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

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

DO FIRM CHARACTERISTICS MATTER IN CAPITAL STRUCTURE DECISION?
AN EMPIRICAL STUDY OF LISTED FOOD PROCESSING COMPANIES IN
VIETNAM
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By
DINH THI THU

Academic Supervisors:
Dr. NGUYEN TRONG HOAI
Mr. NGUYEN XUAN THANH

HO CHI MINH CITY, October 2014


ABSTRACT
The aim of this paper is to explore the firm-specific factors that affect the capital structure
of food processing companies listed in Vietnamese stock exchange. The paper firstly
reviews theories of capital structure: trade-off theory, pecking-order theory and other

related empirical studies. Seven factors are thereinafter concluded and discussed in the
studied model in respect of correlations and the determinants of capital structure by using
panel data procedures for a sample of 41 food processing companies listed on the
Vietnamese Stock Exchange during the period of 2007-2012. Pecking order theory
dominates in explaining financial decision of these firms. There are differences between
the determinants of long-term fund-raising and short-term fund-raising. Profitability, size,
tangibility, earnings volatility and liquidity are found statically significant to short-term
leverage whereas tangibility and earnings volatility is the most important factors impacting
the long-term leverage. Empirical findings suggest some policy recommendations for
sustainable development of the private sector in Vietnam.
Keywords: Capital structure; leverage; food processing; Vietnam listed companies; panel
data


ACKNOWLEDGEMENT
Studying is a long and interesting journey. It would be more interesting if you have a chance
to get to know the talented people and learn from them. This paper could not have been
completed without support from my supervisors, friends and family.
I would like to convey profound appreciation to Dr. Nguyen Trong Hoai, Mr. Nguyen Xuan
Thanh and Mr. Truong Dang Thuy for their guidance in conducting this thesis. My special
thanks go to Mr. Nguyen Xuan Thanh for his valuable guidance, critical comments and warm
support which made this work possible at the crucial stages.
To my family and friends, my sincere gratitude for their unconditional love, support, and
encouragement.


TABLE OF CONTENTS
CHAPTER 1. INTRODUCTION .................................................................................................. 1
1.1 Research background ........................................................................................................... 1
1.2 Problem statement ................................................................................................................ 4

1.3 Research objectives .............................................................................................................. 6
1.4 Thesis structure .................................................................................................................... 7
CHAPTER 2. LITERATURE REVIEW ....................................................................................... 8
2.1 Capital structure definition................................................................................................... 8
2.2 Capital structure theory ........................................................................................................ 8
2.2.1 The trade-off theory ..................................................................................................... 10
2.2.2 Pecking Order theory ................................................................................................... 14
2.3 Comparative look on capital structure theories ................................................................. 15
2.4 Empirical evidence on determinants of capital structure ................................................... 17
2.4.1 Empirical evidence around the world .......................................................................... 17
2.4.2 Empirical studies in Vietnam ...................................................................................... 22
CHAPTER 3. OVERVIEW OF FOOD PROCESSING SECTOR IN VIETNAM .................... 27
CHAPTER 4. CAPITAL STRUCTURE DETERMINANTS – HYPOTHESES ....................... 32
4.1 Profitability ........................................................................................................................ 32
4.2 Tangibility .......................................................................................................................... 33
4.3 Firm Size ............................................................................................................................ 34
4.4 Non-debt tax shields........................................................................................................... 34
4.5 Growth opportunities ......................................................................................................... 35
4.6. Earnings volatility ............................................................................................................. 36
4.7. Liquidity ............................................................................................................................ 36
CHAPTER 5. Methodology AND DATA................................................................................... 39
5.1. Data ................................................................................................................................... 39
5.2. Methods of estimation ....................................................................................................... 39
CHAPTER 6. EMPIRICAL RESULTS ...................................................................................... 42
6.1. Descriptive statistics ......................................................................................................... 42

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6.2. Analysis of the correlation among variables ..................................................................... 43

6.3. Empirical results ............................................................................................................... 46
CHAPTER 7. CONCLUSION .................................................................................................... 53
7.1. Findings ............................................................................................................................. 53
7.2. Policy implications ............................................................................................................ 54
7.3 Limitations ......................................................................................................................... 57
REFERENCES ............................................................................................................................ 59

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LIST OF FIRGURES
Figure 1. Conceptual framework for firm-level determinants of capital structure…………..37

LIST OF TABLES
Table 1. Market capitalization of Vietnam’s stock exchange (2004 – 2012)………..…….…. 3
Table 2. A summary of selected studies on determinants of capital structure in Vietnam…..26
Table 3. Output and export contribution of food processing sector……………………...…..27
Table 4. Number of enterprises manufacturing food and beverages by size of employees
and capital resources .………………….…..……………………...…………………………29
Table 5. Some financial indicators of Vietnamese enterprises……………………..………..30
Table 6. Summary of determinants of capital structure: theory and measurement..…….…...38
Table 7. Summary statistics of sample variables………….………………………………....43
Table 8. Correlation coefficients among variables and VIF coefficients…...…………...…...45
Table 9. Results of Hausman tests for Model 1, 2 and 3……………………………..……....47
Table 10. Estimation results of firm-level factors impacting on total leverage, short-term
leverage and long-term leverage using FEM……………………...…………………………48

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CHAPTER 1. INTRODUCTION
1.1 Research background
Vietnam is a developing country in Southeast Asian region with total area of 331,210
square kilometers and population of over 91 million. Recovering from the war damage
and the rigidities of a centrally-planned economy, the country has become among the
fastest growing economies over the past decades thanks to the Doi Moi reforms in
1986. During this period, the private sector has emerged as one of the most important
driving forces in Vietnam’s economic development. The Enterprise Law in 2000 is
conceived as a remarkable milestone for development of the private business in
Vietnam. This law mainstreams the registration and operation of private companies,
implements a regime of property rights and guarantees equal treatment among
economic sectors. As a result, the period of 2000-2005 witnessed a boom in private
sector development. It is estimated that 160,672 private enterprises were registered
with a total combined capital of US$20 billion during the period of 2000-2005, which
is 3.2 times more than the total number of private enterprises registered during 19911999. The private sector has played an increasingly important role in job creation,
poverty reduction and economic growth. Vietnamese private enterprises annually
contribute about 42% to overall GDP and provide 56.3% of the country's regular job
supply. Nevertheless, these private firms have been facing many challenges in their
existence and competition. One of the biggest challenges is financial capacity. The
majority of Vietnamese firms are small-sized in terms of labor and capital. More than
90 percent of the local businesses are small and medium enterprises. These firms have
been facing tough competition from foreign companies in technology and financial
capacity. Vietnam joined the WTO in 2007 following a long negotiation process of
more than ten years and became the member of Trans-Pacific Partnership trade
agreement in 2010. These turning points have brought both opportunities and
challenges to Vietnamese firms. They have chances to compete in the international
market and expand their markets via goods export. On the other hand, they also face
tough competition from foreign companies when these firms have a free access to the
Vietnamese market. To compete with foreign firms, the local ones need to keep high

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quality products and services with lower costs. It is noticed that many Vietnamese
firms have recently gone bankruptcy due to two important reasons. First, firms could
not sell their products. Second, they faced capital shortage problem. The first reason
can be explained by the current global crisis in which the demand for products declines
in attempts of cutting cost. The second reason of capital shortage is identified as the top
constraint in almost every survey on private small firms in the country. Vietnam is
characterized by a bank-based economy where banking sector is the main source to
finance the economy activities. Financial liberalization has progressed by several
reform policies. In 1998, Vietnam’s financial system was strengthened and readdressed
toward a more market-oriented approach when the Law on the State Bank of Vietnam
No.01/1997/QH10 and Law on Credit Institutions No.02/1997/QH10 came into force.
The reform has led to a significant increase in total credit granted to the domestic
private sector by the state-owned commercial banks in the following decades (World
Bank, 2005). However, the private sector still gets less preferential access to banking
credit than state-owned enterprises (SOEs). Most small businesses continue to finance
their operations through retained earnings or informal sources of credit. The recent
global financial crisis together with macroeconomic instability due to rapid credit
growth has forced Vietnamese government to pursue a tighter monetary policy.
Vietnamese banks are required to adopt conservative credit policies in 2011. As the
result, local firms have limited financing resources for their operation and investment
and face with bankruptcy. Several local firms have chosen alternative channels for
capital mobilization such as bond market or stock market.
Vietnam bond market: Vietnam bond market is in a nascent stage even though its
formation dated in the early 1990s. Local currency bonds are mainly issued by the
government or government sponsored institutions such as Vietnam Development Bank,
Vietnam Bank for Social Policy and Vietnam Expressway Corporation. According to
Vuong and Tran (2010), the overall bond market accounts for about 15% of the total

GDP in comparison with the average percentage of 65% in East Asian region. The
corporate bonds, 92% of which have maturities of 1-3 years, are traded on both HOSE
and HNX and account for 1.4% of GDP. Currently, primary market for corporate bond
is weak while the secondary market is virtually nonexistent. Vietnamese companies,

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most of which are small- and medium- sized, would hardly raise fund for their
operations through the bond market.
Vietnamese stock market: The historical development of Vietnamese stock market
can be traced back with the establishment of Ho Chi Minh Stock Exchange (HOSE) in
July 2000 and Hanoi Stock Market (HNX) in March 2005. Starting with five listed
companies in 2000 with market capitalization of 0.2% of GDP, the number of listed
companies increases to 311 in the year of 2012 with market capitalization of more than
21% of the country's GDP. Even though Vietnamese stock market has nowadays
become an increasingly important channel for medium and long term capital, it is still
far from international standards in terms of market size and market capitalization.
Table 1. Market capitalization of Vietnam’s stock market (2004 – 2012)
Total of listed
Year

domestic
companies

Market capitalization of

Market capitalization of listed

listed companies (US$)

companies (% of GDP)

2004

26

248.012.350,01

0,50

2005

33

461.326.003,81

0,80

2006

102

9.092.539.058,79

13,70

2007

121

19.541.780.000,00

25,24

2008

171

9.589.377.646,86

9,67

2009

196

21.198.623.760,20

20,00

2010

275

20.385.102.198,90

17,58

2011

301

18.316.217.136,95

13,51

2012

311

32.933.061.036,47

21,14
(Source: World Bank)

The Vietnamese stock market has been facing fundamental weaknesses that need to be
resolved properly. During its development, Vietnamese stock market experienced high
volatility. For example, in the period 2006-2007 there was a boom in this market due to
over-expectation of the country’s economy growth and WTO accession. Market
capitalization in 2007 reached 25,24% of GDP. Affected by the global financial crisis,
Vietnamese stock market took a deep plunge in 2008: VN-Index fell down sharply and

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market lost around two-third of its value when foreign investors withdrew their
investment from Vietnamese stock market. The root weakness relates to dismal
transparency, predictability and information clarity for investment decisions. Many
listed companies frequently adjust their business results. Annual reports do not provide

much useful information for investors and the discrepancy before and after auditing are
large. With high information asymmetry, investors have to bear the brunt when
punishment for these practices is not strong enough. Moreover, information on the
macro-economy is unpredictable and uncertain. Consequently, the Vietnamese stock
market can only attracts short-term and unstable funds instead of long-term players
such as retirement funds, public savings funds and becomes a playground for day
traders or hit-and-run investors.
Despite the above-mentioned weaknesses, Vietnamese stock market still plays an
increasingly important role in the national economic development with the increasing
numbers of listed companies and becomes the second important channel in capital
mobilization. Vietnamese firms can choose debt finance via the banking system or raise
equity in the stock market. Therefore, it is worthwhile to study the financing practices
of the listed firms on Vietnamese Stock Market. The general purpose of this paper is to
extend our knowledge of how Vietnamese listed companies choose their capital
structure and to what extent their financing behaviors are consistent with the theoretical
explanations, namely the trade-off theory and pecking order theory.
1.2 Problem statement
There are three major motivations for the study.
First, being not a new research area, capital structure remains one of the most
interesting and puzzling ones. Capital structure refers how a firm uses different sources
of funds to finance its operations and growth. It is recognized that financial capital
plays a crucially important role in the existence and growth of a firm. Good capital
structure decisions not only lead to higher profitability or lower risk but also help firms
to allocate risk as well as control power among various groups of shareholders. Since
first paper of capital research by Miller and Modigliani in 1958, there has been a vast
amount of research on firm capital structure. However, empirical results are

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inconsistent in supporting the two most prominent theories of capital structure: the
trade-off (Modigliani & Miller, 1963) and the pecking order theory (Myers & Majluf,
1984; Myers, 1984). For instance, Hovakimian (2006) shows that the timing of
equity issuance does not have any significant long-lasting impact on capital
structure as the counter-evidence against the pecking order theory. The classic question
“How do firms choose their capital structure?” raised by Myers (1984) remains
unanswered.
Second, there has been an upward trend in bankruptcy as well as acquisition of the
local food processing companies by the foreign ones. Vietnam’s integration into WTO
in has provided the local food processing with a greater access to outside markets.
However, limited capital capacity has put Vietnamese food processing companies the
disadvantage in technology and financial capacity in comparison with the foreign
multinational ones such as Unilever, CP-Meiji and Nestle. These local firms have been
facing the increased competition from foreign firms and being acquired or forced out of
business by the big foreign companies. For example, Kravis Roberts & Co (KKR)
acquired a 10% stake in Masan Consumer for US $159 million in April 2011. Jollibee
Worldwide invested US $25mn to acquire a 50% stake of the SuperFoods business in
early 2012 and has given a US$35mn loan to its partner Viet Thai International Joint
Stock Company. Charoen Pokphand Foods acquired a 74.18% stake of CK Pokphand
in late 2011. Thus, it is worthwhile to study the financial practices of Vietnamese food
processing companies prior to giving any suggestions for their financial capacity
improvement.
Third, the food processing sector of Vietnam has not been yet analyzed independently
given this sector is the top manufacturing industry in Viet Nam. As one of traditional
industry in Viet Nam, the food-processing sector annually accounts for a sizeable
proportion of industrial output and GDP. According to Vietnamese General Statistics
Office, the output of food processing sector is 859,472.5 billion Vietnam dong,
contributing 18.79% of industrial output and 6.2% of GDP in the year 2012. So far,
there have been some studies on capital structure using Vietnamese data such as
Nguyen and Ramachandran (2006); Biger et al. (2008); Nguyen et al. (2012) focusing

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on financial behaviors of SMEs or listed firms in all industries. This paper presents an
empirical analysis of capital structure of food processing sector in Vietnam with most
recent available data.
The puzzling question of capital structure together with local food processing firms’
disadvantage of financial capacity as well as the lack of research using data in Vietnam
motivates the conduct of research on financing practices of Vietnamese listed food
processing companies.
The paper aims to identify determinants of capital structure and to gain a practical
insight into the financing practices of Vietnamese firms in food processing sector so
that corporate managers and policy makers can have optimal capital policy to minimize
financial risk. To this end, this paper will discover how Vietnamese listed foodprocessing firms set their capital structure and to what extent the financing behavior is
consistent with the theoretical explanations.
1.3 Research objectives
The primary objectives of this study are as follows:
(a) To identify firm-level determinants of the capital structure of food processing
companies listed in Vietnamese stock market by including variables based on
different capital structure theories. From the result, we can identify factors that
significantly influence the financing decision in these firms
(b) To recommend some polices for corporate managers and policy makers.
Specifically, the paper addresses the three following research questions:
1. What are the firm-specific variables that determine capital structure of
Vietnamese food processing companies listed on Vietnam Stock Market?
2. Does the empirical evidence support the predictions of the trade-off theory or
the pecking order theory?
3. Based on the empirical evidence, what are the policy implications for firms’
access to finance in Vietnam’s financial system?

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1.4 Thesis structure
The thesis is organized as follows:
Chapter I provides an introduction to the thesis including background, motivation,
objective, methodology and structure of the study.
Chapter II summarizes the most prominent theories of capital structure and relevant
empirical studies that provide a rationale for explaining financial decisions of firms.
Chapter III discusses methodology, descriptions of variables in the studied model and
data to conduct the analysis.
Chapter IV presents the overview of food processing industry and the results of the
analysis including descriptive and econometric findings.
Chapter V provides a summary of issues covered in this thesis and well as policy
implication. Limitations of the study and suggestions for further research are also
mentioned.

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CHAPTER 2. LITERATURE REVIEW
This chapter provides a review of the literature related to the capital structure of firms
to lay the foundation of the analysis. First, capital structure definition is introduced and
the most influential theories of capital structure are summarized. Then, the paper
presents the empirical researches of capital structure choice in respect of firm-specific
characteristics representing taxation, bankruptcy costs, agency costs, information
asymmetries.
2.1 Capital structure definition
As the core element in this research, it is worth to define the concept of firm capital

structure. Different definitions have been used in the capital structure literature.
According to Miller and Modigliani (1958), capital structure is the mix of debt and
equity used by a company which is financing their assets. Brealey, Myers, & Marcus
(2009) defines capital structure as the ’mix of long-term debt and equity
financing’. As such, the capital structure can be defined as the mix of equity
(common equity and preferred equity) and financial debt (long term debt, short term
debt and convertible debt).
The most relevant measure of capital structure is the ratio of leverage. However, the
extent of leverage depends on the research purpose; for example, the leverage ratio can
be stock of debt relative to firm value (Jensen and Meckling, 1976) or interest coverage
ratio (Aghion and Bolton, 1992) or long-term liabilities by total assets (Frank and
Goyal, 2009; Welch, 2011). In this paper, we use three variables as proxy for firm
capital structure, namely, ratio of total debt to total assets debt; ratio of long-term debt
to total assets and ratio of short-term debt to total assets.
2.2 Capital structure theory
Different theories of capital structure have been developed by many researchers. These
theories include: Net income, net operating income, traditional ap proach theory,
Miller and Modigliani theory, trade-off theory, pecking order theory and recently the
market timing theory.

8


The net income approach of capital structure, propounded by David Durand in 1952,
states that firm value can be increased or cost of capital can be lowered by the debt
capital: the higher ratio of debt in capital structure, the lower capital expenditure.
Net operating income states the opposite: firm value and cost of the capital are not
correlated with capital structure because there exists the hidden cost of debt which
fades the benefits of using debt as a cheaper source of finance.
In 1963, Solomon developed the intermediate approach: firm value is positive with

debt capital to a certain level, then remain constant with a moderate use of debt capital,
and finally become negative with debt capital.
Modigliani and Miller (1958) are pioneers in the modern theory of capital structure.
With lots of assumptions of a perfect capital market in which there exist no transaction
costs, no symmetric information, no default risk, no taxation, Modigliani and Miller
claim that firm value depends upon its asset profitability, not on the way in which such
assets are financed or capital structure of a firm.
They have two propositions under these conditions.
Suppose D and E are respectively market values of the firm's debt and equity; V is total
firm value; rA is weighted average cost of capital-the expected return on a portfolio of
all the firm's outstanding securities; rD and rE are respectively the cost of debt and the
cost of equity, defined as the expected rates of return demanded by debt investors and
equity investors.
Proposition 1: r A = rDD/V + rEE/ V
According to Modigliani and Miller, total firm value V and the weighted average cost
of capital rA are constants, regardless of the debt ratio, given that firm asset and growth
opportunities are unchanged.
Proposition 2: rE= rA+ (rA- rD)D/E, derived from Proposition 1, shows that the cost of
equity has positive relationship with the debt-equity ratio D/E. It also shows that
financial leverage does not matter due to unchanged overall cost of capital because the

9


company with debt is involved with higher risk. Thus, a leveraged firm has the same
cost of equity of an unleveraged firm plus an added premium financial risk.
They come to the conclusion that the value of a company is independent of its capital
structure in a perfect capital market.
Nevertheless, the unrealistic assumptions of a perfect capital market suggest that firm’s
capital structure choice becomes relevant when these fundamental assumptions are

removed. Modigliani and Miller themselves also break down one the assumptions in
their seminal paper in 1963. When taking taxation into consideration, they argue that
debt brings a tax benefit shield and firm value can be maximized by using as much debt
as possible. They contend that the value of the levered firm equals the value of the
unlevered firm plus the value of the generated tax benefit. Therefore, capital structure
does matter the value of firms.
Following Modigliani and Miller’s papers, the study of capital structure has attracted
much interest among financial researchers. In general, these theories describe the
consequences when Modigliani and Miller’s assumptions of perfect markets do not
hold. The most prominent theories of capital structure are the trade-off and the pecking
order theory.
2.2.1 The trade-off theory
The trade-off theory suggests that the optimal debt level is determined by balancing the
corporate tax benefits of debt with the cost of bankruptcy (Kraus and Litzenberger,
1973). The advantage in financing with debt is the tax shield. Firms with higher debt
finance can pay lower tax because the interest on debt is tax-deductible expense. On the
contrary, debt also brings higher financial risk that creates costly debt-financing choice,
especially when firms have too high level of debt.
Trade-off theory is grouped into two categories: static and dynamic trade-off models.
According to the static trade-off theory by Kraus and Litzenberger (1973), firms have
their target optimal capital structure based on which firms’ financial decisions will be
adjusted. Firms will borrow more or less so that the debt-equity ratio is at the optimal
level where the debt tax shield is offset by the bankruptcy cost. One major shortcoming

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of the static trade-off theory is not taking into account the transactions for the
adjustment. Later, Fischer et al. (1989) present the dynamic model that incorporates the
costs associated with capital structure adjustment. If the adjustment costs are higher

than the values lost from achieving the optimal capital structure, firms will not adjust
the ratio towards the target.
In what follows, we will discuss in further details the benefits and costs of debt.
2.2.1.1 Benefits of Debt
A. Tax shield
The most significant reason that induces firms to raise debts is that interest payments
are deducted from the corporate taxable income, in other words, interest is a taxdeductible expense. By getting more debt, a firm can enjoy lower expected tax liability
and higher after-tax cash flow. However, Miller (1977) claims that the debt level is
independent of tax rate when both personal and corporate taxes are considered. He
argues that personal income taxes paid by investors in corporate debt offset the
corporate tax shield that the firm enjoys when being in debt, thus the firm optimal level
of debt does not exist.
According to Graham (2003), with the presence of a personal income tax, investors will
demand premiums as the compensation for net income reduction. As a result, the debt
leverage has a negative relationship with the personal income tax rate and positive one
with the company income tax rate. However, the influence of the debt tax shield on
firm leverage depends on whether firms are entitled to carry their loss forward or
backward for tax deduction. Papers by Ashton (1989) and Adedeji (1998) document
that firms prefer use less debt in the UK tax system than in the US tax system.
Different from the UK tax system, the US tax system entitles firms to carry forward or
backward their sustaining loss. Firms can receive cash refunds of previously-paid taxes
or future tax reductions. Therefore, US companies tend to borrow more for their
investment needs.
It is noted that the benefit of debt tax-shield is also influenced by such non-debt tax
shield including investment tax credits, research expenses and depreciation. Firms with

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more debt might face higher bankruptcy risks when firms are not able to meet their

debt obligation on time. Non-debt tax shields is consider as an alternative options,
which is less costly, to reduce income taxes. Given the limited total deductible expense
to income, firms with greater level of non-debt tax shields might find debt more costly
when an extra unit of debt will save less tax in comparison with firms with lower ones.
Thus, these firms tend to borrow less, implying the negative relationship between debt
and non-debt tax shields.
B. Reduction of free cash flow agency costs
Debt financing is not only for the purpose of tax shield but also for mitigating
managerial agency cost (Jensen and Meckling, 1976; Jensen, 1986). The separation
between shareholders’ ownership and managers’ control might bring in manager –
shareholder conflicts. Managers might attempt to benefit themselves at the loss of the
shareholders. They may consume excessive perquisites or invest in unprofitable project
when they have excess cash flow to finance all of the available projects (Jensen, 1986).
By using more debt, shareholders can mitigate the problem of overinvestment in
unprofitable projects and discipline managers’ behaviors. It is noted that firms with
debt financing are obligated to pay back principals as well as loan interests to debtholders, which subsequently reduce the funds available for unprofitable projects. Lasfer
(1995) argues that debt finance motivates managers to be more responsible for their
investment decisions. However, debt finance is not effective in the cases of fastgrowing companies with no free cash flow for their valuable projects (Jensen, 1986).
Such companies frequently mobilize investment capital via the financial market. The
proposed projects will be independently assessed and monitored by bankers and
analysts in this market. As a result, these firms will pay extra financial claims for the
market assessment.
2.2.1.2 Cost of debt
A. Costs of Financial Distress
Even though debt finance brings advantages of tax-shield and reduction in free cash
flow agency costs, it is not always the case. Using too much debt in the capital

12

structure, the firm might face the challenge of meeting its financial obligation. Warner
(1977) and Barclay et al. (1995) state that financial distress has two types of costs:
direct and indirect cost. Direct costs are costs associated with bankruptcy and
reorganization such as cost incurred with selling the liquidated assets and shutting
down operations. It is also noted that the overall firm value will be clear off when it
goes bankrupt and the difference between the firms operating value and its liquidation
value is considered as bankruptcy costs (Wijist and Thurik, 1993). Indirect costs of
financial distress arising from the reluctance to do business with a firm in financial
distress (Brealey and Myers, 2002) such as costs of losing or retaining customers and
firm employees. It also includes the distress costs of the suppliers who will raise input
price, remove discount and demand cash payment in concern of firm’s payment default
risk. Moreover, excessive debt also creates so-called ‘debt overhang’ costs (Myers,
1977). The ‘debt overhang’ problem arises when a firm’s outstanding debt is at some
risk of default and covenants give current debt priority for debt repayment at the
expense of shareholders because a portion of value created by new investments will be
paid for the current outstanding debt to reduce risk of default. The higher probability
of debt default is, the more severe the debt overhang problem becomes. In many cases,
firms might be forced to forgo value-maximizing investments and this will lead to
underinvestment problem (Myers, 1977 and Calomiris, et al., 1994).

B. Agency Costs of Debt
As discussed above, debt can be used as a tool to mitigate the agency costs of managershareholder conflicts. Nevertheless, debt brings about the conflict between debt holders
and shareholders because the debt contract induces shareholders to invest suboptimally. According to Jensen and Meckling (1976), shareholders can take wealth
from debt holders by using existing debt funds to invest in risky projects. This
overinvestment problem originates from the fact that shareholders have limited
liability. By investing in high-risk projects, they have larger opportunity to gain more
profits at the expense of larger potential losses that are expected to be absorbed by
bond holders. Creditors, in anticipation of this kind of shareholders’ behavior, will
demand higher premiums for compensation by raising the cost of debt.

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On the other hand, during the period of financial distress, firms might face the problem
of underinvestment when positive net present value projects are rejected if the
bondholders have higher advantages over the shareholders in terms of received
benefits. The reason behind this phenomenon is that shareholders only have the rights
in claiming of the value of a firm after the debt is paid and debt holders benefit more
from a safe positive net value project than shareholders (Lasfer, 1995). There are two
solutions to alleviate the underinvestment problem. First, firm should finance its
investment with equity rather than debt when investing in positive net present value
projects. Second, firm should issue short term debt instead of long term debt.
2.2.2 Pecking Order Theory
Being initially suggested by Myers and Majluf (1984), the pecking order theory works
on the idea of asymmetry information between a firm and outside investors regarding
the firm’s real value of both current operations and future prospects. The pecking order
theory states that there is no well-defined target debt ratio. Managers avoid issuing
undervalued new shares to finance new projects by using internal funds such as
undistributed earnings. As managers are more knowledgeable of their companies than
outsiders, the adverse selection problem might arise. Outside investors usually find it
hard to discriminate between good and bad projects because managers cannot often
credibly convey their existing assets quality and available investment opportunities to
potential investors. Thus outside investors will demand a premium for their investment.
In other words, the firm information discrepancy leads to under-pricing of firm’s equity
in the market as well as the undervaluation the existing shareholders’ wealth. Aware of
the dilution of shareholders’ wealth, firms tend to borrow through debt instruments as a
substitute for equity to mitigate the investment inefficiencies caused by information
asymmetry.
Myers (1984) argues that firms prefer internal financial sources such as retained
earnings because retained earnings have no adverse selection cost. In case more funds

are required, debt financing will be the next option, then hybrid securities like
convertible bonds, and then equity as a last resort due to accelerating information cost
or adverse selection costs.

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The pecking order theory behavior in reality is due to the transaction costs related with
raising funds externally (debt/equity). The two parts of these costs are the
compensation for dealer and the legal plus administrative costs which are estimated to
account 20% gross proceeds of small stock issue. This fact implies that small firms are
more prone to follow the pecking order theory than large firms as the transactions cost
make up of a significant financing hierarchy for them.
The agency cost between firm stakeholders is another cost that might also affect the
pecking order. Agency theory suggests manager-shareholder-bondholder conflicts will
lead to the incentive problems arising from increasing costs of external funding and
consequently driving firms toward the internal created funds to reduce the agency
costs. As the result, firms might have to face underinvestment problem by giving up
some profitable investment opportunities, reducing their profitability as well as firm
value. Thus, firms having higher agency costs tend to rely on internal funds rather than
external financial support.
2.3 Comparative look on capital structure theories
Despite being regarded as among the most important contributions in the theory of
corporate finance, it is widely believed that the predictions of Miller and Modigliani
theory are incompatible with empirical evidence due to unrealistic assumptions of a
perfect capital market.
As mentioned above, the trade-off theory and the pecking order theory are the two
major theories dominating the decision of capital structure in almost empirical studies.
The trade-off theory assumes that firms have their own target capital structures. Firms
with higher profit and tangible asset will have higher debt ratio than ones with less

profit. Firm will take into consideration the trade-off between benefit of debt tax shield
and the cost of financial distress to decide whether debt or equity will be used for their
financial needs. The trade-off theory works well in explaining the capital structure
behaviors among various industries. For example, high technology firms with large
tangible assets often borrow heavily. However, trade-off theory cannot justify the fact

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that firms with high taxable income borrow less instead of borrowing more to get tax
shelter.
The pecking order theory takes into consideration adverse selection cost that arises
from asymmetric information. The most significant contribution of the pecking order
theory is the explanation for the relationship between leverage decreasing events (i.e.,
new stock offerings) and equity-for-debt exchange schemes with firm’s stock price
decline. Given the assumption of asymmetric information, retained earnings has no
adverse selection cost while debt is associated with less adverse selection cost than
equity.
According to Ross et al. (2012), there are three conflicting implications between the
pecking order theory and the trade off theory.
First, firms do not have a target level of leverage. According to the trade off theory,
there exists an optimal level of leverage where the marginal benefit of debt (e.g. tax
shield) equals its marginal cost (e.g. bankruptcy costs). On the contrary, the pecking
order theory states that the target debt ratio does not exist. Firms will choose their debt
ratio in accordance with their financial needs, first with retained earnings, then debt
issuance and lastly equity.
Second, profitable firms use less debt. Pecking order suggests that profitable firms
generate liquidity internally, thus they depend less on debt and external financing.
The trade off theory does not include this implication: profitable firm will increase its
debt capacity to enjoy the tax shield and other advantages of leverage.

Third, firms desire financial slack for future investment. The pecking order theory
states that firm has difficulty in finding financing sources at a reasonable price. New
share issuance is often underpriced since investors believe that stocks are being
overpriced if managers try to issue more shares. Bond issuance faces the same rational
thought which is definitely lower. As a result, firm will rely on debt as the first priority.
However, bankruptcy costs limit firm from issuing too much debt. Financial slack
would be a proper solution for this case. When companies know that they will have to
finance profitable projects in the near future, they could start accumulating liquidity

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today to avoid being much dependent on external financing when investment
opportunities come. On the contrary, the trade off theory suggests that there is a limit in
the financial slack a firm should keep. Jensen (1986) claims that interest conflicts
between shareholders and managers over payout policies are severe free cash flow is
substantial. The problem is how to motivate managers to disgorge the cash rather than
investing money in inefficient projects. According to his study, increasing firm debt
ratio can significantly reduce agency costs of free cash flows.
We have so far discussed the pecking order theory and the trade-off theory as two main
theories of capital structure. Both theories provide alternative views on how firms
choose their capital structures. We also take a comparative look and present conflict
implications between these two theories. The next section elaborates on the empirical
findings and supporting evidences for the two theories.
2.4 Empirical evidence on determinants of capital structure
The empirical studies have found mixed evidence for the pecking order theory and
trade-off theory. Researchers have attempted to test the explanatory power of capital
structure models on corporate behavior in both developed and developing countries.
The research outcome would be interpreted in favor of a certain capital structure
theory. In most of the cases, it is a contest between the pecking order theory and the

trade-off theory.
In what follows, we will discuss about empirical studies on determinants of capital
structure from other countries and Vietnam so that we can have a general overview
before proposing our research models.
2.4.1 Empirical evidence around the world
Frank and Goyal (2003) test the pecking order theory of corporate leverage on a broad
cross-section of publicly traded American firms for 1971 to 1998, exclusive of
financial firms, regulated utilities and firms involved in major mergers. In their
regression of leverage, they use five factors of tangibility of assets, market-to-book
ratio (growth), log sales (size), profitability and cumulated past financing deficit
(representing the pecking order). Leverage is defined as the ratio of total debt to market

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capitalization. They found that coefficient signs are negative on the market-to-book
ratio and profitability and positive on tangibility and log of sales. The effect of the
financing deficit is significant but it does not have much effect on the magnitudes and
significance of the coefficients on the other conventional variables, meaning pecking
order theory is not supported in this case. In another testing regression similar to
Shyam-Sunder and Myers (1999), they find that small high-growth firms do not behave
according to the pecking order theory. In fact, the pecking order works best in samples
of large firms but the support of pecking order theory is declining over time. They
conclude that many aspects of the evidence pose serious problems for the pecking order
and pecking order theory do not explain broad patterns in the data.
Deesomak et al. (2004) investigates the determinants of capital structure of firms
operating in the Asia Pacific region. Four countries with different legal, financial and
institutional environments are selected for their research: Thailand, Malaysia,
Singapore and Australia. Their testing data obtained from DataStream includes all nonfinancial firms listed in those countries for the period of 1993-2001: 294 Thai firms,
669 Malaysian firms, 345 Singaporean firms and 219 Australian firms. The research

model incorporates firm-specific and country-specific factors such as firm share price,
size, tangibility, profitability, growth, non-debt tax shield, liquidity, earnings volatility,
interest rates and ownership concentration.
The empirical results are as follows:
-

Tangibility is not statistically significant to leverage in most of the studied
countries.

-

Profitability is found insignificantly negative with leverage in most of the
studied countries except Malaysia.

-

Firm size is significantly positive with leverage in most countries except
Singapore.

-

Growth opportunity is negative related to leverage in most countries and its
impact is significant for Thailand and Singapore.

-

The impact of non-tax debt shield, share price performance and liquidity is
significant on leverage in all studied countries.

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-

Earnings volatility has no significant effect on leverage in any country.

-

The financial activity of the stock market has significant and negative impact on
leverage while interest rate impact on leverage changes during crisis time:
insignificant before the crisis; significant and positive after the crisis.

-

The index of creditor’s rights show marginally significant but negative with
leverage before crisis and while it is significant and positive with leverage after
the crisis.

-

The estimated coefficients for ownership concentration are significant and
positive after the crisis but significant and negative before the crisis.

From the testing results, it is found that size, growth opportunities, tax rate and asset
tangibility make influence on capital structure consistently with the predictions of the
trade-off theory. However, the importance of capital structure determinants varies
across countries in the region and the financial crisis of 1997 has a significant but
diverse impact on firm’s capital structure decision across the region. They conclude
that “capital structure decision is not only the product of the firm’s own characteristics
but also the result of the corporate governance, legal framework and institutional

environment of the countries in which the firm operates.”
Frank and Goyal (2009) examine the importance of many factors in the capital
structure decisions of publicly-traded American firms from 1950 to 2003.Their data
sample is taken from Compustat and Center for Research in Security Prices. They use
four alternative definitions of leverage: (1) the ratio of total debt to market value of
assets (TDM), (2) the ratio of total debt to book value of assets (TDA), (3) the ratio of
long term debt to market value of assets (LDM), and (4) the ratio of long-term debt to
book value of assets (LDA). Six “core factors” are used as explanatory variables,
namely industry median leverage, tangibility, profits, firm size, growth (market-tobook assets ratio) and expected inflation. They find that median industry leverage,
tangibility, firm size and expected inflation has positive relationship with market
leverage while growth and profits have negative impact on market leverage. Similar
results are found for book leverage; however the impact of firm size, growth and the
effect of inflation are not significant. They conclude that the empirical results support

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