Therefore, if a firm requires funding, preference is first given to internal sources of finance (i.e. retained earnings) and only once a firm’s internal sources of finance are exhausted will it pursue external sources of finance (Myers and Majluf, 1984). “However, the debt market is called on first, and only as a last resort will companies raise equity finance” (Arnold, 2008, p799). Furthermore, the Pecking Order Theory perceives the importance of bankruptcy costs and interest tax shields as only a secondary concern whereas the Trade-Off Theory perceives these factors as a primary concern (Myers 1984). Therefore, since the Pecking Order Theory claims that firms prefer internal financing over external financing, it is reasonable to assume that under the framework of the Pecking Order Theory, the capital structure of firms will comprise of low levels of debt. In other words, a firm will only seek debt financing when their internal funds cannot serve their investment needs.
  22. 22. 21 Various explanations regarding the behaviour of the Pecking Order Theory can be clarified by the literature on capital structure. For example, the agency problem helps to explain why firms try to avoid external financing. According to Myers (2001, p93), a firm’s preference for internal financing over external financing and the inconsistencies of public firms in issuing stock are associated with “the separation of ownership and control and the desire of mangers to avoid the discipline of capital markets.” Therefore, “a company which makes no direct use of the stock market as a source of capital can, apparently, proceed to make its decisions confident in its immunity from punishment from the impersonal mechanism of the stock exchange” (Baumol, 1965 cited in Myers, 2001, p93). Furthermore, informational asymmetry problems also highlight why firms avoid external financing. Myers and Majluf (1984) built upon and advanced their research on the Pecking Order Theory by accounting for asymmetric information between managers and investors and the effect it has on investment and financing behaviour. Myers and Majluf (1984) argue that since managers are able to easily access private information concerning the firm, they are in a better position to report about the firm’s true value in comparison to outside investors who are less informed. Thus, these investors find it difficult to accurately value issued shares. Therefore, the probability of markets mispricing the shares of a firm are considerably high. Due to this informational disadvantage, equity investors require an increased level of return which signifies additional risk. As a result, due to the existence of an adverse selection premium, equity finance will be more expensive if a firm is unable to persuade investors of their true value (Myers and Majluf, 1984). In addition, Harris and Raviv (1991) claim that the problems caused as a result of informational asymmetry, especially the mispricing of shares, are usually avoided when making capital structure decisions under the framework of the Pecking Order Theory. This situation is justified by the logic of the Pecking Order Theory which argues that firms give preference to internal financing because the use of internal funds avoids sending a signal that the firm is confident in its creditworthiness and it also minimises the probability of inaccurate share valuation (Arnold, 2010).
  23. 23. 22 Additionally, if internal financing is not sufficient then debt is favoured over equity because the use of debt results in minimal value impacts and minimal risks of misinterpretations (Neus and Walter, 2008). Consequently, it is evident that Pecking Order Theory is designed in a manner to avoid such complications. However, this explanation has resulted in criticisms because it fails to account for the agency problem. According to the logic of the Signalling Theory, mangers are expected to act in the best interests of shareholders and avoid misusing or exploiting superior information in order to fulfil their own interests (Neus and Walter, 2008). However, the logic of the Pecking Order Theory suggests that managers should possess unrestricted control over free cash flows (Myers and Majluf, 1984). Jensen and Mecking (1976) on the other hand, recommend the opposite because they claim that managers would take advantage of financial slack in order to fund projects that are not profitable such as; investing in empire building expansion plans which will not be beneficial to shareholders. In order to minimise the related agency costs, it is necessary that shareholders limit the access managers have to internal funds and in doing so this will prompt them to raise finance by external means (Grossman and Hart, 1982). The bases of this argument is centred on the fact that the model assumes that the efficiency of capital markets would without a doubt result in funds being allocated to projects that are profitable (Neus and Walter, 2008). 2.3 DETERMINANTS OF CAPITAL STRUCTURE Following from these theoretical viewpoints, several firm-level variables have been acknowledged as important determinants of capital structure such as; tangibility, profitability, size, liquidity and growth (Titman and Wessels, 1988; Harris and Raviv, 1991; Rajan and Zingales, 1995; Frank and Goyal, 2005). Therefore, the next section of this chapter is going to use the framework of the Trade-Off Theory and the Pecking Order Theory in order to explain the influence that these factors may have on the leverage ratio of firms.
  24. 24. 23 2.3.1 Tangibility In terms of tangibility, a positive relationship exists between this variable and leverage (Niu, 2008). This positive relationship supports the ideas of the Trade-Off Theory because tangible assets can serve as a form of collateral when attempting to acquire a loan hence, limiting the cost of bankruptcy (Myers and Majluf, 1984). As a result, firms that possess a high volume of tangible assets are more likely to possess high levels of debt. This effect is justified by the fact that lenders have an increased willingness lend to firms that own a large volume of tangible assets because if a firm goes bankrupt, their tangible assets can be liquidated to settle their outstanding obligations (Danso and Adomako, 2014). Thus, tangible assets serve as a form of insurance to pay back loans. Furthermore, issuing debt is subject to costs due to the problem of informational asymmetry, that is; managers have better knowledge than outside investors (Myers and Majluf, 1984). According to Myers and Majluf (1984) these costs can be avoided by securing the distribution of debt with a form of collateral because the value of this collateral is known. Thus, when the opportunity presents itself for a firm to use assets as a form of collateral, it is reasonable to assume that these firm will acquire more debt (Elsas and Florysiak, 2008). In addition, Jensen and Meckling (1976) argue that the shareholders of firms that are highly leveraged have an incentive to invest below optimum levels in order to shift wealth from debtholder to shareholders. However, Sheikh and Wang (2011, p122) argue that “debtholders can confine this opportunistic behaviour by forcing them to present tangible assets as collateral before issuing loans, but no such confinement is possible for those projects that cannot be collateralised.” Therefore, this incentive may also induce a positive relationship between tangibility and leverage. Additionally, according to Danso and Adomako (2014), firms that possess a small volume of tangible assets are more likely to face harsh lending conditions which restrain their ability to borrow, as a result these firms are forced to acquire equity instead of debt. Moreover, pervious empirical research such as; Titman and Wessels (1988) and Rajan and Zingales (1995) also found that a positive relationship exists
  25. 25. 24 between tangibility and leverage. Consequently, based on the above discussion the first hypotheses is formulated. H1. Tangibility and leverage will have a positive relationship 2.3.2 Profitability In terms of profitability, there are mixed claims about its relationship with leverage. According to the logic of the Pecking Order Theory, there exists a negative relationship between profitability and leverage because profitable firms are expected to finance their investment projects with low volumes of debt (Fama and French, 2002). Myers and Majluf (1984) claim that according to the Pecking Order Theory, firms use a hierarchical system to make decisions about financing because of the existence of informational asymmetry amongst investors and managers of a firm. Therefore, firms give preference to internal sources of finance such as; retained earnings, over external sources of finance such as; the acquisition of debt or equity, in order to fund their investment activities thereby avoiding the possible erosion of ownership and control (Danso and Adomako, 2014). Furthermore, “profitable firms are expected to hold less debt because they are able to generate adequate funds easily and cost effectively from internal sources for satisfying project costs” (Hossain and Ali, 2012, p166). Hence, this suggests that only when a firm’s internal funds are exhausted, will it pursue the use of external funds and in this instance the managers of a firm will first give preference to debt over equity. On the other hand, the Trade-Off model offers a different perspective to this matter. The Trade-Off Theory proposes that a positive relationship exists between profitability and leverage because profitable firms have more taxable income to shield thus, they are able to generate a larger saving on tax while simultaneously reducing the probability of bankruptcy (Hovakimian et. al., 2004 and Harrison and Widjaja, 2014). Additionally, profitable firms are more capable of tolerating high debt ratios as they tend to generate stable earnings meaning, they are generally in a wealthy position to settle their debts commitments easily and on time (Zhang and Mirza, 2015). As a result, lenders would be more willing to lend to profitable firms. With such different perspective regarding the relationship between profitability and
  26. 26. 25 leverage it is difficult to devise a hypotheses. Hence, this dissertation is going to devises a hypotheses by drawing upon previous empirical research. For example, Titman and Wessels (1988) and Fama and French (2002) discovered that a negative relationship exists between profitability and leverage. Therefore, based on the above theoretical discussion and based on previous research the second hypotheses is formulated. H2. Profitability and leverage will have a negative relationship 2.3.3 Size According to the logic of the Trade-Off Theory, the relationship between firm size and leverage is positive because larger firms are generally more diversified and are more likely to have stable cash flows and little variations in their earnings as opposed to smaller firms (Castanias, 1983). Therefore, large firms are less likely to default on debt payments and they are also less prone to the risks of bankruptcy thereby, reducing bankruptcy costs (Sheikh and Wang, 2011). Consequently, this condition enables large firms to endure high debt ratios. In contrast, the Pecking Order Theory proposes that firm size and leverage have a negative relationship because larger firms encounter minimal problems with informational asymmetry in comparison to smaller firms (Danso and Adomako, 2014). In this regard, “large firms should borrow less due to their ability to issue informationally sensitive securities like equity” (Sheikh and Wang, 2011, p122). Consequently, based on this argument it is reasonable to assume that large firms will possess less debt in their capital structures. With such different perspectives regarding the relationship between profitability and leverage it is difficult to devise a hypothesis. Hence, this dissertation is going to devises a hypothesis by drawing upon previous empirical research. According to Rajan and Zingales (1995) there is a positive relationship between size and leverage. Therefore, based on the above discussion the third hypothesis is formulated. H3. Firm size and leverage will have a positive relationship
  27. 27. 26 2.3.4 Liquidity In terms of liquidity there are two contrasting views regarding its relationship with leverage. The Trade-Off Theory argues that liquidity is positively related to leverage because it is expected that the more liquid a firm is, the more debt it will acquire (Hossain and Ali, 2012). According to Hossain and Ali (2012), the rational for this argument is that if a firm is highly liquid, then it is more capable to settle its short term debt commitments on time because liquid firms can easily covert their liquid assets into debt payments and this is especially important in times of financial distress. In contrast, the Pecking Order Theory proposes that liquidity is negatively related to leverage because liquid firms are more likely to use its liquid assets to finance investment projects (Myers and Majluf, 1984). Therefore, if a firm possess adequate liquid assets to finance investment activities, the firm will not be required to gather external funds. The different perspectives regarding the relationship between liquidity and leverage also makes it difficult to devise a hypothesis. Therefore, this dissertation is going to devises a hypothesis based on previous empirical research. According to De Jong et al. (2008) and Titman and Wessels (1988), they concluded that liquidity and leverage are positively related. Hence, based on this evidence the fourth hypothesis is formulated. H4. Liquidity and leverage will have a positive relationship 2.3.5 Growth According to the logic of the Trade-Off Theory, a negative relationship exists between growth and leverage (Zhang and Mirza, 2015). This can be justified by the fact that growth opportunities is a form of intangible assets hence, firms that have potential growth opportunities are inclined to borrow less because growth opportunities cannot be used as a form of collateral to secure debt (Zhang and Mirza, 2015). The Agency Theory also suggests that there is a negative relationship between growth and leverage. The Agency Theory claims that firms that possess
  28. 28. 27 greater opportunities to grow are usually more flexible to invest below optimal levels and thus transfer wealth from debtholders to stockholders (Sheik and Wang, 2011). “In order to restrain these agency conflicts, firms with high growth opportunities should borrow less” (Sheik and Wang, 2011, p123). Furthermore, previous empirical research such as Titman and Wessels (1988) and Rajan and Zingales (1995) also conclude that negative relationship exists between growth and leverage. Therefore, based on the above theoretical discussion and evidence from previous empirical research, the fifth hypothesis is formulated. H5. Growth and leverage will have a negative relationship 2.4 CAPITAL STRUCTURE DURING A FINANCIAL CRISIS Thus far, the literature review has discussed the capital structure of firms during stable economic conditions. The next section of this chapter is going to focus on how instable economic conditions affect the capital structure of firms. To begin with, this chapter will first give a brief overview of the 2007/2008 global financial crisis. This is then followed by a discussion outlining previous empirical research that have investigated capital structure determinants during financial crisis periods. 2.4.1 The 2007/2008 GlobalFinancialCrisis The global financial crisis, also known as the subprime crisis, began in 2007 as a result of a liquidity deficit amongst financial bodies (Jansen, 2014). After the collapse of the Lehman Brother Banks in 2008, the crisis began to progress systematically because the creditworthiness of banks worldwide were at risk. Furthermore, 2008 also saw the crisis spread from the US to the rest of the world and this cross-border contamination progressed at a quick rate as a result of worldwide financial market integration (Jansen, 2014). According to Claessens et al. (2013) there are several root causes of the recent global financial crisis such as; financial bodies possessing large volumes of debt, the extensive use of complicated financial instruments and the US property bubble collapsing.
  29. 29. 28 2.4.2 Previous Research on Capital Structure Determinants during a FinancialCrisis According to past research, several scholars including Deesomsak et al. (2004) confirm that capital structure determinants are affected by a financial crisis. Deesomsak et al. (2004) based their research on the 1997 Asian financial crisis and they employed a comparative platform to undertake their research. These scholars compared capital structure decisions between two periods; the pre-crisis period and the post crisis period. The research was based on four countries namely; Malaysia, Singapore, Thailand and Australia and tangibility, liquidity, size, earning volatility, non-debt tax shield and share price performance were employed as the variables for the research. Each variable was analysed in relation to leverage during the pre-crisis period and the post crisis period and then compared against each other. Deesomsak et al. (2004) found that liquidity, non-debt tax shield and size were affected by the crisis while volatility of earnings, tangibility and share price performance were unaffected by the crisis. A similar study was conducted by Ariff et al. (2008) which focussed on capital structure adjustments made during the Asian financial crisis of 1997-1998. The research was mainly based on data sets of financially distressed and healthy firms. The research involved examining the speed and determinants of such adjustments by introducing internal and external macroeconomic variables that affect a firm including GDP, exchange rates and money supply as well as introducing lagged leverage variables. Ariff et al. (2008) concluded that the crisis led to firms altering their capital structure. A more recent study was conducted by Zarebski and Dimovski (2012). These scholars examined the effects that the 2008 global financial crisis had on the capital structure of real estate investment trusts in Australia. The research involved analysing the relationship between capital structures determinants and short term, long term and total leverage, before and after the crisis. The period before the crisis was characterised by the years 2006-2007 while the period after the crisis was characterised by the years 2008- 2009. Zarebski and Dimovski (2012) concluded
  30. 30. 29 that the financial crisis affected the capital structure of the sample firms but the results differed according to the type of leverage. Similarly, Harrison and Widjaja (2013) conducted research that was based on the 2008 global financial crisis. They analysed how the financial crisis affected the capital structure of non-financial firms in America. The variables used in their study were tangibility, size, liquidity, profitability and market to book ratio. They also used a comparative platform to determine the relationship between these variable and leverage before the financial crisis and during the financial crisis .Harrison and Widjaja (2013) concluded that during the crisis tangibility and size were positively related to leverage while profitably, market to book ratio and liquidity were negatively related to leverage. It is evident from the above discussion that previous empirical research reveal that capital structure is affected by a financial crisis but there are inconsistent results regarding the impact of a financial crisis on capital structure determinants. As a result, due to this inconsistency there is a gap that still remains in the literature. 2.5 SUMMARY In summary, this chapter presented the main theories relating to capital structure. Firstly, the literature review acknowledged that Modigliani and Miller’s (1958) model initially started the debate on capital structure. According to Modigliani and Miller (1958), the value of a firm is independent of capital structure in a perfect capital market. This chapter then highlights that two prominent theories emerged after the Modigliani-Miller theorem namely; the Trade-Off Theory and the Pecking Order Theory. The literature review is centred on these two theories and depicts them as the dominate theories of capital structure. The Trade-Off Theory and the Pecking Order Theory provide different interpretations of the manner in which firms select their financing structures and they highlight the costs and benefits of alternative financing strategies. This chapter also uses the framework of the Trade-Off Theory and the Pecking Order Theory in order to explain the relationship between leverage
  31. 31. 30 and several firm-level determinants of capital structure such as; tangibility, profitability, size, liquidity and growth. The discussion on these variables leads to several hypotheses being formulated. Finally, this chapter concludes by drawing upon previous empirical research that have analysed the impacts of a financial crisis on the determinants of capital structure. This discussion highlights that a gap exists in the literature.
  32. 32. 31 CHAPTER THREE: METHODOLOGY In the previous chapter, the researcher presented an analytical and critical discussion of the theories relating to capital structure, firm-level determinants of capital structure and the link between a financial crisis and capital structure. There are a significant number of academics that have explored the subject of capital structure and capital structure determinants, as well as the impact of a financial crisis on these determinants (Rajan and Zingales, 1995; De Jong et al., 2008; Zarebski and Dimovski, 2012). Consequently, this dissertation aims to contribute to past and current research on capital structure by analysing the impact that the 2007/2008 global financial crisis had on the capital structure determinants of various non- financial public listed firms. In this regard, this dissertation will be conducted by employing a comparative platform whereby capital structure determinants will be analysed before the 2007/2008 global financial crisis and during the 2007/2008 global financial crisis and then compared against each other in order to identify any particular trends. Therefore, this chapter will present and discuss the research methodology. The researcher will begin by analysing the difference between quantitative research and qualitative research and then discuss why a quantitative research approach has been selected for this research. This chapter will then go on to discuss the data collection process. Next, the variables that are intended to be studied and their mathematical proxies will be presented. The researcher will then outline the sample selection criteria and the rational for the chosen period of analysis. This is then followed by a discussion on the hypotheses formulated in chapter two and the method of analysis. Lastly, the researcher will discuss possible limitations of the chosen methodology and the ethical considerations that the researcher must abide to while undertaking this research.
  33. 33. 32 3.1 QUANTITATIVE RESEARCH According to Given (2008), a quantitative research approach is a systematic empirical process which enables the researcher to gain a general synopsis of the situation or problem at hand by means of mathematical and statistical techniques. One of the most fundamental issues concerning quantitative research, is the ability of the researcher to select an appropriate measurement technique, because this will ultimately determine the answer to a research question as it highlights the link between an empirical study and data that is expressed in mathematical terms (Lafaille and Wildeboer, 1995). Furthermore, quantitative research aids in determining which hypotheses proposed by the researcher stands true. The most significant advantage of using a quantitative research approach in regards to this dissertation is the credibility and confidence that the researcher gains when interpreting data, because quantitative research comprises of several forms of statistical techniques based on mathematical principles. Therefore, this dissertation employs a quantitative research approach as it requires several mathematical calculations to interpret the sample data. 3.2 QUALITATIVE RESEARCH Qualitative research also provides the researcher with a general synopsis of the situation at hand but it also helps the researcher to gain an understanding of the social process and context of the situation (Given, 2008). In addition, Morgan and Margert (1984) claim that a qualitative research method allows the researcher to acquire a greater scope for interpretation and provides them with the opportunity to obtain knowledge. Unlike quantitative research, qualitative research takes the form of words and images rather than numbers (Denscombe, 2014). Qualitative research strategies include interviews, case studies, and observations. There are several downfalls of employing a qualitative research approach in regards to this dissertation. Firstly, a qualitative research approach does not encompass the
  34. 34. 33 use of statistics or any sort of mathematical measurements but researchers often collect data numerically for the analysis (Dane, 1990). Furthermore, a qualitative research approach is generally a time consuming process and data collection can in some instances spread over months or years (Denscombe, 2014). Lastly, Dane (1990) proposes that qualitative research should only be undertake by individuals who are ready to commit to it. Based on the discussion above, a qualitative research approach will not be used for this dissertation because this dissertation relies heavily on mathematical calculations to answer the research questions and since a qualitative research approach holds no mathematical substance, it would be unsuitable. Furthermore, gathering data via interviews with the sample companies is not feasible as they are all international firms with their headquarters in locations outside the UK. Thus gaining access to a financial representative would be impossible. Consequently, this dissertation will not include this method in its analysis. 3.3 DATA In order to conduct this research, secondary data is employed to assist in the discussion regarding the theories of capital structure and capital structure determinants. Additionally, a quantitative research method is employed to undertake this research in order to assess the relationship between independent and dependant variables of capital structure determinants. In order to identify the relationship between these two variables, the Morningstar database will be accessed. Accessing a financial database guarantees that the data used in this dissertation is reliable and accurate thus limiting the likelihood of inaccurate results (Dane, 1990). The Morningstar database comprises of detailed financial information of public listed firms such as; income statements, balance sheets, and financial ratios as well as descriptive and market information. Consequently, accessing the Morningstar database is a suitable source to use in order to compile the required financial data of various non-financial listed companies. The primary focus of the data collection and data processing will be centred on explicit financial records which are associated with the determinants of capital
  35. 35. 34 structure such as; fixed assets, total asset, sales, market value, book value, current liabilities, current assets, equity and total debt. However, since the Morningstar database does not directly provide the calculated ratios that are associated with capital structure, this dissertation will use the Morningstar database to access the balance sheets and income statements of each sample firm, in order to compute the required ratios manually. Section 3.4 will outline the ratios that represent each variable. 3.4 VARIABLES As highlighted earlier, this dissertation aims to examine the relationship between independent and dependant variables of capital structure determinants in order to determine how the 2007/2008 global financial crisis affected capital structure decisions. Therefore, this section will outline the formulas required to calculate each variable. 3.4.1 DependantVariable The dependant variable for this research will be characterised by the degree of leverage of a firm. The ratio of total debt to total assets will be used as the proxy for leverage in this research. Total debt is a widely adopted measure in studies relating to capital structure. For example, this measure is used by several academics including; Titman and Wessels, (1988), Sheikh and Wang (2011) and Zhang and Mirza (2015). 3.4.2 Independentvariables The independent variables for this research will be characterised by tangibility, profitability, size, liquidity and growth. Table 3.1 illustrates the proxy measurements for each variable. Furthermore, the formula for each variable is extracted from previous literature in order to justify the use of each measurement (this is also illustrated in table 3.1).
  36. 36. 35 Table 3.1: Variables and their measurements Variable Proxy measurement Literature Tangibility The ratio of net fixed assets to the book value of total assets Rajan and Zingales, 1995; De Jong et al., 2008; Akdal, 2010 Profitability The ratio of earnings before interest and tax to the book value of total assets Deesomsak et al., 2004; Lemmon and Zender, 2010; Akdal, 2010 Size the natural log of total assets De Jong, 2002; Deesomsak et al., 2004; Degryse et al., 2012 Liquidity The ratio of total current assets to total current liabilities Graham, 2000; De Jong et al., 2008; Akdal, 2010 Growth The ratio of market value of equity to the book value of equity Rajan and Zingales, 1995; Gaud et al., 2005 3.5 RESEARCH SAMPLE The sample for this research is collected from the Forbes website which provides data on the world’s top 100 biggest public companies. The sample is determined by a stratified sampling technique. A stratified sampling technique involves “subdividing the research population into different groups (strata) and then choosing the required number of items or people from within each subgroup using random sampling techniques” (Denscombe, 2014, p38). The concept of a stratified sampling technique is that it ensures that “crucial parts of the population are appropriately represented in the overall sample” (Denscombe, 2014, p38). Consequently, using this method limits the probability of bias problems and ensures that the final result is reliable (Yates et al., 2008). In this respect, the top 100 companies are divided into 10 groups of 10, based on their ranking. In other words, the first group consists of companies that rank from 1 to 10. The next group consists of companies that rank from 11 to 20. Group 3 is made up of those companies which are ranked from 21 to 30 and this grouping proceeds until 10 groups are created. Appendix A illustrates this. Once all 100 companies are assigned to a group a simple random sampling technique is used
  37. 37. 36 to determine the research sample. One company is randomly selected from each group to create a sample of 10 companies. Furthermore, in order to acquire a cohesive and relevant sample, it is necessary to apply filters to the dataset. The use of filters is justified by the fact that it eliminates any outliers that have the potential to distort the overall findings (Denscombe, 2010). There is only one filter that is required for this research in order to obtain unbiased results. This filter is the exclusion of financial firms from the sample. This is due to the fact that the nature of their capital structure is inherently different from the capital structure of non-financial firms (Rajan, & Zingales, 1995). Hence, it is relevant to filter out financial firms from the research sample. Table 3.2 illustrates the selected sample that will be used to facilitate this research. Table 3.2: Research Sample (simple random sample of firms) Ranking as of 01/06/15 Firm Ranking Country General Electric #9 United States Royal Dutch Shell #13 Netherlands Nestle #30 Switzerland Procter and Gamble #36 United States BP #41 United Kingdom Novartis #52 Switzerland Honda Motor #63 Japan Boeing #72 United States Walt Disney #85 United States PepsiCo #99 United States In addition to this, the sample timeline for this research will be centred on two periods; the period before the 2007/2008 global financial crisis and the period during the 2007/2008 global financial crisis. This is necessary in order to compare and contrast any changes in the capital structure determinants of a firm during both periods and thus identify how the 2007/2008 global financial crisis impacted capital
  38. 38. 37 structure decisions. However, there are several debates that surround defining the actual year the financial crisis commenced and thus it is difficult to provide a conclusive statement to identify the onset of the financial crisis. For example, some scholars propose that the period from 2008 till 2009 is a true representation of the subprime crisis (Zarebski and Dimovski, 2012). However, other scholars define the period from 2007 till 2008 as the subprime crisis (Alves and Francisco, 2013). The research conducted by Zarebski and Dimovski (2012) and Alves and Francisco (2013) is based on different countries hence, this could be a possible reason to justify the inconsistency between the crisis definitions (Jansen, 2014). For example, the research conducted by Alves and Francisco (2013) is based on 43 nations around the world, including the US. Since the US is where the subprime crisis originated in 2007, it seems reasonable to declare 2007 as the year the crisis commenced. However, the research conducted by Zarebski and Dimovski (2012) examined companies based only in the UK and Australia and consequently they proposed that the year 2008 was when the subprime crisis commenced. This definition is also justified because cross-border contamination of the crisis was only felt by the rest of the world in September 2008 due to the collapse of the Lehman Brother Bank (Jansen, 2014). Thus, depending on the country in question different years can be defined as the start of the crisis. Based on the evidence above, this dissertation is going to define the year 2007 as the start of the global financial crisis due to the fact that the sample companies originate from the US as well as countries worldwide, thus mirroring the definition of Alves and Francisco (2013). Consequently, the years 2004, 2005 and 2006 will be used to examine the determinants of capital structure before the crisis commenced and the years 2007, 2008 and 2009 will be used to examine the determinants of capital structure during the crisis. 3.6 HYPOTHESES In the previous chapter, the relationship between firm-specific determinants of capital structure and leverage were analysed on a theoretical platform. However, this analysis revealed that there is no agreement among the capital structure theories on the relationship between these determinants and leverage. Due to these mixed theoretical predictions, it was particularly difficult to formulate several hypotheses
  39. 39. 38 based solely on theory. Consequently, in order to counter this inconvenience, the hypotheses formulated in chapter two were based not only on theoretical logic but also on empirical evidence. Table 3.3 illustrates the hypothesis formulated for each capital structure determinant and the theoretical logic behind these hypotheses. Furthermore, the hypothesis devised for each capital structure determinant is used to explore the answer to research question 1, that is; the effect of capital structure determinants on the capital structure of non- financial public listed firms. Therefore, each hypothesis will be tested for the whole sample period (2004-2009). The results of this analysis helps to inform the answer to research question 2 that is; how these determinants were affected by the 2007/2008 global financial crisis. Table 3.3: Hypotheses and Predictions Variable Expected relationship with leverage Prediction of the Trade-off Theory Prediction of the Pecking Order Theory Tangibility (H1) + + Profitability (H2) - + - Size (H3) + + - Liquidity (H4) + + - Growth (H5) - - 3.7 METHOD OF ANALYSIS A correlation analysis is a statistical method that determines the extent to which an independent variable influences a dependant variable (Dane, 1990). The extent to which an independent variable influences a dependant variable can be measured by using the independent variable’s correlation coefficient. Therefore, in order to determine how the 2007/2008 global financial crisis affected the determinants of capital structure, a correlation analysis will be employed for this research. The correlation analysis will test the relationship between the dependant variable (leverage) and each independent variable of capital structure that is; tangibility,
  40. 40. 39 profitability, size, liquidity and growth. The correlation analysis function in excel is used as the medium to evaluate this. Before conducting the correlation analysis, the dependant variable and the independent variables are evaluated for each sample firm across the whole sample period (2004-2009) (appendix B illustrates the calculations for each sample firm and appendix C illustrates the results for each sample firm). Then the mean values for each variable are evaluated for each year. This is illustrated in appendix D. Once the mean values are evaluated, a correlation analysis can be applied. Furthermore, the correlation analysis will be conducted in 3 stages. In the first stage, a correlation analysis is conducted for the whole sample period (2004-2009) and the results obtained aid in either accepting or rejecting the formulated hypotheses. In the second stage, a correlation analysis is conducted for the pre-crisis years (2004- 2006) and in the last stage a correlation analysis is conducted for the crisis period (2007-2009). The results obtained from the pre-crisis period and the crisis period are then compared, outlining any changes in capital structure determinants caused as a result of the financial crisis. 3.8 LIMITATIONS Although the design of this research was constructed carefully, it is important to note that no research is perfect thus, there is bound to be some limitations. The design of this research is no exception. The most significant limitation of this research is the differences in the fiscal year ends of the sample firms. This is problematic because the year 2007 has been selected as the start date of the financial crisis. Hence, all the relevant financial data of the sample firms will be analysed from this year for the crisis period (2007-2009). However, there is inconclusive evidence to pin point the exact day or month the crisis started. According to Kingsley (2012), the financial crisis began in August. Consequently, under this claim this research could lead to unreliable results because the sample firms do not have the same fiscal year ends and thus their financial data may not be representative of the financial crisis. For example, General Electric’s fiscal year, ends in December while Procter and Gamble’s fiscal year, ends in June. Hence, according to Kingsley’s (2010) claims Procter and Gamble would have published their financials before the financial crisis
  41. 41. 40 commenced. Thus, Procter and Gamble’s financials will only be representative of the financial crisis in 2008 as opposed to 2007. As a result, some of the sample firm’s financials may be representative of the financial crisis for 3 years and others for 2 years. 3.9 ETHICS Ethics refers to a system of moral principles by which individuals can judge their actions as right or wrong or good or bad- and social researchers are expected to conduct their research in an ethical manner (Denscombe, 2010). This means when a researcher is undertaking any form of social research they need to incorporate a moral mind-set when designing and conducting the research. Although this dissertation is secondary based and does not require the use of human participants to gather data, this dissertation will still adhere to a set of ethical codes. Since the research for this dissertation is conducted by means of the internet, the researcher will adhere to the ethical principles provided by the Association of Internet Researchers (AoIR). Since the data used in this research is published in a public domain and thus intended for public consumption, there is no requirement to obtain consent before using the material (Denscombe, 2014). However, the researcher will still abide to the set of principles laid out by the Association of Internet Researchers (AoIR) in terms of not manipulating, misrepresenting or compromising the financial data collected from the Morningstar database as a means to gain necessary or specific results (Association of internet research, 2012).
  42. 42. 41 CHAPTER FOUR: EMPIRICAL ANALYSIS In the previous chapter, the research methodology was outlined whereby the data, the sample and the method of analysis were discussed. In addition, the variables used in the research and the formulated hypotheses were discussed in order to understand how firm-level determinants impact capital structure decisions. In this chapter, the results of the correlation analysis are presented and analysed. The results are compared and contrasted against the theoretical discussion presented in chapter two (the literature review chapter). First, the correlation results for the whole sample period (2004-2009) are discussed. This is then followed by a discussion on the correlation results for two sub periods that is; the pre-crisis period (2004-2006) and the crisis period (2007-2009). The results of the pre-crisis period are first discussed and then the results of the crisis period are discussed. Furthermore, the results of the correlation analysis are illustrated by coefficient values. The coefficient values express the degree to which capital structure determinants influence leverage and the coefficient sign illustrates the relationship between the variables, that is; whether the variables are positively or negatively related. 4.1 ANALYSIS OF THE WHOLE SAMPLE PERIOD (2004- 2009) Table 4.1: Correlation analysis for the whole sample period (2004-2009)
  43. 43. 42 Table 4.1 illustrates the results of the correlation analysis for the whole sample period (2004-2009) and it outlines the coefficient value for each independent variable. 4.1.1 Tangibility According to the hypotheses formulated in chapter 2, the first hypothesis (H1) states that tangibility and leverage will have a positive relationship. Based on table 4.1, tangibility has a positive coefficient of 0.559265, as a result H1 is accepted. This positive relationship between tangibility and leverage highlights the importance of owning a large volume of tangible assets as they act as a form of collateral when attempting to acquire debt capital and asset collateralisation also mitigates the risk of default if a firm goes bankrupt (Bradely et al, 1984). Therefore, firms that have a limited availability of tangible assets may experience difficulties when attempting to acquire a loan or they may face harsh lending conditions (Danso and Adomako, 2014). Furthermore, the positive relationship between tangibility and leverage confirms the ideologies of the Trade-Off Theory and this result coincides with previous empirical research such as Titman and Wessels (1988), Rajan and Zingales (1995) and (Danso and Adomako, 2014). 4.1.2 Profitability In terms of profitability, the researcher argues that profitability and leverage will have a positive relationship (H2). Based on the results of the correlation analysis, this hypothesis is accepted as the coefficient for probability is -0.08344. This outcome also supports the prediction of the Pecking Order Theory over the prediction of the Leverage Tangibility Profitability Size Liquidity Growth Leverage 1 Tangibility 0.559265 1 Profitability -0.08344 -0.58660723 1 Size -0.21553 -0.136333353-0.164018677 1 Liquidity -0.23296 0.428489465-0.881765646 0.475768 1 Growth -0.46872 -0.136712518-0.491659211 -0.37089 0.367012 1
  44. 44. 43 Trade-Off Theory. According to the logic of the Trade-Off Theory, profitability and leverage are positively related (Fama and French, 2002). The Trade-Off Theory proposes that profitable firms will have a high amount of leverage as they have “more taxable income to shield” (Harrison and Widjaja, 2014) and they are generally wealthy enough to settle their debt commitments. Therefore, the logic of the Trade- Off Theory fails to justify the behaviour between profitability and leverage in this regard. On the other hand, the Pecking Order Theory argues that firms use a hierarchal system to finance their investments therefore, firms will prioritise the use of internal funds over external funds (i.e. debt or equity) in order to finance their projects (Danso and Adomako, 2014). Consequently, according to the logic of the Pecking Order Theory, the capital structure of profitable firms will comprise of low levels of leverage because profitability signifies high earnings. In other words, the more profitable a firm is, the higher its retained earnings (Zhang and Mirza, 2015). Therefore, based on the logic of the Pecking Order Theory, profitable firms will first give preference to their retained earnings as a source of finance before seeking external sources (Zhang and Mirza, 2015). Furthermore, the result of the correlation analysis is also in line with previous empirical research such as; Titman and Wessels (1988), Rajan and Zingales (1995) and De Jong et.al (2008). 4.1.3 Size The results of the correlation analysis illustrates that size is negatively related to leverage as this variable is characterised by a negative coefficient (-0.21553). However, this research argues that size and leverage will have a positive relationship (H3). Therefore, this outcome is not consistent with the expectations of the third hypothesis and as a result this hypothesis is rejected. Furthermore, the result of the correlation analysis rejects the logic of the Trade-Off Theory. According to the ideologies of the Trade-Off Theory, firm size and leverage should have a positive relationship because large firms tend to be more diversified and thus have less volatile earnings, meaning their risk of default and bankruptcy are minimised
  45. 45. 44 (Sheikh and Wang, 2011). Consequently, based on the Trade-Off Theory the capital structure of large firms should comprise of large volumes of leverage. The Pecking Order Theory however, suggests that large firms prefer internal financing over external financing because the “issue of informational asymmetry is less severe for large firms” (Sheikh and Wang, 2011, p122). Therefore, according to the Pecking Order Theory there should be a negative relationship between firm size and leverage. Consequently, the current result supports the logic of the Pecking Order Theory. Additionally, previous empirical research has also shown similar results. For example Wald (1999) conducted research on the capital structure of firms in 5 different countries; USA, Germany, France, UK and Japan. Wald (1999) concluded that size and leverage were positively related for firms in Japan, France, USA and the UK, however firms in Germany showed a negative relationship between size and leverage. 4.1.4 Liquidity This research argues that there will be positive relationship between liquidity and leverage (H4). However, the results of the correlation analysis illustrates a negative relationship between these two variables as the coefficient value for liquidity is -0.23296. This outcome is not consistent with the expectations of the fourth hypothesis hence, the fourth hypothesis is rejected. Furthermore, the current result supports the prediction of the Pecking Order Theory but rejects the prediction of the Trade-Off Theory (De Jong et al, 2008). According to the logic of the Trade-Off Theory, liquidity and leverage should be positively related because the more liquid a firm is, the better its ability to settle its outstanding obligations on time as liquid firms can easily convert their liquid assets into debt payments (Sheikh and Wang, 2011). Therefore, based on the ideas of the Trade-Off Theory, the capital structure of liquid firms should almost entirely be composed of debt (Hossain and Ali, 2012). Consequently, based on the above argument, it is evident that the logic of the Trade- Off Theory is not consistent with the result of the correlation analysis.
  46. 46. 45 On the other hand, the Pecking Order Theory suggests that there is a negative relationship between liquidity and leverage because firms that are highly liquid tend to possess adequate liquid assets to finance investment projects (Harrison and Widjaja, 2014).Therefore, based on the logic of the Pecking Order Theory, liquid firms will prefer internal financing over external financing. Consequently, it is evident that the result of the correlation analysis supports the prediction of the Pecking Order Theory. Furthermore, this outcome is also supported by previous empirical research such as; De Jong et al (2008) and Sheikh and Wang, (2011). 4.1.5 Growth In terms of growth, the researcher argues that growth and leverage will have a negative relationship (H5). Based on the results of the correlation analysis, the fifth hypothesis is accepted as the coefficient for growth has a negative value of -0.46872. This outcome indicates that the sample firms with future potential growth opportunities “prefer to be less dependent on external financing in the form of debt” (Zhang and Mirza, 2015, p44). This behaviour is consistent with the logic of the Trade-Off Theory. The Trade-Off Theory predicts a negative relationship between growth and leverage because growth opportunities are not a tangible asset and thus it cannot be collateralised to secure debt (Sheikh and Wang, 2011). Furthermore, the outcome of the correlation analysis is also supported by previous empirical research such as; Titman and Wessels (1988), Rajan and Zingales (1995) and Deesomsak et al. (2004). 4.2 ANALYSIS OF THE PRE-CRISIS PERIOD (2004-2006) Leverage Tangibility Profitability Size Liquidity Growth Leverage 1 Tangibility 0.486215 1 Profitability -0.08554 -0.58661 1
  47. 47. 46 Table 4.2: Correlation analysis for the pre- crisis period (2004-2006) Table 4.2 illustrates the results of the correlation analysis for the period before the crisis (2004-2006). It is immediately evident that the coefficient symbols possessed by each independent variable is identical to the results for the whole sample period (2004-2009) presented in table 4.1. Furthermore, it is also evident that the coefficient values for each independent variable (except tangibility) are similar to the results for the whole sample period (2004-2009). Tangibility is the only variable that had an evident decline in the value of its coefficient. The coefficient value for tangibility is 0.559265 for whole sample period (2004-2009) and it dropped to 0.486215 for the pre-crisis years (2004-2006). This significant drop in the coefficient value for tangibility may suggest that in times of economic stability, “tangibility has less dominance in determining the degree of firm leverage” (Harrison and Widjaja, 2014, p70). This outcome may be due to the coefficient values of other variables increasing thereby compensating for the decline in the coefficient value for tangibility. Furthermore, profitability and size are the only two variables that slightly increased in value during the pre-crisis period (2004-2006). Liquidity and growth are the only two variables that had constant coefficients during both periods. Returning to the point of tangibility, as highlighted earlier the availability of tangible assets serves as a form of collateral when a firm attempts to acquire debt. According to Jimenez and Surina (2004 cited in Harrison and Widjaja, 2014, p70), “collateral mitigates adverse selection which comes from asymmetric information between lenders and borrowers.” Therefore, a possible reason for the decline in the coefficient value for tangibility during the pre-crisis years (2004-2006) might be due to lenders encountering minimal problems with adverse selection during periods of economic stability. Furthermore, Harrison and Widjaja (2014) propose that collateral also limits the problem of asset substitution. Problems regarding asset substitution often emerge Size -0.22563 -0.13633 -0.16402 1 Liquidity -0.23296 0.428489 -0.88177 0.475768 1 Growth -0.46872 -0.13671 -0.49166 -0.37089 0.367012 1
  48. 48. 47 when risk is transferred to bondholders from shareholders. This behaviour arises because stakeholder revenue tends to increase whereas bondholder revenue usually remains constant. Harrison and Widjaja (2014, p71) argue that in times of economic stability “the marginal increase in revenue is higher than the marginal increase in risk.” According to Allen and Gales (2000), in times of economic stability, if a firm exploits asset price bubbles, they may be able to generate increased revenues by investing in projects that are marginally risker. Therefore, this rational might possibly indicate that during periods of economic stability, the use of tangible assets as a proxy to minimise the risk of adverse selection is less apparent and as a result this leads to a reduced coefficient value for tangibly in comparison to other periods. 4.3 ANALYSIS OF THE CRISIS PERIOD (2007-2009) Table 4.3: Correlation analysis for the crisis period (2007-2009) Leverage Tangibility Profitability Size Liquidity Growth Leverage 1 Tangibility 0.837368 1 Profitability -0.05274 -0.590043356 1 Size 0.4269 0.85179824-0.925555618 1 Liquidity 0.029899 0.57143184-0.999738653 0.916658 1 Growth -0.69947 -0.195056347-0.676771898 0.347659 0.693425 1 Table 4.3 illustrates the correlation results for the crisis period (2007-2009). Immediately it can be identified that there are significant changes in the results for this period. Firstly it can be identified that the coefficient symbols for size and liquidity are opposite in comparison to the results for the whole sample period (2004-2009). Size and liquidity both have a negative coefficient value for the whole sample period (2004-2009) however, the coefficient value for size and liquidity have changed to positive values for the crisis period (2007-2009). The positive values for size and liquidity during the crisis period (2007-2009) indicates that both size and liquidity have a greater influence on leverage during the financial crisis period.
  49. 49. 48 In terms of size, the positive coefficient value supports the logic of the Trade Off- Theory that “larger firms have a better borrowing capacity relative to smaller firms,” (Deesomsak et. al, 2004, p.14) because larger firms tend to be more diversified, thus they often face reduced transaction costs of borrowing in comparison to smaller firms. Furthermore, this positive correlation is also consistent with previous empirical research such as; Booth et al. (2001), Deesomsak et al. (2004) and Sheikh and Wang (2011). In terms of liquidity, the positive correlation value also confirms the logic of the Trade-Off Theory. The Trade-Off Theory argues that highly liquid firms will acquire more debt because they can use their liquid assets to settle debt obligations on time and this is especially important in times of financial distress (Zhang and Mirza, 2015). Firms that are highly liquid tend to hold their liquid assets and only make use of them in financially distress periods for example during a financial crisis. Furthermore, this positive correlation result is also consistent with previous empirical research such as; Titman and Wessels (1988), Rajan and Zingales (1995) and De Jong et al., (2008). The second distinction that can be identified in the results of the correlation analysis for the crisis period (2007-2009) is that there is a significant change in the coefficient value for tangibility and profitably in comparison to the whole sample period (2004- 2009). In terms of tangibility, the coefficient value for the crisis period (2007-2009) is 49.73 % higher than the coefficient value for the whole sample period (2004-2009). This suggests that the influence of tangibility on leverage increases during the financial crisis. A possible reason for this outcome is that during the crisis lenders may face increased problems of adverse selection thereby resulting in an increase in the coefficient value for tangibility (Harrison and Widjaja, 2014). In terms of profitability, the coefficient for this variable decreased from -0.08344 to -0.05274 (a decreased of 36.79%). This substantial decrease, indicates that profitability has less of an influence on leverage during the financial crisis. A possible
  50. 50. 49 reason for this outcome is that during unstable economic periods, the profitability of a firm is usually significantly lower compared to economic stable periods, meaning the firm generates less retained earnings. As a result, this situation might decrease the firm’s internal financing capability (Harrison and Widjaja, 2014). Consequently, firms may find it particularly difficult to depend on internal financing to fund investment projects. In such instances, external financing may be more favourable to a firm Campello et al (2010). This preference for external financing could potentially result in the decline of the coefficient for profitability (Harrison and Widjaja, 2014). 4.4 SUMMARY In summary, it is evident that the correlation results for the whole sample period cannot be explained solely by one theory of capital structure. For example the logic of the Trade-Off Theory can explain the positive relationship between tangibility and leverage but it fails to explain the negative relationship between profitability and leverage. Similarly, the logic of the Pecking Order Theory can explain the negative relationship between size and leverage but it fails to explain positive relationship between tangibility and leverage. Furthermore, it is evident the Pecking Order Theory has more explanatory power than the Trade-Off Theory for the results of the whole sample period. In addition, the results of the pre-crisis period and the crisis period also cannot be explained entirely by a single capital structure theory. Moreover, it can be identified that the differences in the coefficient values for the crisis period in comparison to the pre-crisis period and the whole sample period, indicates that during the financial crisis there are significant changes in the determinants of capital structure. The following chapter will discuss this in further detail. CHAPTER FIVE: COMPARITIVE ANALYSIS So far this dissertation has examined capital structure determinants for the whole sample period (2004-2009), the pre-crisis period (2004-2006) and the crisis period (2007-2009). However, it is yet to answer the crucial question of how the 2007/2008
  51. 51. 50 global financial crisis affected financing patterns. This chapter is going to answer this question by comparing and contrasting the behaviour of firm-level variables on leverage during the pre-crisis period (2004-2006) and the crisis period (2007-2009). 5.1 PRE-CRISIS PERIOD AND THE CRISIS PERIOD COMPARED Table 5.1: Correlation results across sub-periods. All coefficient values are related to leverage Pre-crisis period (2004-2006) Crisis period (2007-2009) Tangibility 0.486215 0.837368 Profitability -0.08554 -0.05274 Size -0.22563 0.4269 Liquidity -0.23296 0.029899 Growth -0.46872 -0.69947 Table 5.1 illustrates the correlation results for the pre-crisis period (2004-2006) and the crisis period (2007-2009). It is clearly evident that there are significant differences in the coefficients for each independent variable. Therefore, just at face value it is reasonable to assume that the 2007/2008 global financial crisis affected the determinants of capital structure. 5.1.1 Tangibility In terms of tangibility, the coefficient value changed from 0.486215 in the pre-crisis period to 0.837368 in the crisis period (an increase of 72.22%). This substantial increase indicates that during the financial crisis, tangibility had a greater influence on leverage in comparison to the pre-crisis period. As pointed out earlier, the main
  52. 52. 51 purpose of tangibility is to minimise the problem of adverse selection that lenders encounter (Jimenez and Saurina, 2004 cited in Harrison and Widjaja, 2014, p71). According to Barrell and Davis (2008), the 2007/2008 global financial crisis increased the severity of the adverse selection problem. Therefore, it is reasonable to assume that in periods of economic instability, lenders may attempt to compensate for the increasingly severe problems of adverse selection by seeking tangible assets that are of better quality and quantity (Harrison and Widjaja, 2014). Consequently, the extent to which this claim is true, the growing need for security would result in tangibility having an increased influence on firm leverage. Therefore, it is evident that the 2007/2008 global financial crisis affected the behaviour of tangibility on leverage. 5.1.2 Profitability In terms of profitability, the coefficient value for the crisis period is almost 40% lower than the coefficient value for the pre-crisis period. This significant decrease indicates that during the crisis period the influence of profitability on leverage decreased compared to the pre-crisis period. A possible explanation for this outcome is that during the financial crisis, the amount of credit available began to decline as lenders became increasingly vigilant when granting loans to firms (Danso and Adomako, 2014). As a result, during the financial crisis profitable firms had to rely primarily on their retained earnings to finance their activities instead of acquiring debt as instrument to shield their profits (Danso and Adomako, 2014). Consequently, due to the 2007/2008 financial crisis, the importance of profitability in relation to leverage declined. 5.1.3 Size The financial crisis had a substantial effect on the independent variable size, as this variable changed from a negative coefficient value in the pre-crisis period (-0.22563) to a positive coefficient value in the crisis period (0.4269). Furthermore, this positive coefficient value is in line with the prediction of the Trade-Off Theory (Castanias,

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