Corporate capital structure and taxes in the Korean manufacturing sector

Abstract

The Korean securities market is one of the fastest growing emerging capital markets in the world. It is also remarkable for its reliance on debt financing. The bond market accounts for 91.5 percent of the total fund raising activity, while the stock market accounts for only 8.5 percent. The emphasis on debt financing represents one of the major issues related to corporate financial poIicy in Korea. Factors suclt as persistently high international interest rates, foreign exchange rate fluctuations, inflation, international competition and indications of a slowdown in the world trade have led to increased pressure on the liquidity of many growth-oriented Korean firms, especially in the manufacturing sector. Demand for capital to finance rapid expansion needs has forced the leveraged firms to prefer short-term bank borrowing. The excessive use of short-term leverage and the need for improvements in capital structure of firms in Korea has led both researchers and policy makers to insist on reforms in the existing tax legislation. This study examines capita1 structure trends in Korean manufacturing firms with respect to taxes, inflation and interest rates. One aspect of this study is to extend IvEller’s (241 framework into the Korean tax and financial en~ronment, where there are several types of taxes that have implications on the corporate capital structure decisions. Another aspect of this study is the explicit consideration of the dual interest rates associated with corporate debt structures: one, the reguIated rate applied on special loans from the government agency banks; and the other, market interest rate applied to corporate bonds determined by market forces. The study also provides insight into some of the fundamental aspects of corporate capital structure for United States investors considering investment opportunities in the Korean manufacturing sector.