determining the method in which to raise capital, John Martin and David Scott (1974) claim that firms must consider seven conditions. These conditions are: ...
Indian Journal of Economics & Business, Vol. 6, No. 1, (2007) : 1-14
CAPITAL STRUCTURE AND FINANCIAL PERFORMANCE: EVIDENCE FROM OMAN NARENDAR V. RAO Northeastern Illinois University, Chicago
KHAMIS HAMED MOHAMED AL-YAHYAEE Sultan Qaboos University
LATEEF A.M. SYED Robert Morris College, Chicago Abstract This study examines the relationship between capital structure and financial performance. It is motivated by a desire to explain debt use by Omani firms. The results of this study suggest that, contrary to the Trade-off Theory of capital structure, there is a negative association between the level of debt and financial performance. This can be attributed to the high cost of borrowing and the underdeveloped nature of the debt market in Oman. The tax savings that the firm receives by using debt does not seem to be sufficient to outweigh the costs of using debt including the high interest cost. INTRODUCTION
Capital Structure is a topic that continues to keep researchers pondering. Capital Structure refers to the firms financial framework. Primarily, it consists of the debt and equity used to finance the firm. Researchers continue to analyze capital structures and try to determine whether optimal capital structures exist. An optimal capital structure is usually defined as one that will minimize a firms cost of capital, while maximizing firm value. Hence, capital structure decisions have great impact on the success of the firm. Exactly how firms choose the amount of debt and equity in their capital structures remains an enigma. Are firms mostly influenced by the traditional capital structures of their industries or are there other reasons behind their actions? The answers to these questions are very important, because the actions managers take will affect the performance of the firm, as well as influence how investors will perceive the firm. THE RATIONALE FOR THE SELECTION OF THE SULTANATE OF OMAN FOR THIS STUDY
Most of the research studies on capital structure have used data from American or European companies. The Sultanate of Oman was chosen for this study because it has a unique tax environment. The absence of personal taxes of any kind and the very low
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corporate tax rate in Oman, when compared to Western countries, provides a unique environment in which finance theories can be tested. While there is a vast amount of literature on corporate financial policy and impact of debt on performance (Barton and Gordon, 1988; Bettis, 1983; Bradley, Jarrell, and Kim, 1980; Capon, Farley, and Hoenig 1990, Titman and Wessels 1988), these studies focus on firms in developed countries, where there are both corporate taxes and personal taxes. The very few studies that analyze the capital structure and its impact on the firm performance in emerging markets are somewhat dated, use limited data, or have a narrow focus. This study attempts to fill the gap in the literature by looking at this relationship for listed Omani firms. This unique study is the first to look at capital structure and financial performance in the absence of personal taxes, which tended to complicate previous studies. This is also the first study on Capital Structure using data from the Middle-East. The Tax-based theory suggests that in a world with only corporate taxes and no personal taxes, the tax deductibility of interest for corporations creates a clear preference for debt in the corporate capital structure. Therefore, firms that are highly levered are supposed to outperform their counterparts that are less levered. This study provides a unique opportunity to examine the validity of the above statement and whether the financial performance of Omani firms can be explained by Finance theory. OBJECTIVE OF THIS STUDY
The objective of this paper is to investigate the impact of financial leverage on performance of publicly traded Omani companies. Financial leverage refers to the use of debt in a firms capital structure. Although there has been a great deal of research on the subject of capital structure, this study makes a contribution to the literature in this area because it is an attempt to unfold the capital structure practices of companies operating in a unique environment. This is the environment where there are no personal taxes, a flat corporate tax rate, and a financial market system that is not very efficient. Lack of market efficiency means information flow is not objectively available to all the interested parties. However, before looking into the specifics of these companies, it would be more appropriate to review the literature available on this subject to see if the results drawn from our analysis are in conformity with the trends in capital structure. REVIEW OF LITERATURE
It was in 1958, when Modigiliani and Miller (M & M) wrote a paper on the irrelevance of capital structure that inspired researchers to debate on this subject. This debate is still continuing. However, with the passage of time, new dimensions have been added to the question of relevance or irrelevance of capital structure. M&M declared that in a world of frictionless capital markets, there would be no optimal financial structure (Schwartz & Aronson, 1979). This theory later became known as the Theory of Irrelevance. In M & Ms over-simplified world, no capital structure mix is better than another. M & Ms Proposition-II attempted to answer the question of why there was an increased rate of return when the debt ratio was increased. It stated that the increased expected rate of return generated by debt financing is exactly offset by the risk incurred, regardless of the financing mix chosen.
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This is followed by Merton H. Millers 1977 paper, which takes into account not only the corporate taxes but personal taxes as well. The Pecking-order theory and the Tradeoff theory followed Professor Millers seminal paper. Pecking-order theory (Myers, 1984) provides a preferential order in terms of using different financing instruments. Unlike M & Ms over simplified Irrelevance Theory, Pecking Order Theory considers the consequences of debt and equity issues for a firm. It basically states that firms will consider all methods of financing available and use the least expensive source first (Myers, 1984: 581-2; Brealey and Myers, 2000: 524-8). It further suggests that firms should consider financing new projects in the following manner: first use internal equity, next use debt and last use external equity (Titman and Wessels, 1988:6). The important difference is that the equity is divided into two parts, viz., internal equity and external equity. Internal equity is that which is readily available for investment, where as external equity is that which must be obtained from outside sources. Pecking Order theory suggests that firms issuing debt send a positive signal about their future prospects. This also shows that the company has more investment opportunities and growth prospects than it can handle with the internally generated funds. The reasoning behind this is that managers who are unsure of future profitability will not subject the firm to bankruptcy risks. Therefore, only those firms that are confident of their ability to repay obligations will issue debt. In summary, according to signaling theory in finance, equity is issued to spread risk amongst equity holders, while debt is issued to avoid sharing wealth. This aspect of signaling theory is consistent with shareholder wealth maximization, and therefore has wide support. On the other hand, the Trade-off Theory suggests that firms with substantial amount of intangible assets should rely on equity financing, whereas those firms having tangible assets should rely more heavily on debt financing (Harris and Raviv6, 1990:323). However, it is evident that the advantages and disadvantages of offering excessive debt are significant. Trade-off theory acknowledges the tax advantages of debt, while considering the threat of bankruptcy associated with it. According to Myers, Trade-off theory is easily accepted because it explains why firms do not use excessive debt (Myers, 1984: 589)1 SOME RECENT STUDIES
In a recent study, Frank and Goyal (2003) tested the pecking order theory over the 1971 through 1998 period. They found that, in contrast to pecking order theory, internal financing is not sufficient to cover investment spending on average, external financing is heavily used, and debt financing does not dominate equity financing. On the issue of determinants of capital structure, Bancel and Mittoo (2004) found that large firms are less concerned about bankruptcy costs, and high growth firms consider common stock as the cheapest source of funds and use windows of opportunity to issue common stock. Chen (2004) found that Chinese firms prefer short-term finance and have substantially lower amount of long-term debt. However, this result is to be viewed in the context of developing nature of Chinese economy. This paper also concluded that the trade-off model or the pecking order hypothesis, based on Western settings, fail to explain the capital structure preferences of Chinese firms. This could also be true for present study on companies in the Sultanate of Oman. This may be due to the fact that the Omani
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financial market is in a developing stage and, unlike western countries; there are no personal taxes in Oman. Another study by Hovakimian and Tehranian (2004) concluded that the importance of stock returns in studies of corporate financing choices is unrelated to target leverage and is likely to be due to pecking order-market timing behavior. This study also found that profitability has no effect on target leverage. Unprofitable firms issue equity to offset the excess leverage due to accumulated losses. Thus, this study supports the notion that firms have a target capital structure. However, preference for internal financing and the temptation to time the market by selling new equity, when the share price is relatively high, interfere with the tendency to maintain the firms debt ratio close to its target. In order to better understand capital structure, the considerations in raising capital are briefly addressed in Part one of the paper. Part two of the paper discusses the methodology and the sample used in the study. Part four of the paper discusses the results of the study. Part five provides the conclusions and offers some suggestions for future research. PART ONE: CONSIDERATIONS IN RAISING CAPITAL
The topic of capital structure remains elusive due to the number of factors influencing capital structure decisions. At first glance it appears that management must only decide between the amount of debt and equity used in the firms capital structure. But this is far from being the case as there are many more criteria that must be kept in mind. In determining the method in which to raise capital, John Martin and David Scott (1974) claim that firms must consider seven conditions. These conditions are: leverage, liquidity, profitability, dividends, market price, firm size, sales growth and variability. Each of these will be briefly discussed. Leverage refers to debt securities the firm issues in order to raise the needed capital. Careful attention must be given to the amount of leverage a firm carries in its capital structure. Managers must keep in mind the uncertainty of future profitability, as well as the amount of bonds the firm will have outstanding. This is important due to the fact that the company is committing itself to periodical interest payments in addition to the repayment of principal. Due to the legal requirement that a firm commits itself to when issuing bonds, the bondholders have the recourse to force the firm into liquidation if the firm is unable to meet its payment obligations. Given the consequences of issuing debt, it would stand to reason that firms would avoid issuing bonds. However, liquidity must also be considered since a company faced with the threat of bankruptcy would be better able to absorb more debt, given that it owns enough liquid assets. Liquidity measures the ability of the firm to convert its assets quickly by selling them2. Those assets that are most easily converted to cash are called liquid assets or near liquid assets. A company faced with the threat of bankruptcy may convert its liquid assets into the funds required more easily (Ibid: 73; Baumol and Malkiel, 1967: 562). In regards to profitability, an increased use of debt will lead to a higher debt-toassets ratio. The debt-to-assets ratio measures the amount of funds borrowed by the firm in relation to its assets. The leverage (debt equity mix) magnifies the EPS for a
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firm with positive earnings. At the same time, it magnifies the losses for a firm with negative earnings. Profitability is a measure of the earning power of a firm. The earning power of the firm is the basic concern of its owners. Myers (1977) presents evidence that firms prefer raising capital from retained earnings than from debt and the issuance of common equity. This is the so-called Pecking Order theory. If this theory is true, higher profitability will correspond to lower debt equity ratio. Another concern in choosing between debt and equity financing is the companys continued ability to pay out consistent dividends. Dividends could induce a firm to use debt as a tool to maintain them if cash flow became a problem. Jensen et al. (1992), provide empirical evidence to suggest that greater dividends are associated with greater debt use. Should the company choose to issue stock rather than bonds, it is not obligated to make dividend payments. However, the reluctance to pay out dividends has its own consequences. Firms unintentionally send negative signals to investors when there is a decline in consistent dividend payments or a reduction in the amount paid out. This causes a decline in the price of the firms stock (Brigham and Houston, 2004: 488-9; Martin and Scott, 1974: 73; Titman and Wessels, 1988: 2). Next, the size of the company must be considered. Larger, well-known firms have greater access to the long-term capital market than smaller unknown firms. Smaller, unknown firms tend to either borrow short term by means of bank loans, or issue stock (Martin and Scott, 1974: 73; Cragg and Baxter, 1970: 1310-24)3. This explains why larger companies will lean toward debt financing and smaller firms towards equity financing. However, Titman and Wessels state that large corporations who have tax deductions for depreciation expenses, in addition to investment credits will issue less debt. This is due to the fact that firms use tax deductions and credits in lieu of the tax advantages associated with the issuance of debt (Titman and Wessels, 1988:3). Conversely, size could affect debt available to firms due to information asymmetry. Myers and Majluf (1984) state that information asymmetry leads firms to prefer debt, since equity is likely to be undervalued in the market. This suggests that larger firms, with less information asymmetry, will have more debt available to them. Barclay and Smith (1996) found the same and added that larger firms have lower issue costs of debt. The empirical evidence supports this. Brander and Lewis (1986) present a model where they showed that oligopoly is associated with high debt level. Studies by Marsh (1982) and Chung (1993) find that larger firms use more debt in their capital structure. Lastly, firms must consider its sales growth and the variability. A firm whose growth is somewhat stable will feel more confident about its ability to repay debt and will tend to issue bonds. On the other hand, those firms whose sales growth tends to fluctuate more will issue common stock when raising capital (Martin and Scott, 1974:73 and 1975:70). Higher sales are shown to be associated with greater debt in a model by McAndrews and Nakamura (1992), and supported by empirical work carried by Long and Malitz (1985), and Jarrel and Poulson (1988). However, Maksimovic and Zechner (1991) model a negative relationship, and are supported empirically by Kester (1986), Friend and Lang (1988), and Titman and Wessels (1988). The advantage of issuing stocks rather than bonds is that the firm will avoid the bankruptcy risks associated with debt financing. However, the disadvantage of issuing stocks is that it will lead to dilution in earnings per share. Ivo Welch (2004) found that stock returns are a first-
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Narendar V. Rao, Khamis Hamed Mohamed Al-Yahyaee & Lateef A.M. Syed
order determinant of debt ratios. Lastly, investors view stock issuance negatively, since it portends financial problems for the firm. DETERMINATION OF CAPITAL STRUCTURE
Exactly how managers set the proportions of debt and equity used in the firms capital structure continues to remain a puzzle4. It could be reasoned that firms within the same industry would have similar capital structures and behave in a similar manner. However, this is far from being the case, as debt-to-equity ratios continue to vary even between companies within the same industry. Unlike the Pecking Order theory, Trade-off theory does not acknowledge that the issuance of equity reflects the accumulated need for external financing. This, in conjunction with the nature of assets held by individual companies, may account for varying ratios between firms (Myers, 1984:590). In addition, trade-off theory fails to explain why firms, considered most profitable, are generally conservative rather than highly leveraged. Myers believes that more attention should be given to the costs of restructuring the ratios of debt and equity used, and less on perfecting static trade-off theories (Myers, 1984:590). According to Myers, if there were no costs of adjustment, and the static trade off theory is correct, then each firms observed debt-to-value ratio should be its optimal ratio (Ibid: 577). Therefore, Fischer, Heinkel and Zechner choose to view the firms optimal capital structure as dynamic, rather than static (Fischer, Heinkel, and Zechner, 1984: 19-20). In addition to considering the risks involved in debt financing, managers should also consider underlying asset variability, the riskless rate of interest, and the size of costs of recapitalization (Ibid: 20). Hence, viewing capital structures as dynamic, rather than static, would explain why debt ratios vary in companies that have similar capital structures (Ibid: 38-9). As previously stated, larger firms tend to issue more debt than smaller firms. However, Scott and Martins 1975 study of twelve industries yielded results that supported the notion that financial structures are determined by the nature of the industry (Scott and Martin, 1975:69,71). A possible explanation for capital structure differences may be the industry class to which the firm belongs. The results of Titman and Wessels 1988 study implied that low debt ratios were found for firms with unique or specialized products (Titman and Wessels, 1988: 2, 5). Typically, high-tech companies with large amounts of intangible assets will use less debt than companies whose assets are tangible. Pharmaceutical companies will often tend to have low debt ratios since they are highly involved in research and development and the intangible assets associated with such companies are of extreme importance to the continued success of the company (Brigham and Houston, 2004: 492-94). Therefore, we could rationally expect firms belonging to the same industry would exhibit similar capital structures. In addition, larger and more established firms are expected to use more debt than newer firms that do not have a significant track record. PROFILE OF SULTANATE OF OMAN, ITS ECONOMIC STATUS, AND CAPITAL MARKETS
The Sultanate of Oman is one of the Middle-Eastern countries with significant natural resources in the form of oil and natural gas. It has a substantial trade surplus, and low
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inflation. The Government of Oman believes in liberalization of markets. As a result, the process of privatization is currently underway. It has initiated the privatization of its utilities and diversification of its economy to attract foreign investment. Oman joined the World Trade Organization (WTO) in November 2000. Oman produces around 700,000 barrels oil per day and this represents about 90% of Omans exports. With favorable economic conditions, due to high oil prices, Oman is quickly investing in building its infrastructure. It is the only oil-producing nation in the Middle East that is not a member of OPEC. Oman is also making deliberate effort to diversify its resources and wants to have more contribution from non-oil sector in the future. Currently oil contributes 33.5% of the GDP, which would be reduced to 9% by 2020. Further, the government wants to see more contribution to GDP from natural gas and manufacturing sector. The securities market in Oman [also known as Muscat Securities Market (MSM)] is governed by Omani Capital Market Law of 1998. Oman also has a parallel market which is used by those companies that do no qualify for listing in the MSM (Al-Rimawi, 2001). The MSM General Index has peaked to 4832 from 1,919.0 in 2002. PART TWO: DATA COLLECTION
The data required for this study was collected from the Muscat Securities Market (MSM) and the Capital Market Authority of the Sultanate of Oman. ANALYSIS
There are totally 144 companies listed on the MSM. Out of this number, 93 companies are non-financial firms and were chosen for this study. These 93 firms were ranked in descending order by the debt ratio. The top 25% of the companies and the bottom 25% of the companies were chosen and made classified into separate groups. The top 25% of the companies were designated as the high leverage group and the bottom 25% of the companies were designated the low leverage group. Five performance measures were used to determine which group (i.e.) high leverage or low leverage has performed better over the five-year period 1998-2002. PERFORMANCE MEASURES
The performance factors identified in the literature as candidates for the relationship with a firms capital structure are the focus of this study. Management researchers prefer accounting measures of performance, such as return on equity (ROE), return on investment (ROI), and return on assets (ROA), along with the variability in these returns measures. Researchers from finance and economics seem to prefer market returns or cash flow measures along with their variability as performance measures. The performance measures in previous studies typically measure an accounting rate of return. The idea behind this measure is perhaps to evaluate performance from a managerial standpoint. Return on investment (ROI), return on capital (ROC), return on assets (ROA) and return on sales (ROS) are essentially efficiency measures. That is, how well management is using the assets (as measured in dollar terms) to generate accounting returns per dollar of investment, assets or sales. ROA and ROE are the most frequently
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used performance measures in prior studies. (Carter, 1977:279-89; McDougall and Round, 1984:384-98). ROA has been used in this study as the performance measure as it is a commonly used indicator of managerial performance. In addition to ROA, for the companies in each of the groups, other financial performance measures, namely, operating profit margin (OPM), return on equity (ROE), net profit margin (NPM), and earnings per share (EPS) were computed for five years 1998-2002. All explanatory proxies are averaged over a five-year period (1998-2002), to minimize the measurement error due to random year-to-year fluctuation in variables. The standard deviation of these performance measures was also obtained in order to assess the volatility. The results of this first stage of the analysis are shown in Tables 1 and 2. FURTHER EMPIRICAL ANALYSIS
In order to gain further insight into the relationship between financial leverage and performance, a regression analysis was performed. Cross-sectional data on listed Omani companies was obtained from the Muscat Securities Market and carefully examined before the regression analysis was performed. The DEBT RATIO, which is the ratio of total debt to total assets, was used as the principal explanatory variable. The dependent variable was profitability as measured by Return on Assets (ROA). ROA was chosen as the dependent variable because it is an important accounting-based and widely accepted measure of financial performance. In order to recognize the fact that a number of factors may impact on profitability, other variables were also chosen as explanatory variables and are used in this study as control variables. The efficiency in the use of assets is likely to be an important determinant of profitability. Hence, an asset management variable, total asset turnover ratio (TAT) was included. It was expected that TAT would have a positive relationship with performance. Firm liquidity is an actual performance factor that views access to cash from asset conversions or by access to debt markets as good. Myers (1984) and Gertler (1988) argue that small firms are apt to have less liquidity and hence, use less debt. On the other hand, Aggrawal and Nagarajan (1990) find a negative association between liquidity and debt use. The reason for this finding could be that firms are concerned with financial risk. Hence, a liquidity variable, quick ration (QR) was included. If a firm has sizable liquid assets, this is expected to have a negative impact on profitability, as liquid assets are low-yielding assets. Hence, it was expected that QR would have a negative relationship with performance. As the size of the firms may be an important determinant of profitability, a variable SIZE was included. In accordance with standard practice, size was measured as the log of total sales. According to Penrose (1959), larger firms can enjoy economies of scale and these can favorably impact on profitability. Larger firms may also be able to leverage their market power (Shepherd, 1986). Size is expected to have a positive relationship with profitability. The age of the firms may also have an important influence on performance. Hence, a control variable, AGE, was introduced as the number of years since the inception of
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the firm to the observation date. The impact of age on performance was left to be empirically determined. Corporate diversification remains a controversial area with the Finance literature making a strong case against it (Brealey & Myers, 2000), while the Strategic Management literature seems to favor it (especially related diversification). Segment sales information was not available for Omani companies. Hence, an index variable DIVERSIFICATION was included, with a value of 0 for no diversification and 1 for diversification. The impact of diversification on performance was left to be empirically determined. CAPITAL INTENSITY, as measured by the ratio of net fixed assets to total assets, and INVENTORY, the ratio of inventory to total assets, were also included. The impact of capital intensity on performance was left to be empirically determined. As capital is locked up in inventories, holding large amounts of inventory could have a negative impact on profitability. Hence, a negative relationship was expected between inventory and performance. RESULTS Table 1 High Leverage Group: Mean and Standard Deviation Ratio
Average Return
Standard Deviation
OPM NPM ROA EPS ROE
-0.000213758 -0.000169811 -4.780892174 -0.153565217 -3.147982609
0.00037449 0.000369046 6.514311093 0.378084438 40.14688388
Table 2 Low Leverage Group: Mean and Standard Deviation Ratio
Average Return
Standard Deviation
OPM NPM ROA EPS ROE
.00000615131 .00000579483 5.703495652 0.148808696 3.953547826
0.000140306 .00000805556 6.259169417 0.225896585 12.66551202
Tables 1 and 2 clearly show that the low leverage group clearly outperformed the high leverage group. This result was consistent across all five performance measures. The volatility (standard deviations) for all the five performance measures for the low leverage group was lower than that for the high leverage group. The results of the regression are shown in Table 3. The explanatory power of the model was quite good with an R-square of nearly 60%. DR (Debt ratio) was found to be negative and significant. This confirms that financial leverage has a negative relationship with performance. This is also consistent with the findings by Majumdar and Chhibber (1997). Of the seven control variables introduced in the model, three of them are significant, at a minimum of 10% level of significance. CAPINT was significant, but surprisingly had a negative relationship to performance. AGE was positive and
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Narendar V. Rao, Khamis Hamed Mohamed Al-Yahyaee & Lateef A.M. Syed Table 3 Regression Results
Variable
Coefficient Estimate
t-statistic
ROA DR TAT QR Size Age CapInt Inven Divr Constant R-sq. Adj. R-sq. Fstatistic N
0.006409 -0.006727 -0.000159 -0.000825 0.000193 0.000242 -0.000806 -0.001779 -0.00145 -0.006409 0.335 0.597 5.236* 93
1.458 -3.713* -0.197 -3.209* 0.826 3.086* -3.398* -0.389 -1.267
*significant at the 10, 5, and 1 percent level
significant. According to Stinchcombe (1965), older firms can achieve experience-based economies and can avoid the liabilities of newness. QR (Quick ratio) was negative and significant as expected. DISCUSSION AND IMPLICATIONS
The regression results confirm the negative relationship between financial leverage and performance. The regression results further suggest that liquidity, age, and capital intensity also have a significant influence on financial performance. These results suggest that a high debt capital structure is not appropriate for Omani companies. The reasons for this could be the following: 1. Due to the absence of a well developed and very liquid bond market, Omani companies are dependent on banks for debt financing. The interest cost in Oman is very high when compared to Western countries. Even those companies that are good performers at the operating profit level turn out to be poor financial performers at the net profit level due to the high interest cost. Hence, until there is a welldeveloped bond market, it would be prudent for Omani companies to reduce their debt financing and instead use internal cash flow or equity to meet their financing needs. 2. Given the unique tax environment in Oman, there is minimal tax advantage from using financial leverage. Hence, it makes little sense for Omani companies to take on a lot of debt when does not confer the tax benefits in Oman as it does in Western countries. 3. Oman is an emerging economy. Using high amounts of debt in an economy that is in the nascent stage of development is fraught with risk.
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CONCLUSION
This study investigated the relationship between financial leverage and performance for a cross-section of listed Omani companies and found a negative relationship that is contrary to the view held in Western countries. The high cost of bank debt in Oman coupled with the absence of a well-developed bond market was viewed as the primary reasons for the observed relationship. In addition, the very low, flat corporate tax rate in Oman implies that debt does not confer the same level of tax shield benefits in Oman as it does in Western countries. Hence, at this time, use of a high level of debt financing by Omani companies may not be a prudent strategy. IMPLICATIONS FOR MANAGERS
Overall, these results demonstrate a negative association between debt and firm performance. What does this say to managers? We believe that it says that if you can operate your business effectively without going into debt, do so. Avoid debt. This may be particularly relevant to Oman. The cost of borrowing in Oman is phenomenally high by international standards. Whereas investors are currently offered rates of interest between 10% and 15% annually by financial institutions, the costs to borrowers of funds from banks and other financial institutions are much higher, given the risk premium and the administrative costs that are added on. One would hypothesize that the negative aspects of debt noted earlier would be exacerbated by the high current interest premium. NOTES 1.
Firms do not borrow the maximum amount they are able to and hold a reserve of borrowing capacity. This helps to keep the firm within a safe debt range (Myers, 1984: 589).
2.
Liquidity is measured by the firms ability to convert its assets into cash without significant loss of value. For example, consider the fact that treasury bonds held by a firm are more easily converted than a physical asset, such as equipment.
3.
Take note that when external equity is used, smaller firms will suffer larger flotation costs that affects its financing decision. Flotation costs are those costs the firm must pay to issue new stocks or bonds. The higher the flotation cost, the smaller the size of the new issue (Brigham and Houston, 2004: 367-68).
4.
Recall Stewart Myers 1984 paper entitled The Capital Structure Puzzle which raised many questions regarding capital structure. Almost two decades later, the researchers are still attempting to explain and dispute some of the questions and issues raised by Myers (Myers, 1984: 575-592).
REFERENCES Aggrawal, A. and Nandu J.N. (1990), Corporate Capital Structure, Agency Costs, and Ownership Control: The Case of All Equity Firms, Journal of Finance, 45, 606-616. Al-Rimawi, L.M. (2001), Jordanian, Kuwaiti and Omani Securities Regulation: Can they be Subject Matter of a Viable Comparative Study with EU Securities Regulation? (Part Two), Journal of Financial Regulation and Compliance, 9, no. 3, 253-273. Bancel, F and Mittoo, U. (2004), Cross-Country Determinants of Capital Structure Choice: A Survey of European Firms, Financial Management 33, no. 4, 103-132. Barton, S. and Gordon, P. (1988), Corporate Strategy and Capital Structure, Strategic Management Journal, 9, 623-632.
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