A Bayesian Approach for Testing the Debt Signaling Hypothesis in a Transitional Market: Perspectives from Egypt

Abstract

This paper examines the effects of determinants of capital structure on firm's equity market value. The underlying assumption is that when a firm changes its capital structure, it actually changes the relative position and the market values of its securities' holders. This is the signaling hypothesis of capital structure changes. The financial signaling hypothesis is examined in two adaptive stages. The first stage is concerned with determining the relevant determinants of capital structure. The second stage is concerned with examining the signaling effect of the relevant determinants of capital structure. As for the determinants of capital structure, the paper examines a comprehensive number of factors that have been examined in the literature of the three theories of capital structure; trade-off theory, pecking order theory and free cash flow theory. The methodology addresses modeling the determinants capital structure and their signaling effect employing the Bayesian approach.The final results, which are a good match to research results of other developing countries, show that two determinants of capital structure are the most relevant and significant determinant of financial signaling. The two determinants are firm's size and profitability. The contribution of this paper is that the results provide support to other research in capital structure in developing countries although this paper follows different analytical tool that works under different assumptions. This provides validity to research on capital structure in developing countries.