Market Leverage Ratios Research Articles

The Mystery of Zero-Leverage Firms: Evidence from Nigerian Quoted Firms

Objective – Empirical finance literature has added a new twist to the debt conservatism puzzle within the broader capital structure puzzle, namely the phenomenon of zero leverage. Motivated by Strebulaev and Yang (2013), this study investigates the attributes of zero leverage firms in Nigeria in an attempt to add a developing country perspective to the zero-leverage phenomenon observed in firms. Methodology/Technique – The non-financial corporations quoted on the Nigerian Stock Exchange (NSE) for the period 1999-2014 constitute the population of the study. Firms with market leverage ratios ranging from 0% to 5% met the criteria for inclusion. Panel data regression techniques such as the generalized method of moments (GMM) and two stage least squares (2SLS) were used in the study. Findings – Zero leverage is persistent across 13 industries and is a declining function of the marginal tax rate, firm size, profitability, and liquidity. Firms that follow a zero-leverage (and almost zero-leverage) policy have higher growth opportunities, more tangible assets, pay higher dividends, are older, and have access to debt markets. Non-debt tax shields do not explain zero-leverage behaviour. Originality/Value – This study addresses the gaps related to the questions of why and how firm-specific attributes affect zero leverage behaviour among Nigerian quoted firms. It sheds light on the economic mechanisms driving zero leverage phenomenon within firms with high debt capacity. Type of Paper: Empirical. JEL Classification: G30, G32. Keywords: Capital Structure; Zero Leverage Puzzle; Tax Benefits; Debt Capacity; Financing Decisions. Reference to this paper should be made as follows: Paseda, O; Adedeji, B.S. 2020. The Mystery of Zero-Leverage Firms: Evidence from Nigerian Quoted Firms, Acc. Fin. Review 5 (2): 44 – 71. https://doi.org/10.35609/afr.2020.5.2(2)

Option‐for‐guarantee swaps and flexible investment opportunities

AbstractThis paper develops a dynamic structural model to study the interaction between an entrepreneur's initial financing choice and future investment decisions when the firm is financed by an option‐for‐guarantee swap (OGS) contract. We begin under the assumption that the guarantee cost is determined by the bargaining between the entrepreneur and the guarantor at the initial time, and the entrepreneur can exercise investment at each time to adjust the firm's size. We show that both the market leverage ratio and agency cost of debt overhang exhibit a U‐shaped relation with the entrepreneur's bargaining power. Moreover, our model predicts an inverted U‐shaped relationship between the agency cost of debt overhang and the profitability of investment opportunities. In particular, compared to the traditional fee‐for‐guarantee swaps (FGSs), we also demonstrate that firms with OGS financing have a larger bargaining region between the entrepreneur and the guarantor. This means that OGSs can make it easier for the entrepreneur escape initial financial constraints and thus can provide a novel investment‐based explanation for the use of OGSs.

SME financing with new credit guarantee contracts over the business cycle

Two new credit guarantee contracts, called option-for-guarantee swaps (OGSs) and equity-for-guarantee swaps (EGSs), have become the important financial innovations/instruments over the past decade in China’s credit guarantee market and provide small and medium-sized enterprises (SMEs) with stable finance. In this paper we introduce a competitive credit guarantee market along with these two new financial contracts in a classical contingent claims model to analyze SME financing and investment and the incentives that these instruments create for entrepreneurs over the business cycle. We compare the main effects produced by OGSs and EGSs. The model based on our calibration of parameters predicts that financing through an EGS entails a higher market leverage ratio and a higher production capacity and, thus, a higher ex ante firm value than an otherwise identical firm financed with an OGS. We also show that, overall, EGS financing is effective at reducing the asset substitution incentive, while OGSs reduce the debt overhang problem. These findings offer a possible explanation for why these two new credit guarantee contracts are adopted by entrepreneurs in China’s credit guarantee market, and the optimal choice between OGSs and EGSs depends on priorities (attenuate the asset substitution incentive, reduce the debt overhang problem, or enhance value).

Shadow Union in Local Labor Markets and Capital Structure

This paper identifies an externality of a firm's unionization that affects the capital structure decisions of other, non-unionized firms within a local labor market. We find that victory in a firm leads non-unionized firms to increase their market leverage ratio by 0.9 to 1.3 percentage points. This union effect is more pronounced when the probability of unionization rises in a larger margin and firms face higher rents conditional on being unionized. This is consistent with a heightened threat of unionization in the local labor market following shadow organizing. We confirm that this threat is credible enough to shape corporate financing decisions because unionization leads to an increase in wages in the local labor market. The findings suggest that a shadow labor market institution creates a strategic incentive for non-unionized firms to use less conservative financial policies to combat the threat.

The peer effect of corporate financial decisions around split share structure reform in China

AbstractWe examine the peer effects in financial decisions of Chinese listed companies for the period of 1998–2016 as well as around Split Share Structure Reform (SSSR). Consistent with the information‐based theory of learning, Chinese firms do adjust their capital structure in response to the changes in their peers’ market leverage ratios. The industries that are more competitive, with more young firms, and high leverage volatility tend to exhibit stronger peer effects. Within industries, the firms with lower market share and profits, paying no dividends, and being financially constrained mimic their peers more strongly than their counterparts. The evidence around the SSSR reveals that firms tend to follow their industry peers and leaders more closely in making financial decisions after the reform. Finally, the mimicking behavior in financial decisions enhances firm value in the long run and this finding is more evident after the reform.

Capital Structures in German Small and Mid Caps: Does Trade-Off or Pecking Order Theory Explain Current Reality Better?

This paper analyzes the determinants of the capital structure of German companies. The data are based on the year-end values of 44 companies included in the SDAX for the 2017 financial year. The data are examined in a multiple regression analysis according to the ordinary least squares (OLS) method. The result basically shows a strong correlation for the market leverage ratio with the factors of company size and growth opportunities. Profitability plays only a subordinate role. No significant correlation with the capital structure of German companies in the SDAX has been found for the tangibility factor of the assets. Basically, the results of this work support trade-off theory more than pecking order theory and thus point to the existence of an optimal debt ratio.

Stock return volatility and capital structure measures of nonfinancial firms in a dynamic panel model: Evidence from Pakistan

AbstractWe investigate the impact of stock return volatility on different capital structure measures of nonfinancial firms in a dynamic panel model. Two‐step system generalized method of moment dynamic panel estimator is applied to nonfinancial sector's data from Pakistan Stock Exchange over the period 2001–2014. The results imply that stock return volatility has a significant negative impact on book leverage and long‐term market leverage ratios. However, stock return volatility causes the increase in total market leverage ratios. Moreover, book leverage and long‐term market leverage of firms decrease as a result of an increase in stock return volatility in different classification of firms. Conversely, stock return volatility has a significant positive impact on total market leverage ratios in those classifications of firms. Capital structure decisions are more sensitive to stock return volatility as default risk increases. Firms significantly go for the reduction in their debt financing due to high stock returns volatility and to avoid from possible consequences of default. The results are robust to alternative measures such as cash flow volatility and earnings volatility.

The Functionality of Book-to-Market Ratio in Chinese Markets

We investigate the question whether the book to market ratio acts as a “risk-based” or “mispricing-based” proxy for share price formation in Chinese markets. We find that a strong relationship is observed between the firms’ book to market ratio and stock returns both in current and following years, while we cannot find a steady relationship between market leverage ratio and stock returns. In addition, the findings support the notion that a mispricing-based explanation is more plausible in China due to the speculative features of the Chinese markets.

The impact of cash flow volatility on firm leverage and debt maturity structure: evidence from China

PurposeThe purpose of this paper is to investigate the influence of cash flow volatility on firm’s leverage levels. It also analyzes how cash flow volatility influences the debt maturity structure for the Chinese listed firms.Design/methodology/approachThe authors construct the measure for cash flow variability as five-year rolling standard deviation of the cash flow from operations. The authors use generalized linear model approach to determine the effect of volatility on leverage. In addition, the authors design a categorical debt maturity variable and assign categories depending upon firm’s usage of debt at various maturity levels. The authors apply Ordered Probit regression to analyze how volatility affects firm’s debt maturity structure. The authors lag volatility and other independent variables in the estimation models so as to eliminate any possible endogeneity problems. Finally, the authors execute various techniques for verifying the robustness of the main findings.FindingsThe authors provide evidence that higher volatility of cash flows results in lower leverage levels, while the sub-sampling analysis reveals that there is no such inverse association in the case of Chinese state-owned enterprises. The authors also provide novel findings that irrespective of the ownership structure, firms facing high volatility choose debt of relatively shorter maturities and vice versa. Overall, a rise of one standard deviation in volatility causes 8.89 percent reduction in long-term market leverage ratio and 26.62 percent reduction in the likelihood of issuing debentures or long-term notes.Research limitations/implicationsThis study advocates that cash flow volatility is an essential factor for determining both the debt levels and firm’s term-to-maturity structure. The findings of this study can be helpful for the financial managers in maintaining optimal leverage and debt maturity structure, for lenders in reducing their risk of non-performing loans and for investors in their decision-making process.Originality/valueExisting empirical literature regarding the influence of variability of cash flows on leverage and debt maturity structure is inconclusive. Moreover, prior research studies mainly focus only on the developed countries. No previous comprehensive study exists so far for Chinese firms in this regard. This paper endeavors to fulfill this research gap by furnishing novel findings in the context of atypical and distinctive institutional setup of Chinese firms.

Credit expansion, state ownership and capital structure of Chinese real estate companies

Purpose– The purpose of this paper is to explore the impact of the credit expansion in 2009 and 2010 in China on the capital structure of listed real estate companies.Design/methodology/approach– Chinese listed real estate companies are divided into two groups, state-owned and non-state-owned, because their access to credit markets have different priority to state-owned banks that dominate bank lending. The difference-in-differences approach is employed to test the impact of changes in leverage ratios and loan ratios before and after the credit expansion period in state-owned firms and non-state-owned firms.Findings– Using quarterly panel regressions, the authors find that during the credit expansion period, state-owned companies exhibit a relatively greater increase in leverage ratios than non-state-owned firms. State-owned firms have greater increases in book leverage ratios, market leverage ratios and long-term debt ratios by 5.2, 4.9 and 1.1 per cent, respectively. It is also shown that loan ratios have increased more in state-owned firms than non-state-owned firms during the credit expansion period.Research limitations/implications– The paper explores only the impacts of credit expansion on capital structure of listed real estate firms in China. Further studies can be conducted to investigate the impact of credit supply on corporate investment decisions of real estate firms and on real estate markets.Practical implications– The findings can help explain the surge in land and housing prices after 2008 in China. Denget al.(2015) find that state-owned real estate firms paid more for land price than non-state-owned firms, which contributed to upward pressure on housing prices. This paper shows that such “over-investment” may be due to the increase of debt financing and availability of bank loans to real estate firms. Thus the credit market can affect real estate markets through debt financing at company level.Originality/value– This paper is the first to investigate the impact of credit supply on capital structure of real estate companies, and presents evidence of the importance of credit supply as a determinant of capital structure.

Value of Tax Shields (VTS): 3 Theories with 'Some' Sense

The value of tax shields (VTS) defines the increase in the company’s value as a result of the tax saving obtained by the payment of interest. However, there is no consensus in the existing literature regarding the correct way to compute the VTS. Most authors think of calculating the VTS in terms of the appropriate present value of the tax savings due to interest payments on debt, but Modigliani and Miller (MM) propose discounting the tax savings at the risk-free rate (RF), and Miles and Ezzell (ME) and many others propose discounting these tax savings the first year at the cost of debt and the following years at Ku. We develop valuation formulae for companies that maintain a fixed book-value leverage ratio and argue that, for most companies, and especially when calculating residual values, this assumption is more realistic than those of MM and ME. We obtain an intermediate value between those of MM and ME. If a company targets its leverage in market-value terms, it has less value than if it targets the leverage in book-value terms. How could a manager target leverage in market-value terms? However, many authors identify constant leverage with a constant market leverage ratio.

A regret theory of capital structure

This paper examines the optimal capital structure of a firm that delegates its financing decision of a risky project to a manager who is both risk averse and regret averse. Regret aversion is characterized by a utility function that includes disutility from having chosen ex-post suboptimal alternatives. We show that the manager optimally opts for zero leverage if risk aversion is relatively more important than regret aversion in representing the manager’s preferences. Otherwise, the optimal capital structure is interior such that the optimal amount of debt increases when regret aversion becomes increasingly more important than risk aversion in representing the manager’s preferences. We further show that the firm’s market leverage ratio is inversely related to the project’s profitability and to the firm’s market-to-book ratio. These comparative static results are consistent with the robust evidence documented in the literature on empirical capital structure.

Lessons from the European Financial Crisis

This paper distils three lessons for bank regulation from the experience of the 2009-12 euro-area financial crisis. First, it highlights the key role that sovereign debt exposures of banks have played in the feedback loop between bank and fiscal distress, and inquires how the regulation of banks' sovereign exposures in the euro area should be changed to mitigate this feedback loop in the future. Second, it explores the relationship between the forbearance of non-performing loans by European banks and the tendency of EU regulators to rescue rather than resolving distressed banks, and asks to what extent the new regulatory framework of the euro-area banking union can be expected to mitigate excessive forbearance and facilitate resolution of insolvent banks. Finally, the paper highlights that capital requirements based on the ratio of Tier-1 capital to banks' risk-weighted assets were massively gamed by large banks, which engaged in various forms of regulatory arbitrage to minimize their capital charges while expanding leverage. This argues in favor of relying on a set of simpler and more robust indicators to determine banks' capital shortfall, such as book and market leverage ratios.

The impact of culture on market timing in capital structure choices

This study uses Hofstede's (2001) cultural dimensions to investigate the impact of market reception on capital structure. We examine the interaction of these dimensions with stock returns, our proxy for market timing. Based on our market leverage results, we find evidence that firms do engage in market timing by reducing their leverage ratios when their share prices increase. Furthermore, we find that firms in countries with high uncertainty avoidance and high power distance have lower market leverage ratios and that these cultural dimensions serve to reduce the impact of market timing. These results are consistent for developed markets but mixed for emerging markets. On a book leverage basis, the results are generally consistent but less conclusive. To the extent that culture impacts manager perception of risk and investor reception of newly issued shares, we conclude that cultural dimensions impact the degree to which a firm can modify its capital structure to take advantage of perceived market mispricings.

The impact of culture on market timing in capital structure choices

This study uses Hofstede's (2001) cultural dimensions to investigate the impact of market reception on capital structure. We examine the interaction of these dimensions with stock returns, our proxy for market timing. Based on our market leverage results, we find evidence that firms do engage in market timing by reducing their leverage ratios when their share prices increase. Furthermore, we find that firms in countries with high uncertainty avoidance and high power distance have lower market leverage ratios and that these cultural dimensions serve to reduce the impact of market timing. These results are consistent for developed markets but mixed for emerging markets. On a book leverage basis, the results are generally consistent but less conclusive. To the extent that culture impacts manager perception of risk and investor reception of newly issued shares, we conclude that cultural dimensions impact the degree to which a firm can modify its capital structure to take advantage of perceived market mispricings.

How do leverage ratios affect bank share performance during financial crises: The Japanese experience of the late 1990s

This study investigates the relationship between leverage ratios and bank share performance for a sample of Japanese banks during the period of financial crisis in the late 1990s. We differentiate between two types of leverage ratios: book leverage and market leverage. We show that market leverage instead of book leverage observed before the crisis has statistically and economically significant predictive power for the cross-sectional variation in bank performance during the crisis, even after controlling for a variety of other indicators reflecting bank’s characteristics and financial conditions. We also find that banks with lower market leverage ratios were affected more adversely by the failure announcements of large financial institutions during the crisis. The results are robust across alternative model specifications, statistical methodologies, lengths of sample intervals, and measures of bank share performance during the crisis. Our results therefore have important implications for regulators in identifying distressed banks that are vulnerable to the deterioration in conditions of the financial system.

Dividend Changes and Leverage

We document a strong and previously unreported link between changes in dividend policy and subsequent changes in leverage ratios. Large dividend increases and dividend initiations predict significant increases in both book and market leverage ratios over the subsequent five years. However, large dividend decreases do not predict reductions in leverage. The result is robust to many controls, including trade-off variables, reversion of leverage to target, profitability, risk, financing deficits, and firm maturity. The effect is stronger for large firms than for small and medium firms. The results have important implications for tests of pecking order and trade-off theories of leverage, and for dynamic theories of capital structure.

How Do Leverage Ratios Affect Bank Share Performance During Financial Crises: The Japanese Experience of the Late 1990s

This study investigates the relationship between leverage ratios and bank share performance for a sample of Japanese banks during the period of financial crisis in the late 1990s. We differentiate between two types of leverage ratios: book leverage and market leverage. We show that market leverage instead of book leverage observed before the crisis has statistically and economically significant predictive power for the cross-sectional variation in bank performance during the crisis, even after controlling for a variety of other indicators reflecting bank’s characteristics and financial conditions. We also find that banks with lower market leverage ratios were affected more adversely by the failure announcements of large financial institutions during the crisis. The results are robust across alternative model specifications, statistical methodologies, lengths of sample intervals, and measures of bank share performance during the crisis. Our results therefore have important implications for regulators in identifying distressed banks that are vulnerable to the deterioration in conditions of the financial system.

The Impact of Taxes on Firm Value and the Trade-Off Theory of Capital Structure

We offer a new perspective on the well-known trade-off theory of capital structure. As the corporate tax rate rises, the market value of a firm declines. On the one hand, the firm may want to raise more debt as the tax shields increase; on the other hand, the firm is financially constrained as the result of its declining market value. Consequently, corporate leverage may first increase and then decrease as the corporate tax rate rises. We offer robust empirical support for the non-linear relationship between the corporate tax rate and market leverage ratio.

Intellectual Capital and Financing Decisions: Evidence from the U.S. Patent Data

This paper develops a real options model of capital structure to understand two distinct roles played by intellectual capital in corporate financing decisions. First, intellectual capital limits a firm's debt capacity because of its low liquidation value. Second, intellectual capital enhances a firm's debt capacity through its positive impact on the earnings dynamics. We show that the former is dominated by the latter within our model so that intellectual capital positively affects leverage as measured by market leverage, book leverage, and interest coverage ratios. Using three patent-based variables as proxies for intellectual capital, we find robust evidence that a positive relationship between a firm's intellectual capital and its leverage ratio prevails. The effect of intellectual capital on leverage is also economically significant. Specifically, a one-standard-deviation-increase in the level of a firm's intellectual capital increase its market leverage ratio by 11.7-27.3% from the sample mean level (22.2%). We further find that the positive relationship between intellectual capital and leverage is much stronger for high-tech firms than for non-high tech firms. Finally, we document evidence that an increase in intellectual capital leads to an increase in firm leverage over time.