International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 66 (2011)

© EuroJournals Publishing, Inc. 2011
http://www.eurojournals.com/finance.htm

Determinants of Corporate Capital Structure

Under Different Debt Maturities

Ho-Yin Yue
School of Finance, Shanghai University of Finance and Economics, Shanghai, China
E-mail: willyyue@gmail.com

Abstract

The main purpose of this study is to examine the trade-off model and pecking order
model of capital structure under different debt maturities for a sample of 1445 corporates
listed in the Hong Kong exchange market. Empirical results provide evidences that trade-
off model and pecking order are not mutually exclusive. Both trade-off model and pecking
order model play a significant role in determining the total debt level of corporates.
However, empirical results of short-term debt level consistent only with pecking order
model but not trade-off model. This may because financial institutions in Hong Kong do
not concern seriously on the risk of insolvency. Firms with higher risk can access short-
term debt financing as easy as firms with less risk.

Keywords: Capital structure; pecking order theory; trade-off theory

JEL Classification Codes: G00, G32

1. Introduction
In any firm, one of the major duties of manager is determining the capital structure of the firm. In
general, manager can choose any mix of different types of assets to form their capital structure. Firms
can either issue a large amount of debt or very little debt. It can also use lease financing, warrants,
convertible bonds or trade bond swap. However, no matter which combination does the firm chosen,
the aim of the selection is trying to maximize its market value. A number of theories have been
suggested in explaining the capital structure of firms. However, there is no specific method for firms to
choose their optimal debt level yet.
This paper shed some light on the determinants of the capital structure using 1445 firms listed
in the Hong Kong Stock exchange market. We include variables based on different capital structure
theories. I also examine how the variables affect on debt with different maturity i.e. short term, long
term and total debt level of firms. The conclusions of this paper are expected to shed some light on the
possibility that firms choose their capital structures based on several but not one capital structure
theories. Also, this paper helps to understand better whether the determinants of short term and long
term debt are different.
This paper is organized as follows. The next section gives a literature review on the
determinants and effects on the capital structure of firms. Then, data description and justification of the
choice of the variables used in the analysis are discussed in section three. The fourth section presents
the results of the empirical analysis and discusses the conclusion which can be derived from the results.
Finally, I summarize the findings of the research in the last section.
International Research Journal of Finance and Economics - Issue 66 (2011) 100

2. Literature Reviews on Capital Structure

The first attempt to explain the relationship between capital structure and firm value was provided by
Modigliani and Miller (1958). In their frictionless world, there is no optimal structure. Their model is
well known as “capital structure irrelevance” which means the firm’s capital structure does not affect
its value. Thereafter, models with less restrictions in their assumptions were used to examine the
realtionship between capital structure and firm’s value. For example, Modigliani and Miller (1963)
took taxation under consideration. They showed that debt would cause the value of firm rise by the
amount of the capitalized value of the tax shield. Therefore, firms should employ as much debt as
possible in order to maximize its value. Miller (1977) used the corporate tax rate, the tax rate imposed
on the dividend income and the tax rate imposed on the income of interest inflow to explain the
optimal captial structure of firms. According to Miller, the optimal capital structure denpends on the
relative value of the different tax rate.
Besides tax aspects, researchers have incorporated other factors, such as imperfect competition,
bankruptcy costs and asymmetric information to explain how firms choose their capital structures.

2.1. Trade-off Model: Bankruptcy Costs

The optimal debt level of a firm is determined by the benefits of debt and the cost of the debt. Firms
will balance their benefits and cost of debt to choose their debt level in the way that maximizing the
firm’s market value (Myers, 1984). The main benefit of debt financing is the “tax shield”. Tax shield
allows firms pay lower tax because the interest of the debt capital is deducted in the taxable income.
Bankruptcy cost is one of the cost of debt. It incurs with the perceived probability that the firm cannot
deal with its debt obligations is greater than zero. Risky firms have higher bankrupty costs, thus risky
firms borrow less.

2.2. Agency Cost Model

The agency cost model was first introduced by Jensen and Meckling (1976). According to the agency
cost model, there is conflict between firm’s owners and managers. Harris and Raviv (1990) suggested
that the conflict between firm’s owners and managers arises because managers do not totally own the
frm.
Typically, managers of firms are hired by firm’s owners to act as their agents and have the
authority to use firm’s resources for the owner’s benefit. However, instead of maximizing the firm’s
value and owner’s benefit, managers are more interested in their own benefit which may differes from
owner’s benefit. They will act in their own interests for higher salaries, job security, perquisities or
even direct exploitation of the firm’s cash. The differences of interest between managers and firm’s
owner may sometimes even opposite to each others. Although the firm’s owners may want to prevent
the benefit transfer by the managers, managers have the authority to manager the firm. Therefore, the
owners may try to prevent the benefit transfer by external monitor, such as supervision by independent
directors. These kinds of monitoring and control methods need cost, the cost is called agency cost.
Acency cost is extremely costly if firm’s owners want to have a perfect control over the
company. Firm’s owners prefer to use other methods which spend less while still able to monitor and
control manager’s operations. A method to monitor manager’s operationns in less cost or even adding
values to the firm is through debt capital. Debt should pay back in cash together with the interest.
Therefore, the free cash flows that the managers can be diverted. Thus debt can be vieved as a
mechanism to discipline the manager from benefit transfer and lower the agency cost (Jensen M. ,
1986). The optimal captial structure under agency cost model is the balance between the benefits of
debt and the cost of debt. Firms will choose their own capital structure which mininize its total agency
cost.

2.3. Pecking Order Model

The pecking order model ( Myers (1984) and Myers and Majluf (1984)) and its entensions (Lucas &
McDonald, 1990) are based on the idea of asymmetric information between firm’s managers and
101 International Research Journal of Finance and Economics - Issue 66 (2011)

investors. Managers know more about the firm’s true value than outside investors. To maximize the
welth of existing shareholders, managers avoid issuing undervalued new share to finance new projects.
Thus, issuing new equity is interpreted as a negative signal, in the snese that the equity is being
overvalued. This negative signal results in the decline of stock price. The relation between the issue of
new shares and the decline of stock price is confirmed in several studies (Asquith & Mullins, 1986).
According to pecking order model, managers tend to finance a new project initally by
undistributed earnings which is no existence of information asymmetry and will not be undervalued.
Then, they will try on debt capital if extra funds are still needed. Issuing new share is treat as the final
source of funds.
Fllowing the idea of pecking order model, firms with higher profitability generate more
earning. Therefore, firms with higher profitability depend more on internal funds while less depend on
debt capital. Several researches have tested the effects of profitability on debt level. Kester (1986),
Friend and Lang (1988) and Shyam-Sunder and Myers (1999) concluded that there is a significant
negitive relation between profitability and debt level. Wald (1999) found a significant negitive relation
between profitability and debt level for firms in seveal countries.

3. Data and Measurement of Variables

In this paper, I investigate the determinants of capital structure for the 1445 firms listed in the Hong
Kong exchange market in the year of 2010. There are three dependent variables, total leverage, short-
term leverage, and long-term leverage. The total leverage (TDebt) is the total debt divided by the
equity. Short-term leverage (SDebt) is the total short term debt divided by equity while the long-term
leverage (LDebt) is the total long term debt divided by the equity.
The independent variables used are price-to-earnings ratio (pe), logarithm of market
capitalization (lnsize), return on total asset (roa) and dividend payout ratio (div). The basic decriptive
statistics are shown in Table 1.

Table 1: Description Ststistics of variables

TDEBT LDEBT SDEBT ROA SIZE DIV

PE
(%) (%) (%) (%) (HKD $’000,000) (%)
Mean 51.86502 28.35840 23.50662 19.16150 7.031287 21172.56 40.30724
Median 38.29000 15.16000 13.92000 11.55500 6.030000 3972.455 27.16000
Maximum 505.3000 402.4900 202.7900 1432.000 36.30000 1401589. 1600.000
Minimum 0.000000 0.000000 0.000000 0.360000 0.010000 23.39000 1.260000
Std. Dev. 55.27285 38.19612 29.14478 67.49269 4.752368 81425.29 85.59515
Skewness 3.240426 3.931768 2.495054 19.50600 1.515356 12.43056 13.80133
Kurtosis 20.14855 28.81871 11.01404 407.0347 7.040518 191.7366 238.3726

3.1. Selection of Independent Variables

3.1.1. Growth Opportunities
Growth potential of a firm is supposed to affect capital structure. According to agency cost model,
firm’s managers act as the the agent of debt holders. Thus, firms have tendency to expropriate wealth
from debt holders. Firms with higher growth opportunities have more possibility to invest suboptimally
and expropriate wealth from debtholders to shareholders because the asset substitution effect. Firms
with considerable growth opportunities imply higher agency cost, and thus have lower leverage. Myers
(1977) confirms this and concludes a negative relation between growth opportunities and leverage
level. Auerbach (1985) also argues that leverage level is negative related to growth opportunities
because the tax shield from debt is less valuable in fast growing firms.
Growth opportunities can be measured by many different variables. For example, market-to-
book ratio, price-to-earning ratio or R&D divided by total sales. In this paper, I use price-to-earnings
ratio (pe) as a proxy of growth opportunities. price-to-earnings ratio is calculated by dividing the
International Research Journal of Finance and Economics - Issue 66 (2011) 102

market price per share by the annual earnings per share. I expected that growth opportunities is
negative related to debt level.

3.1.2. Firms’ Size

Size plays an important role in determining the capital structure of a firm. Large firms are less likely
bankruptcy because their business are more diversified than smaller firms (Ang & McConnel, 1982).
Following the trade-off model, large firms have a higher leverage because they have a lower debt cost
than small firms. According to Whited (1992), small firms have higher difficulities in accessing long-
term debt since their growth opportunities usually excess their collateralizable assets. Berryman (1982)
added that, there is a negative relation between firm size and probability of insolvency. Thus, small
firms is much difficult to access debt capital.
Titman and Wessels (1988) report a negative relation between firm size and leverage. They
argue that small firms depend more on debt financing rather than equity finacing, because the cost for
small firms to issue new share is higher than large firms.
I use the logarithm of market capitalization (lnsize) as a proxy of size of a firm. I expected that
firm size is positive related to debt level.

3.1.3. Profitability
Profitability represents the power of making profit of firms. According to the trade-off model,
profitable firms have high tax burden and low bankruptcy risk. Therefore, profitable firms are more
likey to employ a higher leverage than those less profitable (Ooi, 1999). Empirical evidences can be
found in studies ((Bowen, Daley, & Huber, 1982), (Dammon & Senbet, 1988) and (Givoly, Hayn,
Ofer, & Sarig, 1992)) which support trade-off mdoel.
Contray to trade-off model, according to pecking order model, profitable firms tend to have
lower debt level (Myers, 1984). Barton and Hill (1989) agrees that firms with higher profitability have
lower debt level because they can generate much internal funds than firms less profitable. Empirical
studies ( (Al-Sakran, 2001), (Chittenden, Hall, & Hutchinson, 1996), (Coleman & Cole, 2000) and
(Griner & Gordon, 1995)) suggest pecking order model is more approiate in explaining the relation
between firm’s profitability and debt level. Among different studies, most of them found a negative
relation between profitability and debt level.
I use the return on total asset (roa) as a proxy of profitability in this paper. Return on total assets
is calculated by dividing a firm’s annual earnings by its total assets. Return on total assets indicate how
efficient managerment is at using its assets to make profit. Other possibile measures of profitability are
the ratio of earnings before tax, interest payments, and depreciation to the book value of assets
(EBITDA) or the ratio of operating cash flow to total assets. EBITDA measures firm’s profitability
ignoring the effect of different taxation system while the ratio of operating cash flow to total assets
measures firms’ internal cash generating ability.
I expect the profitability is inverse related to debt level.

3.1.4 Agency Cost

Accoring to Jesen (1986), firms can reduce its agency cost by employing a higher level level of debt or
dividends. A high level of debt or dividends reduces the free cash flow available for managers to
overinvestment. Thus, agency cost for overinvestment is reduced. In long term, firm’s return on
investment is increased over time. Lang and Litzenberger (1989) show the effect of dividend policy on
agency cost.
We use dividend payout ratio (div) as proxy of agency cost. High dividend payout ratio can
lower free cash flow effectively. Therefore, agency costs for firms having a high dividend payout ratio
are lower than firms having a low dividend payout ratio. Firms with low agency cost tend to depend
less on debt financing.
I expect a negative relation between firm’s dividend payout ratio and leverage.
103 International Research Journal of Finance and Economics - Issue 66 (2011)

4. Model and Empirical Results

OLS is used to investigate the determinants of capital structure of firms in this paper. Three different
regression equations are formulated as follow:
log(TDebt) = β1 log(pe) + β2 log(lnsize) + β3 log(roa) + β4 log(div) + constant (1)
log(SDebt) = β1 log(pe) + β2 log(lnsize) + β3 log(roa) + β4 log(div) + constant (2)
log(LDebt) = β1 log(pe) + β2 log(lnsize) + β3 log(roa) + β4 log(div) + constant (3)
Table 2 shows the regression results of equation of total debt level. All independent variables
are significant at 1% level. The regression results suggest that both the trade-off model and pecking
order model have explanation power on the capital structure of firms in Hong Kong.
The results indicate a negative relation between growth opportunities and total leverage level of
firms. My results agree with the findings by Auerbach (1985), Rajan & Zingales (1995) and
Chittenden, Hall, & Hutchinson (1996). A firm with higher growth opportunities have more uncertainy
than firms with lower growth opportunities. Therefore, the agency cost for debt holders is higher in
lending capital to firms with high growth opptunities than firms with low growth opportunities.
According to the empirical results, company size is positive related to the total debt level. As
mentioned in the previous section, large firms have lower risk in insolvency. Thus, large firms are
easier to access the debt capital. My results agree with the findings of Berryman (1982) and Whited
(1992).
The empirical results indicate a inverse relation between profitablity and total debt level which
agree with several studies ( (Griner & Gordon, 1995) and (Coleman & Cole, 2000)). On the other hand,
my results contray to the findings by Dammon & Senbet (1988) and Ooi (Ooi, 1999) which found a
positive relation between debt level and firms’ profitability. The results suggest that pecking order
model explains the relation between profitability and total debt level better than trade-off model for
firms in Hong Kong. According to pecking order model, profitable firms tend to depend on internal
funds rather than external financing. Therefore, the debt level of high profitability firms is lower than
firms which are less profitable. On the other hand, trade-off model suggests that profitable firms have
high tax burden. In Hong Kong, the tax duty is extremely low, tax burden for profitable firms is
insufficient. Thus, trade-off model cannot explain the debt level of firms in Hong Kong very well.
Dividend payout ratio shows a inverse relation with the total debt level of firms. High dividend
payout ratio reduces the agency cost effectively (Lang & Litzenberger, 1989). Thus, firms do not need
to reduce agency cost through debt capital.
Table 3 and Table 4 show the regression results of long-term debt level and short-term debt
level respectively. In the regression results of long term debt level, all independent variables are
significant at 1% level. Thus, the empirical results of long-term debt agree with both trade-off model
and pecking order model. On the other hand, only return on assets and dividend payout ratio are
significant at 1% level, while growth opportunities and firm’s size are insufficient in the regression.
The regression results can be explained by the fact that firms can access short-term debt capital
easily in Hong Kong. When financial institutions do not concern seriously on the risk of insolvency.
Firms with higher risk can access debt financing as easy as firms with less risk. As mentioned in the
previous section, bankruptcy risk is related to the firm’s size and agency cost for debt holder is related
to the price-to-earnings ratio. When debt holders do not concern bankruptcy risk and agency cost
seriously when lending out short-term debt, firm’s size and price-to-earnings ratio will become
unrelated to the short-term debt as well.
From the regression results of short-term debt level, return on asset and dividend payout ratio is
significant related to the short-term debt level. It suggests that pecking order model and agency cost for
firm’s owner are able to explain how firms select their short-term debt level. Pecking order model and
agency cost model concern the internal management style of firms. Thus, the ease in obtaining short-
term debt capital does not affect firm’s management style, and also the description ability of the
pecking order model and agency cost model.
International Research Journal of Finance and Economics - Issue 66 (2011) 104
Table 2: Regression Results of total debt level

Dependent Variable: LOG(TDEBT)

Variable Coefficient Std. Error t-Statistic Prob.
LOG(PE) -0.482780** 0.091144 -5.296884 0.0000
LOG(SIZE) 0.264463** 0.037829 6.990965 0.0000
LOG(ROA) -0.928721** 0.081163 -11.44269 0.0000
LOG(DIV) -0.239455** 0.082871 -2.889484 0.0040
C 4.534895 0.401476 11.29557 0.0000
Adjusted R-squared 0.219419
Durbin-Watson stat 1.016954
F-statistic 40.63469
Prob(F-statistic) 0.000000
** significant at 1% level.

Table 3: Regression results of long-term debt level

Dependent Variable: LOG(LDEBT)

Variable Coefficient Std. Error t-Statistic Prob.
LOG(PE) -0.537900** 0.114287 -4.706570 0.0000
LOG(SIZE) 0.427562** 0.046532 9.188488 0.0000
LOG(ROA) -0.860621** 0.104194 -8.259822 0.0000
LOG(DIV) -0.325044** 0.103880 -3.129027 0.0019
C 2.673197 0.498198 5.365728 0.0000
Adjusted R-squared 0.225363
Durbin-Watson stat 0.514168
F-statistic 35.03857
Prob(F-statistic) 0.000000
** significant at 1% level.

Table 4: Regression results of short-term debt level

Dependent Variable: LOG(SDEBT)

Variable Coefficient Std. Error t-Statistic Prob.
LOG(PE) -0.046029 0.104235 -0.441594 0.6590
LOG(SIZE) 0.010692 0.042227 0.253207 0.8002
LOG(ROA) -0.584710** 0.095245 -6.139006 0.0000
LOG(DIV) -0.470011** 0.093612 -5.020841 0.0000
C 4.997019 0.452060 11.05387 0.0000
Adjusted R-squared 0.120552
Durbin-Watson stat 1.721601
F-statistic 16.45540
Prob(F-statistic) 0.000000
** significant at 1% level.

5. Conclusion
The empirical results of the factors affecting the debt level of firms in Hong Kong suggest that pecking
order model and trade-off model are not mutually exclusive. My results agree with the findings of
Fama and French (2002). Firms tend to select their levelage level according to both pecking order
model and trade-off model. However, factors affecting the short-term debt level and long-term debt
level are different. The empirical results suggest that, short-term debt level consistent with pecking
order model. On the other hand, factors related to the risk of insolvency do not affect short-term debt
level of firms. The empirical results agree with Hovakimian, Opler, and Titman (2001). They
concluded that debt ratio and debt-equity issue choice appear to be consistent with pecking order
behavior in short-run. In short, empirical results suggest that short-term debt level of firms in Hong
Kong consistent with pecking order model. Apart from this, the long-term debt level and the total debt
105 International Research Journal of Finance and Economics - Issue 66 (2011)

level of firms in Hong Kong consistent with both pecking order model and trade-off model. Evidences
show that pecking order model and trade-off model are not mutually exclusive.

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