Analysis of the most important factors for

financing structure
- Case study: before vs. after crisis for U.S.A. -

Author: Onea Andreea

COORDINATOR:Prof. Univ. Dr. Anamaria Ciobanu

INTRODUCTION

This paper is developed in order to analyze and highlight, in the context of existing
theories and models until now, how the global economic crisis started in 2008 influenced the
financing decision and capital structure of U.S. pharmaceutical companies listed at New York
Stock Exchange, where the research and development expenses must be significant and
should not be reduced disregarding the economic context.
Part one of the paper describes the general aspects of financing a company. A number
of theories and models of capital structure have been developed over time by the most
important economists. These theories try to explain the percentage of debt and equity in
balance. The starting point for explaining the capital structure is considered to be Modigliani
and Millers theory, even if five years later this theory has been disputed, being considered a
model without a solid empirical foundation. But the capital structure theories developed later,
such as tradeoff theory, pecking order theory or agent theory have shown that an enterprise
can change the market value and the growth rate by changing the ratio between equity and
debt. These modern theories of capital structure take into consideration for establishing the
optimal structure of capital, taxes, costs due to lack of liquidity, information asymmetry, agent
costs, the effects of market imperfections and institutional constraints.
Titman and Wesselss paper (1988), The Determinants of Capital Structure
Choiceanalyzes the explanatory power of some recent theories of optimal capital structure.
Theories suggest that firms select the capital structure depending on the attributes that
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determine different costs and benefits associated with debt and equity financing. The study
extends empirical evidence on capital structure in three ways presented in the extended thesis.
The results of this study show that companies with unique and specialized products have
relatively low debt indicators.

In this context, uniqueness is given by research and

development expenses, sales expenses or the rate at which employees leave work voluntary.
Also, authors have noticed that small firms tend to use significantly more short-term debt than
larger firms.
The literature has been highlight a number of determinant of capital structure, which
are divided into two groups: on the one hand are external factors, including country-specific
economic framework where a particular company operates, and on the other hand specific
factors of comapnies that are linked to their performance. Most important external factors that
influence directly economic capital structure in different countries, are the macroeconomic
indicators. More specifically, it is inflation, interest rate and economic growth which lead to
cost and financing structure changes. Among internal factors, those that are specific to each
entity separately, we can mention the degree of profitability, firm size, assets tangibility,
bankruptcy costs and development opportunities.
Modigliani-Miller model, developed in 1958, is the first rigorous theoretical work with
the object of study to determine the financial structure of enterprises. The authors postulated
the existence of perfect capital markets, arguing that firms value does not depend on the
financing structure, in a given risk class. According to two authors, financing structure is
expressed by the debt ratio, which is equal to the ratio of debt financing (eg loans from banks,
government securities, etc..) and total business assets.
After the analysis made by the two authors, they found two sentences, as follows: the
first one indicates that a company's market value is independent of capital structure, in other
words the market value is constant regardless of the weight of debt and equity . The second
sentence supports the point that the average cost of capital of an enterprise does not vary with
the ratio between debt and equity, so it is not influenced by the indebtedness of the company.
Also, Modigliani and Miller found that the value of a company depends only on
income from its assets and not on the way in which the income is distributed between
dividends and accumulated profits.

In a new article, published in 1963, 5 years after developing the first model, the two
teachers cancel one of the initial hypotheses, the absence of taxation. Introducing taxation in
the analysis they have made it, and calculating the amounts of income directed to state from
the capital of investors, the two authors have developed two sentences: the amount of
indebted companies is the same with one of a company without debt (in the same class of risk
conditions), plus the gain resulting from financial leverage. The second sentence reffers to the
cost of equity of a indebted company which is equal to the cost of capital of a company
without debt, plus a risk premium that can be deduct from a number of factors such as: degree
of financial leverage, income tax rate, or the difference between cost of equity and borrowed
capital cost (the case of a company without debt).
Agent theory starts with Jensen and Meckling (1976) Theory of the Firm: Managerial
Behavior, Agency Costs and Ownership Structure. This paper focuses on aspects of agent
theory, property rights theory and the theory of finance, in order to develop a theory of the
firms ownership structure. The agent theory shows that leverage is directly proportional to
the importance of reputation management, enterprise value, treasury, and its liquidation value.
However, there is inverse relationship between leverage and interest rate, growth
opportunities and growth prospects of determining the cost of the company.
Information assymetry reserach began with Ross, Leland and Pyle (1977). Ross's
theory indicates that managers are those who hold the information in unaltered state on
business results and their distribution, and not investors. This aspect leads to a problem with
the weakness caused by lack of information of investors, resulting in an asymmetry of
information between individuals within the company, especially managers, and outside
persons, namely investors.
The economists Kraus and Litzenberger (1973) have developed a version of the
classical trade-off theory, which argues that optimal leverage shows a balance between tax
benefits of debt and bankruptcy costs. The two authors have introduced taxes and bankruptcy
costs in an econometric model of capital market conditions, resulting the idea that the market
value of an indebted company is the same as a company without debt plus the present value of
the reduction applied tax interest, less the present value of bankruptcy costs.
Pecking order theory was developed following two papers written in 1984 by Stewar
Myers and Nicholas Majluf, in order to try to highlight the costs of information asymmetry,
since investors dont know the true value of assets and business development opportunities, so
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they can not properly evaluate the shares of the company, in order to finance other new
investements.
Part two presents the typology of existent models and analyses for developed
countries and for Romania. Also I tried to explian the necesity of perform the study before
and after economic crisis.
One of the most significant analyzes was the study realized by swedish researcher
Han-Suck Song, in 2004. He studied data from 6,000 Swedish companies, in a panel data
analysis, between 1992 and 2000, choosing three methods for measuring the level of debt,
according to their relevance and importance.The first was based on the ratio of total debt and
total assets, because this report represents the general definition of a companys. The second
method of measuring started from the long-term debt in total assets, in this case excluding
accounts payable, in particular for suppliers. The third method of measuring debt analyzed by
Han-Suck Song, refers to the ratio between debt and equity, which is considered the most
relevant method of calculation because it takes into account the impact of financing decisions
taken in the past .The conclusion reached by Han-Suck Song was that debt, disregardless of
the method of calculation, has determinants like the weight of fixed assets in total assets,
profitability and income variability. For the firms studied in that period, other factors,
including research and development expenditure ratio in turnover, have very low relevance
for debt.
The study of Murray Frank and Vidhan Goyal analyzed companies operating in the
U.S. and listed on the stock exchange, using data from the period 1950-2000, in order to
determine factors influencing the leverage. The two researchers studied 29 factors, but after
applying the model, the results demonstrate that are only 7 relevant factors, which provides
the model a strong basis. From the fact that the two researchers have found seven factors that
influence directly the leverage, it results that it is possible to find in the near future a unified
theory of the leverage.
Another baseline study on capital structure for firms in developed countries was
developed in 1988 by researchers Sheridan Titman and Roberto Wessels. They analyzed a
total of 469 firms using data for the years 1974 to 1982, and their model was based on the
study of eight explanatory variables for capital structure, as follows: the structure of assets,
taxation, growth, product uniqueness, industry classification, size, volatility and profitability.
Atfer applying the regression analysis, the two researchers have concluded that the most
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relevant factors for the capital structure of studied enterprises were, in this order: the structure
of assets, uniqueness (measured as the ratio of research and development expenditures to
sales), industry classification, size, volatility and profitability.
The study developed by Nikolaos Daskalakis and Maria Psillaki in 2009 was based on
an analysis of panel data from a sample of companies from Greece, France, Italy and
Portugal, between the years 1998-2002. The two authors have made a comparison between
the four countries and between factors influencing capital structure for firms in each country.
Factors outlined and studied by the authors were the structure of the assets, firm size, growth
rate, profitability and risk.
Empirical studies in this area have been developed for the case of Romania too, by
Romanian researchers.
First of all, the study of Mihaela Dragot in 2005 (PhD thesis) - "Analysis of the
determinants factors of financing policy of companies listed on capital markets' it main
objective was to identify policy issues with applicability on the case of firms acting on the
Romanian economic area. Period analyzed in this study was between the years 1997 - 2003,
on a sample of about 50 companies listed on Bucharest Stock Exchange, whose assets were
approximately 10% -11% of GDP. The author of the paper has used a number of five
indicators and divided the periodbetween two sub-periods, noting that the first sub-period the
indebtedness degree had higher values, taking into account the fact that the indicators were
expressed in market values and thus the undervaluation of listed secutrities reduced the value
of market capitalization.
The study of Dan Nicolae Ivanescu (PhD thesis) - "Analysis of the determinants of
financial structure of the company" started also from a sample of Romanian companies listed
on Bucharest Stock Exchange. A first result was a very low proportion of long-term debt due
to high costs of Romanian companies resources. The main source of financing is the equity,
followed by liabilities of operations and financial liabilities. As stated in previous subsections,
financing and capital structure are strongly influenced by the macroeconomic environment,
through inflation, interest rate, exchange rate etc.
The last part of chapter two was dedicated to analyze the opportunity of developing
the model for Romanian economy. In the case of Romania, the drastic decrease in
consumption since 2010, political instability and the tendency of banking to grant loans in
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much difficult conditions until the crisis in our country, have led to environmental
degradation and economic fluctuations in the finance business and external factors were more
important than internal ones in the capital structure of Romanian companies.We considered it
appropriate to conduct a survey on the U.S. economy, specifically the pharmaceutical
companies listed on stock exchanges, because it can be accurately highlight the factors that
influenc capital structure, especially their evolution after the outbreak of the crisis, compared
with the period immediately preceding the crisis.
Part three starts withthe study based on a sample of 70 companies listed on the New
York Stock Exchange, analyzed on the period 2006-2011. Because I thought it is important to
observe the effects of economic crisis, this period was divided into two sub-periods, namely
2006 - 2008, respectively from 2009 to 2011. Financial and accounting information necessary
for the study were obtained from several sources, but the main site that provides this type of
information is http://pages.stern.nyu.edu/~adamodar/ created by Aswath Damodaran,
Professor of Finance at the University of New York.
Choosing a variable indicating a fairly indebtedness of a firm is not a standard
procedure and there are several indicators that can illustrate the indebtedness. Over time, in
the literature, were found several methods of calculating indebtedness, and of all we find that
the most suitable for this analysis is indicatorTotal Debt / Total Assets, which will be the
dependent variable in the presented model. After justify the selection made for the calculation
of indebtedness, we still must find the relevant factors which influence

it. Thus, for

determining the economic indicators that are important in the capital structure, we performed
a wider selection of indicators that can become explanatory variables in a regression equation
for determining the degree of indebtedness, and after a descriptive analysis we selected only
those indicators relevant to the study.
Atfer performing the descriptive statistic tabel, we observed that the average of
leverage was 34,2%. Also we find an average of 13,6% of tangible assets and the market-tobook-value (MBR) shows growth possibilities of the enterprise, its average is higher than one
suggesting possibility of increasing investments in these companies, at least for the period
studied. The average value of 11.83 which indicates the weight of R & D expenditures in total
turnover shows that U.S. pharmaceutical companies directs large sums of money to this
department. In the second period, 2009 2011, indebtedness increased by 11.6 percentage

points to 45.8% value, which is somewhat surprising, since the crisis, risk and fear of debt in
a turbulent period of global economy supposed to lead to lower leverage.
To quantify the relationship and correlation of chosen indicators it is essential to
effectuate the correlogram, with which we can determine whether or not exist a strong a
correlation between two or more indicators. Because indicators like CPR/AT (equity / total
assets) and LNCA (logharitm of size) are strongly correlated with some of the other
indicators, the risk of distorting the regression equation coefficients by decreasing its
significance is very high. As these two parameters directly influence other indicators, they
will not take account in the econometric model in order to determine factors and their
influence on capital structure.Regarding GROWTH indicator, it was removed from the
analysis because in the regression analysis for 2006-2008, it showed statistically
insignificant,because its associated coefficient had a probability of 39%,and the relevance
level at which we work is 5%.
The regression equation for 2008 has the following form:

From this determination function of indebtedness, we observe that the greatest

influence has assets tangibility (TANG), while the value of the ratio of R & D expenses
(RDCA) has almost no influence on leverage. The only variable that has a negative influence
is profitability, explained by the reduction trend of debt when profitability increases. Assets
tangibility increases leverage because lenders require tangible assets as collateral for loans, so
the more assets tangibility is higher, the greater is the indebtedness.
For the comparative analysis before versus after economic crisis, the results are
similar. For the analysis before the crisis we have the following results:
The coefficient of determination R-square, with a high value of 0.88 indicates that
leverage changes are well explained by variations in the other variables. Thus, we can state
that leverage is influenced to a large extent by the values of the factors that compile the
independent variables.Durbin-Watson test (DW) can range between 0 and 4, and a value less
than 2 signifies a positive autocorrelation, and when is greater than 2 there is a negative
autocorrelation at a significance level . Obviously, a value of DW around 2 indicate lack of

autocorrelation. In our test, Durbin - Watson has a value of 2.25, being the threshold of
acceptability of the hypothesis that there is no residual autocorrelation variable.
For the analysis after the economic crisis, the coefficient of determination R-square
has a similar value, of 0,89, but the Durbin-Watson test indicates a value of 2,59 so the errors
are negative autocorrelated. One of the most important conclusions is based on comparing the
results obtained in the two periods analyzed, as follows:
a) Profitability decreased leverage influence after the crisis, so the coefficient of this
indicator reduced to a value close to zero which means that its influence decreased
significantly after establishment of the crisis. This indicates that profitable companies were
not financed from loans during economic prosperity, while during the crisis, profitability has
not influenced the financing decision of the companies so much. Market instability and falling
investor confidence have led to this situation.
b) Assets tangibility maintained constant influence on leverage. This is by far the
indicator which largely determine the degree of leverage, so that, in times of economic crisis
and in the preparatory too, companies with high assets tangibility have shown a trend towards
debt. The reason is that credit grantors take measures to protect themselves, demanding
tangible assets as collateral. When assets tangibility is higher, the rise will increase lenders to
lend, thus increasing indebtedness.
c) The influence on leverage of the ratio of market value and book value has increased
slightly but it remained very low, but not negligible. Explanation of the positive influence of
this report is given by the fact that a change upward in the market value of an enterprise
involves new investments for production, development and innovation, investments that
companies prefer to do by increasing debt, despite economic crisis .
d) The ratio of research and development expenses to sales has no significant impact
on leverage in any of the periods studied. There is one change in sign of the coefficient of this
indicator caused by the establishment of crisis, from plus to minus. This can show future trend
to an inverse relationship between leverage and the ratio of R & D expenses amid economic
recession. This is explained by the fact that pharmaceutical companies tend not to debt during
the crisis to support research and development department, despite the potential high costs for
this activity.

The way in which the influence of the factors listed above has determined the capital
structure in the two periods studied, show us that the impact of economic crisis on the
financial statements of U.S. pharmaceutical companies was not so severe, and they continue
to be attractive for investors, to realize investments, to fall into debt, even more than the
period preceding the full installation of the economic crisis.
One of the main conclusions of this paper is that the assets tangibility is the most
important variabile that has a great influence on the debt of a company, and, more than this,
its influence wasnt affected by the crisis at all. In the opposite way, the explanatory variabile
that had almost no influence on the financing structure was the ratio of research and
development costs over the income of a company. From another point of view, I can say that
the theory that best suits the studied companies is the pecking order theory.
Another important conclusion of this study is that the debt of companies that sell
indispensable products (that have an inelastic demand) doesnt shrink during recession
periods, because the pharmaceutical enterprises studied had increased their debt after 2008,
using tangible assets as loan securities.
As a future research direction, I can say that it would be very interesting to investigate
how does the financing structure and debt of these companies evolves after the end of the
financial crisis, thus completing an entire economic cycle. This can be later transformed into a
general model that could provide help for those who make decisions regarding optimal
financing structure, so that the financing of a company will imply a lower risk and also
provide a greater company value.

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http://pages.stern.nyu.edu/~adamodar/ - informaii financiare pentru popularea bazei de date
http://nasdaq.com/ - informaii financiare pentru popularea bazei de date
http://investing.businessweek.com - informaii financiare pentru popularea bazei de date

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