CAPITAL STRUCTURE AND FIRM PERFORMANCE

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HOCHIMINH CITY
oOo


HUỲNH ANH KIỆT


CAPITAL STRUCTURE AND FIRM PERFORMANCE:
CASE STUDY: LISTED COMPANIES IN
HOCHIMINH STOCK EXCHANGE





MASTER THESIS




Ho Chi Minh City – 2010

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HOCHIMINH CITY
oOo


HUỲNH ANH KIỆT

CAPITAL STRUCTURE AND FIRM PERFORMANCE:
CASE STUDY: LISTED COMPANIES IN
HOCHIMINH STOCK EXCHANGE

MAJOR: BUSINESS ADMINISTRATION
MAJOR CODE: 60.34.05

MASTER THESIS
INSTRUCTOR : PROFESSOR NGUYỄN ĐÔNG PHONG




Ho Chi Minh City – 2010

i

ACKNOWLEDGEMENT

I would like to express my deepest gratitude to my research Instructor, Professor
Nguyen Dong Phong for his intensive support, valuable suggestions, guidance and
encouragement during the course of my study.
My sincere thanks are also due to Dr. Vo Thi Quy and Dr. Tran Ha Minh Quan for
their valuable time as the members of the proposal examination committee. Their
comments and constructive suggestions were of great help in my completing this
study.
My sincere thanks is extended to Assistant Professor Nguyen Dinh Tho, Dr. Tran
Ha Minh Quan, Dr. Truong Tan Thanh, Dr. Pham Huu Hong Thai, Dr. Bui Thanh
Trang for their valuable time as members of examination committee. Their

comments and suggestions were of great value for my study.
I would like to express my sincere gratitude to all of my teachers at Faculty of
Business Administration and Postgraduate Faculty, University of Econimics
Hochiminh City for their teaching and guidance during my MBA course.
I would like to specially express my thanks to all of my classmates, my friends
from www.caohockinhte.vn for their support and encouragement.
I would also like to avail this opportunity to express my appreciation to Professor
Nguyen Dong Phong, UEH Board of Directors for creating MBA program in
English and Dr. Tran Ha Minh Quan for his support during the course.
Finally, I heartily dedicate this study to my beloved parents and my wife, Vu Thi
Huyen who have always sacrificed to encourage and support me during my study.


ii

ABSTRACT

This study investigates the relationship between firm capital structure and firm
performance. The author explores both the effect of firm performance on firm
captial structure as well as the effect of capital structure on firm market
performance using cross-sectional data representing of 162 Vietnamese companies
in Hochiminh Stock Exchange for 2008. According to the results, a firm
profitability is found to have a significant and negative impact on all firm capital
structure. This finding support pecking order theory of Myers and Majluf (1984).
An interesting finding is that firm size has a positive and significant impact on the
leverage, which consistent with a previous study of Rajan and Zingales (1995), and
indicating that a firm size is an important determinant of corporate capital
structure. Firm capital structure is confirmed to have positive and significant
impacts on firm market performance which is measured by Tobin’s Q. The author
also finds that firm growth opportunities have a positive and significant impact on

the firm value Tobin’s Q.

Keywords: Capital structure, corporate performance, Vietnam, HOSE.










iii

TABLE OF CONTENTS

ACKNOWLEDGEMENT i
ABSTRACT ii
TABLE OF CONTENTS iii
LIST OF FIGURES v
LIST OF TABLES vi
ABBREVIATIONS vii
CHAPTER 1: INTRODUCTION 1
1.1 BACKGROUND 1
1.2 RESEARCH PROBLEMS 3
1.3 RESEARCH OBJECTIVES 4
1.4 RESEARCH METHODOLOGY AND SCOPE 5
1.5 STRUCTURE OF THE STUDY 5
CHAPTER 2: LITERATURE REVIEW 7

2.1 INTRODUCTION 7
2.2 CAPITAL STRUCTURE 7
2.3 FIRM PERFORMANCE 11
2.4 HYPOTHESIS AND EMPIRICAL MODEL 12
2.4.1. Model 1: The Leverage Model 12
2.4.2. Model 2: The Firm Value Model 15
CHAPTER 3: RESEARCH DESIGN 18
3.1 INTRODUCTION 18
3.2 DATA 18
3.3 RESEARCH DESIGN 18
3.3.1. Research Sample 19
3.3.2. Data Analysis Method 20
3.4 VARIABLES MEASUREMENT FOR MODEL 1 20
3.4.1. Dependent Variables 20
3.4.2. Independent Variables 21
3.5 VARIABLES MEASUREMENT FOR MODEL 2 21
3.5.1. Dependent Variables 21
3.5.2. Independent Variables 22
3.6 FRAMEWORK OF THE STUDY 23
3.7 SUMMARY 24
CHAPTER 4: EMPIRICAL RESULTS OF THE RESEARCH 25
4.1 INTRODUCTION 25
4.2 CHARACTERISTICS OF RESEARCH SAMPLES 25
4.3 DESCRIPTIVE STATISTICS 26
4.4 REGRESSION ANALYSIS 29
4.4.1. Model 1: The Leverage Model 29
4.4.2. Model 2: The Firm Value Model 32
CHAPTER 5: CONCLUSIONS, RECOMMENDATIONS AND LIMITATIONS 38
5.1 INTRODUCTION 38
5.2 CONCLUSIONS 38

iv

5.3 RECOMMENDATIONS 39
5.4 LIMITATIONS 40
REFERENCES 41
APPENDIX A 44
APPENDIX B 45
APPENDIX C 51




v

LIST OF FIGURES

Figure 1: The Leverage Model 14
Figure 2: The Firm Value Model 17
Figure 3: Research Process 19
Figure 4: Framework of the study 23

vi

LIST OF TABLES

Table 1: Dependent variables for model 1 20
Table 2: Independent variables for model 1 21
Table 3: Dependent variables for model 2 22
Table 4: Independent variables for model 2 22
Table 5: Summary Statistics of the Explanatory Variables 26
Table 6: Correlation Matrix of the Explanatory Variables for Model 1 28
Table 7: Correlation Matrix of the Explanatory Variables for Model 2 28
Table 8: Estimate Results for Model 1 29
Table 9: Estimate Results for Model 2 Using TDTA 32
Table 10: Estimate Results for Model 2 Using TDTE 33
Table 11: Estimate Results for Model 2 Using LTDTA 34
Table 12: Estimate Results for Model 2 Using STDTA 35

vii

ABBREVIATIONS

HOSE Hochiminh Stock Exchange
GROWTH Growth opportunities
LTDTA Long-term debt to total assets
PE Price-to-Earnings Ratio
PROF Profitability
ROA Return on assets
ROE Return on equity
ROI Return on investment
SIZE Firm Size
STDTA Short-term debt to total assets
TA Asset tangibility
TDTE Total debt to total equity
TDTA Total debt to total assets
TOBIN Tobin’s Q








Capital Structure and Firm Performance
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CHAPTER 1: INTRODUCTION

1.1 BACKGROUND
The theory of the capital structure is an important reference theory in firm's
financing policy. The capital structure refers to firm includes mixture of debt and
equity financing. The topic of optimal capital structure has been the subject of
many studies.
The modern theory of the capital structure originate from the contribution of
Modigliani and Miller in 1958, under the perfect capital market assumption
1
Jensen and Meckling (1976) introduce the concept of agency costs and investigate
the nature of the agency costs generated by the existence of debt and outside
equity. When considering corporation tax, bankrupt costs and agency costs at the
same time, trade-off theory can be introduced to derive the existence of the
optimum capital structure. Leland (1994) extends the results of Merton (1974) and
Black and Cox (1976) to include taxes, bankruptcy costs to derive the optimal
capital structure. Deangelo and Masulis (1980) argue that the existence of non-debt
corporate tax shields such as depreciation deductions is sufficient to overturn the
leverages irrelevancy theorem. Hovakimian, Opler, and Titman (2001) test the
hypothesis that firms tend to a target ratio when they either raise new capital or
retire or repurchase existing capital. They found firms should use relatively more
debt to finance assets in place and relatively more equity to finance growth
opportunities.
that if
there is no bankrupt cost and capital markets are frictionless, if without taxes, the
firm value is independent with the structure of the capital. In 1963, under
considering the corporate taxes, Modigliani and Miller modified the conclusion to
recognize tax shield. Because debt can reduce the tax to pay, so the best capital
structure of enterprises should be 100% of the debt. But this seems to be
unreasonable in the real world.

It has also been argued that profitable firms are less likely to depend on debt in
their capital structure than less profitable ones. It has been argued that firms with a
high growth rate have a high debt to equity ratio. Bankruptcy costs (proxied by
firm size) are also found to be an important effect on capital structure (Kraus and

1
Perfect capital markets means that the following assumptions hold: (a) there are no taxes, (b) there are no
transaction costs, (c) there is symmetrical information, (d) there are homogenous expectations, and (e)
investors can borrow at the same rate as corporations.
Capital Structure and Firm Performance
Page 2
Litzenberger, 1973; Harris and Raviv, 1991). If these three factors are considered
as determinants of capital structure, then these factors could be used to determine
the firm performance.
In practice, firm managers who are able to identify the optimal capital structure are
rewarded by minimizing a firm’s cost of finance thereby maximizing the firm
revenue. If a firm capital structure influences a firm performance, then it is
reasonable to expect that the firm capital structure would affect the firm health and
its likelihood of default. From a creditor’s point view, it is possible that the debt to
equity ratio aids in understanding banks’ risk management strategies and how
banks determine the likelihood of default associated with financially distressed
firms. In short, the issue regarding the capital structure and firm performance are
important for both academics and practitioners.
There is lack of empirical evidence about the effect of firm performance on capital
structure in Vietnam. Then, the first objective of this study is to examine the effect
which firm performance has on capital structure of listed companies in Hochiminh
Stock Exchange. Trần Hùng Sơn and Trần Viết Hoàng (2008) find a positive and
significant impact of firm leverage on firm accounting performance, but have not
used market performance measures. Thus, the second objective of this study is to
examine the effect which firm capital structure has on corporate market

performance.
This study contributes to literature in two directions: (1) by using ordinary least
square regression model to investigate the relationship between capital structure
and firm performance to fill the gap in corporate finance literature in Vietnam; (2)
by employing different measures of capital structure such as short-term debt to
total assets, long-term debt to total assets, total debt to total assets, and total debt to
total equity to investigate the effect of the debt structure on corporate market
performance in Vietnam. This study contributes to practical implications by
investigating the effect of capital structure on corporate performance using market
measures to provides evidence about whether the stock market is efficient or not. It
also provides managers a structure approached to plan their firm capital structure
strategies and improve the firm value.



Capital Structure and Firm Performance
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1.2 RESEARCH PROBLEMS
Problem definition is essential before conducting a study, especially quantitative
research. Zikmund (1997, p. 82) recommends that formal quantitative research
should not begin until the problem has been clearly defined. In Vietnam, lack of
empirical evidence, that investigate the relationship between firm capital structure
and firm performance, is an issue for both academics and practitioners.
There is lack of empirical evidence that investigate the relationship between firm
capital structure and firm performance in Vietnam. In 2008, Trần Hùng Sơn and
Trần Viết Hoàng tested the relationship between capital structure and firm
performance by using data sample of 50 non-financial companies in Hochiminh
Stock Exchange for the period September 2008. The results show that there is a
positive correlation between a firm capital structure and performance, which is
measured by average of return on assets and return on equity. The corporate

performance has a strong quadratic or cubic correlation with the capital structure
when they use the debt ratio under 100%. The performance has a positive
correlation with the capital structure when the debt ratio is in the range from
0.9755 to 2.799. However, they have not used market performance measures and
have not explored the optimal capital structure to maximize the performance of the
firm. They have not tested the correlation between the distribution of debt ratio and
corporate performance to each type of companies, as well as each industry. Their
research recommended that further research should be implemented.
Margaritis and Psillaki (2007) use a sample of 12,240 firms from the 2004 New
Zealand Annual Enterprise Survey to investigate the effect of leverage on firm
performance as well as the reverse causality relationship. They use quantitative
regression analysis to show that the effect of efficiency on leverage is positive at
low to mid-leverage levels and negative at high leverage ratios. In Vietnam, there
is no empirical evidence related to the effect of firm performance on capital
structure.
Therefore, the problem to be addressed in this study is to examine the effect of firm
performance on firm capital structure combined with others variables such as firm
size, growth and asset tangibility on firm capital structure. In addition, the author
will explore the effect of firm capital structure on firm market performance, known
as firm value of listed firms in Hochiminh Stock Exchange.


Capital Structure and Firm Performance
Page 4
1.3 RESEARCH OBJECTIVES
A research objective is the researcher’s version of a business problem. Objectives
explain the purpose of the research in measurable terms and define standards of
what the research should accomplish (Zikmund 1997, p. 89). In solving the
research problem mentioned previously, this study has the following objectives:
• Determine the effect of firm profitability, size, growth opportunities and

asset tangibility on listed firm capital structure in Hochiminh Stock
Exchange.
• Determine the effect of capital structure on listed firm market performance
combined with others variables such as firm size and growth opportunities
in Hochiminh Stock Exchange.


Research Questions
Research questions involve the research translation of “problem” into the need for
inquiry. The research problems defined above leads to the following research
questions:
• What are the relationship between firm capital structure and firm
profitability, size, growth opportunities and asset tangibility of listed firms
in Hochiminh Stock Exchange?
• What are the relationship between firm capital structure, size, growth
opportunities and firm market performance of listed firms in Hochiminh
Stock Exchange?

Two research variables of the topic:
• Capital structure
• Firm performance


Capital Structure and Firm Performance
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1.4 RESEARCH METHODOLOGY AND SCOPE
The object of this research is all listed non-financial companies in Hochiminh
Stock Exchange (HOSE) at the end 2008. Sample size: 162 (See more in Chapter
3).
Quantitative research based on ordinary least square regression model to estimate

the relationship between firm profitability, size, growth, asset tangibility and firm
capital structure, as well as the relationship between firm leverage and firm market
firm performance. This model was used in the previous studies of Tian & Zeitun
(2007), Margaritis & Psillaki (2007), Rajan and Zingales (1995).
The author use data analysis tools to implement the research such as: descriptive
statistics, multiple regression models with Eviews 6 for Windows.

1.5 STRUCTURE OF THE STUDY
The structure of the study consist five chapters:
Chapter 1: Introduction
This chapter presents research background of the study, as well as, research
problems, research objectives, research methodology and scope.
Chapter 2: Literature Review
In this chapter, I summary the literature review and present the fundamental ideas
on capital structure, as well as firm performance. This chapter also presents a
research model of the study.
Chapter 3: Research Design
Based on the research objectives and scope, research methodology concerned in
chapter 1, and literature review and empirical model presented in chapter 2, this
chapter particularly presents the research methodology, data, research design and
research process.
Chapter 4: Empirical Results of the Research
Chapter 4 presents the characteristics of research samples and measures concepts
of the research. I use descriptive statistics to explore the features of explanatory
variables, as well as the relationship between each variable in two models.
Capital Structure and Firm Performance
Page 6
Furthermore, I use regression analysis to explore the relationship between the
capital structure and market performance of listed companies in Hochiminh Stock
Exchange.

Chapter 5: Conclusions, Recommendations and Limitations
Chapter 5 presents main conclusions and recommendations based on the results of
the previous chapters, as well as the limitations of this study.


















Capital Structure and Firm Performance
Page 7
CHAPTER 2: LITERATURE REVIEW

2.1 INTRODUCTION
Chapter 2 summaries the literature review and present the fundamental ideas on
capital structure, as well as firm performance. This chapter also presents a research
model of the study.

2.2 CAPITAL STRUCTURE
The modern theory of capital structure began with the celebrated paper of
Modigliani and Miller (1958). In this paper they claim that under perfect capital
market conditions, a firm value depends on its operating profitability rather than its
capital structure. In 1963, Modigliani and Miller argued that, when there are
corporate taxes then interest payments are tax deductible, 100% debt financing is
optimal. In this framework, firms target an optimal capital structure based on tax
advantages and financial distress disadvantages. Firms are thought to strive toward
their target and can signal their future prospects by changing their structure.
Adding more debt increases firm value through the market’s perception of higher
tax shields or lower bankruptcy costs. But optimal capital structure at a 100% debt
financing are clearly incompatible with observed capital structures, so their
findings initiated a considerable research effort to identify costs of debt financing
that would offset the corporate tax advantage.
Since bankruptcy costs exist, deteriorating returns occur with further use of debt in
order to get the benefits of tax deduction. Therefore, there is an appropriate capital
structure beyond which increases in bankruptcy costs are higher than the marginal
tax-sheltering benefits associated with the additional substitution of debt for equity.
Firms are willing to maximize their performance, and minimize their financing
cost, by maintaining the appropriate capital structure or the optimal capital
structure. Harris and Raviv (1991) argue that capital structure is related to the
trade-off between costs of liquidation and the gain from liquidation to both
shareholders and managers. So firms may have more debt in their capital structure
than is suitable as it gains benefits for both shareholders and managers.
Since then, extensions of the Modigliani and Miller theory have been provided by
the following researches. Robichek and Myers (1966) argue that the negative effect
Capital Structure and Firm Performance
Page 8
of bankruptcy costs on debt to prevent firms from having the desire to obtain more
debt. Jensen and Meckling (1976) emphasize the importance of the agency costs of

equity in corporate finance arising from the separation of ownership and control of
firms whereby managers tend to maximize their own utility rather than the value of
the firms. The general result of these extensions is that the combination of leverage
related costs (such as bankruptcy and agency costs) and a tax advantage of debt
produces an optimal capital structure at less than a 100% debt financing, as the tax
advantage is traded off against the likelihood of incurring the costs. This leads us to
Jensen’s (1986) “free cash flow theory” where as stated by Jensen (1986, p. 323)
“the problem is how to motivate managers to disgorge the cash rather than
investing it below the cost of capital or wasting it on organizational inefficiencies”.
In other words complete contracts cannot be written. A higher level of leverage
may be used as a disciplinary device to reduce managerial cash flow waste through
the threat of liquidation (Grossman and Hart, 1982) or through pressure to generate
cash flows to service debt (Jensen, 1986).
Titman (1984) demonstrates an idea of indirect bankruptcy costs. He argues that
stakeholders did not represent at the bankruptcy bargaining table, such as
customers, could suffer material costs resulting from the bankruptcy. Leland (1994)
demonstrates a standard trade-off model. At the optimal capital structure, marginal
bankruptcy costs associated with firm’s debt are equated with marginal tax
benefits. The static tradeoff theory is the original retort to the theory of capital
structure relevance.
However, as stated in the previous literature, underestimating the bankruptcy costs
of liquidation or reorganization, or the aligned interest of both managers and
shareholders may lead firms to have more debt in their capital structure than they
should (see, for example, Harris and Raviv, 1991). Krishnan and Moyer, (1997)
find a negative and significant impact of total debt to total equity (TD/TE) on
return on equity (ROE). Another study by Gleason, Mathur and Mathur, (2000)
find that firm capital structure has a negative and significant impact on firm
performance measures return on assets (ROA), growth in sales (Gsales), and pre-
tax income (Ptax). Therefore, high levels of debt in the capital structure would
decrease the firm performance.

However, not only does a firm’s level of leverage affect corporate performance and
failure but also its debt maturity structure (Barclay and Smith, 1995 and Ozkan,
2002). Schiantarelli and Sembenelli (1999) investigate the effects of firm’s debt
maturity structure on profitability for Italy and the United Kingdom. They find a
positive relationship between initial debt maturity and medium term performance.
Capital Structure and Firm Performance
Page 9
A study by Barclay and Smith (1995) provide evidence that large firms and firms
with low growth rates prefer to issue long-term debt. Another study by Stohs and
Mauer (1996) suggest that larger and less risky firms usually make greater use of
long-term debt. They also find that debt maturity is negatively related to corporate
tax, the firm’s risk and earnings surprises. In other words, the choice of debt
structure could have an impact on both corporate performance and failure risk.
Furthermore, there are other factors, besides capital structure, that may influence
firm performance such as firm size, age, growth, risk, tax rate, factors specific to
the sector of economic activity, and factors specific to macroeconomic
environment of the country.
Dilip Ratha, et al (2003) studies the relationship between corporate performance
(as measured by its profit rate or earnings before interest and taxes) and corporate
finance (debt/assets ratio) in developing countries. First, they find out that both
profits and earnings before interest, taxes, depreciation, and amortization decline as
a percentage of assets as firms take on more debt relative to their assets. This is
similar to the finding of Harvey, Lins, and Roper (2001) that; while some debt may
improve market discipline in firms, the effect may be overcome by increasing
financial risks. Second, the marginal (negative) effect of an increase in leverage on
earnings is larger for firms that participate in international debt markets than for
other firms. However, they have not used market performance measures to study
the relationship of corporate finance and corporate performance.
Wei Xu, et al (2005) analyzes the relationship between corporation performance
and capital structure of 1,130 listed companies in China. The results show that the

firm’s performance has a strong negative correlation with the capital structure. It
does not agree with the western empirical result for the higher debt ratio. The
corporation performance has a strong quadratic or cubic correlation with the capital
structure when they use the debt ratio under 100%. The performance has a positive
correlation with the capital structure when the debt ratio is in the range from
24.52% to 51.13%.
Allan N. Berger, et al (2006) uses a new approach to test agency theory in US
banking industry and the findings are consistent with the agency costs hypothesis -
higher leverage or a lower equity capital ratio is associated with higher profit
efficiency over almost the entire range of the observed data. And the results are
statistically significant, economically significant, and robust.
Margaritis and Psillaki (2007) use a sample of 12,240 firms from the 2004 New
Zealand Annual Enterprise Survey to investigate the relationship between firm
Capital Structure and Firm Performance
Page 10
efficiency and leverage as well as the reverse causality relationship. They find
evidence supporting the theoretical predictions of the Jensen and Meckling (1976)
agency cost model. More precisely, they find support for the core prediction of the
agency cost hypothesis in that higher leverage is associated with improved
efficiency over the entire range of observed data. They use quantitative regression
analysis to show that the effect of efficiency on leverage is positive at low to mid-
leverage levels and negative at high leverage ratios. Thus their results suggest that
in the upper range of the leverage distribution the income effect resulting from the
economic rents generated by high efficiency dominates the substitution effect of
debt for equity capital. They also show that the more efficient firms will choose
higher debt ratios because higher efficiency acts as a buffer against the expected
costs of bankruptcy or financial distress. The effect of tangibles and profitability on
leverage is positive. Firm size has a negative effect on leverage at the lower half of
the leverage distribution and a positive effect at the upper half of the distribution.
The effect of intangibles and other assets is estimated to be negative.

Tian & Zeitun (2007) examine the impact which capital structure has had on
corporate performance in Jordan in which they controlled the effect of industrial
sectors, regional risk, such as the Gulf Crisis 1990-1991 and the outbreak of
Intifadah in the West Bank in September 2000. They have used a cross-sectional
data representing of 167 Jordanian companies during 1989-2003. The results show
that a firm capital structure has a significantly negative impact on the firm
performance measures, in both the accounting and market measures. An interesting
finding is that the short-term debt to total assets level has a significantly positive
effect on the market performance measure (Tobin’s Q), which could to some extent
support Myers (1977) argument that firms with high short-term debt to total assets
have a high growth rate and high performance. Firm size is found to have a positive
impact on a firm performance, as large firms have low bankruptcy costs. The
insignificance of the market performance measure PE indicates that the Jordanian
equity market is not efficient, so the best performance measure is the accounting
performance measure ROA.
In Vietnam, Trần Hùng Sơn and Trần Viết Hoàng (2008) test the relationship
between firm capital structure and performance by using data sample of 50 non-
financial companies in Hochiminh Stock Exchange for the period September 2008.
The results show that there is a positive correlation between a firm capital structure
and performance. The corporation performance has a strong quadratic or cubic
correlation with the capital structure when they use the debt ratio under 100%. The
performance has a positive correlation with the capital structure when the debt ratio
is in the range from 0.9755 to 2.799. State owned ratio has negative impact on firm
Capital Structure and Firm Performance
Page 11
efficiency, but firm growth, size (measured by logarithm of the firm’s assets) and
tangibility had no significant impact on firm performance. However, they have not
used market performance measures and did not explore the optimal capital
structure to maximize the performance of the firm. They have not test the
correlation between the distribution of debt ratio and corporate performance to

each type of companies, as well as each industry.

2.3 FIRM PERFORMANCE
The concept of performance is a controversial issue in finance largely due to its
multidimensional meanings. Research on firm performance emanates from
organization theory and strategic management (Murphy et al., 1996). Performance
measures are either financial or organizational. Financial performance such as
profit maximization, maximizing profit on assets, and maximizing shareholders'
benefits are at the core of the firm effectiveness (Chakravarthy, 1986). Operational
performance measures, such as growth in sales and growth in market share, provide
a broad definition of performance as they focus on the factors that ultimately lead
to financial performance (Hoffer and Sandberg, 1987).
The usefulness of a measure of performance may be affected by the objective of a
firm that could affect its choice of performance measure and the development of
the stock and capital market. For example, if the stock market is not highly
developed and active then the market performance measures will not provide a
good result. The most commonly used performance measure proxies are return on
assets (ROA) and return on equity (ROE) or return on investment (ROI). These
accounting measures representing the financial ratios from balance sheet and
income statements have been used by many researchers (e.g., Demsetz and Lehn,
1985; Gorton and Rosen, 1995; Mehran, 1995; and Ang, Cole and Lin, 2000).
However, there are other measures of performance called market performance
measures, such as price per share to the earnings per share (PE) (Abdel Shahid,
2003), market value of equity to book value of equity (MBVR), and Tobin’s Q.
Tobin’s Q mixes market value with accounting value and is used to measure the
firm's value in many studies (e.g., Morck, Shleifer, and Vishny, 1988; McConnel
and Serveas, 1990; and Zhou, 2001). The performance measure ROA is widely
regarded as the most useful measure to test firm performance (Reese and Cool,
1978; Long and Ravenscraft, 1984; Abdel Shahid, 2003, among others). The stock
Capital Structure and Firm Performance

Page 12
market efficiency and other economic and political factors could affect a firm
performance and its reliability (See Abdel Shahid, 2003).
Firm performance may also affect the choice of capital structure. As Berger and
Bonaccorsi di Patti (2006) point out, regressions of firm performance on leverage
may confound the effects of capital structure on performance with the reverse
relationship from performance on capital structure. This reverse causality effect is
in essence a feature of theories considering how agency costs (Jensen and
Meckling, 1976; Myers, 1977; and Harris and Raviv, 1990); corporate control
issues (Harris and Raviv, 1988); and in particular, asymmetric information (Myers
and Majluf, 1984; Myers, 1984) and taxation (DeAngelo and Masulis, 1980; and
Bradley et al., 1984) are likely to affect the value of the firm.

2.4 HYPOTHESIS AND EMPIRICAL MODEL
2.4.1. Model 1: The Leverage Model
Profitability (PROF) is used to measure firm performance to test the impact of firm
performance on firm capital structure. Profitability is calculated by pre-interest and
pre-tax operating surplus plus depreciation divided by total assets. There are
conflicting theoretical predictions on the effects of profitability on leverage (Harris
and Raviv, 1991; Rajan and Zingales, 1995; Barclay and Smith, 2001; and Booth et
al., 2001). Myers and Majluf (1984) predict a negative relationship because they
argue that firms will prefer to finance new investments with internal funds rather
than debt. According to their pecking order theory, because of signaling and
asymmetric information problems, firms financing choices follow a hierarchy in
which internal cash flows (retained earnings) are preferred over external funds, and
debt is preferred over equity financing. Thus, they argue, we should expect a
negative relationship between past profitability and leverage. On the other hand,
using arguments based on the trade-off and contracting cost theories we can predict
a positive relation between profitability and leverage. For example, the trade-off
theory suggests that the optimal capital structure for any particular firm will reflect

the balance (at the margin) between the tax shield benefits of debt and the
increasing agency and financial distress costs associated with high debt levels
(Jensen and Meckling, 1976; Myers, 1977; and Harris and Raviv, 1990). Similarly,
Jensen (1986) argue that if the market for corporate control is effective and forces
firms to pay out cash by levering up, then there will be a positive correlation
between profitability and leverage. Thus, the hypothesis 1 is:
Capital Structure and Firm Performance
Page 13
H1: The firm profitability has a positive correlation with firm capital structure.
Growth opportunities (GROWTH) are likely to put a strain on retained earnings
and push the firm into borrowing (Michaelas et al., 1999). On the other hand,
Myers (1977) argues that firms with growth potential will tend to have lower
leverage. He argues that growth opportunities can produce moral hazard effects and
can push firms to take more risk. This may explain why firms with ample growth
opportunities may be considered as risky and thus face difficulties in raising debt
capital on favorable terms. Thus, hypothesis 2 can be stated as follows:
H2: Growth opportunities decrease firm leverage.
Firm size (SIZE) is measured by the logarithm of the firm’s sales (Titman and
Wessels, 1988; Rajan and Zingales, 1995; and Ozkan, 2001). As larger firms are
more diversified and tend to fail less often than smaller ones, I would expect that
size will be positively related to leverage. However, Rajan and Zingales (1995)
discuss the possibility that size may also be negatively correlated with leverage.
They argue that size may act as a proxy for the information outside investors have,
and that informational asymmetries are lower for large firms which implies that
large firms should be in a better position to issue informational sensitive securities
such as equity rather than debt. Thus, hypothesis 3 can be stated as:
H3: Firm size is expected to have a positive influence on a firm capital structure.
Asset Tangibility (TA) is measured by the ratio of fixed tangible to total assets
(Titman and Wessels, 1988; Rajan and Zingales, 1995; Frank and Goyal, 2003; and
Hall et al., 2004). The existence of asymmetric information and agency costs may

induce lenders to require guarantees materialized in collateral (Myers, 1977; Scott,
1977; and Harris and Raviv, 1990). For example, if a firm retains large investments
in land, equipment and other tangible assets, it will normally face smaller funding
costs compared to a firm that relies primarily on intangible assets. Moreover,
Berger and Udell (1994) show that firms with close relationship with creditors need
to provide less collateral. They argue this is because the relationship (and more
informed monitoring by creditors) substitutes for physical collateral. If so, I should
find tangibility mattering less in the “bank oriented” countries. Thus, I would
expect that tangibility should be positively related to debt. And, hypothesis 4 is:
H4: Asset Tangibility is expected to be positively related to corporate leverage.
I use the basic ordinary least squares regression model to test the hypotheses that a
firm profitability, growth opportunities, size, asset tangibility influence its capital
structure for my data. The empirical models to be estimated as follows:
Capital Structure and Firm Performance
Page 14
Model 1: y
i
= β
0
+ β
1
PROF
i
+ β
2
Growth
i
+ β
3
Size

i
+ β
4
TA
i
+ u
Where i refers to the individual companies, and y is leverage for firm i. The
independent variables are represented by Prof, Growth, Size and TA. Four
measures of leverage are used in the study: total debt to total assets (TDTA), total
debt to total equity (TDTE), long-term debt to total assets (LTDTA), short-term
debt to total assets (STDTA).
i

Based on the hypotheses, the author presents the leverage model (Figure 1):
• Dependent variable: Firm Capital Structure is alternatively measured by
total debt to total assets (TDTA), total debt to total equity (TDTE), long-
term debt to total assets (LTDTA), short-term debt to total assets (STDTA).
• Independent variables: Firm Profitability, Firm Growth, Firm Size, Firm
Asset Tangibility.






Firm Profitability
(PROF)
Firm Growth
(Growth)
Firm Size

(Size)
Firm Asset
Tangibility (TA)
Firm Leverage
(TDTA, TDTE,
STDTA, LTDTA)

H1

H2

H3

H4

Figure 1: The Leverage Model
Capital Structure and Firm Performance
Page 15
2.4.2. Model 2: The Firm Value Model
A firm performance could be affected by the capital structure choice and by the
structure of debt maturity. Debt maturity affects a firm investment options. Also,
the tax rate is expected to have an impact on a firm performance. So, investigating
the impact of capital structure variables on a firm performance will provide
evidence of the effect of capital structure on firm performance.
The author uses two measures of corporate market performance, known as firm
value: market value of equity plus book value of debt to the book value of assets
(Tobin’s Q), and price per share to the earnings per share (PE). Tobin’s Q has been
used as a major indicator of firm performance. Even Tobin’s Q, as agreed by many
researchers, is a noisy signal. Because of the limitations of Tobin’s Q, other
performance measures, PE is employed as supplementary measures. Using market

measures of performance may shed light on the stock market activity and if there is
other factors that may affect corporate performance.
If capital structure does affect a firm performance and value, then a strong
correlation between the firm performance and capital structure would be found. So,
I argue that a firm debt ratio affects its performance and value negatively.
Furthermore, it has been argued that short-term debt influences a firm performance
negatively, because short-term debt exposes firms to the risk of refinancing. It is
expected that the debt maturity ratios (short-term debt and long-term debt) will
have a significant impact on corporate performance because of the banking credit
policy. Thus, the hypothesis is:
H5: A firm capital structure does influence its market performance.
Myers (1977) argues that firms with high growth opportunities have high agency
costs of debt and will be able to borrow less. In contrast, the pecking order theory
suggests that high growth firms have a greater need for funds and therefore can be
expected to borrow more. Wei Xu (2005) shows that there is a strong positive
correlation between growth and return on equity (ROE). So, it is expected that
firms with high growth opportunities have a high value, as growth firms are able to
generate profit from investment. Growth opportunities are expected to positively
affect a firm market performance. Thus, hypothesis 6 can be stated as follows:
H6: Growth opportunities increase firm market performance.
A firm size is measured by log of sales (SIZE). The firm size is hypothesized to be
positively related to the firm performance, as bankruptcy costs decrease with size.
Capital Structure and Firm Performance
Page 16
Thus, a firm size is expected to have a positive influence on a firm performance,
because potential bankruptcy costs make up a smaller proportion of value for larger
firms. In addition, there are economies of scale in transactions costs associated with
long-term debt that are not available to smaller firms. Gleason, among others, finds
that firm size has a positive and significant effect on firm performance (ROA).
Tian & Zeitun (2007) find that firm size has a positive and significant impact on

firm performance ROA, PROF, and Tobin’s Q. In contrast, many other researchers
such as Mudambi and Nicosia (1998), Lauterbach and Vaninsky (1999), Durand
and Coeuderoy (2001), and Tzelepis and Skuras (2004) have found an insignificant
effect of firm size on the firm performance. Based on this discussion, hypothesis 7
can be stated as:
H7: A firm size is expected to have a positive influence on a firm market
performance.
I use the basic ordinary least squares regression model to test the hypotheses that a
firm capital structures influence its market performance for my data. The empirical
models to be estimated as follows:
Model 2: y
i
= β
0
+ β
1
Leverage
i
+ β
2
Growth
i
+ β
3
Size
i
+ u
Where i refers to the individual companies, y is alternatively Tobin’s Q, PE, for
firm i as a measure of market performance. The independent variables are
represented by Leverage, Growth and Size. Four measures of leverage are used in

the study: total debt to total assets (TDTA), total debt to total equity (TDTE), long-
term debt to total assets (LTDTA), short-term debt to total assets (STDTA). I use
more than one proxy for leverage as different hypotheses for leverage were
developed to investigate their effect on corporate value. For example, the STDTA
and LTDTA are used to investigate the effect of short-term and long-term debt on a
firm performance. The proxy of TDTE was used in the study to validate the result.
i

Based on the hypotheses, the author presents the empirical model (Figure 2):
• Dependent variable: Firm Value is alternatively measured by Tobin’s Q, PE.
• Independent variables: Firm Leverage, Firm Growth, Firm Size.