International Journal of Science Commerce and Humanities Volume No 2 No 7 October 2014

DETERMINANTS OF THE CAPITAL STRUCTURE: EMPIRICAL STUDY

FROM THE KOREAN MARKET
Doug S. Choi
Metropolitan State University of Denver

INTRODUCTION
This study intends to examine the important determinants of the capital structure of the Korean firms. In
general, the existing empirical studies on the issue of capital structure decision have analyzed the role of firm-
specific characteristics that represent taxation, bankruptcy costs, agency costs, and information asymmetries.
However, the extant empirical studies in this area have been confined to the U.S. and a handful of other
developed countries. Different studies (Mayer 1990; Kunt and Maksimovic 1994) have suggested that financial
decisions in developing countries are somehow different from those of developed ones because of their
institutional differences such as level of transparency and investor protection, besides the bankruptcy and tax
laws. There have been many empirical studies in this area on U.S. domestic firms, but not on international
firms. The important factors of the financial leverage studied for U.S. firms may, or may not, be relevant to
those for international firms. In this regard, this study intends to highlight those different factors of the financial
leverage, if any, for international firms. The results of this examination will reveal if the experiences of U.S.
firms hold true in the Korean financial community. The capital structure studies incorporating recent
developments in the Korean market are beneficial to U.S. as well as Korean firms since many U.S. firms have
become heavily involved with many Asian firms through direct and indirect investment. The asymmetric
information hypothesis, supporting Myers’ modified pecking order theory, can be tested by examining market
reactions to the announcement of external financing decisions.

RATIONALE FOR THE EXPLANATORY VARIABLES

In order to examine the recent developments in Korean firms’ capital structure, the variables supporting
Myers’ modified pecking order theory and the static trade-off variables with strong empirical validity were
selected for this study. The variables considered in this study exhibit good theoretical foundations and empirical
supports. A substantial amount of research has been carried out on the determinants of the capital structure.
Most of these empirical studies employ models that involve the regression of the observed leverage ratio against
a number of explanatory variables. Typically the explanatory variables include profitability, asset structure, size,
earnings volatility, internal cash-generating abilities, nondebt tax shields, and growth opportunities. This study
measures leverage as the total debt divided by total assets. In fact, various capital structure studies have not
specified which leverage measure should be used (Rajan and Zingales 1995). However, the majority of the
research on the issue of capital structure decision has employed this measure for leverage.

Profitability
Trade-off and pecking order theory have different views on the relationship between leverage and
profitability. Modigliani and Miller (1963) maintain that firms generally prefer debt for tax consideration. More
profitable firms would therefore employ more debt since increased leverage would increase the value of their
tax shield. Besides the tax advantage of debt, agency and bankruptcy costs may encourage highly profitable
firms to have more debt in their capital structure. This is because highly profitable firms are less likely to be
subject to bankruptcy risk because of their increased ability to meet debt repayment obligations. However, the

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pecking order theory of Myers and Majluf (1984) and Myers (1984) maintains the opposite view. The pecking
order theory holds a negative association between leverage and profitability since highly profitable firms will be
able to generate more cash flows through retained earnings and then have less leverage. This study uses the
ratio of earnings before interest and taxes to the total assets as a measure of profitability.

Tangibility of Assets
The tangibility of assets represents the effect of the collateral values of assets on the firm’s leverage level.
The trade-off theory predicts a positive relationship between the financial leverage and the tangibility of assets.
The underlying argument behind the use of tangible assets as collateral for debt is the higher liquidation value
of these assets in the event of financial distress or bankruptcy (Rajan and Zingales 1995). The risk of lending to
firms with more tangible assets is expected to be low and, hence, lenders will demand a low-risk premium.
Furthermore, the firm’s opportunities to engage in asset substitution can be reduced by issuing secured debt.
Myers (1984) states that the market value of the assets does include intangibles and growth opportunities as
well as tangibles. He proposes the firm’s tangible assets as an important variable for leverage decisions by
indicating that the level of borrowing is determined not just by the value of a firm’s assets but also by the type
of assets-in-place. Myers and Majluf (1984) conclude that issuing debt secured by property avoids the costs
associated with issuing shares. This suggests that firms with more collateralized assets (fixed assets) will be
able to issue more debt at an attractive rate as debt may be more readily available. This results in a positive
association between leverage and tangibility. This study employs the ratio of fixed assets to the total assets as a
measure of tangibility.

Industry Type
The relationship between industry class and financial leverage is not very conclusive in empirical studies.
Ferri and Jones (1979) used two different measures of industry type: (a) the conventional four-digit SIC code,
and (b) grouping firms with similar product lines and SIC codes. They found that industry class was linked to a
firm’s leverage but in a less pronounced and direct manner than had been previously suggested. Titman and
Wessels (1988) used a dummy variable for industry classification and found insignificant association between
industry and financial leverage. Stonehill et al. (1975) and Sekely and Collins (1988) also found minimal
industry influences on the capital structure decisions with international data. On the other hand, Bradley, Jarrell,
and Kim (1984) observed strong industry influences on firm leverage ratios. Their cross-sectional regressions
on industry dummy variables explained 54 percent of variation in firm leverage ratios. Aggarwal (1981), using
data for the largest five hundred European industrial firms, found that industry classifications were a significant
determinant of capital structure. The current study used a dummy variable with a value of 1 for the
manufacturing firms and a value of 0 for the nonmanufacturing firms.

Firm Size
Many studies of the static trade-off theory suggest a direct relationship between firm size and level of debt.
The most obvious explanation relies on the bankruptcy costs, which are related to the firm size (Warner 1977).
Warner maintains that there are ―scale economies‖ regarding bankruptcy costs, such that these costs constitute a
larger proportion of the firm’s value as that value decreases. Titman and Wessels (1988) also maintain that
larger firms are more diversified and less susceptible to bankruptcy than smaller ones. This suggests that firm
size is inversely related to the bankruptcy risk and larger firms have higher debt capacity since they can borrow
at more favorable rates than smaller firms. Myers (1984) emphasizes the importance of the asset type over the
asset size of a firm to a firm’s leverage decision. However, he does not eliminate the importance of the asset
size to the leverage decision. According to Kadapakkam et al. (1998), size can be regarded as a proxy for
information asymmetry between managers and outside investors. Large firms are subject to being more closely
observed by the investors and less subject to information asymmetry than small firms. Thus they should be
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more capable of issuing equity, which is more sensitive to information asymmetry, and have lower debt (Rajan
and Zingales 1995). Pecking order theory suggests a negative association between leverage and firm size. In this
study, the natural logarithm of the total assets was used as a proxy for size.

Business Risk
A firm’s risk depends on a number of factors (e.g., earnings volatility and operating leverage). The
traditional view of the static trade-off theory suggests that there exists an inverse relationship between a firm’s
risk and debt ratio because firms with high business risk tend to have low debt capacity. Firms with high
earnings volatility face a risk of the earnings level dropping below their debt servicing commitments, thereby
incurring a higher cost of financial distress (Bhaduri 2002). Accordingly, these firms should reduce their
leverage level to avoid the risk of bankruptcy or to rearrange their funds at high cost. The pecking order theory,
on the other hand, suggests a positive relationship between business risk and debt ratio since high operating
variance may reduce the agency cost of debt in the presence of growth-induced agency problems. This study
employed coefficients of variation in volatility of earnings over time as proxy for a firm’s risk.

Growth Opportunities
Growth opportunities represent the expected growth of a firm’s intangible assets that is created by
managerial skills, goodwill, and competence. The trade-off theory suggests an inverse relationship between
leverage and growth opportunities since these assets have no collateral value and decline rapidly in value if
bankruptcy or financial distress occurs. This will lower the ability of firms to raise their debt financing and,
consequently, result in more reliance on equity financing as tested by Titman and Wessels (1988) and Rajan and
Zingales (1995).

The pecking order theory, however, suggests that leverage and growth opportunities are positively related,
since internal funds for growing firms may be insufficient to finance their positive investment opportunities and,
hence, they are likely to be in need of external funds. According to Myers and Majluf (1984) and Myers (1984),
if external funds are required, firms will prefer debt to equity because of lower information costs associated
with debt issues. This results in a positive relationship between leverage and growth opportunities. We test the
two conflicting predictions of the trade-off theory and pecking order theory by investigating the relationship
between leverage and growth opportunities. The ratio of market-to-book value is used as a proxy for growth
opportunities (Rajan and Zingales 1995; Bevan and Danbolt 2004).

Tax Shield Substitutes

The trade-off theory suggests that the main advantage of borrowing is the tax advantage of interest payments.
Therefore firms that are subject to corporate tax will increase their leverage in order to reduce their tax bill
(Modigliani and Miller 1963). However, firms with other tax shields, such as depreciation and investment tax
credit deductions, will have less incentive to increase leverage for tax considerations since these deductions are
independent from the firm’s choice of financing its investments, whether it uses debt or not (Ozkan 2001).
Firms with tax deductions for depreciation and investment tax credits, as a result, may consider these deductions
as a substitute for the tax shield. Furthermore, the existence of nondebt tax shields makes leverage more
expensive, because the marginal tax savings from an additional unit of debt decreases with increasing nondebt
tax shields (DeAngelo and Masulis 1980), since the probability of bankruptcy may increase with financial
leverage, which makes the marginal benefit low. Following Titman and Wessels (1988) and Ozkan (2001), we
use the ratio of annual depreciation to total assets as a proxy for nondebt tax shields. The annual average of
depreciation charges divided by the fixed assets is used as a proxy for the tax shield substitutes.

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Corporate Taxes
Since the works of Modigliani and Miller, the tax advantages of debt financing have been one of the most
controversial areas in the capital structure theory. In this study, with corporate tax, any tax-paying firm gains by
borrowing; the greater the marginal tax rate, the greater the gain. Miller (1977) proposes that personal income
taxes on interest payments would exactly offset the corporate interest tax shield. Flath and Knoeber (1980) and
Haugen and Senbet (1986) find a positive association between taxes and level of debt.

The pecking order theory, however, doubts that the tax effects have been empirically supported. The firms
with higher corporate tax rate, according to Myers (1984), should borrow more than the firms with lower
corporate tax rate, if the tax side of the static trade-off theory is correct. Taub (1974) and Kim and Sorensen
(1986) find that increases in the tax rate have a negative impact on the desired debt-equity ratio, a finding
contrary to the traditional static trade-off theory. Williamson (1981) and Long and Malitz (1983) studied the tax
effect on capital structure, and they did not find any significant association between taxes and level of debt. The
ratio of taxes paid divided by earnings before taxes is used in this study as a proxy for taxes.

HYPOTHESIS
The hypothesis tests the variables that are expected to explain the financial leverage of the firms in the
Korean market. The coefficients are tested to determine whether there is a significant relationship between the
financial leverage decisions and the explanatory variables employed in this study.

Hoj: bj = 0; there is no significant relationship between the financial leverage and the
jth explanatory variable. (1)
Haj: bj ≠ 0; there is a significant relationship between the financial leverage and the jth
explanatory variable. (2)
Where j is the respective explanatory variable employed in this study.

DATA SOURCES AND METHODOLOGY

In choosing the firms for the multiple regression analysis, the 50 firms providing balance sheet and financial
statement information in the Moody’s International Manual for five consecutive years from 2008 to 2012 are
selected and tested.

The explanatory variables that are expected to explain the financial leverage of the Korean firms in the
regression model are profitability (PRFT), tangibility of assets (TANG), industry types (INTP), firm size
(SIZE), business risk (RISK), growth opportunities (GROW), tax shield substitutes (TSUB), and corporate
taxes (CTAX).

DEBT = b0 + b1 PRFT + b2 TANG + b3 INTP + b4 SIZE + b5 RISK + b6 GROW +

b7 TSUB + b8 CTAX (3)

Table 1 summarizes the definitions of the variables employed in this study.

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TABLE 1: DEFINITIONS OF THE EXPLANATORY VARIABLES EMPLOYED

Variable Definition
PRFT EBIT / total assets
TANG plant and equipment / total assets
INTP dummy variable
SIZE natural logarithm of total assets
RISK coefficient of variation in EBIT
GROW market-to-book ratio
TSUB depreciation charges / total assets
CTAX taxes/EBIT

* The values of the variables are based on the five-year averages for the period 2008 to 2012.

Table 2 summarizes the predictions of the trade-off theory and pecking order theory for the relationship
between leverage and the variables that are suggested as determinants of optimal leverage. The trade-off and
pecking order theories, as observed in this table, have no common predictions for most of the explanatory
variables.

TABLE 2: THE SUGGESTED SIGNS OF THE EXPLANATORY VARIABLES EMPLOYED

Pecking Order
Variable Trade-off Theory
Theory

Profitability Positive Negative

Tangibility of Assets Positive Positive

Industry Types Positive Negative

Firm Size Positive Negative

Business Risk Negative Negative

Growth Opportunities Negative Positive

Tax Shield Substitutes Negative -

Corporate Taxes Positive -

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RESULTS OF THE STUDY

An analysis of variance is used to measure overall effectiveness of the multiple regression models. It is an
arithmetic process for partitioning a total sum of squares into components associated with recognized sources of
variation. The ANOVA results are presented in table 3, and the table shows an R-square of 0.7653; i.e., a
relatively high portion (76.53 percent) of the total variation is associated with the eight explanatory variables of
the multiple regression models. It is concluded that, to a large extent, the financial leverage is determined
systematically by the variables included in the model. The variables tested here are profitability, tangibility of
assets, industry types, firm size, business risk, growth opportunities, tax shield substitutes, and corporate taxes.
The means and standard deviations for the above variables are presented in table 4.

The model seems to explain the level of debt with a high value of R-square and five of eight explanatory
variables in the model are statistically significant at the 10 percent level or better. The result presents that
profitability, and tangibility of assets, and firm size are significantly positively related to the financial leverage,
while growth opportunities and tax shield substitutes are significantly negatively related to the financial
leverage.

TABLE 3: TEST RESULTS OF ANALYSIS OF VARIANCE

Source DF Sum of Squares Mean Square F-Value Prob>F

Model 8 2.78676 0.34834 35.91 0.0001
Error 41 0.39771 0.00970
Total 49 3.18446

R-square 0.7653 Adjusted R-square 0.7485

TABLE 4: TEST RESULTS OF PARAMETER ESTIMATES

Explanatory Degree of Parameter Standard T-value

Variables Freedom Estimates Deviation
INTERCEPT 1 -0.270237 0.143736 -1.88
PRFT 1 0.148750 0.066406 2.240
TANG 1 0.149421 0.073353 2.037
INTP 1 0.025668 0.030303 0.847
SIZE 1 0.017695 0.009554 1.852
RISK 1 0.037337 0.107492 0.347
GROW 1 -0.027913 0.011530 -2.421
TSUB 1 -1.143591 0.303985 -3.762
TAX 1 -0.077869 0.084697 -0.919

Contrary to the studies of the U.S. firms, profitability (PRFT) is found to be positively related to leverage
and statistically significant with the t-value of 2.24. This result supports the trade-off theory over the pecking
order theory. This finding suggests that highly profitable Korean firms are less likely to experience bankruptcy
costs, consequently enabling them to raise more debt at an attractive rate (Tong and Green 2005; Baskin 1989).
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Korean banks, due to their conservative credit policies, usually offer debt to less risky firms at lower rates, and
highly profitable Korean firms may increase their ability to reduce the costs of debt for higher financial leverage.

The tangibility of assets (TANG) is found to be positively related to leverage and statistically significant.
The TANG has a coefficient of 0.149421 and a t-value of 2.037, indicating a direct association that the debt
ratio increases by approximately 0.15 percent when TANG increases by 1 percent. The findings support trade-
off and pecking order theories that the leverage decision is determined not only by the value and risk of the
firm’s assets, but also by the type of assets it holds. The importance of net fixed assets to the leverage decision
is also realized by the static trade-off theory. The findings in the Korean firms may not support the view of Kunt
and Maksimovic (1994) and Booth et al. (2001) that markets for long-term debt are not effectively functioning
in developing countries. It may indicate that the financial leverage decisions regarding TANG among the
Korean firms are showing the patterns of the developed countries.

The INTP has a positive coefficient, but it is not statistically significant with a t-value of 0.847. The results
indicate that industry type may not have a strong association with the leverage decision among the Korean
firms. The association between industry type and debt level is not very conclusive in past empirical studies with
U.S. firms either. The two types of industries, manufacturing and nonmanufacturing, do not show substantial
differences in the debt financing decisions.

The firm size (SIZE) has a significantly positive coefficient of 0.017695 with the t-value of 1.852, indicating
that as SIZE increases by 1 percent the debt ratio increases by approximately one-fifth of a percent. This result
is consistent with the findings of Rajan and Zingales (1995) and Bevan and Danbolt (2002, 2004) with the U.S.
firms. This finding supports the trade-off theory over the pecking order theory and suggests that borrowing
capacity for Korean firms is significantly limited by their bankruptcy or financial distress risks. It also supports
the view that larger firms may be more diversified and fail less often. As large Korean firms are diversified in
many product markets, their risk to face financial distress is expected to be low, where the failure of one
product market can be compensated by another. To the extent that this is the case, this finding implies that the
cost of bankruptcy or financial distress is one of the main determinants of the leverage ratio for the Korean
firms.

The business risk (RISK) has an insignificantly positive coefficient of 0.037337 with the t-value of 0.347.
This result may refute the static trade-off theory that firms with higher risk have lower debt capacity. The result
also tends to indicate that the leverage decision is not substantially affected by the volatility of the earnings in
Korean firms.

The market-to-book ratio, which is used as a proxy for a firm’s growth opportunities (GROW), is negatively
and significantly related to the financial leverage. GROW has a significantly negative coefficient of -0.027913
with the t-value of -2.421. This finding supports the prediction of the trade-off theory and may refute the
pecking order theory that firms with higher growth opportunities have higher debt capacity. A possible
explanation for this finding is that increases in stock prices in recent years in the Korean market have reduced
the cost of equity capital, encouraging Korean firms to go to the stock market for financing. This is because
firms with higher market valuation can issue equity at lower costs of information asymmetries, saving their
borrowing capacity for the future financing requirements (Kayham and Titman 2007). This supports the view of
Baker and Wurgler (2002) that at a higher market-to-book ratio, the equity market is strongly favorable for
increasing funds externally.

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The TSUB, which measures the tax shield substitutes, exhibits a very significant negative association with
financial leverage. The coefficient of the TSUB is -1.143591 with a t-value of -3.762. The debt ratio decreases
by approximately 1.14 percent when TSUB increases by 1 percent. Consistent with the prediction of the trade-
off theory, tax shield substitutes are found to be negatively related to the financial leverage. Similar evidence is
presented by Ozkan (2001), Banerjee et al. (2000), and Flannery and Rangan (2006). The negative relationship
may support the view that the existence of tax shield substitutes, such as depreciation, reduces the importance of
the tax advantages of debt financing and consequently reduces the need to raise debt for tax consideration. This
view seems to be relevant in the Korean market, where the tax laws prevent Korean firms from benefiting on
excessive debt financing. It is therefore concluded that the level of depreciation is an important factor in
leverage decisions for Korean firms.

The tax advantage of debt financing has been a controversial topic since the original works of Modigliani
and Miller. In this study, the variable corporate tax (TAX) exhibits an insignificant negative estimate of the
coefficient. The coefficient of TAX is -0.077869 with a t-value of -0.919. The low t-value for TAX tends to
confirm Myers’ proposition that taxes are not an important factor for leverage decision making. The relatively
lower corporate tax rate and relatively higher personal tax rate in Korean firms may explain the weak
association between taxes and level of debt since lower corporate tax rates could discourage the use of debt for
tax purposes.

CONCLUSION
A static model has been developed to explain how the optimal capital structure of Korean firms is
determined. The estimated static model indicates that the financing decisions of the Korean firms can be
explained by the determinants suggested by the typical corporate finance models. The model seems to well
explain the level of debt with a high value of R-square and adjusted R-square, and five of eight explanatory
variables in the model are statistically significant at the 10 percent level or better. The result presents that
profitability, and tangibility of assets, and firm size are significantly positively related to the financial leverage,
while growth opportunities and tax shield substitutes are significantly negatively related to the financial
leverage. The most significant explanatory variable—depreciation charges as a percent of total asset—is
unexpected. This relationship emphasizes the importance of tax shield substitutes for the firms in our sample.
Furthermore, it would be valuable to conduct similar tests using different markets. This study may have reached
different conclusions if the sample firms had been taken from different markets in Europe or other parts of Asia.
Research covering different markets would enhance the quality of the study by providing more generalized
information on the capital structure practices, which are not particular from one market to other markets.

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