Abstract
Firms in South Africa and other developing countries are facing a rapid increase in capital cost accompanied by an increase in leverage as a result of operating in uncertain environments, which complicate firms’ financing decisions and strategies. This paper examined the impact of rising leverage levels on firm’s cost of capital and the effect of country risk shocks on cost of capital and financing decisions among JSE listed firms. A dynamic panel model estimated with twostep system generalised methods of moments (GMM) was used to analyse panel data from 198 listed non-financial firms. The results suggest that the rising debt levels of JSE listed firms are negatively associated with weighted average cost of capital and cost of debt. Cost of equity was found to be an increasing function of firm leverage. High financial risk was found to be associated with an increase in cost of capital, high political risk associated with an increase in cost of equity and weighted average cost of capital (WACC), while an increase in economic risk is associated with high WACC and cost of debt. The study establishes that disaggregated country risk shocks significantly affect firms financing decisions. Keywords: Cost of capital, Leverage, Country risk components, GMM
Highlights
The proponents of the capital structure theory, Modigliani and Miller (1958), assuming a perfect market in a world without taxes, initially argued that the capital structure of a firm is irrelevant in determining the cost of capital of a firm
Developments in capital structure theories reveal that debt financing is cheaper and the tax shield advantage lowers the average cost of capital of a firm and increases firm value (Yuan & Motohashi, 2014)
The ratio of debt to total assets is at 16 percent, indicating that South African firms use leverage conservatively compared to developed economies standards with debt ratios in excess of 40 percent
Summary
The proponents of the capital structure theory, Modigliani and Miller (1958), assuming a perfect market in a world without taxes, initially argued that the capital structure of a firm is irrelevant in determining the cost of capital of a firm. Developments in capital structure theories reveal that debt financing is cheaper and the tax shield advantage lowers the average cost of capital of a firm and increases firm value (Yuan & Motohashi, 2014). One could ask whether the development indicates a different phenomenon, which can be explained by the peculiar characteristics of developing economies such as higher risk, sluggish economic growth, poor credit ratings and low financial development This may be the case for South Africa, which suffers from high levels of corruption, civil unrests (demonstrations and strikes) and high crime (Asiedu, 2006). The present paper, examines the effect of political, economic and financial components of country risk shocks on the JSE firms’ financing decisions
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