DETERMINANTS OF CAPITAL STRUCTURE IN EMERGING CAPITAL MARKETS

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CAPITAL STRUCTURE IN EMERGING MARKETS Topic:
“The Determinants of Capital Structure in Emerging Capital Markets: Evidence from the leading business firms in the UK”

Context
Modigliani and Miller (1958) initiated the process of research on this topic after which there has been a vast amount of theoretical literature on the variables which define the optimal financial structure for a firm. Theories like pecking order model (Myers & Majluf 1984) and Litzenberger and Kraus’s trade off theory (1973) have been developed and elaborated and empirically tested by many researchers in this field.

They indicate towards certain particular determinants that affect a company’s capital structure. Still, after such huge amount of theoretical and experimental literature, finance scholars have failed to reach any conclusion. This leaves one of the most basic financial decisions of the companies still open to debate and investigation.

Following the research literature in this regard, we see the rejection of trade off theory in Sunder, Shyam and Myers’ paper, “Testing Static Trade-off against Pecking order Models of Capital Structure” (1999) and Fama and French’s (2002) conclusion that both of these theories define only particular aspects of a firm’s financing strategies, CAPITAL STRUCTURE IN EMERGING MARKETS therefore they can neither be universally accepted nor rejected. The literature also concedes to the fact that companies are inclined to have a large optimal capital structure, but they fail to agree upon the effect of determinants of this ideal structure.

There has also been a huge amount of research literature that focuses on doing a comparative study of capital structures in various countries such as Rajan and Zingales (1995) worked in testing the factors of capital structuring of firms in G7 countries, Booth et al (2001) observed the financial structuring decisions of companies from the emerging economies of Mexico, Brazil, south Korea, India, Malaysia, Jordan, Thailand, Pakistan, Zimbabwe and Turkey, CAPITAL STRUCTURE IN EMERGING MARKETS Antoniou did the caparison between financial structures of companies in Japan, UK, USA, France and Germany while Deesomsak (2004) studied the factors which determine the capital structures in Asia Pacific countries of Australia, Thailand, Singapore and Malaysia.

These researchers also fail to concede to a point as to what are the financial determinants and what is their nature in suggesting the optimal financial structure of a business. However, CAPITAL STRUCTURE IN EMERGING MARKETS the study of this literature makes one thing very clear that the capital structuring decisions are specific to the economic and institutional setting in which these businesses operate.

Therefore research in the specific environment of UK is crucial to understanding the optimal financial structuring in UK. Fortunately, we have a wide collection of research particular to the UK market, each specific to its context. These academic endeavors suggest that both gearing level and the factors which determine this level vary considerably on the characterization of gearing adopted by each research (Rajan & Zingales 1995); (Bevan & Danbolt 2002); (Chittenden 1996); (Michaelas 1999); (Bevan & Danbolt 2002). We also see that although the general level of gearing of studied firms has stayed quite stable, relativity of different explanatory variables of debt has changed significantly over time.
Prior research on financial structuring also suggests that the choice of determining variables which cause cross-sectional disparity in capital structures is very problematic (Titman & Wessels 1988) (Harris & Raviv 1991). However, we also see a general consensus in the significance of a few variables in suggesting the optimal gearing for a firm (Rajan & Zingales 1995) (Bevan & Danbolt 2002):
• Growth
• Size
• Profitability
• Tangibility
We find an ample amount of literature in all of these individual concepts and their relation with capital structuring:
Growth
For growth we see studies like Myers (1977), Michaelas et al. (1999), Stohs and Mauer (1996), Barclay and Smith (1999), Barnea et al., (1981), and Ozkan (2000) arguing that development opportunities and leverage have different relations in terms of long term and short term debt and the companies prefer to use the short term form to the long term one in order to mitigate the conflict with the stockholders, particularly for small companies as for them the agency conflict is quite a severe issue (Smith & Warner 1979) and (Michaelas 1999). Titman and Wessels (1988), Chung (1993), Rajan and Zingales (1995), Barclay and Smith (1996) and Chen et al., (1997) suggest that there is a negative correlation between growth levels and debt; both total debt and its long term debt component. However, contrastingly, Bevan and Danbolt (2002) conclude from their study that growth levels are positively linked with the total gearing with growth firms preferring short term debt to ensure their development.

Against the view of Bevan and Danbolt (2002), come Stohs and Mauer (1996) and Barclay and Smith (1996) who suggest that there should be a lower level of gearing, of all types, for growing firms with Rajan and Zingales (1995) further elaborating on this point that “Larger firms tend to be more diversified and fail less often, so size … may be an inverse proxy for the probability of bankruptcy.” We also find that these results are specific to the methodology of estimation used by each group of researches.
Size
For the link between the size of the company and its capital structuring, we have the works of Bennett and Donnelly (1993), Crutchley and Hanson (1989), CAPITAL STRUCTURE IN EMERGING MARKETS Bevan and Danbolt (2002), Barclay and Smith (1996), and Rajan and Zingales (1995) which suggest a healthy contribution of company size to the gearing and contrasting work of Remmers et al. (1974) which advocates that the firm’s size has no influence on gearing and then we have Kester’s paper on “Capital and ownership structure: A comparison of United States and Japanese manufacturing corporations” (1986) which argues that there is no considerably negative correlation between the two.
Profitability
The majority of research in profitability’s relation with capital structuring is based upon the effect of tax shields on the company’s cost saving. There is the argument that because of this tax shield over interest payments, businesses have a preference of debt financing over equity funding (Modigliani 1958). However, DeAngelo and Masulis (1980) debate on the fact that tax deductibility over on interest payments is unimportant to the companies.
In addition to the tax shield matter, there is also the concern over symmetry of information which is addressed by Myers and Majluf (1984) and Myers (1984) who maintain that due to the asymmetry of information, businesses prefer to have internal capital resources to external sources. This illustrates the establishment of a pecking order in such firms while their counterparts that have high profit levels are likely to sponsor their investments with their retained earnings instead of by debt financing. This notion remains consistent in further researches of Kester (1986), Bennett and Donnelly (1993), Toy et al., (1974), Titman and Wessels (1988), Rajan and Zingales (1995) and Bevan and Danbolt (2002), all of which agree that profitability levels are negatively related to gearing.
Tangibility
There is always a conflict over the interests of stock holders and debtors (Jensen & Meckling 1976) due to which the investors demand security which gives importance to the collateral value as a major determinant of debt financing levels that are available for the firm. We have the work of Williamson, (1988); Scott, (1977); Harris and Raviv, (1990); Stiglitz and Weiss, (1981). Titman and Wessels (1988), Bradley et al., (1984) and Rajan and Zingales (1995) which suggests a significant and positive relationship between total debt financing and tangibility, CAPITAL STRUCTURE IN EMERGING MARKETS Walsh and Ryan (1997) and Marsh (1982) also conclude from their findings that the prospect of debt financing is positively linked to the firm’s fixed asset ratio. Bevan and Danbolt (2002) and Chittenden et al., (1996) argue that this correlation between debt and tangibility actually depends upon the measures through which debt is employed while Stohs and Mauer (1996) consider that debt maturity is positively related to asset maturity of the firm.
The Significance of this study
The prior researches on this matter depended upon utilization of various estimation techniques and illustrative variables for analysis; hence their inferences were based upon the parameters that were established without accounting for the heterogeneity of firms which may lead to altogether different results. Therefore, it is imperative to study the capital structuring determinants while considering the firm specificity. The previous research is also subject to differ with relation to the different estimation methodologies which also holds true for the researches for fixed firm effects. Another matter of concern is the amount of substantial changes in the comparative relevance of different components of gearing.
There is also a lack of study on the various components of debt in capital structuring and lastly, CAPITAL STRUCTURE IN EMERGING MARKETS there is no recent study on time tested and successful firms in the UK market and their capital structuring that has helped them to gain this position. This is the matter which this research will address, studying the leading firms in UK and the capital structure that they have employed through their history and their current capital structuring.
Research Question
The primary issue which this research will endeavor to answer is “What are the determinants of capital structure in an emerging UK market?” To find and optimal answer to this question, this report shall study the leading companies of UK and analyze their capital structuring to answer following questions which will subsequently help in addressing our primary thesis question:
• What determinants should be considered most important in deciding a firm’s capital structure?
• What particular effects do these determinants have in the specific setting of the UK market?
• What are the effects of these variables on individual components of gearing for a firm?
• How the consistency or adjustments in capital structures contributed to the success of studied firms?
• What factors were revised through time and what remained constant? and
• Which determinants gained more importance over others and which were restricted to their specific scenarios?
Methods
This research will use both primary and secondary research methods (Charmaz 2011) to answer, the above mentioned, six main research questions.
The secondary research will entail the review of the academic literature available on this topic. The online and offline data of the selected companies will be explored to find relevant information that relates to the context of our study. The literature review will be used to determine the gearing components and the variables that determine the capital structure.
Prior researches unanimously suggest that gearing levels depend largely upon the characterization of leverage applied. Therefore in this report we shall also focus on various short term and long term components of debt rather than maintaining a holistic view of debt. These long term and short term elements will be classified by using the methodology proposed by Bevan and Danbolt’s (2002) paper on “Capital structure and its determinants in the United Kingdom – A decompositional analysis”.
The review of research of Bevan and Danbolt (2002) and Rajan and Zingales (1995) indicates big significance on four business characteristics: the size of the firm, the level of growth opportunities, profitability and tangibility. This assessment will be tested empirically and it shall be established whether it holds true or not in the case of leading firms of UK market. It shall be modified according to the findings of empirical research.
For empirical research, the main dataset will be obtained by using the DataStream and the accounting and other financial information of selected businesses of UK market. All the leading firms selected have sufficient data available for our research. When the data is obtained outliers will be identified and will be eliminated in order to keep the data clean and relevant.
For determining the leverage and debt maturities, we shall use the following equation,
“Leverageit = t + 1Tangibilityit + 2Profitabilityit + 3ASmalli + 3BLargei + 4GDP/Capt +
5Growtht + 6Inflationt + 7Interestt + 8Taxt + it”

The definition of leverage that will be used in this research is “total liabilities divided by total assets for firm at time t” (Rajan & Zingales 1995); (Booth & V. 2001). Debt maturities would include both the short term borrowing and the long term borrowing. “Long term liabilities to total assets” would be determined as long term debts and “short term liabilities to total assets” would be called short term debt (Demirgüç-Kunt & Maksimovic 1999).
Following the process of data collection, relevant data will be selected, studied and examined to achieve a positive outcome in this manner:
• Collecting information, followed by an assortment and grouping of it.
• Evaluating the processed information and ordering of it in proper timeline. At this level, the outliers will be removed from the collected data.
• Formation of linkages from the literature review
• Forming connections between the concepts studied from the secondary methodology and the facts gained from the primary research.
• Reviewing and then presenting the findings.
A quantitative methodology will be applied to this research because of its relevance to the subject of our study. The most relevant estimation model shall be applied to the collected data. The learning from the literature review is that the four most significant variables in determining the gearing are the size of company, profitability, tangibility and level of growth opportunities.
Tangibility will be calculated as “total assets minus current assets (fixed assets) divided by total assets for firm at time t” (Rajan & Zingales 1995); (Booth & V. 2001). Profitability will be defined as earnings before taxation for the firm upon the total assets at time t. The size of the company will be a dummy variable to proxy size of the firm. The classification would be: a small firm would have less than 50 employees, a medium size firm will have between 51-500 employees and a large firm would have more than 500 employees.
The assessment of the prior researches will be analyzed in empirical evidences gained from the data of the leading firms of UK. It will then be placed in a holistic perspective along with the works of previous scholars to fill in the gaps which are present in the discourse of capital structuring decisions.
Reflections
The process of studying the capital structuring decisions is fraught with limitations that are present due to the vastness of the scope of this subject and the specific methods one can apply to study this topic. The nature of every firm is different and if a large data is collected, then it is imperative to use the quantitative method, however in doing so, we miss on the most important variable of all; the particularity of the business functions of the firm which also require it to have a specific degree of leverage and equity investments.
This research addresses this issue by selecting a smaller sample size, but of the successful companies that are operating in the UK market. Through this approach, we shall be able to assess the determinants of firms’ capital structures with consideration to their work nature. However, here also a more worrisome limitation arises that the scope of study becomes very limited through this process. Due to the smaller sample size and the criteria for selection of leading firms, we shall not be able to cater to a bigger collection of companies and it will have the risk of becoming specific to large firms only.
Time constraint is also an important restriction in this study. Due to this limitation, the matter can either be approached in a holistic sense or in a very specific manner. We are following the specific methodology in this regard, but it is essential to mention that this keeps the research oblivious to other variables that come outside the scope of this project. Time will also limit the periods of our study. The objective is to acquire as much current data as humanly possible to assist in this study, however historical is very significant in determining the financial modeling of firms. It will be our best effort to increase the time period of the relevant date of companies but due to limited time, it shall not be what the ideal situation is.
The research is also subject to imperfect data. There is always a chunk in firm’s financial statements where a crucial piece of information is missing. If such figures are detected then we shall eliminate that particular firm from study to keep the statistics clean from any discrepancies. Although one other discrepancy can arise from the use of mean values by firms when there is a missing value. It can cause distortion and imprecision to the data.
Lastly, the possible endogeniety of financial structuring is also a limitation of this study where the dynamic effects of gearing are neglected. No ethical or moral values will be broken or attempted to break in this research. The data will be kept clean to the best of our efforts.
The Conclusion
There is a huge assortment of theoretical and experiential research on the subject of financial structuring and its determinants. All of these studies are performed in a very variable specific manner although the number of variables addressed through this wide array of studies is still quite large. However, there is a gap in this discourse which is linked to two aspects: qualitative assessment of capital structuring and empirical evidence from the most successful of the players in the market.
This research endeavors to answer these concerns. By analyzing just the leading firms of UK, we shall attempt to include the qualitative data along with the primary quantitative methodology which is also absolutely crucial to this study and secondly, through our analysis, we shall be able to provide the time tested financial structures that have been successfully implemented and transformed according to their specific setting.
This study shall assess the contradictions present in the research literature spanning over more than half a century and evaluate which models are more correct in assuming the optimal capital structure. It shall also consider the transformation of determining variables over time and further estimate which researches can be deemed invalid in present times due to their limitation of scope.
It shall be a new addition to the various particular aspects of research in the capital structuring determinants, one that shall in future prospects, provide a viable direction to applying the theoretical background in this field with practical implications…