Capital structure and firm performance –

A study of Swedish public companies

Bachelor’s thesis, Business Administration

Accounting
Spring 2014
Supervisor: Johan Åkesson
Authors: Richard Dumont, Robert Svensson
Bachelor’s thesis Business Administration, Handelshögskolan Göteborgs
Universitet,
Accounting, Spring 14

Authors: Richard Dumont and Robert Svensson

Supervisor: Johan Åkesson

Title: Capital structure and firm performance – A study of Swedish public companies

Background and problem: Developments in capital structure during the last 30 years
have resulted in a number of capital structure theories. At the same time, and in spite of
all research on the topic, capital structure policies were one of the reasons for many
company problems when the financial crisis hit in 2008. It is therefore interesting to look
at how capital structure has evolved in the last decade as well as to test the functional
relationship between capital structure and firm performance on a large scale.

Purpose: To map and explain the development of capital structure and firm performance
in Swedish companies during the last decade.

Limitations: The thesis will only focus on companies listed on the Swedish stock
exchange and with yearly sales amounting to at least SEK 10m.

Method: A large-scale quantitative cross-sectional study including some 300 Swedish

companies and 8 years of financial statements data. Relationships have been tested with a
multiple regression model and developments of financial data have been tracked and
compared over an 8-year period.

Results and conclusions: There is a negative relationship between debt-to-equity and

return on equity for Swedish firms during 2005-2012. Companies can thereby increase
their return on equity by decreasing their debt-to-equity levels.

Further research: A study of optimal capital structure for Swedish firms, using the latest
developments in capital structure theory and using similar data as in this study.

Key words: Regression model, capital structure, return on equity

Table of Contents
1. Introduction ....................................................................................................................... 1
1.1 Purpose ....................................................................................................................................... 2
2. Literature review .............................................................................................................. 3
2.1 Trade‐off theory ........................................................................................................................... 3
2.2 Pecking order theory ................................................................................................................. 5
2.3 Financial crisis .............................................................................................................................. 5
3. Methodology ....................................................................................................................... 7
3.1 Methodology for describing developments in firm performance and capital
structure ................................................................................................................................................ 7
3.1.1 Use of measures ................................................................................................................................... 7
3.1.2. Definition of measures ..................................................................................................................... 8
3.1.2.1 Return on assets ............................................................................................................................................ 8
3.1.2.2 Return on equity ........................................................................................................................................... 9
3.1.2.3 Debt‐to‐equity ratio ..................................................................................................................................... 9
3.1.2.4 Average interest on debt ......................................................................................................................... 10
3.2 Methodology for linear regression analysis ................................................................... 11
3.2.1 Description of control variables ................................................................................................. 12
3.2.2 Hypothesis development .............................................................................................................. 13
3.2.3 Multicollinearity ............................................................................................................................... 14
3.2.4 Goodness‐of‐fit .................................................................................................................................. 14
3.2.5 Causality versus correlation ........................................................................................................ 15
3.3 Data collection ....................................................................................................................... 16
4. Results ............................................................................................................................... 17
4.1 Variable developments .......................................................................................................... 17
4.2 Regression analysis ................................................................................................................. 20
5. Analysis ................................................................................................................................. 22
5.1 Discussion of financial ratios ............................................................................................... 22
5.2 Analysis of regression results .............................................................................................. 23
6. Conclusions ......................................................................................................................... 26
7. References ........................................................................................................................... 27
Appendix ................................................................................................................................... 30
 1. Introduction
Capital structure is an important issue from a financial standpoint because it is linked to
the firm’s ability to meet the objectives of its stakeholders (Simerly & Li, 2000).
Modigliani and Miller (1958) argued that in a perfect market, the value of a firm is
unaffected by how it is financed. When imperfections of real markets are taken into
account, however, capital structure can have a substantial impact on firm performance
(Abor, 2005; Denis 2012). Modigliani and Miller (1963) found that higher leverage leads
to increased performance due to tax benefits.

Developments in capital structure research during the last 30 years have resulted in a
number of capital structure theories that predicts somewhat contradictory results (Baker
& Martin, 2011). For instance, trade-off theory suggests a positive relationship between
firm performance and leverage (Margaritis & Psillaki, 2010), whereas the pecking-order
theory predicts a negative relationship (Baker & Martin, 2011). Additionally, research
has shown that the effect of leverage on firm performance might depend on the specific
environment of the firm (Simerly & Li, 2000).

Because of the inconsistent theories that exist within the field it is important to provide
empirical results that can help validate or disprove these theories. Bertmar and Molin
(1977) carried out a comprehensive study during the period 1966 to 1972 to map the
developments and relationships between a set of financial measures and capital structure.
They found that the level of debt financing increased in Swedish firms during the studied
period. Perhaps Bertmar and Molin’s (1977) analysis of financial performance and capital
structure of Swedish companies is the most widely known field study in this area. Apart
from this, not much research has been done on capital structure and firm performance
among Swedish companies. It is therefore interesting to update some of the research and
compare and analyze the result in light of the new important developments in capital
structure research (Denis, 2012).

In addition, the financial crisis during 2008 and 2009 also makes it interesting to look at
the developments of capital structure. This is because many problems that companies
experienced were created specifically from capital structure policies (Baker & Martin,
2011). Financial economists have critically evaluated capital structure theory as a result
(Baker & Martin, 2011). The years before, during and after the financial crisis thereby
provides a good period for studying the relationship between firm performance and
capital structure in different economic environments, which has been found to have an
effect on the relationship (Margaritis & Psillaki, 2010).

1
The present thesis aims to study firm performance and capital structure in a similar
manner as Bertmar and Molin (1977). This will be done by answering the following
research questions:

 How have ROE and ROA developed between 2005 and 2012?
 How has average interest on debt developed between 2005 and 2012?
 How has debt-to-equity ratio developed between 2005 and 2012?
 How do capital structure choices influence firm performance?

1.1 Purpose

The objective of the present study is twofold. The first objective is to quantitatively
describe developments of firm performance and capital structure before, during, and after
the financial crisis 2005 to 2012. Secondly the objective is to find how capital structure
choices have influenced firm performance during the period and to understand if the
relationship is different during the boom, crisis years and the following recession.

2
 2. Literature review
This section primarily reviews literature connected to capital structure and the
relationship between capital structure and firm performance. Moreover, the financial
crisis is described with regards to causes and possible effects, on the economy and
businesses in general and on capital structure in particular.

The studies of capital structure are usually said to have started with Modigliani and
Miller (1958). They described how capital structure affects a company’s value in a
perfect economy. In that case, companies get an increase in profitability from the higher
leverage that exactly corresponds to the rise in discount rate due to the higher risk, thus a
company’s valuation would be unaffected by its capital structure. However, Modigliani
and Miller (1963) later concluded that, in practice, capital structure does affect company
valuation since higher leverage gives greater benefits from tax shielding. Kraus and
Litzenberger (1973) expanded on the concept of tax shields when they introduced the
trade-off theory and the notion of an optimal capital structure. This theory, along with
another important capital structure theory; the pecking order theory (Myers and Majluf,
1984), will be further reviewed in sections 2.1 and 2.2 respectively.

In an attempt to explain the relation between firm profitability and capital structure,
Johansson and Runsten (2005) presented the following formula:

Equation 1.

In the formula, IR represents the average interest of a company’s loans, TL/E is the total
liabilities-to-equity ratio, ROA is return on assets and ROE is return on equity. Important
to note is that a company can increase their ROE by changing their capital structure. As
long as the return on assets is higher than the average interest rate, the ROE will increase
with higher leverage. Several studies have been done on the relationship between firm
performance and capital structure (see for example Simerly & Li, 2000; Margaritis &
Psillaki, 2010). Bertmar and Molin (1977) studied capital structure and profitability in
Swedish companies from 1966 to 1972. They found that debt-to-equity ratio and return
on equity have a negative correlation.

2.1 Trade-off theory

In contrast to dividend, interest payments on debt reduces a company’s taxable income.

At the same time, debt increases the likelihood of bankruptcy for a company. According
to the trade-off theory, capital structure reflects the trade-off between tax-benefits and
expected costs of bankruptcy. (Kraus & Litzenberger, 1973)

3
 Equation 2. The firm’s value in trade-off theory

1
1
2 2

The firm’s choice of leverage is then determined by maximizing V in the equation above.
In the model, R is a random cash flow of a firm. T denotes the constant corporate tax rate
and D is the required debt payments. The first-order condition with respect to D is:

Equation 3.

A number of relationships can be derived from the formulas and can hence be used to
explain capital structure decisions by the companies studied (Baker & Martin, 2011).
When the tax increases in the equation, the debt should also increase since higher tax will
give higher tax advantages. There should also be a positive relationship between debt and
profitability because expected bankruptcy costs and tax shields are more valuable for
profitable firms. There is, however, mixed empirical results for the relationships
predicted by the formula (Baker & Martin, 2011).

One of the reasons that capital structure research has been generating a variety of
different results ever since the work of Modigliani & Miller (1958; 1963) is the
complexity of measuring tax benefits (Graham, 2000). The reason for the complexity has
been mainly data problems and the complex tax codes (Graham, 2000). In addition,
quantifying the interest taxation effects and understanding the bankruptcy process and
financial distress is also prominent issues (Graham, 2000). Graham (2000) developed a
new measure of tax benefit that included the entire tax benefit function. As a result, it is
concluded that the typical US firm can double tax benefits by issuing debt until the
marginal tax benefit begins to decline (Graham, 2000).

It has been a central issue in financial research that firms are consistently having lower
debt levels than what is predicted as optimal levels by the trade-off theory (Ju et al.,
2005). The traditional literature on optimal capital structure using the trade-off theory
usually only includes bankruptcy costs and tax shields (Ju et al., 2005). The problem with
these studies is that they are static and hence do not incorporate the rights of bondholders
to force firms in to bankruptcy (Ju et al., 2005). As a result, few traditional studies have
not yet provided compelling response to what the optimal value-maximizing capital
structure is, Ju et al. (2005) being among the exceptions.

Ju et al. (2005) suggests that the traditional research with a trade-off theory perspective
usually suggests that firms are overleveraged. That is, firms would benefit from reducing
their debt-to-equity ratio. When managers make capital structure decisions with the

4
objective to maximize firm performance, however, Ju et al. (2005) finds empirical
evidence that the median firm in Standard & Poor’s Compustat database is
underleveraged and hence would benefit from increasing their debt-to-equity ratio.

One major problem with the trade-off theory is that it assumes market efficiency and
symmetric information (Baker & Wurgler, 2002). The decision to issue new equity
depends on the stock market performance. The market timing theory suggests that
companies are issuing debt depending on the business cycle. When the general economy
is in bad condition, firms will not issue equity. When the economy is booming, however,
equity issuance is high. That is, during good times, the debt-to-equity ratio should
decrease (Baker & Martin, 2011).

2.2 Pecking order theory

The pecking order theory was popularized by Myers (1984) and Myers and Majluf (1984)
and is based on asymmetric information between firms and investors (Baker & Martin,
2011; Frank & Goyal, 2008). The principle of pecking order theory is that equity is a less
preferred way to finance a firm because investors believe that managers will only issue
new equity when the equity is overvalued. Specifically, managers of a firm are supposed
to use a pecking list when they need to finance their operations (Graham & Harvey,
2001). As a result, investors will pay a lower value for the issued equity (Myers &
Majluf, 1984). Empirical evidence also suggests that issuance of new equity result in
stock price reductions (Baker & Martin, 2011).

The pecking-order theory does not suggest a specific debt ratio as optimal, but instead
seek external financing only when there are insufficient internal funds (Graham &
Harvey, 2001). And when they do seek external financing, they always prefer debt over
issuing new equity (Myers, 1984). The pecking order theory suggests a negative
correlation between debt and profitability (Baker & Martin, 2011). This is because high-
quality firms tend to use internal funds for financing its operations, whereas low-quality
firms have to seek external financing, usually debt, in absence of profits. There is also a
correlation between the level of asymmetric information and the incentive to issue new
equity (Baker & Martin, 2011).

Tong and Green (2005) set up a study to test whether the trade-off theory or the pecking
order theory best predicted the performance of Chinese companies. They found
statistically significant support for the pecking order theory over the trade-off theory.
Specifically, they found that there was a negative correlation between debt and
profitability.
2.3 Financial crisis

The financial crisis started in 2007 in the United States before spreading to Europe in the
middle of 2008 (Crotty, 2009). It caused indexes on several global stock markets,
including the U.S and Sweden, to fall by over 50% and is considered the worst crisis
since the Great Depression in the 1930s (Crotty, 2009). One of the main reasons for the

5
crisis was the loose monetary policy employed by the Federal Reserve. For a couple of
years before the crisis, the federal funds interest rate was set well below the level
historical experience would suggest given the situation (Taylor, 2009). This led to a large
amount of mortgage sales and a housing boom, which subsequently resulted in a bust and
thereafter a bank run that gave many financial institutions liquidity problems (Crotty,
2009).

Cornett et al. (2011) conclude that the liquidity crisis that many banks experienced led to
a decrease of credit supply, thus making it more expensive for firm’s to borrow money.
New lending volumes in the US fell with 47% during the fourth quarter of 2008 to a level
79% lower than during the credit peak in 2007 (Ivashina & Scharfstein, 2010). The effect
of this is highlighted in a study by Campello et al. (2010), where a majority of the
surveyed companies were said to be affected by the worsened access to credit markets.
Affected firms were restricted in terms of investments and a majority of them were forced
to cancel or turn down interesting projects, resulting in hindered economic growth
(Campello et al., 2010).

Most studies have focused on the effects of the decreased credit supply (see for example
Popov & Udell, 2012; Chor & Manova, 2012) but apart from this, the crisis also brought
about lower demand for goods and increased risk. In an empirical study, Kahle and Shulz
(2011) find that net equity issuance starts to decrease before net debt issuance and
remains on a low level during the crisis. This finding implies that credit supply may not
be the dominating factor behind firms’ restrained financial and investment policies.
Reasons for this would be the fact that the increased risk results in a higher cost of equity
and that the expected cash flows as well as investment opportunities decrease (Kahle and
Shulz, 2011). Altogether, the drop in credit supply resulting in higher interest rates and
the regression of capital demand mean that lending volumes decreased even more than
during a normal recession (Ivashina & Scharfstein, 2010).

6
 3. Methodology
The methodological approach for the present study is divided into two main parts. The
source data is extracted from the same database and the same definitions apply to the
whole study. The first part of the method presents the approach taken to answer the first
part of the study; describing how the financial ratios have developed during the studied
period. This section includes definitions of the financial ratios and motivations of the
various choices taken in terms of P&L and balance sheet items. The second part of the
section presents the selected research approach for the regression analysis used to study
the relationship between debt-to-equity and return on equity. Lastly, this section also
includes a description of how the data were collected.

The objective of this study is to map and describe the development of key financial ratios
and the relationship between return on equity and debt-to-equity. Therefore, results and
analysis are separated into different sections in order to be able to emphasize the
empirical findings of the study, rather than the analysis.

3.1 Methodology for describing developments in firm performance and

capital structure

This section will describe the methodology that was used in order to fulfill the first part
of the research objective, describing the developments in company performance and
capital structure for Swedish companies. Firstly, the measures that have been used are
presented along with explanations as to why they are relevant. Secondly, the chosen
measures are defined in more detail.

3.1.1 Use of measures

When evaluating a company’s performance, Johansson and Runsten (2005) argue that net
income is useless as a measure. Standing alone, it does not give information about
whether a company generates any return to its shareholders, which is necessary in order
to ensure the company’s survival. Net income is instead meaningful first when it is put in
relation to the capital that was required in order to produce the profit. Based on this
discussion, a company’s performance will in this study be measured by using the
financial ratio return on equity after taxes (ROE). According to Johansson and Runsten
(2005), this is the most important financial ratio from a shareholders’ perspective since it
can easily be compared to the market cost of capital. The measure is calculated as the
percentage of the net income compared to shareholder equity.

Return on equity is influenced by firms’ decisions regarding capital structure. A

performance measure free from the influence of financial decisions, return on assets
(ROA), has also been used in this study to assess companies’ performance. While return
on equity can be made to look good by utilizing high leverage, return on assets considers
both debt and equity and is thus not affected by the leverage. However, return on assets is
a more industry-dependent variable and does not offer the same comparability as return
on equity (Hawawini et. al, 2003). Altogether, by utilizing both the described measures
7
this report aims to present a clear picture of Swedish companies’ performance during the
studied period.

For describing the development in capital structure for Swedish companies, the debt-to-
equity (D/E) ratio will be calculated. Also included as a variable for this study is the
companies’ average interest on debt. In the literature review 2.3, it was mentioned how
low interest rates were one of the drivers for the financial crisis and therefore it is
interesting to see how this number have changed over the studied period. Furthermore,
there is a probable correlation between average interest on debt and the debt-to-equity
ratio. For example, Bertmar and Molin (1977) found that average interest on debt and
debt-to-equity ratio have a positive correlation. Therefore, the average interest measure
may help to explain the development in capital structure.

The results are presented with the median and one aggregate number for each measure.
The aggregate number is the result of all companies’ numbers weighted together, e.g. the
combined earnings before interest expenses divided by the combined average total assets
give the aggregate number for ROA. Thus, larger companies will contribute to a greater
extent to this number. The median does not take any company specific variables into
account but is simply the middle number in a sample arranged from lowest to highest
value. Because of the characteristics of the data, the median rather than the average was
used (Bertmar & Molin, 1977). Several smaller companies have numbers that can be
considered outliers and would skew the result if using the average. The aim of the median
is to show the value for the “typical” company in the data set.

Data is gathered from companies’ yearly income statements and balance sheets. The
income statement shows the sum of a company’s revenues and expenses over a period,
usually a calendar year. The balance sheet summarizes a firm’s assets, equity and
liabilities at a certain point in time, usually the end of a calendar year. Usually, return on
assets and the average interest on debt is calculated based on an average of the opening
and closing balances (Johansson & Runsten, 2005). This approach will also be used in
this study and in order to be consistent, all numbers taken from balance sheets will
represent averages.

3.1.2. Definition of measures

The four financial ratios are defined more closely in this subsection. Each financial ratio
will be broken down in its component parts, in order to increase the transparency and
motivate the choices of the study.

3.1.2.1 Return on assets 

The first performance measure, return on assets is defined the following way:

8
 Equation 4.

For the calculations, the definition from Bertmar and Molin (1977) has been applied.
Here, earnings before interest expenses (named EBI) consist of the following entries in
the income statement: profit/loss after financial expenses (RR1), extraordinary income
(E1), extraordinary expenses (EE), group contribution (E2), external interest costs (IC1)
and interest expenses to group companies (IC2).

Equation 5.

1 1 2 1 2

Accordingly, the metric does not consider taxes, neither year-end accounting
adjustments. Group contribution is excluded since it cannot be derived directly from the
day-to-day activities of the company while other extraordinary incomes and expenses
can, at least from a long-term perspective (Bertmar & Molin, 1977). Interest costs are
excluded in order to make the metric independent of the firm’s capital structure. Average
total assets are simply generated from the Total Assets line in the balance sheet and
represents an average, i.e. average total assets for 2012 corresponds to the average of the
numbers from the year-end reports of 2011 and 2012.

3.1.2.2 Return on equity 

Return on equity is calculated from the following numbers:

Equation 6.

The bottom line from the income statement, net income, is used since that represents the
profit attributable to the shareholders. Again, the definition from Bertmar and Molin
(1977) has been applied to calculate equity in the denominator. More specifically, the
entries gathered from the balance sheet were Total Equity and Untaxed reserves. Untaxed
reserves are postponements of taxable income and therefore, one part of it can be
considered as unpaid tax debt, while the other is considered as equity (Hoogendoorn,
1996). As tax rate, the Swedish corporate tax for each year has been used, meaning
28.0% for years 2005-2008 and 26.3% for years 2009-2012 (Ekonomifakta, 2014).
Again, an average is used for the numbers taken from the balance sheet.

3.1.2.3 Debt‐to‐equity ratio 

The debt-to-equity measure is used to represent the capital structure of the firm’s over the
studied period. There are a number of ratios used for this, where total liabilities divided

9
by equity is the basic one most often used by Swedish companies (Johansson & Runsten,
2005). However, this measure includes also non-interest-bearing debt, which does not
inflict any financial costs on the company and thus is not associated with the same
financial risk. Therefore, the number may not always provide an accurate picture of a
firm’s financial position (Johansson & Runsten, 2005). For example, a company can
increase their total liabilities-to-equity ratio if they gain a better market position that
allows them to increase the days payable outstanding. This would result in a higher
amount of accounts payable and thus a higher total liabilities-to-equity ratio, which could
lead to the belief that the firm’s financial position has weakened when the company in
fact has strengthened their market position. Due to this, the globally more widely used
definition of debt-to-equity ratio, the interest-bearing liabilities divided by equity, is
better suited for this study.

The data used for this study does not include any information about which parts of the
liabilities in the balance sheet that is interest bearing and which is not. Consequently, we
needed to decide on another measure that as accurately as possible could represent a
firm’s financial position while being feasible to use given the data available. In the
balance sheets, a distinction is made between short- and long-term liabilities. Short-term
liabilities are loans and obligations that last less than a year. It includes for example
accounts payable, tax debt and advance payments, which are normally categorized as
non-interest bearing (Johansson & Runsten, 2005). Therefore, these liabilities have been
excluded from the debt-to-equity ratio used in this study, which now can be defined by
the following formula:

Equation 7.

/
1

Long-term debt includes the entries bond loans, long-term liabilities to credit institutions,
long-term liabilities to group/associated companies and other long-term liabilities in the
balance sheet. Equity has been calculated the same way as in 3.1.2.

3.1.2.4 Average interest on debt 

Like with the debt-to-equity ratio, calculating average interest on debt based only on non-
interest-bearing liabilities can provide a better picture of a firm’s financial position
(Johansson & Runsten, 2005). Again, it is not possible to distinguish between interest-
bearing and non-interest-bearing debt in the data so long-term debt will serve as an
estimate. Also, using the same type of debt as for the debt-to-equity ratio gives the
opportunity to better study a possible correlation between the two in the analysis. The
following formula will be used:

Equation 8.

10
Interest costs include the entries interest expense to group companies and external
interest costs. The long-term debt is calculated the same way as in 3.1.3.

3.2 Methodology for linear regression analysis

In order to test the relationship between different variables, a linear regression analysis
will be carried out. Hypotheses will be formed about the linear relationships in the
following form:

Equation 9.

The basic question of this equation is how y varies with x. In any econometric study,
there are basically three issues that have to be covered (Wooldridge, 2012). The first
issue concerns how other factors that influence y is allowed in the model. The second
issue is to describe or determine the functional relationship between y and x. The third
issue is to determine how the ceteris paribus effect between the variables can be captured.
The simple regression model represents the ambiguity of these three issues (see equation
above).

The dependent variable, y, is representing the return on equity and is the variable that is
supposed to be explained in the analysis (Montgomery & Runger, 2007). Debt-to-equity
ratio is the dependent, or explanatory, variable. That is, the objective is to find out if, and
in that case how, the dependent variable is causing any variance in the independent
variable. Specifically, the intention is to understand if changes in return on equity can be
explained by changes in debt-to-equity (Wooldridge, 2012).

As mentioned initially in this chapter, however, one of the main issues with the simple
regression model for empirical studies is that it is difficult to make ceteris paribus
conclusions about how the studied variables actually affect each other (Wooldridge,
2012). In our case, a simple regression analysis would assume that all other factors that
affect ROE are completely uncorrelated with D/E, which is unrealistic. Therefore, a
multiple regression model is necessary because it allows for several factors, which all
together affect the independent variable. The power of the multiple regression model is
that it makes it possible to change one dependent variable at the same time as the other
dependent variables are held fixed (Montgomery & Runger, 2007). The multiple
regression model is presented in the following equation.

Equation 10.

The disturbance term in the regression model contains all other factors that are not
included as control variables. These are the unobserved factors of the model
(Wooldridge, 2012). The β1 –term in the equation will explain the functional relationship
between leverage and return on equity.
11
Throughout the study, ordinary least squares (OLS) method is used to estimate the
unknown parameters in the linear regression model. The reason for choosing the OLS
estimator method is justified by the Gauss-Markov Theorem, because it creates the result
with the smallest variance in the coefficients (Wooldridge, 2012). That is the OLS
estimators are the best estimators which minimize the vertical square errors between the
data points and the regression line (Wooldridge, 2012).

3.2.1 Description of control variables

The criteria for selecting the control variables are that they are factors, which affect the
ROE and are correlated with D/E. If these types of factors were not explicitly included as
control variables in the multiple regression model, it would generate a biased OLS
estimator of β1 (Wooldridge, 2012). That is, the benefit of explicitly including the
control variables in the regression model, as opposed to keep them in the error term of the
model, is that the variables will be held fixed as the model is executed. Several other
studies of similar nature were used to derive proper control variables and avoid under-
specification of the model and biased results (Simerly & Li, 2000; Margaritis & Psillaki,
2010; Abor, 2005).

The control variables used in this study is size, growth, asset turnover, and business risk.
The size of a firm has been found to be influencing several important aspects of a firm,
such as structure, decision-making, and performance (Simerly & Li, 2000; Abor, 2005).
The sizes of the sample companies are measured by the natural logarithm of yearly
turnover (Margaritis & Psillaki, 2009). Size is therefore included explicitly in the study as
a control variable. The sales is used in logarithmic form to make the data more normally
distributed (Wooldridge, 2012). Researchers of social sciences often use the log values
for large integer values (Wooldridge, 2012; Freund et al. 2006).

The second control variable is business risk, which is defined as the fluctuations in return
on assets (Johansson & Runsten, 2005). Business risk will influence both D/E and ROE
for firms. Since the business risk is often industry specific, firms will look at their total
risk preference and then adjust the gap between the industry-specific business risk and
the total risk they are willing to take (Johansson & Runsten, 2005). For instance,
commercial banks tend to have a very low business risk and hence is compensating with
taking a higher financial leverage in order to generate an attractive return on equity for
shareholders (Johansson & Runsten, 2008). Some similar studies have used industry as a
control variable (Bradley et al., 1984). The reason industry is not included as a control
variable in this study is two-fold. First, the industry data that could be generated in the
employed database was of poor quality. The second reason is that industry is often
correlated with business risk (Johansson & Runsten, 2005), and including such a variable
would increase the multicollinearity of the results.

The third control variable is growth, defined as yearly growth in total assets. Firm growth
has been found to have a positive correlation with firm performance (King & Santor,

12
2008; Claessens et al., 2002). Growth has also been used as control variable in other
studies (Abor 2005).

The fourth control variable is total asset turnover. The rationale for including this variable
was the absence of good quality data on industry and asset turnover is rather correlated
with different industries (Johansson & Runsten, 2005). For instance, capital intensive
energy firms tend to have asset turnover ratios in ranging from 0.4 to 0.7, whereas
manufacturing firms might have between 0.8 and 1.6 (Johansson & Runsten, 2005).

The general form of the multiple regression model was then developed to the following
model, containing the main variable under investigation and the control variables.

Equation 11.

∗ ∗ SIZE ∗ GROWTH ∗ ASS. TO ∗ BUS. RISK

If a coefficient of a factor in the model is zero even after controlling for the other
variables in the model, that factor is probably an inclusion of an irrelevant variable
(Wooldridge, 2012). All coefficients of factors included in the model will be analyzed
after the computations of the model in order to identify potential over-specifications in
the model.

3.2.2 Hypothesis development

The problem set up for investigation in this study is to test whether the D/E has an effect
on ROE. The null hypothesis is therefore H0: β1 = 0. The alternative hypothesis is H1: β1
≠ 0, which means that there is a statistically significant relationship between D/E and
ROE. A t-test was conducted in order to ensure that the estimated coefficient is not due to
sampling error. Rather than only selecting a specific critical value for the t statistic, an
analysis of the p-value will be conducted. This approach is more informative than using a
predetermined critical value for rejecting the null hypothesis (Wooldridge, 2012). The p-
value expresses the smallest significant value at which the null hypothesis would have
been rejected (Montgomery & Runger, 2007). Practically, this means that a small p-value
is evidence against the null hypothesis and vice versa. The significance level of the
regression model is selected as 99%. That is, the required p-value for rejecting the null
hypothesis was selected to be 0.01. The reason for selecting a high significance level is
that the sample size is fairly large (Wooldridge, 2012). Even though there are no standard
rules for selecting significant levels, 99% is common when having a few thousand data
points (Wooldridge, 2012). For example, if the p-value is 0.01, it means that if the null
hypothesis were true, one could observe an equally large t statistic 1% of the time,
providing some evidence against the null hypothesis. Specifically, the p-value is the
probability of obtaining a test statistic at least as extreme as the one that was actually
observed (Wooldridge, 2012). The null hypothesis is summarized in the table below.

13
 Hypothesis test ‐ Testing correlation between D/E and ROE
H0 β1  = 0 There is no a statistically significant relationship between D/E and ROE
H1: β1 ≠ 0 Null hypothesis rejected
Significant at 0,01
Table 1

The F test is conducted in order to evaluate how much of the variation that was captured
by the regression. The F test statistic is calculated as the mean squared error of regression
(MSR), which is the mean squared error of the regression, divided by the mean squared
error (MSE), which is the average square of errors of the OLS estimator. MSE is the
squared distance that the OLS estimator is from the population value (Wooldridge, 2012),
and it is that same as the variance plus the square of any bias. The F-value is then
translated to a significance level automatically by the model. The F value measures the
significance of the multiple regression overall. The significance of the F test is equal to
the p-value of the test.

Equation 12.

3.2.3 Multicollinearity

A multicollinearity test was conducted in order to ensure that the regression model had no
multicollinearity. The test was performed with the NumXL Pro add-in in Microsoft Excel
with the Variance Inflation Factor (VIF) method (See Appendix A). High correlation
between two or more of the independent variables is referred to as multicollinearity
(Wooldridge, 2012). The problem of multicollinearity is commonly discussed in
econometric studies (Bradley et al., 1984), and sometimes even overly empathized by
econometricians (Wooldridge, 2012). The effect of multicollinearity is basically the same
as having a small sample size because both drive a high variance of the coefficients
(Wooldridge, 2012). The only way to reduce the multicollinearity problems in this study
would be to exclude one of the control variables. By doing excluding one of the
explanatory variables, however, might cause the results of the model to be biased
(Wooldridge, 2012). In spite of the attempt to minimize multicollinearity, it is always a
fundamental problem in cross-sectional regression studies.

3.2.4 Goodness-of-fit

14
The coefficient of determination, or R-squared, in the regression analysis measures how
much of the variation in ROE that can be explained by the debt-to-equity ratio
(Wooldridge, 2012). It is important to note that R-squared is not a variable that will
influence the generation of the model. Some studies tend to construct their studies in
order to get a desirable R-squared (Wooldridge, 2012). As a result, they are likely to
introduce multicolliniearity in the model (Wooldridge, 2012). R-squared is defined as
follows:

Equation 13.

In addition, the adjusted R-squared will also be generated in the model. This is calculated
in addition to R-squared because R-squared is always increasing as more regressors are
added to the model. The adjusted R-squared penalizes the R-squared for having
numerous explanatory variables according to the equation below (Wooldridge, 2012),
where k denotes the number of explanatory variables and n is the total number of
observations.

Equation 14.

1
1
1

It is important not to overemphasize the goodness-of-fit by including too many control

variables in the model (Wooldridge, 2012; Freund et al. 2006). As mentioned earlier, the
selection of control variables is a trade-off between biased results and introducing
multicollinearity. That also means that there is always a good idea to include explanatory
variables that affect y and are uncorrelated with all the other independent variables
(Wooldridge, 2012).

3.2.5 Causality versus correlation

The present study has a similar challenge as many other statistical studies, which is to
evaluate whether the leverage actually has got a causal effect on firm performance as
opposed to having merely a correlating relationship, which can be achieved by keeping
all factors but the test variables equal (Wooldridge, 2012). It is rarely possible, however,
to keep all other factors equal when performing analysis on economic data, but it is rather
a question of holding enough other factors fixed to make a case for causality
(Wooldridge, 2012). In order to make the case for causality in this study, a number of
control factors derived from theory will be included in the regression analysis (see
“description of control variables”). This is an attempt to isolate the ceteris paribus effect
of the studied variables, which is carried out using the Data Analysis add-in in Microsoft
Excel. By explicitly including factors that has been found to affect the ROE by other
authors, these factors can be held fixed and a ceteris paribus effect can be analyzed
(Freund et al., 2006).

15
One part of this study was to find evidence that the D/E does have an effect on the ROE.
An equally important part, however, was to describe the functional relationship between
the variables. The coefficient β1 will explain that if that relationship is positive or
negative as well as to give an indication of the magnitude of the causality. It is also
important to emphasize the difference between statistical significance and economic
significance. Statistical significance is only related to the size of the t statistic, whereas
the economic significance is more related to the size and sign of the coefficients
(Wooldridge, 2012).

3.3 Data collection

The sample used for this study consists of Swedish public companies. Numbers are
obtained from the database Retriever Business that has annual account figures for all
companies listed on the Swedish stock exchange. Since the information dates back to
2004 and averages are used for calculating some of the variables, the presented numbers
in the analysis start at year 2005. The majority of the companies have not registered
numbers for year 2013 in the database, thus making 2012 the last year analyzed. The
original sample consisted of 492 companies. Some of the companies have incomplete
numbers for the period, i.e. they became listed on the stock exchange later than 2004.
After excluding these companies the sample consisted of 369 companies. Additionally,
the sample was adjusted to exclude very small companies with below SEK 10m in
revenues. Specifically, all companies that did not have at least SEK 10m in revenues
every year of the studied period were excluded. The reason was that some of these
smaller companies were having highly questionable data logged in the “Retriever
Database”. For instance, some of these companies were not having any sales at all some
of these years. After excluding these companies the final sample consisted of 299
companies. For a more detailed description of the studied companies, see Appendix D &
E.

For the regression analysis, another type of adjustment to the data was made, where a
number of outliers were excluded. A residual output analysis was used to identify the
outliers, see Appendix C. These single observations had a major influence on the result of
the model. An outlier is defined as an observation that is so extreme that when dropping
it, the OLS estimators change by a practically large amount (Wooldridge, 2012). Because
the original sample is a few thousand data points, the impact on the quality of the study
should not be noticeable (Wooldridge, 2012). After adjusting the data set, 2337 data
points remains.

The data is based on figures presented by the studied companies, and can therefore be
subject to accounting choices made by the companies. That is, we can only make
conclusions about the volatility in certain financial measures presented by the companies.
However, we have not used any of the KPIs already calculated by the companies and thus
the study will not be affected by company-specific choices regarding KPI definitions.

16
 4. Results
In this section, the results of the study are presented. First, the developments in the
different studied variables are described. Secondly, the results from the regression
analysis are presented.

4.1 Variable developments

The description of firm performance is made based on the measures return on equity and
return on assets.

ROE
25,0%

20,0%

15,0%

10,0%

5,0%

0,0%
2005 2006 2007 2008 2009 2010 2011 2012
Aggregate 21,3% 19,2% 16,5% 3,3% 12,2% 17,0% 10,8% 12,8%
Median 13,0% 14,4% 13,7% 5,7% 4,9% 9,3% 9,7% 6,3%
Figure 1. Return on equity for Swedish companies 2005-2012

Figure 1 shows the return on equity by two metrics, the aggregate of all studied
companies and the median of the sample, over the years 2005 to 2012. It shows a steady
decline in the aggregate metric between 2005 and 2007 before the financial crisis in
2008, which results in a steeper downwards curve, hitting the bottom at around 3%. The
aggregate curve rebounds the year after with an increase of approximately 9 percentage
points and in 2010 the number is back to the level of 2007. In 2011, the aggregate
number takes a downturn again from 17% to around 11% before a slight increase in 2012
to end the period.

For the median number, the fluctuations are smaller than for the aggregate number. The
largest difference between two years for the median is 8 percentage points and 13 for the
aggregate, both between 2007 and 2008. There are differences in the direction of the
curves for several of the analyzed years. In 2005 as well as in 2011, the median number
increases while the aggregate decreases and the opposite occurs in both 2009 and 2012.
The values for the median are generally lower than for the aggregate number with the
exception of 2008 where the median value is 2 percentage points higher. Over the whole

17
period, the aggregate number is on average 4.5 percentage points higher. Both curves
have a substantial decrease in 2008 corresponding to the financial crisis and they end the
period with significantly lower values than they started with in 2005.

Figure 2. Return on assets for Swedish companies 2005-2012.

Figure 2 shows the median and aggregate number for return on assets in Swedish public
companies over the period from 2005 to 2012. Similar to return on equity, the aggregate
number shows a steady decline between the years 2005 and 2007. During 2008, there is a
significant drop from 12% to 5%, which is the lowest point of the period. Then in the two
following years the measure recovers by increasing 3 percentage points each year before
turning down again in 2011. Altogether, the aggregate number drops 6 percentage points
from 14% to 8% between 2005 and 2012. While the aggregate number decreases between
2005 and 2007, the median increases during these years, though not by much. As with
return on equity, the median number for return on assets varies less than the aggregate
number. It also takes a lower value for the whole period with the aggregate number being
on average 4 points higher.

18
 Figure 3. Debt-to-equity ratio for Swedish companies 2005-2012.

The description of capital structure is made based on the measure debt-to-equity ratio.
Figure 3 shows the aggregate and median value of the debt-to-equity ratio for Swedish
companies during the years between 2005 and 2012. The values show that there is a
significant difference between the aggregate number and the median company with the
aggregate number being on average 157% larger over the period. While the median has
been fairly steady over the period, the changes in the aggregate number is considerable.
The ratio decreases slightly during 2006 before starting to trend upwards. In 2008, there
is an increase of approximately 0.100 followed by a slight increase also during 2009. The
peak is reached in the last year of the period, 2012, when the debt-to-equity ratio
increases to 0.473, a value 52% higher than in 2005.

19
 Figure 4. Average interest on debt for Swedish companies 2005-2012.

Figure 4 shows the average interest on debt for Swedish public companies from 2005 to
2012, both by the aggregate and median number. In this case, the median is consistently
larger than the aggregate number. The curves are very similar, both in terms of their
variation and in the direction of the slopes. Every time the median increases, so does the
aggregate number. There is an evident increase in average interest at the beginning of the
financial crisis in 2008, most clearly shown in the median curve. Thereafter comes a
sharp decline until the lowest level for both curves is hit in 2010. From the start of the
period to the last year in 2012 the aggregate number of average interest decreases by 2
percentage points. However, the median company has approximately the same average
interest on debt in 2012 as in 2005.

4.2 Regression analysis

The result of the full period in of the multiple regression model is presented in table 2.
The Analysis of the Variance (ANOVA) table includes valuable data for understanding
the characteristics of the test. As expected, the model has five degrees of freedom which
corresponds to the number of explanatory variables in the regression model.

Regression output
Regression statistics ANOVA
R‐squared 24.1% F 148
Adjusted R‐squared 23.9% Significance F 1,8E‐136
N 2337 df 5
Table 2

20
The purpose of the regression model is, naturally, to explain the variation in ROE with
the variation in D/E. The F statistic is 148, which gives a significance for the entire
multiple regression model of well under the selected significance level of 0.01.

The R-squared of the regression is 24.1% for the full period, which means that 24.1% of
the total variation in ROE can be explained by the explanatory variables. In addition, the
adjusted R-squared of the model is just slightly lower at 23.9%

The coefficients of the multiple regression model is read from table 3 and represents the
estimates of the coefficients in the regression equation. The most interesting coefficient
in this study is the coefficient for debt-to-equity, which explains the functional
relationship between ROE and leverage. The null hypothesis cannot be rejected in the
period between 2010 and 2012. For the other two sub-periods and the full period, the null
hypothesis can indeed be rejected and hence debt-to-equity has a significant statistical
impact on ROE. The negative sign for β indicates a negative relationship between the
debt-to-equity and ROE for all periods, with the strongest functional relationship during
the crisis years in 2008 and 2009. That is, companies with lower debt-to-equity any given
year, presents a higher ROE in the end of that year.

Summary statistics of dependent variables ‐ size and significance
2
Debt‐to‐Equity Size Growth ATO Business risk R
Year β p‐value* β p‐value* β p‐value* β p‐value* β p‐value*
2005‐2007 ‐0,080 0,001 0,045 0,000 0,000 0,697 0,060 0,000 ‐3,721 0,000 33%
2008‐2009 ‐0,136 0,000 0,056 0,000 0,000 0,040 0,070 0,001 ‐1,121 0,000 24%
2010‐2012 ‐0,018 0,478 0,064 0,000 0,000 0,304 0,093 0,000 ‐0,318 0,099 23%
2005‐2012 ‐0,070 0,000 0,054 0,000 0,000 0,031 0,081 0,000 ‐1,444 0,000 24%
*significant at p<0.01; marked with bold text
Table 3

Furthermore, it is also interesting to discuss the impact of control variables on the

independent variable, ROE. Size has a p-value under 0.01 in all periods and hence the
null hypothesis can be rejected, which indicate that larger companies are having higher
ROE during the studies period. In contrast, the null hypothesis cannot be rejected for
growth during any period at the 0.01-level. There are however large differences between
the periods. When looking at the full period, the null hypothesis would have been rejected
at a 3% significance level. For the periods 2005 to 2007 and 2012 to 2012, however, the
null hypothesis would not have been rejected even at the 10% significance level, which is
commonly used as the highest acceptable value by many researchers (Wooldridge, 2012).
The asset turnover ratio is positive and significant for all periods as the p-value is less
than 0.01.The positive sign of the OLS estimators indicate that companies with higher
total asset turnover are generally having a higher ROE. Lastly, the null hypothesis can be
rejected for business risk in all periods except for the period 2010 to 2012. Business risk
has the steepest slope of the OLS estimators in all periods, and has a negative sign, which
indicate that companies with lower business risk are having higher ROE.

21
5. Analysis
The analysis of the presented results is divided into two parts. First, the financial ratios
are analyzed and possible explanations for the developments are discussed. Regression
model output is discussed in the second part, where the results are analyzed from the
perspective of capital structure theories and other empirical studies.

5.1 Discussion of financial ratios

The performance of the companies during the studied years has varied greatly, in part due
to the financial crisis, which takes place in the middle of the period. The median metric
has a smaller variance in both of the performance measures. Looking at the
characteristics of the data, this is not all that surprising. A small number of companies
have a large impact on the aggregate number, whereas all participating companies affect
the median number equally. For example, in 2012 ten companies represented 70% of the
aggregate net income. Consequently, a significantly changed result for one of the largest
companies has considerable impact on the aggregate performance measures. It is also
clear from the results that the financial crisis really hit Swedish companies in the year of
2008. Performance had been trending downwards in the years before as well but not to
the same extent. There is a larger drop for the aggregate number of both the ROA and
ROE measure, indicating that larger companies were more affected in that year.
However, they also seem to recover quicker as evidenced by the fact that the aggregate
number changes direction in 2009 while the median keeps sloping downwards. A trend
during the period is that performance turns for smaller companies seem to lag behind
larger companies. This can be seen in 2005-2006 and 2011-2012 apart from the already
mentioned 2009. The observation holds for both measures, even though the pattern is
clearer in return on equity. Another observation is that the aggregate number outperforms
the median over the whole period with the only exception being ROE in 2008, meaning
larger companies in general perform better than smaller companies.

The slopes for ROA and ROE look very similar, which is to be expected since they both
measure the profitability of a firm in some way. Furthermore, the value of ROE is
generally higher than for ROA, which can be explained by financial decisions that
generates leverage effects on ROE, see Equation 1. Leverage also explains the fact that
the ROE measure is fluctuating more than the ROA. Only during 2008 does ROE fall
below the value for ROA, indicating that the financial part of the equation has negative
impact and thus that the ROA is lower than the average interest on loans1.

Fluctuations in the performance measures can to a large degree be attributed to changes

in the result rather than in equity or assets. While the aggregate profit/loss is very much
affected by the unstable business cycle, the growth in assets and also equity is fairly
stable over the period. The steady equity growth means that the increase in long-term

1
The average interest on loans in this case shall not be confused with our definition of
average interest on debt but refers to the Rs used in Johansson and Runsten’s equation.
22
debt-to-equity ratio is a result of the long-term debt levels rising even more. During the
crisis years, 2008 and 2009, companies’ long-term debt increases with a total of 37%
compared to 2007. This happens even though the credit supply is supposedly tightened
during these years (Cornett et al., 2011; Ivashina & Scharfstein, 2010). As expected, this
results in large interest costs during these years, especially during 2008 before the
average interest on debt starts to fall in 2009. Logically, the average interest should rise
because of the lower credit supply but such an effect is not seen except for a little bit
during 2008. For the remainder of the period the average interest lies below the levels
from before the crisis. This can probably be explained by the very low prime rate set by
the Swedish National Bank in the beginning of 2009. The rate was held under 1% for
most of 2009 and for the whole 2010, while for a large part of this period being as low as
0.25% (Riksbanken, 2014). These numbers are very low, especially compared to the rate
levels in 2007 and 2008 of between 3 and 5%. Small increases in the official rate were
done during 2011 and a subsequent increase of average interest on debt for Swedish
companies followed.

Regarding the debt-to-equity ratio, the aggregate number does, as previously mentioned,
rise during the financial crisis. The median is, however, remarkably steady during the
whole period, while also residing at significantly lower levels than the aggregate. This
could be interpreted as a sign that larger companies tend to have higher debt-to-equity
ratio than smaller companies. Furthermore, the aggregate number changes in accordance
with the market timing theory that says debt-to-equity ratio should be lower during good
times than bad. A possible explanation to the fact that the median does not change during
the crisis is that banks may have been more reluctant to issue loans to smaller companies.
The corporate tax rate in Sweden was reduced in 2009, which according to the trade-off
theory should lessen the incentives of carrying debt. No correlation between the debt-to-
equity rate and the reduced tax rate can be distinguished from the data since many factors
impact the results but it could be interesting to evaluate if such an effect occurs for the
larger tax reduction in 2013.

Average interest on debt is interesting since it is the only measure where the median
consistently shows higher values than the aggregate. This could be due to the fact that
banks give larger companies better terms on their loans and as mentioned earlier, larger
companies will largely affect the aggregate number. The two curves are otherwise very
similar and they both correlate significantly with the changes in the Swedish prime rate.
Bertmar and Molin (1977) found a positive correlation between average interest on debt
and debt-to-equity ratio. Such correlation cannot be seen in this sample, rather the
opposite. Judging by the aggregate numbers, companies reach the highest point of
leverage during the end of the period when the average interest is at its lowest. This
seems reasonable from the borrowing companies’ perspective since loans become more
attractive when the rate is low.

5.2 Analysis of regression results

23
The results of the regression model presented in this report clearly suggest a negative
relationship between debt-to-equity and return on equity. The overall model has a R-
squared at about 24%, which means that the regression model can explain about 24% of
the variation in return on equity. This means that the model explains a decent share of the
total variation and that the model has some credibility. A more interesting question,
however, is whether the identified relationship is actually demonstrating a causal effect or
if it is merely a correlation. The ambition of the study was to simulate a ceteris paribus
effect, and the important question is whether that is achieved to a satisfying degree. Of
course, a real ceteris paribus effect in this kind of study is illusionary and not really
attainable, which is also demonstrated by the R-square of 24%. The control variables
selected in the regression model are surely relevant factors but there are certainly relevant
factors that are not explicitly included in the model. As a result, the answer to the
causality versus correlation question is indeed rather subjective and it is up to each reader
to gauge the quality of the methodological approach. It should strengthen the credibility
of this report, however, that there are both theoretical and empirical evidence for its
conclusions. The significance of three out of four control variables indicates that the
selected control variables indeed are relevant factors to consider.

The negative relationship between debt-to-equity and return on equity suggested in the
regression model is more comparable to the pecking order theory than the trade-off
theory. There is an important difference between these theories and this study, however.
The trade-off theory and the pecking order theory is focused on the reverse relationship
of debt-to-equity and profitability. That is, they suggest that the profitability of the firm
drives the capital structure decisions whereas this study is concerned with the reversed
causality. However, the trade-off theory suggests that more profitable firms should
increase their debt because they have low expected bankruptcy costs and benefit more
from the tax shield benefits. The main purpose of this study is descriptive in nature and
do not aim to completely explain the reasons for the results. There could be some interest
in looking at some of the results from a trade-off theory perspective, however.

Using the trade-off perspective, one possible explanation for the negative relationship
between debt-to-equity and return on equity could be that companies are having higher
debt than what is optimal from a tax shield and expected bankruptcy cost perspective. For
instance, if a company is not profitable, the tax benefit of higher debt will evaporate at
the same time as the expected bankruptcy costs would increase. That is, the company
fails to utilize the full potential benefits of increased debt while at the same time having
to bear the drawbacks of increased risk. One can get additional support for that argument
by looking at the functional relationship between debt-to-equity and return on equity
during the different periods (See table 3). During the boom between 2005 and 2007, the
OLS estimator had a value of -0.08. In contrast, when the financial crisis hit and profits
decreased, the slope of the OLS estimator increased to -0.136, indicating a stronger
functional relationship. That is, decreasing debt during times with lower profitability was
even more important, indicating that firms could utilize even less potential benefits
related to the tax shield possibility.

24
As presented in the literature review, researchers have been generating different results
on what the optimal capital structure really is in the trade-off theory. Some research has
come to the conclusion that firms should increase their debt and some has come to the
opposite conclusion. The results of this study cannot tell anything about what the level of
that optimum might be, but only that Swedish companies seem to benefit from a lower
debt-to-equity ratio during the studied period.

Although the pecking order theory provides limited guidance for explaining the reverse
causality of debt on profitability, it does provide some insight in combination with the
result of the study. The regression analysis suggests a significantly negative relationship
between debt-to-equity and return on equity, which means that higher profitability is
often associated with lower levels of debt-to-equity ratios. This is in line with what the
pecking order theory suggests. So while the pecking order theory explains cause and
effect between capital structure and profitability from the reverse standpoint, the general
negative relationship between profitability and debt is consistent with the regression
model. In that sense, the pecking order theory is more aligned with the conclusions form
this study, which is also consistent with what other empirical studies have found when
comparing trade-off theory with pecking order theory (Tong & Green, 2005; Fama &
French, 2002; Shyam-Sunders & Myers, 1999). One explanation of these results might
indeed be due to the complexity in measuring imperative variables of the trade-off theory
as discussed by Graham (2000) and Ju et al. (2005). The negative relationship between
debt-to-equity and return on equity is also supported by a number of other empirical
studies. Bertmar and Molin (1977) found also found a negative relationship between the
two variables in Swedish firms between 1966 and 1972.

25
6. Conclusions
The results presented in this thesis show that firms’ performance has been significantly
affected by the financial crisis in 2008 and 2009. The two performance measures, ROE
and ROA, fluctuate in a similar manner, with a huge drop coinciding with the first crisis
year. Furthermore, Swedish companies are yet to recover fully and reach the profitability
levels they had before 2008. Companies’ debt-to-equity ratios start the period on a low
level before rising during the crisis, something that is consistent with existing research on
the subject. The pattern is mainly existent in larger companies, while smaller companies
seem to keep a steady debt-to-equity ratio throughout the period. Average interest on debt
show signs of correlating with the prime rate and the measure reaches its peak at the
beginning of the financial crisis.

The regression model suggests a significant relationship between the debt-to-equity and
return on equity for the full period between 2005 and 2012. The result is also consistent
over all sub periods, which represents the periods before, during and after the financial
crisis. The result was strongest during the actual crisis, which might indicate that Swedish
firms are having higher than optimal debt-to-equity ratios. Indeed, the results show that
Swedish firms could increase return on equity by reducing debt-to-equity. In addition, the
results are consistent with some of the earlier research on the topic as well as with the
pecking order theory.

The study has both practical and theoretical contributions. The practical contributions
consist mainly of decision support for managers operating in Swedish companies.
Although there have been quite some research on capital structure during the last decade,
few studies are committed to Swedish companies. Another important edge of this study is
that it concentrates on the reverse causality between return on equity and debt-to-equity
compared to the most widely recognized capital structure theories as pecking order theory
and trade-off theory. The main academic contribution lies in the large amounts of
quantitative data and sophisticated statistical methods utilized in materializing the
regression model.

A number of future research ideas have been identified during the project. One such idea
would be to look closer at optimal capital structures for Swedish companies, using parts
of the data generated in this study. Such a study would be an attractive complement to the
present study because these results indicate that companies would benefit from lower
debt-to-equity but not how low they should go.

26
7. References

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Baker, H. K., & Martin, G. S. (2011). Capital structure and corporate financing
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Baker, M., & Wurgler, J. (2002). Market timing and capital structure. The journal of
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Bertmar, L., och Molin, G., (1977), Kapitaltillväxt, kapitalstruktur och räntabilitet. En
analys av svenska industriföretag. The Economic Research Institute, Stockholm School
of Economics.

Bradley, M., Jarrell, G. A., & Kim, E. (1984). On the existence of an optimal capital
structure: Theory and evidence. The journal of Finance, 39(3), 857-878.

Campello, M., Graham, J. R., & Harvey, C. R. (2010). The real effects of financial
constraints: Evidence from a financial crisis. Journal of Financial Economics, 97(3), 470-
487.

Chor, D., & Manova, K. (2012). Off the cliff and back? Credit conditions and
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29
Appendix
A. Multicollinearity test

Multicollinearity test
Variable VIF
Debt‐to‐equity 1,08
Size 1,30
Growth 1,04
ATO 1,10
Business risk 1,19

The multicolliniearity test was conducted with the Variance Inflation Factor (VIF)
method. A rule of thumb is that there is no problem with multicollinearity if VIF is below
4, which means that the current levels are very good (O’Brien, 2007).

B. Regression output

SUMMARY OUTPUT 2005‐2007

Regression Statistics
Multiple R 0,575475
R Square 0,331172
Adjusted  0,327301
Standard  0,439181
Observati 870

ANOVA
df SS MS F Signif. F
Regressio 5 82,5162162 16,5032432 85,56233 4,47E‐73
Residual 864 166,6481199 0,19287977
Total 869 249,1643361

Coeff. Std. Err. t Stat P‐value Lo 95% Up 95% Lo 95,0% Up 95,0%

Intercept ‐0,49906 0,075586053 ‐6,6025197 7,05E‐11 ‐0,64741 ‐0,3507 ‐0,64741 ‐0,3507
D/E ‐0,07991 0,023129569 ‐3,4547096 0,000578 ‐0,1253 ‐0,03451 ‐0,1253 ‐0,03451
Size(log o 0,045462 0,005891037 7,71717547 3,28E‐14 0,0339 0,057025 0,0339 0,057025
Growth (i 1,12E‐09 2,86791E‐09 0,38967824 0,696871 ‐4,5E‐09 6,75E‐09 ‐4,5E‐09 6,75E‐09
Kapitalom 0,060462 0,015464725 3,90968607 9,97E‐05 0,030109 0,090815 0,030109 0,090815
Business r ‐3,72106 0,291787657 ‐12,752618 2,98E‐34 ‐4,29375 ‐3,14836 ‐4,29375 ‐3,14836

30
SUMMARY OUTPUT 2008‐2009

Regression Statistics
Multiple R 0,488473
R Square 0,238606
Adjusted  0,231997
Standard  0,405805
Observati 582

ANOVA
df SS MS F Signif. F
Regressio 5 29,72555 5,945111 36,10142 3,51E‐32
Residual 576 94,85453 0,164678
Total 581 124,5801

Coeff. Std. Err. t Stat P‐value Lo 95% Up 95% Lo 95,0% Up 95,0%

Intercept ‐0,77277 0,092959 ‐8,31304 6,74E‐16 ‐0,95535 ‐0,59019 ‐0,95535 ‐0,59019
D/E ‐0,13551 0,029217 ‐4,63807 4,36E‐06 ‐0,19289 ‐0,07813 ‐0,19289 ‐0,07813
Size(log o 0,056124 0,007086 7,92009 1,23E‐14 0,042206 0,070042 0,042206 0,070042
Growth (i 6E‐09 2,91E‐09 2,060216 0,039827 2,8E‐10 1,17E‐08 2,8E‐10 1,17E‐08
Kapitalom 0,069545 0,021664 3,210104 0,001401 0,026994 0,112096 0,026994 0,112096
Business r ‐1,12088 0,273061 ‐4,10488 4,63E‐05 ‐1,6572 ‐0,58457 ‐1,6572 ‐0,58457

31
SUMMARY OUTPUT 2010‐2012

Regression Statistics
Multiple R 0,479054
R Square 0,229493
Adjusted  0,22511
Standard  0,390269
Observati 885

ANOVA
df SS MS F Signif. F
Regressio 5 39,8757 7,97514 52,36132 1,34E‐47
Residual 879 133,8803 0,15231
Total 884 173,756

Coeff. Std. Err. t Stat P‐value Lo 95% Up 95% Lo 95,0% Up 95,0%

Intercept ‐0,95262 0,074849 ‐12,7272 3,53E‐34 ‐1,09953 ‐0,80572 ‐1,09953 ‐0,80572
D/E ‐0,01783 0,025107 ‐0,71 0,477894 ‐0,0671 0,031451 ‐0,0671 0,031451
Size(log o 0,06352 0,005609 11,3246 7,57E‐28 0,052511 0,074529 0,052511 0,074529
Growth (i 3,37E‐09 3,28E‐09 1,027685 0,304381 ‐3,1E‐09 9,81E‐09 ‐3,1E‐09 9,81E‐09
Kapitalom 0,093314 0,015748 5,925434 4,47E‐09 0,062406 0,124223 0,062406 0,124223
Business r ‐0,31778 0,192411 ‐1,65155 0,098983 ‐0,69541 0,059862 ‐0,69541 0,059862

32
SUMMARY OUTPUT ‐ full period

Regression Statistics
Multiple R 0,49047
R Square 0,240561
Adjusted  0,238932
Standard  0,423073
Observati 2337

ANOVA
df SS MS F Signif. F
Regressio 5 132,1617 26,43234 147,6741 1,8E‐136
Residual 2331 417,2282 0,178991
Total 2336 549,3899

Coeff. Std. Err. t Stat P‐value Lo 95% Up 95% Lo 95,0% Up 95,0%

Intercept ‐0,73883 0,046731 ‐15,8104 1,45E‐53 ‐0,83047 ‐0,64719 ‐0,83047 ‐0,647191
D/E ‐0,06952 0,014954 ‐4,64891 3,52E‐06 ‐0,09884 ‐0,0402 ‐0,09884 ‐0,040195
Size(log o 0,053842 0,003558 15,13187 2,05E‐49 0,046865 0,06082 0,046865 0,0608198
Growth (i 3,78E‐09 1,75E‐09 2,16107 0,030792 3,5E‐10 7,22E‐09 3,5E‐10 7,216E‐09
Kapitalom 0,080743 0,009984 8,087216 9,71E‐16 0,061164 0,100321 0,061164 0,1003213
Business r ‐1,44398 0,143627 ‐10,0537 2,62E‐23 ‐1,72563 ‐1,16233 ‐1,72563 ‐1,162333

The Sum of Squares (SS) column presents important information about the variation in
the test. The SST measures the total variation in the test. The SSR can be described as the
amount of the variability that can be explained by the regression. The SSE is the
difference between the SST and the SSR and hence the amount of the variation that
cannot be explained by the regression.

C. Residual output

33
RESIDUAL OUTPUT full period

Observation Predicted Re Residuals Standard Residuals

1 0,164871602 ‐0,122134894 ‐0,288994345
2 ‐0,319939792 0,228358737 0,540340122
3 ‐0,185824032 0,333985467 0,790273015
4 0,007438747 0,130025781 0,307665681
5 0,290543007 ‐0,133357435 ‐0,315549007
6 0,141748937 ‐0,037150562 ‐0,087905281
7 0,043269168 ‐0,38957935 ‐0,921818696
8 ‐0,206963961 0,1137859 0,26923904
9 ‐0,106651112 ‐0,309106905 ‐0,731405614
10 0,106330691 0,00448987 0,010623885
11 0,232587879 0,071269129 0,168636288
12 ‐0,050887617 ‐0,329716903 ‐0,780172783
13 ‐0,208106374 ‐1,11976966 ‐2,649587583
14 ‐0,195855267 0,269514592 0,637722687
15 ‐0,035597612 ‐0,127578861 ‐0,301875803
16 0,07150775 0,103298601 0,244424098
17 0,33947827 ‐0,210553224 ‐0,498208898
18 0,099460173 ‐0,898490975 ‐2,126000209
19 ‐0,06763249 0,319022696 0,754868258
20 0,259325755 ‐0,031253939 ‐0,073952754
21 0,254779771 ‐0,131432815 ‐0,31099499
22 0,233960725 ‐0,022333431 ‐0,052845138
23 ‐0,203676152 0,204914715 0,484867114

Sample of residual output used for identifying outliers and influencers in the regression
data.

D. Companies

Companies included in the study

2E Group AB  Bergs Timber AB (publ) 
AB Novestra  Betsson AB 
AB Sagax  Betting Promotion Sweden AB 
AB Traction  Bilia AB 
ABB AB  BillerudKorsnäs Aktiebolag (publ) 
Acando AB  BioGaia AB 
ACAP Invest AB  BioInvent International AB 
Accelerator Nordic AB  Biotage AB 

34
ACTIVE Biotech AB  Björn Borg AB 
Addnode Group Aktiebolag (publ)  Boliden AB 
Addtech AB  Bong AB 
ADDvise Lab Solutions AB (publ)  Boule Diagnostics AB 
Aerocrine Aktiebolag  Bredband2 AB 
Agellis Group AB  Bringwell AB (publ) 
AIK Fotboll AB  BTS Group AB 
Aktiebolag Fagerhult  Bure Equity AB 
Aktiebolaget Electrolux  Business Control Systems Sverige AB 
Aktiebolaget Geveko  Caperio AB 
Aktiebolaget Industrivärden  Castellum Aktiebolag 
Aktiebolaget SKF  Catena AB 
Aktiebolaget Volvo  CellaVision AB 
Alfa Laval AB  Cision AB 
Allenex AB  Commodity Quest AB (publ) 
AllTele Allmänna Svenska 
Tfn.aktie.bol.  Concordia Maritime Aktiebolag 
ALM Equity AB  Confidence International Aktiebolag 
AlphaHelix Molecular Diagnostics AB  Connecta AB 
Amasten Holding AB (publ)  Conpharm AB (publ) 
Anoto Group AB  Consilium Aktiebolag 
AQ Group AB  Corem Property Group AB 
Aqeri Holding AB  Cryptzone Group AB 
Arc Aroma Pure AB  CTT Systems AB 
Arcam Aktiebolag (publ)  CybAero AB 
Arctic Gold AB (Publ)  CYBERCOM GROUP AB 
Arctic Paper Sverige Aktiebolag  DEFLAMO AB (publ) 
Aspiro AB  DGC One AB 
ASSA ABLOY AB  DIBS Payment Services AB (publ) 
AstraZeneca AB  DORO AB 
Atlas Copco Aktiebolag  Drillcon Aktiebolag 
Atrium Ljungberg AB  Duni AB 
Auriant Mining AB  Duroc Aktiebolag 
Autoliv Aktiebolag  ECOMB AB (publ) 
Availo AB (publ)  EcoRub AB 
Avanza Bank Holding AB  Elanders AB 
Avega Group AB  Electra Gruppen AB (publ) 
AVTECH Sweden AB (publ)  Elekta AB (publ) 
Axfood Aktiebolag  Ellen Aktiebolag 
Axis Aktiebolag  Elos AB 
B&B TOOLS Aktiebolag  Elverket Vallentuna AB 
BE Group AB (publ)  Empire AB 
Beijer Alma AB  Enea Aktiebolag 
35
Beijer Electronics Aktiebolag  Eolus Vind Aktiebolag (publ). 
eWork Scandinavia AB  KABE AB 
Exini Diagnostics Aktiebolag  KappAhl AB (publ) 
Fabege AB  Kentima Holding AB (publ) 
Fastighets AB Balder  Klick Data Aktiebolag 
FastPartner AB  Klövern AB 
Feelgood Svenska Aktiebolag (publ.)  Knowit Aktiebolag (publ) 
Fenix Outdoor AB  Kungsleden Fastighets AB 
Fingerprint Cards AB  Lagercrantz Group Aktiebolag 
FormPipe Software AB  Lammhults Design Group AB 
Forsstrom High Frequency AB  Lappland Goldminers AB 
G & L Beijer AB  LifeAssays AB (publ) 
Generic Sweden AB (publ)  Lovisagruvan AB (publ) 
Genesis IT AB  Lundin Mining AB 
Genovis Aktiebolag  Lundin Petroleum AB 
Getinge AB  Mackmyra Svensk Whisky AB 
Malmbergs Elektriska Aktiebolag 
Ginger Oil AB  (publ) 
Glycorex Transplantation AB (publ)  Mangold Fondkommission AB 
Gunnebo Aktiebolag  Meda Aktiebolag 
H & M Hennes & Mauritz AB  Medirox Aktiebolag 
Haldex Aktiebolag  Medivir Aktiebolag 
Heba Fastighets Aktiebolag  Micro Systemation AB (publ) 
Hemtex Aktiebolag  Micronic Mydata AB (publ) 
Hexagon Aktiebolag  Micropos Medical AB (publ) 
Hexatronic Scandinavia AB (publ)  Midsona AB 
Hifab Group AB  Midway Holding Aktiebolag 
Modern Ekonomi Sverige Holding AB 
HiQ International AB  (publ) 
HMS Networks AB  MSC Konsult Aktiebolag 
Holmen Aktiebolag  MultiQ International Aktiebolag 
HomeMaid AB (publ)  NCC AKTIEBOLAG 
Hufvudstaden AB  Nederman Holding Aktiebolag 
Husqvarna Aktiebolag  Net Entertainment NE AB 
I.A.R. Systems Group AB  Net Insight AB 
ICA Gruppen Aktiebolag  New Wave Group AB 
IDL Biotech AB  NGS Group Aktiebolag 
Image Systems AB  NIBE Industrier AB 
Impact Coatings AB (publ)  Nischer Aktiebolag (publ) 
Industrial and Financial Systems, IFS 
Aktiebolag  Nobia AB 
Indutrade Aktiebolag  Nolato Aktiebolag 
Insplanet AB (publ)  Nordic Camping & Resort AB 

36
International Hairstudio M & R AB  Nordic Service Partners Holding AB 
Intrum Justitia AB  NordIQ Göteborg AB 
Investment AB Kinnevik  Nordkom AB 
Investment AB Öresund  Nordnet AB 
Investmentaktiebolaget Latour  NOTE AB (publ) 
Investor Aktiebolag  Oasmia Pharmaceutical AB 
Invisio Communications AB  Obducat Aktiebolag 
InXL Innovation AB  Odd Molly International AB 
ITAB Shop Concept AB  Oden Control AB 
JLT Mobile Computers AB (publ)  OEM International Aktiebolag 
JM AB  Oniva Online Group Europe AB 
Josab International AB (publ)  Online Brands Nordic AB 
Opcon Aktiebolag  Skånska Energi Aktiebolag 
Opus Group AB (publ)  Smarteq AB (publ) 
OraSolv AB  Softronic Aktiebolag 
Orexo AB  SSAB AB 
Oriflame Cosmetics AB  Starbreeze AB 
Ortivus Aktiebolag  Stille AB 
PA Resources Aktiebolag  Stockwik Förvaltning AB 
Paradox Entertainment AB (publ).  Stora Enso AB 
Parans Solar Lighting AB (publ)  Stora Enso Skog Aktiebolag 
PartnerTech AB  Studsvik AB 
Paynova AB  SWECO AB (publ) 
Peab AB  Svedbergs i Dalstorp AB 
Pfizer Health AB  Swede resources AB (publ) 
Pilum AB (publ)  Swedish Match AB 
PolyPlank Aktiebolag (publ)  Swedish Orphan Biovitrum AB (publ) 
Poolia AB  Swedol AB (publ) 
Precise Biometrics AB  SwitchCore AB (publ) 
Precomp Solutions Aktiebolag (publ)  Systemair Aktiebolag 
Prevas Aktiebolag  TagMaster Aktiebolag 
Pricer Aktiebolag  Tele2 AB 
Proact IT Group AB  Telefonaktiebolaget L M Ericsson 
PROBI Aktiebolag  TeliaSonera Aktiebolag 
Thenberg & Kinde Fondkommission 
Proffice Aktiebolag  Aktiebolag 
ProfilGruppen AB  Tieto Sweden AB 
Rasta Group AB  TradeDoubler Aktiebolag 
Ratos AB  Transcom Aktiebolag 
RaySearch Laboratories AB (publ)  Trelleborg AB 
ReadSoft Aktiebolag  TrustBuddy International AB 
Real Point Investment AB ( publ )  Uniflex AB 
Rederi AB Transatlantic  United Media Group Nordic AB 
37
Rejlers AB (publ)  Unlimited Travel Group UTG AB (publ) 
Respiratorius AB (publ)  Wallenstam AB 
RNB RETAIL AND BRANDS AB (publ)  VBG GROUP AB (publ) 
Rottneros AB  VENDATOR AB 
Russian Real Estate Investment 
Company AB  Venue Retail Group Aktiebolag 
Rörvik Timber AB  WeSC AB (publ) 
Sandvik Aktiebolag  West International Aktiebolag (publ) 
SAS AB  Vindico Security AB (publ) 
SBC Sveriges BostadsrättsCentrum AB  Vitec Software Group AB (publ) 
Seamless Distribution AB  Vitrolife AB 
SECTRA Aktiebolag  XANO Industri AB 
Securitas AB  XCounter AB 
Selena Oil & Gas Holding AB  ZetaDisplay AB 
Semcon Aktiebolag  ÅF AB 
Sensys Traffic AB    
Senzime AB (publ.)    
SinterCast Aktiebolag    
SJR in Scandinavia AB    
Skanska AB    
SkiStar Aktiebolag    
Skåne‐möllan Aktiebolag    

E. Sampling of companies

Sample selection
# of companie
Available in database 492
Missing data for the wh 124
Turnover below SEK 10 69
Final sample 299

38