Leverage Decisions Research Articles

Determinants of Capital Structure – A study of selected Pharma Companies

Capital structure is fundamentally permanent long term financing of a firm. The objectives of this study are to identify the significant determinants of capital structure of the listed Pharmaceutical companies in NSE/BSE during the period 1999–2013. In relation to the study determinants are considered are profitability, tangibility, growth, size, debt service capacity, tax rate, non debt tax shields, financial leverage cost of debt and cost of equity. The study uses correlations and multiple regression analysis, to find the relationship between Debt-equity ratio (i.e., Dependent variable) and determinants of capital structure (independent variables), The policy implication is that the financial managers should consider these determinants as yardsticks before taking the leverage decisions in order to choose the most favorable capital structure for the company so that it maximizes the shareholders’ value.

Market timing behaviour, bankruptcy costs and capital structure decisions in MENA: the case of Egypt

This paper investigates the determinants of capital structure and in particular the influence of market timing behaviour and bankruptcy costs on leverage decisions in Egypt. Using a panel data model and a range of econometric techniques, it is shown that the effects of market timing on the capital structure of Egyptian listed firms are not consistent over the time. The findings also suggest that bankruptcy cost has a negative impact on leverage ratios and capital structure decisions in the Egyptian companies. In addition, through an analysis of the target capital structure, the paper shows that the Egyptian companies considered here are moving fairly quickly towards their target level of leverage.

Dynamic Investment, Capital Structure, and Debt Overhang

We develop a dynamic contingent-claim framework to model S. Myers’s idea that a firm is a collection of growth options and assets in place. The firm’s composition between assets in place and growth options evolves endogenously with its investment opportunity set and its financing of growth options, as well as its dynamic leverage and default decisions. The firm trades off tax benefits with the potential financial distress and endogenous debt-overhang costs over its life cycle. Unlike the standard capital structure models of Leland, our model shows that financing and anticipated endogenous default decisions have significant implications of firms’ growth-option exercising decisions and leverage policies. The firm’s ability to use risky debt to borrow against its assets in place and growth options substantially influences its investment strategies and its value. Quantitatively, we find that the firm consistently chooses conservative leverage in line with empirical evidence in order to mitigate the debt-overhang effect on the exercising decisions for future growth options. Finally, we find that debt seniority and debt priority structures have both conceptually important and quantitatively significant implications on growth-option exercising and leverage decisions as different debt structures have very different debt-overhang implications.

Dynamic Investment, Capital Structure, and Debt Overhang

We model dynamic investment, financing and default decisions of a firm, which begins its life with a collection of growth options. The firm exercises them optimally over time, and finances the costs of investment by trading off tax benefits of debt with both distress costs and agency costs of debt. Conflicts of interests between equityholders and various classes of debtholders are managed through optimal choice of investment triggers, capital structure, and default triggers. We show that (i) existing debt may significantly distort investment decisions (debt overhang and risk shifting); (ii) anticipating distortions induced by debt, firms with more growth options on average have lower leverages, consistent with empirical evidence; (iii) the seniority structure of debt has significant effects on the firm's default, leverage, and investment decisions, when existing debt is exogenously given; (iv) when future growth options are anticipated, the firm optimally chooses its initial investment and leverage decisions, which substantially mitigate the anticipated endogenous debt overhang, and make debt seniority structure much less relevant.

Firm leverage decisions: Does industry matter?

We use a standard capital structure mode l to investigate the firm leverage decisions of 1620 companies listed in the Australian Securities Exchange (ASX) across a span of 13 years (2000–2012), dividing the sample into mining and other industries (non-mining). We also test for significant differences in leverage decisions between these two groups by applying a dummy variable approach. Our findings show that fundamental differences exist between mining and non-mining companies when making leverage decisions. We find evidence that mining firms are more sensitive to profitability and asset tangibility where neither profitability nor asset tangibility has significant association for non-mining firms. Overall results suggest that industry-type does matter for firms making leverage decisions.

The effects of the split share structure reform on Chinese listed firms’ leverage decisions

Abstract This paper examines the effects of China's split share structure reform on the leverage decisions of listed firms. The results show that there are two effects, multiple large shareholders and liquidity that affect the leverage ratio. In non-state controlled firms, multiple large shareholders are able to monitor the controlling shareholders which reduce the leverage ratio. However, in state-controlled firms, they collude with the controlling shareholders to expropriate through debt financing. State ownership plays a decisive role in driving multiple large shareholders to collude with the controlling shareholders.

Correlated leverage and its ramifications

Abstract This paper develops a theory in which housing prices, the capital structures of banks (mortgage lenders) and the capital structures of mortgage borrowers are all endogenously determined in equilibrium. There are four main results. First, leverage is a “positively correlated” phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks, and higher house prices lead to higher leverage for both. The intuition is that first-time homebuyers with fixed wealth endowments must borrow more to buy more expensive homes, whereas higher current house prices rationally imply higher expected future house prices and therefore higher collateral values on bank loans, inducing banks to be more highly levered. Second, higher bank leverage leads to greater house price volatility in response to shocks to fundamental house values. Third, a bank’s exposure to credit risk depends not only on its own leverage but also on the leverage decisions of other banks. Fourth, positive fundamental shocks to house prices dilute financial intermediation by reducing banks’ pre-lending screening, and this reduction in bank screening further increases house prices. Empirical and policy implications of the analysis are drawn out, and empirical evidence is provided for the first two main results. The key policy implications are that greater geographic diversification by banks, tying mortgage tax exemptions to the duration of home ownership, and increasing bank capital requirements when borrower leverage is high can help reduce house price volatility.

Controlling Shareholder, Expropriations and Firm's Leverage Decision: Evidence from Chinese Non-Tradable Share Reform

In this paper we examine the effect of excess control rights on the leverage decisions of Chinese non-SOEs before and after the reforms of non-tradable shares. We identify that both inter-corporate loans and related party transactions are channels through which controlling shareholders expropriate minority shareholders by adopting a policy of excess leverage. We found that firms with more excess control rights also have more excess leverage and the controlling shareholders of these firms used the resources they obtained to facilitate tunneling activities rather than invest in positive NPV projects. We also found that the excess leverage in firms with excess control rights decreased after the non-tradable shares were reformed. We further found a positive market reaction to firms’ announcement of related party transactions and better performance in firms with more excess control rights after the reform, confirming a reduction in the controlling shareholder’s tunneling behavior. We argue that in emerging markets when legal protection for both creditors and shareholders is weak, controlling shareholders borrow excess debt to tunnel.

Practical Applications of The Role of Financial Leverage in the Performance of Private Equity Real Estate Funds

Leverage is the scourge of private equity real estate funds, according to the results of this detailed research on the three main investment styles: Core, value-added and opportunistic. Investors beware: Base your manager selection decisions on underlying sector and market knowledge, rather than implied skill at using and timing leverage, the authors caution. Leverage may add positive returns in the short term, but managers are not good at predicting a downturn or of reducing leverage in anticipation of a downturn, they explain. “A lot of private equity real estate managers claim to have done things well-to correctly time the market (in leverage decisions)—but, in fact, they did not,” says co-author Andrew Baum, Honorary Professor of Real Estate Investment at the University of Cambridge . The article was co-written by Jamie Alcock , Associate Professor at the University of Queensland in Australia and Lecturer at the University of Cambridge , Nicholas Colley, Senior Analyst at Property Funds Research , and Eva Steiner , PhD candidate at the University of Cambridge .

Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion

We propose a unified model of limited market integration, asset-price determination, leveraging, and contagion. Investors and firms are located on a circle, and access to markets involves participation costs that increase with distance. Due to a complementarity between participation and leverage decisions, the market equilibrium may exhibit diverse leverage and participation choices across investors, even though investors are ex-ante identical. Small changes in market-access costs can cause a change in the type of equilibrium and lead to discontinuous price changes, de-leveraging, and portfolio flow reversals. Moreover, the market is subject to contagion, in that an adverse shock to investors in a subset of locations affects prices everywhere.

Correlated Leverage and its Ramifications

This paper develops a theory in which housing prices, the capital structures of banks that make mortgage loans and the capital structures of borrowers who take these loans are all endogenously determined in equilibrium. There are four main results. First, leverage is a phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks. Both borrower and bank leverage are higher when house prices are higher. First-time homebuyers with fixed wealth endowments must borrow more to buy more expensive homes, whereas higher current house prices rationally imply higher expected future house prices and therefore higher collateral values, inducing banks to be more highly levered. Second, higher bank leverage leads to greater volatility of house prices in response to shocks to fundamental house values. Third, a bank's exposure to credit risk depends not only on its own leverage but also on the leverage decisions of other banks. Fourth, positive fundamental shocks to house prices dilute financial intermediation by reducing banks' pre-lending screening, and this reduction in bank screening further increases house prices. Empirical and policy implications of the analysis are drawn out, and empirical evidence is provided for the first two predictions. The key policy implications are that greater geographic diversification by banks, tying mortgage tax exemptions to the duration of home ownership, and increasing bank capital requirements when borrower leverage is high can help reduce house price volatility.

Presales, Leverage Decisions, and Risk Shifting

We set up a game-theoretic model for a market where the presale method (to sell a property before its completion) can be used together with construction loans and mortgages as a developer's financing tool for project developments. This model captures the interactions and dynamics among four players (developer, buyer, mortgage lender, and construction loan lender) involved in the presale market. We find that the use of the presale method together with an increase in leverage (by using construction loan or mortgage) have risk-shifting effects to other players in the market. In our model setup, the developer is the one who benefits if the mortgage lender and construction loan lender do not adjust their interest rates based on the developer's presale strategy.

The Role of Financial Leverage in the Performance of Private Equity Real Estate Funds

The authors study a unique data set in order to examine the performance of a sample of 169 global private equity real estate investment funds across the core, value-add and opportunistic investment style categories over the most recent property cycle (2001–2011). We employ a multifactor asset pricing model to measure the impact on the funds’ total excess returns of the underlying real estate market, managerial skill measured by Jensen’s alpha, leverage and, for the first time, managerial skill as it relates to timing leverage decisions to anticipated future market trends. find evidence consistent with the hypotheses that i) fund performance is almost directly proportional to the return on the underlying real estate market, ii) there is evidence for systematic underperformance as measured by Jensen’s alpha, possibly related to market frictions, iii) leverage cannot be viewed as a long-term strategy to enhance performance, and iv) timing leverage choices to the expected future market environment does not appear to add significantly to fund excess returns. <b>TOPICS:</b>Private equity, real estate, global, manager selection

Role of personal taxes in capital structure decisions: Evidence from India

The study investigates the role of personal taxes in corporate financing decisions and its impact on the corporate tax advantage of debt in domestic manufacturing companies in India. Incremental financing decisions have been analyzed through pooled cross section of time series data on 288 firms from 1989-2011. The effect of personal taxes is captured through two different methods; in one specification marginal tax rates have been adjusted for personal tax penalty and in the other, effect of personal taxes has been captured separately. Results reveal a strong effect of relative personal tax disadvantage of debt on leverage decisions of Indian firms. After including personal taxes, marginal taxes become insignificant. The study also documents that the specification considering the individual effects of corporate and personal taxes is found to be better than the one which adjusts corporate taxes for personal tax penalty.

The Role of Financial Leverage in the Performance of Private Equity Real Estate Funds

We study a unique data set in order to examine the performance of a sample of 169 global private equity real estate investment funds across the core, value-add and opportunistic investment style categories over the most recent property cycle (2001-2011). We employ a multi-factor asset pricing model to measure the impact on the funds’ total excess returns of the underlying real estate market, managerial skill measured by Jensen’s alpha, leverage and, for the first time, managerial skill as it relates to timing leverage decisions to anticipated future market trends. We find evidence consistent with the hypotheses that i) fund performance is almost directly proportional to the return on the underlying real estate market, ii) there is evidence for systematic underperformance as measured by Jensen’s alpha, possibly related to market frictions, iii) leverage cannot be viewed as a long-term strategy to enhance performance, and iv) timing leverage choices to the expected future market environment does not appear to add significantly to fund excess returns.

National cultural effects on leverage decisions: Evidence from emerging-market ADRs

We examine leverage decisions in the context of national culture over the 1996–2010 period. Cultural characteristics can explain capital structure decisions from emerging-markets cross-listings. The results show that firms from countries with high Individualism and Indulgence employ more debt. Firms located in countries with high Power Distance, Masculinity, Uncertainty Avoidance, and Long-term Orientation are less leveraged. Additionally, Exchange-traded and capital-raising ADRs are more likely to be from countries with weaker corporate governance. Univariate tests show that capital-raising ADRs employ less debt relative to non-capital-raising ADRs, and notably, in the post-cross-listing period. Interestingly, the home country's cultural characteristics of capital-raising and exchange-traded ADRs exert less influence on their capital structure decisions. Our findings suggest that there is a value discount associated with increased firm leverage. Our insights have practical implications for portfolio managers attempting to enter emerging markets through the use of ADRs. Moreover, investors can evaluate the often neglected effect of cultural values into firm performance.

National Cultural Effects on Leverage Decisions: Evidence from Emerging Market ARDs

We examine the leverage decisions in the context of national culture over the 1996-2010 period. Cultural characteristics can explain capital structure decisions from emerging-markets cross-listings. The results show that firms from countries with high Individualism and Indulgence employ more debt. Firms located in countries with high Power Distance, Masculinity, Uncertainty Avoidance, and long-term Orientation are less leveraged. Moreover, Exchange-traded and capital-raising ADRs are more likely to be from countries with weaker corporate governance. Univariate tests show that capital-raising ADRs employ less debt relative to non-capital-raising ADRs, and notably, in the post-cross-listing period. Interestingly, the home country’s cultural characteristics of capital-raising and exchange-traded ADRs exert less influence on their capital structure decisions. Our findings suggest that there is a value discount associated with increased firm leverage. Our insights have practical implications for portfolio managers attempting to enter the emerging markets through the use of ADR. Additionally, investors can evaluate the often neglected effect of cultural values into firm performance.

Effect of Financial Leverage and Earnings on Dividend Policy

The interrelationship among financial leverage, earnings and dividend decision has long been a subject of interest to various researchers, professionals and investors. The key objective of this study is to examine the effect of financial leverage, earnings on dividend policy. In this study, it is found that previous year dividend amount plays a significant role in current year dividend decision.

Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion

We propose a unified model of limited market integration, asset-price determination, leveraging, and contagion. Investors and firms are located on a circle, and access to markets involves participation costs that increase with distance. Due to a complementarity between participation and leverage decisions, the equilibrium may exhibit diverse leverage and participation choices across investors, although investors are ex ante identical. Small changes in market-access costs can cause a change in the type of equilibrium, leading to discontinuous price changes, deleveraging, and portfolio-flow reversals. Moreover, the market is subject to contagion—an adverse shock to investors in some locations affects prices everywhere. (JEL D83, G11, G12, G32, G35)

Leverage Decisions: A Case of Textile &amp; Readymade Garments Industry of the Indian Corporate Sector

This empirical paper attempts to study the leverage decisions of Textile & readymade garments industry of the Indian corporate sector. The study is limited to top 19 firms from Textile & readymade garments out of top 500 manufacturing firms selected on the basis of the turnover for the year 2004-2005 which covers the time span of eleven years commencing from 1995-96 to 2005-06. The study reveals that around half of the companies (47.29 percent) in this industry are in 0-100 percent capital structure range which means that these companies are using lesser amount of debt capital as compared to their own capital in their capital structure which is below the well-established standard range of 2:1 during the study period. It is found that one-third companies (33.50 percent) in this industry are in 100-200 percent capital structure range which means that these companies are using more amount of debt in their capital structure than their own capital but less than the well-established standard range of 200 percent (2:1) during the study period. Number of companies in this range is considerably more. It has been observed that around one-fifth companies (19.21 percent) in this industry are lying in more than 200 percent capital structure ranges during the study period. Such companies are using debt beyond the well-established standard range of 200 percent (2:1) during the study period. Number of companies in this range is considerably more. It is also observed that 5.42 percent companies in this industry are in 190 to 210 percent (1.90:1 to 2.10:1) capital structure ranges which are nearing to the well-established standard range of 200 percent (2:1) during the period under study. Thus, the study reveals that in this industry, around half of the companies are following low degree leverage, one-third of the companies are following moderate degree leverage and rest of the companies are following high degree leverage in their capital structure during the study period. Overall, Textile & readymade garments industry is following moderate approach of leverage in their capital structure during the study period.