ABSTRACT
This paper seeks to empirically identify the determinants of the capital structure of
listed firms on the Ghana Stock Exchange during the most recent six-year period.
Ordinary Least Square model is used to estimate the regression equation. The
results indicate that, total debt constitutes more than half of the capital of listed
firms in Ghana. The results also show positive associations between debt ratio
(capital structure) and firm size and growth, while asset tangibility, risk, corporate
tax and profitability are negatively related to debt ratio. The results generally
support the pecking order theory proposed by the theoretical model.
INTRODUCTION
The capital structure of a firm is actually a specific mixture of debt and equity a firm employs
in financing its operation. The capital structure decision is crucial for any business
organization. The decision is important because of the need to maximize returns to various
organizational constituencies, and also because of the impact such a decision has on an
organization’s ability to deal with its competitive environment. In an attempt to set a capital
structure that maximizes overall market value, firms do differ with regard to their capital
structure. That is why there are various theories of capital structure that try to explain this
cross-sectional variation.
Correspondence to
Joshua Abor joshabor@ug.edu.gh
The paper is organized as follows. The next section gives a review of the extant theoretical and
empirical literature on the determinants of capital structure. Section three explains the
methodology adopted for the study. The empirical results are presented and discussed in
section four. Finally, section five summarizes the findings of the research and also concludes
the discussion.
Corporate taxes allow firms to deduct interest on debt in computing taxable profits. This
suggests that tax advantages derived from debt would lead firms to be completely financed
through debt. This benefit is created, as the interest payments associated with debt are tax
deductible, while payments associated with equity, such as dividends are not tax deductible.
Therefore, this tax effect encourages debt use by the firm, as more debt increases the after tax
proceeds to the owners (Modigliani & Miller, 1963; Miller, 1977).
Bankruptcy costs are the cost directly incurred when the perceived probability that the firm will
default on financing is greater than zero. The bankruptcy probability increases with debt level
since it increases the fear that the company might not be able to generate profits to pay back the
interest and the loans. The potential costs of bankruptcy may be both direct and indirect.
Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy
process. Haugen and Senbet (1978) argue that bankruptcy costs must be trivial or nonexistent if
one assumes that capital market prices are competitively determined by rational investors.
Examples of indirect bankruptcy costs are the loss in profits incurred by the firm as a result of
the unwillingness of stakeholders to do business with them (Titman, 1984).
The use of debt in capital structure of the firm also leads to agency costs. Agency costs arise as
a result of the relationships between shareholders and managers and those between debt-
holders and shareholders (Jensen & Meckling, 1976). According to Harris and Raviv (1990),
the conflict between shareholders and managers arises because shareholders hold the entire
residual claim and consequently managers do not capture the entire gain from their profit-
enhancing activities but they do bear the entire cost of these activities. Separation of ownership
and control may result in managers exerting insufficient work, indulging in perquisites,
choosing inputs and outputs that suit their own preferences. On the other hand, the conflict
between debt-holders and shareholders is due to moral hazard.
The concept of optimal capital structure is also expressed by Myers (1984) and Myers and
Majluf (1984) based on the notion of asymmetric information. The conclusion drawn from the
asymmetric information theories is that, there is a hierarchy of firms’ preferences with respect
to the financing of their investments (Myers and Majluf, 1984). This “pecking order” theory
suggests that firms will initially rely on internally generated funds, i.e. undistributed earnings,
where there is no existence of information asymmetry, then they will turn to debt if additional
funds are needed and finally they will issue equity to cover any remaining capital requirements.
The order of preferences reflects the relative costs of various financing options. Myers and
Majluf (1984) maintain that, firms would prefer internal sources to costly external finance.
Firms that are profitable or generate high earnings are therefore expected to use less debt
capital than those that do not generate high earnings
The pecking order theory would indicate that the profitability of a firm affects its financing
decisions. If it issues debt, this means that the firm has an investment opportunity that exceeds
its internally generated funds. So, changes in the capital structure often serves as a signal to
outsiders about the current situation of the firm as well as the managerial expectations
concerning future earnings. This is called the signalling theory. The debt offering is believed to
reveal information the management of a firm is expecting about future cash flows if it will
cover the debt costs. However, the bankruptcy fears still impact the signal and intensify the
cost of this signal (Asquith and Mullins, 1986; and Eckbo, 1986).
2.1.3 Profitability
The relationship between firm profitability and capital structure can be explained in terms of
the pecking order theory. According to this theory, firms prefer internal sources of finance to
external sources. The order of the preference is from the one which is least sensitive (and least
risky) to the one which is most sensitive (and most risky) that arise because of asymmetric
information between corporate insiders and less well-informed market participants (Myers
1984). By this token, profitable firms, which have access to retained profits, can rely on it as
opposed to depending on outside sources (debt). Titman and Wessels (1988) and Barton et al
(1989), agree that firms with high profit rates, all things being equal, would maintain relatively
lower debt ratio since they are able to generate such funds from internal sources. Empirical
evidence from previous studies seems to be consistent with the pecking order theory. Most
studies found a negative relationship between profitability and capital structure (Friend and
Lang, 1988; Barton et al, 1989; Shydam-Sunder and Myers, 1999; Jordan et al, 1998; Mishra
and Mc Conanghy, 1999, Al-Sakran, 2001; Hovakimian et al, 2004).
2.1.5 Growth
The relationship between growth and capital structure can also be explained by the pecking
order hypothesis. Growing firms place a greater demand on the internally generated funds of
the firm. According to Marsh (1982), firms with high growth will capture relatively higher debt
ratios. There is also a relationship between the degree of previous growth and future growth.
Michaelas et al (1999) argue that future opportunities will be positively related to leverage, in
particular short term leverage. They argue that agency problem and consequentially the cost of
financing are reduced if the firm issues short term rather than long-term debt. Myers (1977)
however, holds that view that firms with growth opportunities will have smaller proportion of
debt in their capital structure. This is due to the fact that, conflicts between debt and equity
holders are especially serious for assets that give the firm the option to under take such growth
opportunities in the future. Empirical evidence seems inconclusive. Some researchers found
positive relationship between sales growth and leverage. (Kester, 1986; Titman and Wessels,
1988; Barton et al, 1989). Other evidence showed that higher growth firms use less debt, as
such indicated negative relationship between growth and debt ratio (Kim and Sorensen, 1986;
Stulz, 1990; Rajan and Zingales, 1995; Mehran, 1992; Roden and Lewellen, 1995; Al-Sakran,
2001).
2.1.6 Taxation
There have been numerous empirical studies of the impact of taxation on corporate financing
decisions in the major industrial countries. Some are concerned directly with tax policy, for
example: Auerbach (1984), Mackie-Mason (1990), Shum (1996), and Graham (1996, 1999).
MacKie-Mason (1990) studied the tax effect on corporate financing decisions. The study
provided evidence of substantial tax effect on the choice between debt and equity. He
concluded that changes in the marginal tax rate for any firm should affect financing decisions.
When already exhausted (with loss carry forwards) or with a high probability of facing a zero
tax rate, a firm with high tax shield is less likely to finance with debt. The reason is that tax
shields lower the effective marginal tax rate on interest deduction. Graham (2002) concluded
that, in general, taxes do affect corporate financial decisions, but the magnitude of the effect is
mostly “not large”. On the other hand, DeAngelo and Masulis (1980) show that there are other
alternative tax shields such as depreciation, research and development expenses, investment
deductions, etc., that could substitute the fiscal role of debt. Empirically, this substitution effect
is difficult to measure as finding an accurate proxy for tax reduction that excludes the effect of
economic depreciation and expenses is tedious (Titman and Wessels, 1998).
With respect to the variables used in the analysis, the capital structure or debt ratio, which is
the dependent variable, is defined as the ratio of total debt divided by the total capital. Total
debt contains both long-term and short-term debts. The strict notion of capital structure refers
exclusively to long-term leverage. However, firms in Ghana use either very little or no long-
term capital, mainly because of the difficulty in obtaining long-term financing from the
banking sector with attractive terms. As a result, they mostly turn to short-term borrowing to
finance their long-term projects. Thus, debt includes both long-term and short-term debt
financing. The explanatory variables include size, asset tangibility, profitability, risk, growth
and corporate tax. The debt ratio is regressed against the six explanatory variables.
The panel character of the data allows for the use of panel data methodology. Panel data
involves the pooling of observations on a cross-section of units over several time periods and
provides results that are simply not detectable in pure cross-sections or pure time-series studies.
The panel regression equation differs from a regular time-series or cross section regression by
the double subscript attached to each variable. The general form of the panel data model can be
specified more compactly as:
Yit = α i + β X it + ë it (1)
with the subscript i denoting the cross-sectional dimension and t representing the time-series
dimension. The left-hand variable Yit , represents the dependent variable in the model, which is
the firm's debt ratio. X it contains the set of explanatory variables in the estimation model, αi
is taken to be constant overtime t and specific to the individual cross-sectional unit i. If αi is
taken to be same across units, Ordinary Least Squares (OLS) provides a consistent and
efficient estimate of α and β . The model for estimating the determinants of capital structure
based on the variables discussed in section 2.1 is therefore given as follows:
4. EMPIRICAL RESULTS
The coefficient of asset tangibility variable is negative and significant for the panel data
estimations. The results suggest that, for Ghanaian firms, a higher proportion of fixed assets
lead to the use of less debt financing in relative terms.
The regression coefficient for the effect of profitability on leverage is negative and highly
statistically significant. The results, which are also consistent with previous studies show that,
higher profits increase the level of internal financing. Firms that generate internal funds,
generally tend to avoid gearing (debt). While profitable firms may have better access to debt
finance than less profitable ones, the need for debt finance may possibly be lower for highly
profitable firms if the retained earnings are sufficient to fund new investments. The findings
clearly provide support for the pecking order theory that denotes that profitable firms prefer
internal financing to external financing.
The negative impact of risk for the OLS estimation implies that, firms which perform below
average are less leveraged. In other words, companies with high operating risk try to control
total risk by limiting financial risk which is associated with debt financing. Firms with high
degree of business risk have less capacity to sustain financial risks and thus, use less debt. High
risk firms are also said to have low cash flow for debt service.
The results show a positive sign of growth. The sample of listed firms in this study suggests
that growth is associated in a direct manner with financial leverage. If this is generally the case,
then firms with high growth will require more external financing to finance their growth and
should therefore display higher leverage. This view is supported by previous empirical studies
(Kester, 1986; Titman and Wessels, 1988; Barton et al, 1989).
The empirical results in this study also show a negative relationship between corporate tax and
capital structure. In Ghana, the relationship could be attributable to the special tax rebate for
listed firms. Firms that go public tend to enjoy tax reduction compared to unlisted firms.
Companies have an incentive to get listed given the tax incentive they receive. Thus, a general
increase in corporate tax would be associated with increasing equity capital since firms would
be encouraged to go public and enjoy the special tax rebate. This position appears to be
contrary to traditional capital structure theory but may be reasonable in the Ghanaian context.
This paper presents a study of the determinants of capital structure of listed firms in Ghana.
The analyses are performed using data derived from the financial statements listed firms on the
GSE during the most recent six-year period. Ordinary Least Square model is used to estimate
the regression equation. The results indicate that, total debt constitutes about 59% of the total
capital of listed firms in Ghana. The results also show that the capital structure of the firms
studied is positively related to firm size and growth. The analysis suggests that, larger firms
employ more debt capital in comparison with smaller firms. Also, firms with high growth
require more external financing to finance their growth and therefore display higher leverage.
Asset tangibility, risk, corporate tax and profitability also have negative impacts on leverage.
The peculiar negative relationship between asset tangibility and capital structure suggests that
higher proportion of fixed assets leads to the use of less debt financing. The results also
indicate that firms with high degree of business risk have less capacity to sustain financial risk
which is associated with debt financing and thus, use less debt. The negative relationship
between corporate tax and capital structure could be attributed the special tax rebate listed
firms in Ghana enjoy. Companies therefore have an incentive to get listed given the tax
incentive they receive. The negative association between profitability and leverage also
suggests that, firms with high profitability tend to use less debt. This finding is consistent with
the activities following the financing procedure implied by the pecking order theory. High
profitable firms generate high internal cash flows to finance their investment. The results of
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