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Paper for EFMA 2002 Annual Meeting

The Influence of Capital Structure on Company


Value with Different Growth Opportunities

Kaifeng Chen

FAME and University of Lausanne

Abstract
In this paper, we will try to empirically test the influence of the debt structure on the
company value given different growth opportunities with the companies incorporated
in the Netherlands. It is well accepted that the market value of any firm is independent
of its capital structure, given the assumptions of capital markets are perfect. It is
observed that the optimal capital structures are closely related to the growth potential
of the firms and some other variables, such as: the size and the industry
characteristics. Building on the argument that high-growth firms corporate value is
negatively correlated with leverage, whereas for lowgrowth firms corporate value
is positively correlated with leverage, we should observe that the growth opportunities
may influence the optimal capital structure. The reason is that the optimal leverage
may shift with the changes of growth opportunities that lead to the changes of agency
costs of debt and cost of managerial discretion. In this context, we will try to
empirically test 1: The correlation between Tobins Q and leverage will be positive
given the differences in growth opportunities; and 2: The correlation between Tobins
Q and leverage will be negative for high-growth firms and positive for low-growth
firms. We expect that the signalling function of the debt will overweight the influence
of the growth opportunities on the debt structure if hypothesis one is proved.
Otherwise, the influence of the growth opportunities on the shift of the agency cost of
debt and agency cost of managerial discretion will dominate the model. Finally, the
influence of zero-debt capital structure is tested and discussed.

Address: Chemin de Champrilly 26, 1008 Lausanne, Swiss. Tel: +41-21-692-3332. Fax: +41-22-3121026. E-mail: kevin6557@yahoo.com

Index

1.Introduction.................................................................................................................3
2.Data description...........................................................................................................5
3.Empirical tests.............................................................................................................7
3.1 Capital structure and company value....................................................................7
3.2 Robustness ..........................................................................................................13
4. Conclusion and discussion....................................................................................13
5. References .............................................................................................................14

1.Introduction
One of the cornerstones of the modern corporate finance theory is the capital structure
irrelevancy proposition (Modigliani-Miller 1958). Modigliani and Miller (1958)
conclude that the market value of any firm is independent of its capital structure,
given the assumptions of capital markets are perfect, which means arbitrage-free,
competitive and efficient, no tax distortions and no bankruptcy. After tax is
introduced into their model, tax shield and bankruptcies costs add more complications
to the optimal capital structure decision-making process. It is observed that the
optimal capital structure are closely related to the growth potential of the firms
(McConnel & Servaes1995; Jung, Kim, & Stulz 1996) and some other variables, such
as: the size and the industry characteristics (Titman & Wessels1988). In this paper, we
will try to empirically test the influence of the debt structure on the company value
given different growth opportunities with the companies incorporated in the
Netherlands.
Debt policy and equity ownership structure matter and that the way in which they
matter differs between firms with many and firms with few positive net present value
projects (McConnel & Servaes). Leland & Pyle (1977) and Ross (1977) propose that
managers will take debt/equity ratio as a signal, by the fact that high leverage implies
higher bankruptcy risk (and costs) for low quality firms. Since managers always have
information advantage over the outsiders, the debt structure may be considered as a
signal to the market. Rosss model suggests that the values of firms will rise with
leverage, since increasing leverage increases the markets perception of value.
Suppose there is no agency problem, i.e. management acts in the interest of all
shareholders. The manager will maximize company value by choosing the optimal
capital structure: highest possible debt ratio. High-quality firms need to signal their
quality to the market, while the low-quality firms managers will try to imitate.
According to this argument, the debt level should be positively related to the value of
the firm.
Assuming information asymmetry, the pecking order theory (Myers and Majluf,
1984) predicts that firm will follow the pecking order as optimal financing strategy.
The reason behind this theory is that if the manager act on behalf of the owners, they

will issue securities at a higher price than they are truly worth. The more sensitive of
the security, the higher the cost of equity capital, since the action of the manager is
giving a signal to the market that the securities is overpriced.
Stulz (1990) argues that debt can have both a positive and negative effect on the value
of the firm (even in the absence of corporate taxes and bankruptcy costs). He develops
a model in which debt financing can both alleviate the overinvestment problem and
the underinvestment problem. Stulz (1990) assumes that managers have no equity
ownership in the firm and receive utility by managing a larger firm. The power of
manage may motivate the self-interest managers to undertake negative present value
projects. To solve this problem, shareholders force firms to issue debt. But if firms are
forced to pay out funds, they may have to forgo positive present value projects.
Therefore, the optimal debt structure is determined by balancing the optimal agency
cost of debt and the agency cost of managerial discretion.
Building on the argument that high-growth firms corporate value is negatively
correlated with leverage, whereas for lowgrowth firms corporate value is positively
correlated with leverage (McConnell & Servaes, 1995), we should observe that the
growth opportunities may influence the optimal capital structure. The reason is that
the optimal leverage may shift with the changes of growth opportunities that lead to
the changes of agency costs of debt and cost of managerial discretion (Jung, Kim,
Stulz. 1996). Assuming that the managers are self-interest, the growth opportunities of
the firm may be positively related to the level of the goal congruent of the firm and its
manager, therefore negatively related to the cost of managerial discretion (Jung, Kim,
Stulz. 1996). On the other hand, the agency cost of debt is positively related to the
growth opportunities.
According to Stulz (1990), McConnell & Servaes (1995), Jung, Kim, Stulz (1996),
the influences of the debt on the firms value depending on the presence of growth
opportunities. For firms facing low growth opportunities, the debt ratios are positively
related to the firm value. For firms facing high growth opportunities, the debt ratios
are negatively related to the firm value.

In this context, we will try to empirically test the relationship between capital
structure and the company value given the presence of different growth opportunities.
Hypothesis 1: The correlation between Tobins Q and leverage will be positive given
the differences in growth opportunities.
Hypothesis 2: The correlation between Tobins Q and leverage will be negative for
high-growth firms and positive for low-growth firms.
Our first Hypothesis is based on the argument by Ross (1977), and the second
Hypothesis is based on the argument by Stulz (1990), McConnell & Servaes (1995),
Jung, Kim, Stulz (1996). We think that the signalling function of the debt will
overweight the influence of the growth opportunities on the debt structure if
hypothesis one is proved. Otherwise, the influence of the growth opportunities on the
shift of the agency cost of debt and agency cost of managerial discretion will
dominate the model.

2.Data description
We gathered the data from Compustat. We concentrate our study on the data on
March 2001. The first criterion for data selection is that the companys country of
incorporation is the Netherlands. The sample includes 203 firms incorporated in the
Netherlands at the end of March 2001. Then we exclude companies belong to
financial industry. Since the previous literature as well as empirical study proved that
financial service companies have different characteristics from the other companies in
respect to the financial structure. This criterion reduces the sample to 176 firms.
Follow McConnell and Servaes (1995), in order to solve outlier problems, firms were
further deleted if their market to book value (Tobins Q), exceeded 6.0 or were less
than 0.16. From statistical point of view, outliers will strongly affect the samples
statistics characteristics. This further reduced the final sample to 127 firms.
The data included in this research include P/E ratio, Tobins Q, Pre-tax Profit Margin
(the sum of Pre-tax Income divided by Sales/Turnover (Net) plus Operating Revenues

and multiplied by 100), Tax Rate (the sum of Income Taxes divided by the Pre-tax
Income less Appropriations to Untaxed Reserves and multiplied by 100), Total
Capital Expenditures, Total Current Liabilities, Total Long Term Debt, and Total
Assets.
Table 1 reports the descriptive statistics of our sample. The mean price-to-earnings
ratio, P/E, is 21.55, while the median P/E is 8.65. The largest P/E ratio is 449.89,
which comes from KLM-Royal Dutch Airlines. The mean current liabilities to assets
ratio and long-term debt to assets ratio is 42.12 and 11.10 respectively. In the sample
there are 11 firms has no debt at all, while 22 firms long-term debt to total assets
ratio are between zero and one per cent. Totally 25.98% of the firms in our sample
have chosen near zero debt financial structure. By construction, the Tobins Q are
between 0.16 and 6, and the median of Q is 1.73. The median of our samples total
assets is 193.13 million United States Dollar, USD. The largest firm in our sample is
ROYAL DUTCH PETROLEUM NV, whose total assets book value is 36,184.10
million USD.
Table 1
Descriptive Statistics
PE
Mean
21,55
Median
8,65
Maximum 449,89
Minimum -17,27
Std. Dev.
61,29
Skewness 6,06
Kurtosis
41,42
Obser.
112

TQ
2,12
1,73
5,80
0,18
1,36
0,87
2,82
112

PM
TR
3,81
31,04
4,61
32,47
100,25 226,75
-169,39 -14,82
23,84
28,96
-4,31
4,39
35,94
29,13
112
112

CE
7,17
6,50
29,41
0,00
4,98
1,47
6,28
112

TC
42,12
40,03
78,76
5,16
16,45
0,07
2,61
112

TL
TA
11,10 1741,05
7,49
193,13
57,38 36184,10
0,00
4,11
12,12 5236,88
1,20
5,43
4,11
34,67
112
112

Definition of the variables :


PE:
Price to Equity ratio
TQ:
Tobin's Q, Market to book ratio
PM:
Pre-tax Profit Margin
TR:
Tax Rate
CE:
Capital Expenditures to Total Asset
ratio
TC:
Current Debt to Total Asset ratio
TL:
Long-term Debt to Total Asset ratio
TA:
Total Assets

3.Empirical tests
3.1 Capital structure and company value
McConnell and Servaes (1995) conjecture that the correlation between Tobins Q and
leverage will be negative for high-growth firms and positive for low-growth firms.
They employ samples of 1173 firms in 1976, 1093 firms in 1986 and 830 firms in
1988, which are listed on the New York Stock Exchange or American Stock
Exchange, and use P/E ratio to differentiate the sample to high-growth subsample and
low-growth subsample. They find evidence to support their conjecture.
Follow their methodology, we use P/E ratio to differentiate our sample. Firms are
ranked according to their P/E ratio. The one-third of the firms with the highest P/E
ratio is placed into a high-growth sample, and the one-third with the lowest P/E ratio
is placed into a low-growth sample. Thus there is a high-growth sample of 42 firms
and a low-growth sample of 42 firms. Table 2 presents the summary statistics of
subsamples.
Table 2
Summary statistics of subsamples

PE
TQ
PM
TR
CE
TC
TL
TA

Definition
PE:
TQ:
PM:

Mean
Median
Mean
Median
Mean
Median
Mean
Median
Mean
Median
Mean
Median
Mean
Median
Mean
Median

LowGrowth
2,30
5,67
1,51
1,10
-4,78
4,80
29,84
32,07
7,56
7,34
42,89
41,70
12,53
8,61
1758,56
129,35

HighP Value
Growth
of Diff.
53,60
0,00
18,81
0,00
2,67
0,00
2,29
0,00
9,44
0,02
4,33
0,24
35,25
0,54
32,72
0,37
7,10
0,70
6,28
0,18
37,46
0,22
38,06
0,17
11,22
0,33
4,47
0,36
2367,24
0,57
183,50
0,88

of the variables :
Price to Equity ratio
Tobin's Q, Market to book ratio
Pre-tax Profit Margin

TR:
CE:
TC:
TL:
TA:

Tax Rate
Capital Expenditures to Total Asset
ratio
Current Debt to Total Asset ratio
Long-term Debt to Total Asset ratio
Total Assets

We use Eview to test the equality of the mean and median. When we do the test of the
equity of sample median, we use the method of Wilcoxon / Mann-Whitney. By
construction, the differences in the P/E ratios between the high- and low-growth
samples are dramatic. For example, the low-growth samples median P/E ratio is 5.67,
while the high-growth samples median P/E ratio is 18.81. Similarly, the average Q
ratios are dramatically different for the high- and low-growth samples: the median Q
of the former is 1.10 and the median Q of the later is 2.29. Both the short-term and
long-term leverage of the low-growth samples is larger than the high-growth one. But
the p-values of the tests of equity of means and medians of the low-growth samples
and the high-growth samples suggest that neither of them is significantly unequal.
These data cannot prove a significantly negative relation between growth
opportunities and leverage, which is reported by McConnell and Servaes (1995).
To see the relation of Capital structure and company value, we develop regressions.
The dependent variable in the regression is Tobins Q. The independent variables are
total debts to assets ratio, pre-tax profit margin ratio, tax rate, capital expenditures
ratio and total assets. The capital expenditures ratio is included here as proxy to
represent firms investment to future development. Pre-tax profit margin ratio, tax
rate, capital expenditures ratio and total assets are included as control variables.
Morck, Shleifer and Vishny (1988) report that there is non-linear relation between
corporate value and insider equity ownership.
We can test whether the relation between corporate value and the debt differs between
firms with few and those with many growth opportunities. Consider in cross-sectional
regression

analysis,

there

is

heteroskadasticity

exists,

we

use

White

Heteroskedasticity-Consistent method. In the regressions, corporate value and debt


are standardized by the book value of assets. In the low-growth sample, the
coefficient of debt is positive and significant (p-value is 0.00). In the high-growth

sample, the coefficient of debt is positive but insignificant (p-value is 0.17). The result
of the regressions is reported in Table 3.

Table 3
The relation between corporate value and debt of firms
with different growth opportunities
Low-growth
Variable Coefficient
Prob.
n
42
Intercept
0.33
0.54
TB
0.03
0.00
PM
-0.01
0.06
TR
-0.00
0.84
CE
-0.06
0.19
TA
0.000026
0.04
R-squared
Adj. Rsquared
TB:
PM:
TR:
CE:
TA:

High-growth
Coefficient
Prob.
42
1.58
0.14
0.02
0.17
0.04
0.22
-0.01
0.28
0.01
0.69
-0.000037
0.58

0.23
0.10

0.14
0.00

Total Debt to Total Assets ratio


Pre-tax Profit Margin
Tax Rate
Capital Expenditures to Total Asset
ratio
Total Assets

Our regression doesnt include equity ownership data since we cant find them in our
data source. It may affect the robustness of our results. But from McConnell and
Servaes (1995)s regression results, we think that insider equity ownership will not
influence the robustness of our general conclusion. Statistically speaking, it will not
cause a big problem. Note in their high-growth subsamples, the null hypothesis of
coefficients of insider equity ownership and square of insider equity ownership equal
zero cant be rejected in 1976 and 1988 sample. While the 1986 samples p-value is
0.04 and 0.06 respectively. Similarly, without large blockholders and institutional
investors holding will not cause the coefficient of debt ratio become insignificant.
Our preliminary regression results weakly support Ross model since it predict a
positive relation between the debt ratio and firm value in both high growth and low
growth sample. And we cannot draw a conclusion in respect to the validity of

McConnell and Servaes model since it require a negative and significant relation
between the debt ratio in high growth sample. The insignificant positive debt
coefficient in our high growth sample is incapable of proving both of the hypotheses.
As in accounting, current debt item mainly comes from accounts payable, which we
think is dealing with short-term cash short fall. The payment of short-term borrowing
comes from foreseeable sources. Long-term debt has larger influence on the
companys capital structure decision. So we divide the debt to current debt and longterm debt and develop the second regression models. The dependent variable in the
regression is Tobins Q. The independent variables are current debt to assets ratio as
well as long-term debt to asset. Control variables are pre-tax profit margin ratio, tax
rate, capital expenditures ratio, and total assets.
Table 4
The relation between corporate value, short-term and long-term
debt of firms with different growth opportunities
Low-growth
Variable Coefficient
Prob.
n
42
Intercept
0.03
0.97
TC
0.04
0.02
TL
0.02
0.25
PM
-0.01
0.05
TR
0.00
0.72
CE
-0.04
0.31
TA
0.000032
0.00
R-squared
Adjusted
R-squared

0.26
0.11

High-growth
Coefficient
Prob.
42
1.92
0.10
0.01
0.62
0.04
0.11
0.04
0.27
-0.01
0.26
0.02
0.51
-0.000052
0.50
0.17
0.10

Again, the regression results weakly support Ross model (the positive coefficient of
long term debt in the high-growth sample are significant at 10% level), but fail to
support McConnell and Servaes model. Increasing either current debt or long-term
debt will increasing company value, no matter if the companies have positive net
present value investment opportunities or not.
In our sample 25.98% of them has long-term debt to total assets ratio less than one per
cent. Why these firms in our sample chose such an extreme financial structure? Note

10

the largest firm in our sample, Royal Dutch Petroleum NV, also choose zero debt
capital structure. Table 5 reports the descriptive statistics of this subsample. The mean
P/E ratio is 32.81, much higher than the whole sample, whose mean P/E ratio is 21.55.
The mean and median Q is 2.31 and 2.29, also higher than the whole sample, whose
value is 2.12 and 1.73 respectively. As the statistics software we used (Eview 3.0)
cant do equality test of samples with different number of observations, we cant say
whether it is significantly higher. But we think that it might be an interesting topic to
investigate.
Table 5
Descriptive Statistics of Near Zero Debt Firms
PE
Mean
Standard Error
Median
Minimum
Maximum
Sum
Count

TQ

PPM

TR

CE

TC

32.81
2.31
9.60
26.98
6.21
39.28
13.78
0.25
3.48
2.69
0.94
3.46
9.85
2.29
5.23
32.99
4.21
38.43
-6.78
0.40 -30.05
-0.07
0.00
5.16
438.66 5.06 100.25
60.14
29.41
78.76
1082.71 76.21 316.76 890.18 204.87 1296.38
33
33
33
33
33
33

TL

TA

0.11
1184.40
0.04
1089.83
0.00
32.00
0.00
6.92
0.92 36046.73
3.79 39085.19
33
33

In corporate governance theory, debt-discipline is part of corporate discipline


mechanism. Firms choose no debt mean that they dont want this discipline
mechanism. It will have negative impact on the company based on Ross (1977) model
since debt are positively related to the firm value in that model. A negative
consequence of long-term debt issue is the cost of disclosure. By disclosing the
financial information, firms are viable to public supervision and bankruptcy cost.
On the other hand, Stulz (1990) argues that debt can have negative effect on the value
of the firm. Managers of firms with high growth opportunities may have to forgo
positive present value projects, if firms have debt outstanding. So zero debt is good
news for high growth firms.
We add dummy variable of zero-debt to our regression (table 6). The dummy variable
of zero-debt is defined to equal one if the firms long-term debt ratio is less than one

11

per cent, other wise equal zero. The dependent variable in the regression is Tobins Q.
The independent variables are zero-debt dummy, current debt to assets ratio, longterm debt to asset, pre-tax profit margin ratio, tax rate, capital expenditures ratio, and
total assets. Our regression (table 6 regression1) result indicates zero-debt capital
structure has significantly positive impact to company value. The coefficient is 0.91,
with p-value 0.01. One problem of our regression is the dummy is correlated to longterm debt ratio. So we run our regression again without long-term debt ratio variable
in regression 2. The coefficient of zero-long-term-debt dummy becomes insignificant
(p-value 0.33), but still positive.
Table 6
Tests the Effects of Zero Debt
Regression 1

Variab. Coef.
Interc. 0.63
TC
0.02
TL
0.04
TD
0.91
PM
0.00
TR
-0.01
CE
0.00
TA 0.0000
22
Rsqua.
Adj. Rsqua.

Prob.

Regression 2

Coef.

0.18
1.53
0.00
0.02
0.01
0.01
0.31
0.43
0.00
0.17
-0.01
0.87
-0.01
0.23 0.0000
32

Prob.
0.00
0.04
0.33
0.87
0.09
0.79
0.18

Regression 3
Low-Growth
High-Growth
Coef.
-0.17
0.03
0.03
0.75
-0.01
-0.00
-0.03
0.0000
32

Prob.
0.80
0.01
0.04
0.19
0.19
0.57
0.54
0.00

Coef.
0.50
0.02
0.06
0.95
0.05
-0.01
0.03
-0.00
0066

Prob.

Regression 4
Low-Growth
High-Growth
(New)
(New)
Coef. Prob. Coef. Prob.

0.72
-0.11
0.26
0.03
0.03
0.03
0.23
0.67
0.20
-0.01
0.47
-0.00
0.34
-0.01
0.43 0.0000
27

0.82
0.00
0.02
0.13
0.32
0.38
0.60
0.01

0.25
0.03
0.06
0.88
0.05
-0.01
0.01
-0.00
0081

0.13

0.06

0.25

0.23

0.24

0.23

0.07

0.01

0.10

0.08

0.14

0.11

To test whether the relation between corporate value and zero-debt capital structure
differs between firms with few and those with many growth opportunities, we run
regression again with low-growth sample and high-growth sample separately (table 6
regression 3). In both samples, the coefficient is insignificantly positive. But if we
define high-growth sample as the one-half of the sample (new) with higher P/E ratios,
the coefficient becomes significantly positive (regression 4). Regression results are
reported in Table 6.

12

0.80
0.04
0.01
0.07
0.03
0.45
0.62
0.12

3.2 Robustness
To test our results robustness, we choose March 1995 (randomly selected) data from
Compustat to do our regression test again. The data selection criteria stay the same:
company incorporated in the Netherlands, not belong to financial industry, and
Tobins Q between 0.16 and 6.0. The sample includes 72 observations.
In the regressions, corporate value and debt are standardized by the book value of
assets. For the limited number of observations, we divide the sample to one half with
higher P/E ratio and the other half with lower P/E ratio. In the low-growth sample, the
coefficient of debt is positive and significant (p-value is 0.00). In the high-growth
sample, the coefficient of debt is positive and significant too (p-value is 0.00). To
investigate the effect of current liabilities and long-term debt separately, we use
current liabilities ratio and long-term debt ratio in our regressions. The coefficients of
current liabilities of the low-growth sample and the high-growth sample are all
positive and significant, while the coefficients of long-term debt are positive but
insignificant. Since the general conclusion is the same, we did not include the table in
this paper.

4. Conclusion and discussion


Our empirical tests provide weak support for the Ross (1977) model, but failed to
support the McConnell and Servaes (1995) model. We think that the particular
governance structure in the Netherlands may provide us partial explanation for the
insignificant positive coefficient of the debt ratio to firm value. The strong position of
the management board and the close link between the firm and the bank make the
debt an ineffective disciplining mechanism. Given the small number of observations,
it is difficult to generalise the conclusion. On the other hand, we also find evidence
that the company value will be increased if the company chooses no debt capital
structure in the Netherlands.

13

5. References
Jung, K., Kim, Y.C., and Stulz, R.M. 1996 Timing, investment opportunities,
managerial discretion, and the security issue decision, Journal of Financial
Economics
Leland, H. E. and Pyle, D. H. 1977 Informational asymmetries, financial structure,
and financial intermediation, Journal of Finance
McConnell, J. J & Servaes, H. 1995 Equity ownership and the two faces of debt,
Journal of Financial Economics
Modigliani, F. and Miller, M. H. 1958 The cost of capital, corporation finance and
the theory of investment, American Economic Review
Morck, R., Shleifer, A. and Vishny, R.W. 1988 Management ownership and market
valuation: an empirical analysis, Journal of Financial Economics
Myers, S. C. & Majluf, N.S. 1984 Corporate financing and investment decisions
when firms have information that investors do not have, Journal of Financial
Economics
Ross, S. A. 1977 The determination of financial structure: the incentive-signalling
approach, The Bell Journal of Economics
Stulz, R. 1990 Managerial discretion and optimal financing policies, Journal of
Financial Economics
Titman, S. and Wessels, R. 1988 The determinants of capital structure choice,
Journal of Finance

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