The Determinants of Capital Structure Choice: A Survey of European Firms Franck Bancel (ESCP-EAP) Email: bancel@escp-eap.net Usha R.

Mittoo (University of Manitoba, Canada) Email: umittoo@ms.umanitoba.ca. ABSTRACT We survey managers of firms in seventeen European countries on their capital structure choice and its determinants. Our main objective is to explore the link between theory and practice of capital structure. Preliminary analysis of the survey shows some interesting findings. Financial flexibility, credit rating and tax advantage of debt are the most important factors influencing the debt policy while the earnings per share dilution is the most important concern in issuing equity. Evidence also supports that the level of interest rate and the share price are important considerations in selecting the timing of the debt and equity issues respectively. Hedging consideration are the primary factors influencing the selection of the maturity of debt or when raising capital abroad. We also propose to compare the responses of European managers with those of the U.S. in Graham and Harvey (2001) as well as across countries based on the English, French, German and Scandinavian law. This analysis would be completed by March 2002. Keywords: Capital Structure, European Managers, Survey, Debt, Equity JEL Classification: G32, G15, F23. Acknowledgements: Mittoo acknowledges part of the funding from the Social Sciences and Humanities Research Council and from the Bank of Montreal Professorship. All correspondence to: Usha R. Mittoo Bank of Montreal Professor in Finance Asper School of Business 181 Freedman Crescent University of Manitoba Winnipeg, Manitoba, R3T 5V4. Phone: (204) 474-8969, FAX: (204) 474-7545, EMAIL: umittoo@ms.umanitoba.ca.

The Determinants of Capital Structure Choice: A Survey of European Firms

I. Introduction How firms make their capital structure decisions has been one of the most extensively researched area in corporate finance. Since the seminal work of Modigliani and Miller (1958) on the irrelevance of capital structure in investment decision, a rich theoretical literature has emerged that models firms capital structure choice under different assumptions. For example, theories such as trade off theory rely on traditional factors such as tax advantage and potential bankruptcy cost of debt while others use the asymmetric information or game theoretical framework in which debt or equity is used as a signalling mechanism or strategy tool. Many of these theories have also been empirically tested. Yet there is little consensus on how firms choose their capital structure and much remains to understand the link between theory and practice of capital structure. In a recent paper, Graham and Harvey (GH)(2001) try to fill this gap by providing evidence on the practice of corporate finance theories through a comprehensive survey of the managers of U.S. firms. Our study attempts to do the same in the European context but differs largely in the focus and the scope of our survey. Unlike GH who examine many aspects of corporate finance including capital budgeting, cost of capital, and capital structure, our survey is focused primarily on capital structure. Our sample, on the other hand, spans 17 European countries: Austria, Belgium, Greece, Denmark,
These include the trade off theory, the pecking order theory, agency cost theory, and signalling information theory. See for example, Scott (1977), Miller (1977), Myers and Majluf (1984), Myers ( 1984), Ross (1977), Leland and Pyle (1977), Bradley et al. (1984), Jensen ( 1986), Kale et al. ( 1992), Barclay and Smith (1995), Jung et al. ( 1996), Graham (1996), Opler (1998), Sunder and Myers (1999), Titman and Wessels (1998), and Graham and Harvey (2001) for a review of capital structure literature.

Finland, Ireland, Italy, France, Germany, Luxembourg, Netherlands, Norway, Portugal, Spain, Switzerland, Sweden, U.K. Our study makes two important contributions to the literature. First, most of the capital structure theories have been tested in the U.S. context. To what extent, these theories are portable across different countries has become increasingly important with the globalization of financial markets in recent years. Some recent studies have explored this issue but the evidence is unclear. For example, Rajan and Zingales (1995) compare capital structure choices in seven developed countries, and Booth, Aivazian, Demirquc Kunt, and Maksimovic (2001) undertake a comparative study of capital structure policy in ten developing countries. Both conclude that although some insights from the U.S. context are portable across countries, much remains to understand the impact of different institutional features on capital structure choices. One problem in such research is that differences in legal and institutional environment as well as in accounting practices make it difficult to compare and interpret financial data across countries. A direct comparison of managerial responses is one way of overcoming the difficulties in data comparisons in different countries. Our study complements this literature because despite its limitations, survey approach allows us to collect qualitative data that may be difficult to obtain other wise and gives us information about managerial beliefs on factors that drive financial policy decisions. In our study, we compare responses of European managers in our survey to those of the U.S. managers in Graham and Harvey (2001) study to gain some insights into the common and different determinants of capital structure choice between the U.S. and European firms.

Our paper also contributes to another newly emerging strand of literature. An increasing number of studies in recent years have hypothesized that financial development in a country is closely linked with the legal and institutional environment of that country. For example, La Porta etc (1997) compare external finance across 49 countries based on English, French, German, or Scandinavian law and show that the countries with better legal protection have more external finance in the form of both higher valued and broader capital markets. La Porta etc. (1998) also show that the differences in legal protections of investors explain why firms are financed and owned so differently in different countries. Other researchers also document differences in financing and ownership patterns in different countries. The general consensus in this literature is that the differences in legal rules regarding investor protection and the quality of their enforcement influence both the nature and effectiveness of financial systems around the world. In our study, we examine whether the legal environment influences capital structure choice of firms by comparing responses of managers in countries based on the English, French, German, or Scandinavian law. Our survey analysis is at the initial stages and is likely to be completed by end of March 2002. Preliminary analysis on a subset of sample firms, however, shows some interesting findings about theory and practice of capital structure. Financial flexibility, credit rating and tax advantage of debt are the most important factors influencing the debt policy while the earnings per share dilution is the most important concern in issuing equity. Evidence also supports that the level of interest rate and the share price are modestly important considerations in selecting the timing of the debt and equity issues respectively. Hedging
See for example, Demirguc-Kent and Maksimovic (1996, 1999), Kester (1986), Mayer ( 1990), Remmers et al. (1974), Rutherford (1988), Stonehill et al. (1975), and Toy et al. (1974).

consideration are the primary factors influencing the selection of the maturity of debt or when raising capital abroad. The rest of the paper is organized as follows. The next section discusses the research design and methodology and discusses the characteristics of the sample firms. The empirical analysis is presented next and summary and conclusions in the last section..

2. Methodology 2.1 Survey Questionnaire Our survey focuses primarily on the determinants of the capital structure policy of firms and we ask questions regarding firms debt, equity and convertible debt policies. We also include some question on the cost of capital or other areas that are closely related to the capital structure. For example, we ask the managers about their approximate cost of equity, how they estimate their cost of equity (with CAPM or other methods), and how important the weighted average cost of capital is in the determination of their capital structure. The first draft of the survey was developed after a careful review of the capital structure literature pertaining to the U.S. and European countries. For ease of comparability, we tried to keep the format and design of our survey similar to that of Graham and Harvey (2001) but modified or added several questions that are likely to be relevant in the European context. For example, literature on corporate governance issues suggests that there may be strong differences in corporate objectives between Anglo-American and the Continental European financial systems. While the Anglo-American capital markets model is characterized by the objective to maximize shareholder wealth, the Continental

European model is driven by the philosophy that a corporations objective should be to maximize wealth of all stakeholders including management, labour, the local community, suppliers, creditors and even the government. To examine this difference, we ask the CFOs about the extent to which different shareholders such as stockholders, bondholders, etc. influence their firms financial decisions. Further, we also ask the firms whether they have voting or non voting shares and the percentage of free float shares. Finally, a large number of European firms are also listed on foreign exchanges. Pagano et al. (1999) show that there are significant differences in the characteristics of foreign listed and domestic listed European firms, especially in their debt to equity ratio, growth, and capital raising needs. To examine whether these differences affect their capital structure choices, we ask the firms information about their foreign exchange of listing, foreign sales, and capital raising in foreign markets. We also ask managers about the factors that influence their decision to issue equity debt or equity in foreign markets. The first draft of the survey was presented to academics and was also tested by three financial executives in summer 2001. The survey was revised after incorporated their suggestions. Our final survey questionnaire is structured around nine topics and contains eight questions. We limited the length of the survey to two pages to increase the response rate; tests showed that it takes approximately 15 minutes to complete. 2.2 Sample The choice of our initial sample was based on selecting firms that are representative population of European firms, are comparable across countries, and have publicly available information. These criteria are important for minimising firm-specific

See for example, Eiteman, Stonehill, and Moffet (1998, page 8).

differences across countries and in examining potential non response bias between respondents and non-respondents. Our initial sample consists of a total of 737 firms from seventeen European countries. The list of non-French firms is obtained from the French Financial Journal La Tribune. Two types of firms are reported in this journal: one consists of large firms in each country which are also generally part of the national stock indexes of their country and the other includes small or technological firms belonging to new markets such as European Nasdaq. This provides a wide representation of large and small firms from different countries. A total of 621 non-French firms were included from this list. Another 116 French firms were added to this list; these are part of the SBF 120 index. From this sample, 17 firms were deleted because of non-availability of addresses and another 10 firms declined to participate in the survey leaving a final sample of 710 firms. Table I presents the market capitalization and total sales of the population firms we contacted to participate to the study and it shows representation of firms from several European countries with different market values and sales levels. The survey was mailed to the Chief Financial Officers (CFO) of the sample firms whose names and addresses were obtained from the Bloomberg data base. The survey was anonymous as this was an important criteria to obtain sincere responses. Three mailings were undertaken for the survey. The first mailing was done in September 2001, the second in November 2001 and the third in January 2002. In each mailing a letter was included that was addressed to the CFO or CEO explaining the objective of the study and

Bancel and Mittoo (2001) find that perceptions of net benefits of European managers are strongly related to listing on both European and U.S. stock exchanges. The survey was mailed to the Chief Executive Officer (CEO) when the name of the CFO was not available.

we also promised to send a copy of the findings to those who wished to receive it. In some cases, we also tried to contact the CFO or CEO by phone. We received the questionnaire either by mail or by fax. Table II shows the description of the sample firms by country and by the legal origin of their country. The largest number of firms (about 45%) of the sample belong to the French law countries and about 20 percent of the sample firms belong to each of the German law, Scandinavian law, and English law countries. Our response rate (approximately 8-10%) is similar to that of Graham and Harvey (2001) based on the preliminary analysis of a subset of 61 responses. Preliminary analysis shows that all regions are represented and the response rate is similar in all regions except that it is somewhat higher in German law countries and lower in English law countries. A majority of firms (about 84 percent) are from non-English law countries which provides us a reasonable sample to compare the responses of the English law countries including the U.S. with non-English law countries. The largest percentage of firms are from the French law countries (about 40 percent), followed by German law countries (25 percent). The remaining are approximately equally divided between English and Scandinavian law countries. The largest proportions of respondents are from France, Germany, and U.K. (about 50 percent). This is not surprising keeping in view that these countries also represent about half of the population firms as shown in Table II. 2.3 Summary Statistics of Respondent Firms The survey analysis is still in progress. The following analysis is based on a subset of 58 surveys analyzed so far. Figure 1 presents the characteristics of the respondent firms. A large proportion of our respondents (over 80 percent) are large firms with sales of over $1

billion euros. This is not surprising since a majority of our population consists of large European firms. The distribution of respondents is, however, more evenly distributed when size is proxied by market value of equity. About 62 percent of sample firms have market capitalization less than 1000 million euros or between 1000 million to 5000 million euros. The sample firms represent a variety of industries with a larger concentration in manufacturing and financial (17 percent each) and mining and construction (12 percent) sectors. About one fourth of respondent firms are diversified into more than one industrial sector. Both growth and non-growth firms are well represented. High growth firms, defined as firms with price to earnings ratio greater than 14, comprise about 60 percent of the sample. About 67 percent of the firms are widely held public firms and about 30 percent have multiple classes of shares. Over 90 percent of the firms are nonutility firms and an overwhelming majority of them (98 percent) pay regular dividends. About three fourth of firms have a target debt to equity ratio, and about half of these firms maintain a debt to equity ratio of one. Surprisingly, a large percentage of firms (about 60 percent) do not have a credit rating for their debt. Further, many respondents have a large percentage (over 50 percent) of their total debt in short term. Over 70 percent of respondents have issued equity, and about 45 percent of them have issued convertible debt during the last ten years. About 75 percent of respondents report that they calculate their cost of equity, and over 70 percent of them employ CAPM to calculate this cost. The estimated cost of equity ranges between 9 percent to 15 percent; with only few firms reporting cost of capital greater than 15 percent.

A majority of the respondent firms are also internationally oriented; about 60 percent have foreign sales greater than 50 percent, and about the same percentage have issued debt or equity in foreign markets in the last ten years. About 40 percent of the respondents are also listed on foreign exchanges, with about 30 percent of these listed on the U.S. exchanges, about 20 percent on the European exchanges, and about 40 percent on both European and US stock exchanges. Overall, our respondents are large multinational firms that are internationally oriented, and have raised capital in both domestic and foreign markets. We also collect information on the characteristics of CEOs of the respondent firms. About 60 percent of CEOs are between 50-59 age category, and about 20 percent are older than 59. Their average tenure is evenly spread in various categories with about 37 percent having tenure of less than 4 years, 28 percent between 4 to 9 years, and 33 percent greater than 9 years. The CEOs of our sample firms are also highly educated; about 70 percent them have a Masters degree (42 percent have an MBA), and about 16 percent have a Ph.D. degree. A vast majority of the CEOs and other top managers (about 90 percent) own less than 5 percent their firms stock; only about 6 percent own more than 20 percent of their firms stock.

3. Results 3.1 Theory and Practice of Capital Structure We asked managers about their opinion on various factors that are likely to influence capital structure policies of firms. Three sets of factors were selected based on a review of literature. The first set of factors was based on the implications of different capital

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structure theories such as the trade off theory, the pecking order theory, and the asymmetric information theory. The second set of factors related to the managers selection of timing of issue when raising capital since literature suggests that managers use windows of opportunities to issue debt or common stock and are really concerned by financial flexibility. Finally, the last set of factors were based not on any theoretical considerations but on commonly held beliefs among managers about impact of capital structure changes such as the impact of debt or equity issue on earnings. We also asked questions on the determinants of convertible debt and foreign debt and equity. The managers were asked to rank the importance of each factor on a scale of 0 to 4 (with 0 as not important and 4 as very important). We also examine differences in managerial responses on selected firms characteristics: size, industry, P/E ratios, investment grade, and the level of foreign sales. We first present the analysis of responses in each category, and then discuss the implications of these findings. 3.2 Debt Policy We asked three questions relating to the debt policy. The first question asked the managers how they choose the appropriate amount of debt for their firm? Figure 2 and Table 3 present the summary of responses. Financial flexibility is ranked as the most important determinant of debt (mean rank=3.4). About 88 percent of the managers rate financial flexibility as either important (rating=3) or very important (rating=4). Credit rating is ranked as the next important factor, considered important or very important by over 72 percent of managers (mean rating 2.72), particularly for managers of large firms.

We adopt the Modigliani and Miller definition of Financial flexibility. As they stated in their 1963 paper, "the need for preserving flexibility will normally imply the maintenance by the corporation of a substantial reserve of untapped borrowing power" (p. 442). See Korajczyk, Lucas, and McDonald (1991), and Bayless and Chaplinsky (1996) for tests of window of opportunity hypothesis.

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Other important factors include the interest tax savings (mean rank 2.63), and volatility of earnings (mean rank 2.44). The concerns of customer/suppliers about firms financial stability and transaction costs of debt are also considered modestly important (mean rank >2) but potential costs of bankruptcy or debt levels of industry peers are rated less important (mean rank <2). Factors that relate debt to strategy or tactical reasons such as to motivate managers to work hard, or to reduce attractiveness of firms as a target are rated as unimportant (mean rank < 1). In another related question, we asked managers about the factors that influence their debt policy (Table 5). Over 72 percent respondents view lowering of weighted average cost of capital as either important or very important (mean rating of 2.79). This view is consistent with the importance of the tax advantage of debt that received a mean rating of 2.63 in another question. The factors relating to the timing of the debt or equity issue are also viewed as modestly important. The level of interest rate and the valuation level of equity in the stock market both received a mean rank of higher than 2. This evidence supports the notion that managers use windows of opportunity to raise capital. Although transaction costs of debt are considered important, few managers delay the issuance of debt because of the transaction costs. There is also little support for the factors relating to the signalling theory or the pecking order theory. For example, factors such as issuing equity gives a better impression than issuing debt or statement that we issue debt when recent profits are not sufficient to support our activities are not considered important by managers. The third question related to the maturity of debt and asked managers opinions on the factors driving the choice between short term and long term debt (Figure 3 and Table 4).

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Over 79 percent of the respondents consider the matching principle, matching the maturity of debt with the maturity of assets, as either important or very important factor (mean rank=3.12). About 75 percent of the managers (particularly those of small size firms) view that issuing long term debt minimizes the risk of refinancing in bad times is important or very important factor (mean rank=2.93). This is another evidence of the managerial interest for financial flexibility. Again, there is some support that managers select timing of the debt issue since many managers issue short term debt when they are waiting for the long term interest rates to decline (mean=1.86). There is little evidence that debt is used for strategy or tactical reasons. For example, the support for issuing short term debt to capture higher returns for shareholders or for reducing the chance that firm will undertake risky projects is almost negligible. There are some differences based on size, investment grade, and the international orientation of the firms (Tables 3-5). For example, compared to smaller firms, larger firms are influenced more by debt levels of their industry peers but are less concerned about potential bankruptcy costs, and about issuing long-term debt to minimize the risk of having to finance in bad times. Internationally oriented firms place higher value on financial flexibility and tax advantage of interest deductibility than their domestic oriented counterparts (Tables 3-5). There are some differences among firms based on industry and investment grade pertaining to the timing of the debt issue such as interest rate level and issuing debt when recent profits are insufficient but these are less pronounced.

Some managers we met to prepare the content of the questionnaire explained us that it is really important to "negotiate financing when you don't need it".

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3.3 Common Stock policy A large number of respondents (over 70 percent of respondents) have issued equity in the last ten years. (Table 6 and Figure 4). About 64 percent of those managers who had undertaken an equity issue view earning per share dilution as important or very important factor in issuing equity (mean rank 2.75). A related question pertaining to the dilution of the holding of certain shareholders was also ranked modestly important (rank=1.84). This evidence supports the literature that there is common belief among managers that issuing additional shares has a negative impact on earnings per share. About 27 percent of managers also view the ability to issue common stock for paying a target as useful for using pooling of interest method and rate this as important or very important (mean rank 1.56). This evidence suggests that the impact of equity issue on financial statements of a firm does influence managers decision regarding equity issue. Managers issue stock for various reasons. To maintain a target debt to equity ratio is the most important factor; about 54 percent of managers report that this factor is important or very important (mean rank 2.59). Other reasons that are modestly important include shares for employee stock option plans (mean rank 2.14), and insufficient funds to finance firms activities (rank=1.89). Inability to obtain funds from other sources, or maintaining debt to equity ratios similar to peers are considered as relatively unimportant factors in issuing equity. There is also strong evidence that managers select timing of the equity issue based on market share price. About 57 percent of the respondents report that issuing stock after a rise in stock price is an important or very important factor (mean rank 2.57) Alternatively, it can also be interpreted as evidence supporting the importance of earning

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per share dilution since issuing stock after a rise in stock prices is likely to reduce the risk of earning per share dilution (the dilution being an inverse function of the PE ratio). Another related question about the significance of the amount by which the stock was overvalued or undervalued in issuing equity also received a similar ranking (mean rank 2.38). Very few managers, however, believe that common stock is the least risky source of financing. There are significant differences in the responses between the high growth (defined as P/E >14) and low growth firm (defined as P/E <14). Compared to the low growth firms, more high growth firms view equity as a less risky and cheapest source of funds and as a signal of better impression than debt, pay more attention to stock price level when issuing equity, use equity issue for employee stock option plan, and are concerned about dilution of equity of certain shareholders (Table 6). Less pronounced differences are observable in responses based on industry and investment grade. 3.4 Convertible debt Managers highly value the ability to call or the flexibility to force conversion of convertible debt when they want to (Table 7 and Figure 5). About 55 percent of respondents rate this factor as important or very important (mean rank 2.37) About half the respondents also value the convertible debt for its flexibility and as an inexpensive way to issue delayed common stock (mean rank 2.27). Again, consistent with their views on equity issue, managers consider avoiding short-term equity dilution as an important advantage of issuing convertible debt (mean rank 2.19). Other factors such as convertible debt is less expensive than debt or that it is attractive for investors who are unsure about the riskiness of the firm are considered only modestly important with a

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mean ranking of 1.77 and 1.70 respectively. Factors relating to strategy or tactical uses of convertible debt such as to protect bondholders against the actions of stockholders or managers, and following industry peers are considered relatively unimportant. There are no noticeable differences in responses on major factors based on firm characteristics. 3.5 Foreign debt or equity A large percentage of our respondent firms have issued debt or equity in foreign markets. Hedging issues are cited as the most important factors for raising capital abroad (Table 8 and Figure 6). Providing a natural hedge is cited as important or very important reason by over 76 percent of managers (mean rank 2.91) who raised capital abroad. Matching the sources of fund with its uses is rated a close second with a mean rating of 2.77. These views are similar to and consistent with the selection of debt maturity. Favourable tax treatment and better market conditions relative to Europe are also ranked modestly important with a mean ranking of about 2. Surprisingly, while the level of interest rate is considered important by managers when issuing debt in domestic market, it is relatively unimportant (mean rank 1.47) when issuing debt abroad. Overall, hedging consideration appears to be the driving factor in raising capital abroad. There are few significant differences in responses based on firm characteristics.

4. Summary and Conclusions

We can draw several important conclusions from the preliminary analysis of our sample. Two main considerations seem to drive the behaviours of managers facing financial policy decisions: the search for financial flexibility and the impacts on the financial

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statements. Financial flexibility is a key issue for managers who want their firm to have access to external financing whatever the economic outlook. This financial flexibility is obtained by selecting the timing of the issue based on interest rate levels or market value of equity. This evidence is consistent with the window of opportunity hypothesis

discussed in the literature. Our survey also confirms that managers are concerned about the impact of their decisions on financial statements. The concern about earnings per share dilution is rated as an important concern in issuing common stock and is valued as a major advantage in issuing convertible debt. Credit rating and target ratios are also important issues for managers, which means that they are very sensitive to external bearings. The weighted average cost of capital and tax advantage of debt rate are also important for managers, but these factors do not appear to drive the determination of European firms capital structure policies of European firms. While the cost of financing is a concern for managers, it does not seem to be a first level constraint. Finally, we find little evidence that firms follow industry norms of capital structure or that managers use debt or equity for tactical reasons such as to pressure employees or to motivate managers to work harder. The survey analysis is at the initial stages and the above findings are only preliminary as these are based on a subset of sample firms. Future analysis would include a comparison of the responses of our study with those in Graham and Harvey (2001) as well as a comparison of responses in countries based on the English, French, German and Scandinavian law. This analysis is likely to be completed by March 2002.

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Table 1 Description of the Population Firms by Country of Origin

Country of Origin No. of Firms Austria Belgium Denmark Finland France Germany Greece Ireland Italy Norway Portugal Spain Sweden Switzerland The Netherlands United Kingdom Total 18 21 26 26 112 93 29 12 59 30 14 47 22 25 39 137 710 Average (Mil ) 1,073.5 4,535.7 2,709.5 7,119.8 9,485.6 9,046.3 1,180.8 5,655.8 6,953.5 980.3 3,571.7 7,341.0 7,989.7 19,475.7 11,143.2 15,521.5 9,074.7 Market Capitalization Median (Mil ) 456.8 969.7 1,505.4 665.1 2,773.4 2,112.0 430.6 3,346.9 2,772.2 335.7 1,864.4 1,787.7 5,337.9 5,818.3 3,393.8 5,420.9 2,666.3 Sales 2001 St. Dev. 1,218.5 5,589.8 3,662.2 25,820.2 17,261.2 16,616.8 1,547.4 4,831.2 10,302.9 2,322.4 3,819.1 14,492.0 12,581.9 27,585.2 15,515.5 32,226.7 19,969.9 Average (Mil ) 1,820.8 6,037.0 1,638.8 3,552.3 9,561.8 14,257.0 5,035.3 2,788.6 7,752.3 1,946.6 2,494.6 4,576.9 8,059.9 5,457.0 8,638.6 6,987.4 7,568.7 Median (Mil ) 1,189.0 2,204.0 946.5 948.0 4,441.5 2,065.0 350.5 1,343.0 2,408.0 373.7 1,389.1 1,724.6 5,602.7 1,565.3 4,294.1 2,879.0 2,113.3 St. Dev. 1,939.0 6,686.4 1,463.7 6,632.3 25,828.2 16,961.9 19,124.8 2,745.2 12,962.7 4,297.0 1,868.4 8,781.2 6,845.4 7,789.6 14,209.6 16,828.9 16,176.0

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Table 2 Description of the Sample by Country of Origin

Legal System of the Country of Origina French Law Countries France Belgium Greece Italy Portugal Spain The Netherlands German Law Countries Germany Austria Switzerland Scandinavian Law Countries Denmark Finland Norway Sweden English Law Countries United Kingdom Ireland Total a. b. No. of Sample Firms 321 112 21 29 59 14 47 39 136 93 18 25 104 26 26 30 22 149 137 12 710 Percentage of Sample Firms 45.21% 34.9 2.9 4.04 8.3 1.95 6.6 5.72 19.15% 12.97 2.51 3.48 14.65% 3.62 3.62 4.18 3.34 20.99% 19.38 1.67 100.00% Percentage of Respondentsb 42.62% 13.11% 1.64% 4.92% 3.28% 6.56% 8.20% 4.92% 26.23% 19.67% 1.64% 4.92% 16.39% 4.92% 6.56% 1.64% 3.28% 14.75% 11.48% 3.28% 100.00%

Based on La Porta etc (1997). Preliminary analysis based on 61 surveys

22

Table 3 Survey response to the question: What factors affect how you choose the appropriate amount of debt for your firm?
% Important or very important Mean Size Small g) Financial flexibility d) Our credit rating (as assigned by rating agencies) a) The tax advantage of interest deductibility m) The volatility of our earnings and cashflows h) We limit debt so our customers/suppliers are not worried about our financial stability e) The transactions costs and fees for issuing debt b) The potential costs of bankruptcy or near bankruptcy financial distress c) The debt levels of other firms in our industry f) The personal tax cost that our investors face when they receive interest income l) To ensure that upper management works hard and efficiently i) We try to have enough debt so that we are not an attractive target j) If we issue debt our competitors know that we are very unlikely to reduce our output k) A high debt ratio helps us bargain for concessions from our employees 87.93 72.22 59.64 50.88 38.59 37.94 28.57 22.41 10.72 10.53 5.26 1.75 0.00 3.40 2.72 2.63 2.44 2.14 2.03 1.68 1.79 0.89 0.86 0.84 0.47 0.25 3.42 2.36 2.60 2.53 2.03 2.19 2.03 1.55 0.83 1.13 0.93 0.50 0.33 Large 3.32 3.38*** 2.64 2.50 2.29 1.73 1.29** 2.14** 0.95 0.59* 0.82 0.45 0.14 P/E Growth Non-G 3.33 2.35 2.1** 2.22 2.17 1.56 1.83 2.00 0.5** 1.11 0.83 0.39 0.22 3.41 2.96 2.89 2.22 2.04 2.07 1.35 1.67 1.08 0.85 0.78 0.52 0.26 Industry Manu. 3.67 2.87 1.10 2.80 2.13 2.45 1.60 1.87 0.93 0.83 0.67 0.13 0.13 Others 3.30 267.00 1.27 2.31 2.14 1.37 1.71 1.77 0.88 1.03 0.91 0.60 0.29 Investment Grade Yes 3.43 2.51 2.54 2.50 2.33 2.19 1.71 1.76 0.93 0.73 0.90 0.40 0.17 No 3.40 3.5*** 2.90 1.8* 1.67* 1.50 1.33 1.90 0.89 1.10 0.60 0.60 0.20 Foreign Sales <25% 3.08 2.64 2.08 2.08 2.23 2.15 1.75 1.92 1.08 1.00 1.08 0.54 0.31 >25% 3.48* 2.73 2.78* 2.56 2.07 2.00 1.63 1.71 0.85 0.78 0.71 0.41 0.22

Respondents are asked to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important). ***,**,* denotesa significant difference as the 1%, 5%, and 10% level, respectively.

23

Table 4 Survey response to the question: What factors affect your firm's choice between short- and long-term debt?
% Important or very important Mean Size Small b) Matching the maturity of our debt with the life of our assets f) We issue long-term debt to minimize the risk of having to finance in bad times a) We issue short term when we are waiting for long term market interest rates to decline c) We borrow short-term so that returns from new projects can be captured by shareholders d) We expect our rating to improve, so we borrow short term until it does e) Borrowing short-term reduces the chance that our firm will want to take on risky projects 79.31 3.12 3.13 Large 3.14 P/E Growth Non-G 3.04 3.22 Industry Manu. 2.93 Others 3.19 Investment Grade Yes 3.05 No 3.50 Foreign Sales <25% 3.46 >25% 3.00

75.44

2.93

3.20

2.64**

2.85

2.83

3.20

2.83

2.93

2.80

2.54

3.02*

31.03

1.86

1.94

1.91

1.96

1.67

1.53

1.98

1.76

2.20

2.23

1.74

5.17

0.98

1.10

0.86

1.11

0.78

0.87

1.02

1.02

0.70

1.15

1.00

3.64

0.84

0.86

0.86

1.04

0.64

0.53

0.95*

0.75

1.00

1.00

0.80

1.75

0.54

0.67

0.36*

0.56

0.56

0.40

0.60

0.54

0.40

0.77

0.51

Respondents are asked to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important). ***,**,* denotesa significant difference as the 1%, 5%, and 10% level, respectively.

24

Table 5 Survey response to the question: What other factors affect your firm's debt policy?
% Important or very important i) With the use of debt, we try to minimize the weighted average cost of capital c) We issue debt when interest rates are low d) We use debt when our equity is undervalued by the market a) We issue debt when our recent profits are not sufficient to fund our activities b) Using debt gives investors a better impression of our firms prospects that issuing stocks j) We prefer banks to bonds because it avoids our firm to disclose too much information g) Changes in the price of our common stock e) We use debt because of our close relationship with a bank (house bank) f) We delay issuing or retiring debt because of transactions costs and fees h) We issue debt when we have accumulated profits 71.93 48.27 37.93 29.31 21.43 16.07 12.28 5.26 5.26 0.00

Size Mean 2.79 2.24 1.95 1.66 1.57 1.13 1.28 0.75 1.04 0.63 Small 2.77 2.42 2.16 1.81 1.77 1.47 1.60 1.00 1.23 0.70 Large 2.95 2.09 1.82 1.45 1.35 0.76** 0.96** 0.41** 0.68** 0.52

P/E Growth 2.78 2.33 1.89 1.51 1.46 1.23 1.30 0.62 0.96 0.69 Non-G 2.56 1.89 1.94 1.56 1.59 1.11 0.94 0.94 0.83 0.56

Industry Manu. 2.67 1.73 1.73 2.33 1.40 1.06 1.33 0.60 1.00 0.47 Others 2.83 2.42** 2.02 1.41*** 1.63 1.14 1.26 0.81 1.05 0.68

Investment Grade Yes 2.90 2.24 1.83 1.83 1.65 1.20 1.22 0.80 1.15 0.63 No 2.1* 2.00 2.00 0.7*** 1.20 0.60 1.30 0.2** 0.3*** 0.60

Foreign Sales <25% 3.15 2.61 1.85 1.69 1.38 1.15 1.15 0.58 0.92 0.77 >25% 2.68 2.07 2.05 1.64 1.60 1.18 1.34 0.81 1.04 0.58

Respondents are asked to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important). ***,**,* denotesa significant difference as the 1%, 5%, and 10% level, respectively.

25

Table 6 Survey response to the question: Has your firm seriously considered issuing common stock? If yes, what factors affect your firms decisions about issuing common stock?
% Important or very important Mean Size Small m) Earning per share dilution a) If our stock price has recently risen, the price at which we can issue is high e) Maintaining a target debt-to-equity ratio c) Providing shares to employee stock option plan k) The amount by which our stock is undervalued or overvalued by the market j) Diluting the holdings of certain shareholders g) Whether our recent profits have been sufficient to fund our activities n) In case of paying a target by shares, the ability to use the pooling of interest method b) Stock is our "least risky" source of funds f) Using a similar debt/equity ratio as is used by other firms in our industry d) Common stock is our cheapest source of funds h) Issuing stock gives a better impression of our firm's prospects than using debt i) The capital gains tax rates faced by our investors (relative to tax rates on dividends) l) Inability to obtain funds using other sources 63.89 56.76 54.05 50.00 45.95 35.14 27.03 26.47 24.32 21.62 8.11 8.11 8.11 2.70 2.75 2.57 2.59 2.14 2.38 1.84 1.89 1.56 1.32 1.73 0.62 1.08 0.97 0.84 2.63 2.69 2.38 2.31 2.38 1.89 1.94 1.93 1.76 1.69 0.81 1.31 1.13 1.13 Large 3.06 2.56 2.67 1.88 2.56 1.94 1.72 1.19 0.78*** 1.72 0.17** 0.89 0.89 0.56* P/E Growth Non-G NA 2.81* 2.38 2.38*** 2.62 2.05* 1.76 1.6 1.62* 1.48 0.71* 1.29* 1.1** 0.67 NA 2.11 2.33 0.75 1.89 0.77 2.11 0.71 0.78 1.78 0.22 0.67 0.33 0.78 Industry Manu. NA 2.63 3.13 2.63 2.63 2.63 2.13 1.5 1.38 1.75 1.13 0.5 0.63 1.38 Others NA 2.55 2.45 2 2.31 1.62* 1.83 1.6 1.31 1.72 0.48 1.24** 1.07* 0.69* Investment Grade Yes NA 2.6 2.71 2.2 2.33 1.67 2.08 1.46 1.67 1.79 0.79 1.29 1.67 0.92 No NA 2.3 2.43* 2 2.57 2.29 1.57 1.67 0.3*** 1.59 0.29 0.71 0.29*** 0.29** Foreign Sales <25% 2.89 2.88 2.50 1.88 2.38 1.25 2.63 1.86 1.88 1.75 0.63 1.65 1.38 0.63 >25% 2.67 2.43 2.57 2.15 2.36 2.00 1.68** 1.38 1.11* 1.64 0.50 0.89* 0.86 0.90

Respondents are asked to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important). ***,**,* denotesa significant difference as the 1%, 5%, and 10% level, respectively.

26

Table 7 Survey response to the question: Has your firm seriously considered issuing convertible debt (or issued debt in last ten years)? If yes, what factors affect your firm's decision to issue convertible debt?
% Important or very important Mean Size Small g) Ability to "call" or force conversion of convertible debt if/when we need to e) Avoiding short-term equity dilution f) Our stock is currently undervalued a) Convertibles are an inexpensive way to issue "delayed" common stock h) To attract investors unsure about the riskiness of our firm c) Convertibles are less expensive than debt d) Other firms in our industry successfully use convertibles b) Protecting bondholders against unfavourable actions by managers or stockholders 55.56 51.85 51.85 50.00 29.63 26.92 14.81 3.70 2.37 2.19 2.48 2.27 1.70 1.77 1.00 0.81 2.30 2.46 2.69 2.00 1.92 2.17 1.23 0.84 Large 2.55 2.00 2.10 2.36 1.36 1.27* 0.64 0.82 P/E Growth 2.47 2.80 2.46 2.29 1.53 1.79 1.00 0.93 Non-G 2.60 1.4** 2.40 2.00 1.40 1.40 0.80 0.60 Industry Manu. 2.14 1.42 2.29 2.43 1.90 2.00 0.86 0.57 Others 2.45 2.45* 2.55 2.21 1.65 1,68 1.05 0.90 Investment Grade Yes 2.50 2.10 2.50 2.22 2.00 1.78 1.22 1.00 No 2.00 2.20 2.60 2.50 0.6** 1.75 0.2* 0.2** Foreign Sales <25% 2.20 3.00 3.00 2.00 1.80 2.25 1.20 1.40 >25% 2.38 2.10 2.33 2.40 1.57 1.57 0.81 0.62*

Respondents are asked to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important). ***,**,* denotesa significant difference as the 1%, 5%, and 10% level, respectively.

27

Table 8 Survey response to the question: Has your firm seriously considered issuing (or issued) common stock or debt in foreign countries in the last decade? If yes, what factors affect your firms decisions about issuing in foreign markets?
% Important or very important c) Providing a "natural hedge" b) keeping the "source of funds" close to its "use a) Favorable tax treatment relative to Europe f) Market conditions may be better than domestic conditions d) Lower interest rates in foreign markets e) Foreign regulations require us to issue abroad 76.47 68.57 50.00 45.71 21.88 17.65

Size Mean 2.91 2.77 1.97 2.06 1.47 1.12 Small 3.15 2.93 2.43 2.29 1.58 1.23 Large 2.78 2.67 1.53 1.72 1.29 1.00 Growth 2.58 2.60 1.74 2.20 1.39 0.84

P/E Non-G 3.43 3.14 1.43 0.86** 0.86 1.00

Industry Manu. 2.67 2.33 2.11 1.56 1.00 1.44 Others 3.00 2.92 1.92 2.23 1.63 1.00

Investment Grade Yes 2.65 2.78 1.93 1.87 1.27 1.30 No 3.38 2.63 1.43 2.50 1.86 0.63

Foreign Sales <25% 2.67 3.17 1.50 2.83 1.33 1.00 >25% 2.88 2.59 1.96 1.89 1.42 1.10

Respondents are asked to rate on a scale of 0 (not important) to 4 (very important). We report the overall mean as well as the % of respondents that answered 3 and 4 (important and very important). ***,**,* denotesa significant difference as the 1%, 5%, and 10% level, respectively.

28

Figure 1
Mining, Construction Manufacturing

50% 40% 30% 20% 10% 0%

100499 500999 10004999

Retail and wholesale

60% 50% 40% 30% 20% 10% 0% 1%10% 11%24% 24%49%

25% 20% 15% 10% 5% 0%

Transport./Energy

Communication/Media

>5000

>50%

D: Price/earnings ratio 35% 30% 25% 20% 15% 10% 5% 0% <10 1014 1519 2024
40% 35% 30% 25% 20% 15% 10% 5% 0%

E: Market capitalization (m illion euro)

F. Long term debt ratio (%) 40% 35% 30% 25% 20% 15% 10% 5% 0% 0 1-9 10- 20- 3019 29 39 40- >49 49

>24

<1000

10005000

>5000

G: Credit rating

H: CEO Age (Years) 70% 60% 50% 40% 30% 20% 10% 0%

I: CEO Tenure (Years) 40% 35% 30% 25% 20% 15% 10% 5% 0%

60% 50% 40% 30% 20% 10% 0%

Not A+ Rated A AB+ Other

<40

40-49

29

50-59

>59

<4

4-9

High tech

>9

Other

A: Sales ( m illions)

70%

30%

Bank/Finance/Insura nce

B: Foreign Sales (% of total)

C: Industry

J: Approximate cost of equity

50% 40% 30% 20% 10% 0%
<9% 9%12% 12%15% >15%

k: Exec. stock ownership

100%
80%

L: Percent that considered issuing...

80%
60%

60% 40% 20% 0% <5% 5%10% 10%20% >20%

40% 20% 0%

Common stock

Convertibl e debt

Foreign debt

No

Yes

No

Yes

No

Yes

70% 60% 50% 40% 30% 20% 10% 0% No Yes

M: Foreign Listing
80% List on Foreign Exchanges ? Foreign Exchange s of listing 70% 60% 50% 40% 30% 20% 10% US Europe US & Other Europe 0% No Yes Multiple calss of shares

N: Other characteristics

Target debt ratio?

Use CAPM?

No

Yes

CAPM

Other

30

Figure 2

F in a n cia l fle xib ility C re d it ra tin g In te re st ta x s a vin g s E a rn in g s a n d ca sh flo w s vo la tility L e ve l o f In te re st ra te C u sto m e rs/su p p lie rs co m fo rt T ra n sa ctio n s co sts a n d fe e s E q u ity u n d e rva lu a tio n /o v e rva lu a tio n In su fficie n t in te rn a l fu n d s B a n kru p tc y/d is tre ss co sts C o m p a ra b le firm d e b t le ve l 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

P e rc e n ta g e o f C F O 's id e n tify in g fa c to r a s im p o rta n t o r v e ry im p o rta n t

Figure 3

M a tc h i n g t h e m a t u r i t y o f d e b t a n d a s s e ts

T o m i n i m iz e f in a n c i n g in b a d ti m e s

W a it in g f o r l o n g t e r m m a r k e t in t e r e s t r a t e s t o d e c lin e

0%

10%

20%

30%

40%

50%

60%

70%

80%

S e le c ti n g M a tu r i t y o f D e b t

31

Figure 4

Earning per share dilution High stock pice Maintaining a target debt-to-equity ratio Providing shares to employee stock option plan Undervalued or overvalued of stock Diluting the holdings of certain shareholders Sufficient funds from profits In case of paying a target by shares, the ability to use the pooling of interest method Stock is our "least risky" source of funds Using a similar debt/equity ratio as is used by other firms in our industry

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

70,00%

COMMON STOCK POLICY

32

Figure 5

Ability to "call" or force conversion of convertible debt

Our stock is currently undervalued

Avoiding short-term equity dilution

Inexpensive way to issue "delayed" common stock To attract investors unsure about the riskiness

Less expensive than debt

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

Convertible Debt Policy

33

Figure 6

Providing a "natural hedge"

keeping the "source of funds" close to its "use Favorable tax treatment relative to Europe Market conditions may be better than domestic conditions Lower interest rates in foreign markets Foreign regulations require us to issue abroad 0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00% 70,00% 80,00%

Foreign Debt or Equity

34