BRAZILIAN FIRMS CAPITAL STRUCTURE DECISIONS : AN EMPIRICAL SURVEY

Prof. Ms. Almir da Silva Mota (almirsmota@mackenzie.com.br , or, asmota@klabin.com.br ) Prof. Dr. Wilson Toshiro Nakamura (wtnakamura@mackenzie.com.br ) Key words: capital structure, trade-off theory and pecking order theory 1. Introduction Capital structure decisions are considered very important in a corporate financial management context and are mainly related to the establishment of an ideal indebtment policy, i.e., a policy that tends to maximize the market value of firms, and consequently, also maximize the wealth of shareholders. Capital market provides firms with their needed long-term funding in the United States and other more advanced economies; besides, traditionally, banks hold alternatives of longterm financing and a multitude of possible conditions. This is not the prevailing reality in Brazil, in which even big businesses do not have the availability of a great number of long-term lines of credit. The truth is that firms needing financing for their investment projects end up depending strongly on the BNDES, National Bank for Economics and Social Development. As a result, Brazilian firms suffer restrictions to take long-term funding, in the form of own capital, or in the form of third party capital. Many times, these restrictions are likely to compromise the normal flow of capital investment process. With reference to short-term lines of credit, the Brazilian financial market, mainly by means of commercial banks, provides in a general sense lines of credit to firms. But as known, the Brazilian market interest rates are among the highest ones in the world because of the numerous economic crises of Brazil, a country that has many unsolved problems in the field of public finance. Having in mind all the limitations imposed to the Brazilian firms, it is the duty of financial managers to establish an adequate finance policy, taking the predominant theoretical knowledge in consideration, and search for the sources that fit best the financial needs of the firm and the concern of stockholders to have their wealth maximized. 2. Objective and motivation We have collected in this research data through the use of a questionnaire regarding the practices of capital structure decisions in our market and applied to a representative sample of Brazilian firms. Two of the most accepted theories were the main subjects of this survey: the trade-off theory and the pecking order theory. The trade-off theory suggests the existence of an optimal indebtment level that should be considered as the target capital structure of companies. The pecking order theory, on its turn, considers that firms establish a hierarchy of financing sources; the first choice is internal funds followed by external debt, being share issues the last choice, just applied after trying other possibilities. We also explored in this paper the main factors that tend to explain how firms decide on their capital structure; these factors are appointed by the theory, empirical evidences and by the practical aspects of reality.

Papers relating to modern and relevant issues on corporate finance are always welcome, principally in countries with peculiar economic and managerial conditions. Capital structure, in particular, is a subject that deserves more attention of Brazilian researchers, attributable to the fact that many times Brazilian financial managers because they are mainly accustomed to manage short-term issues and also because of the Brazilian economic reality - tend to ignore fundamental financial theories that could help them with a successfully decision-making. This study wishes to provide an incentive for other researches to publish other new studies concerning not only the subjacent theories on capital structure but also studies on the practical reality of firms. These studies are the ones that effectively should analyze the academically developed theories. 3. Theoretical reference Capital structure is considered one of the most important subjects of finances and it has called the attention of many researchers that have being, mostly, developing empirical or theoretical studies. The pioneering study of Modigliani and Miller, published in 1958, complemented afterwards by their 1963 paper is considered the starting point of many other studies on capital structure. In the last forty years or so, there has emerged several thought concerning this theme. However, up to today there are not models that allow firms to determine their optimal level of indebtment, that is, a policy that tends to maximize market value of firms. Modigliani and Miller, in their 1958 paper assume a perfect capital market, in which, among other characteristics, there are neither taxes nor transaction costs and all the players in the capital market share the same information at zero cost. In a world based on a perfect market, everyone firms and people are allowed to lend or borrow, based on single risk free interest rate defined by the players of this market. By assuming a perfect market, Modigliani and Miller developed a theoretical model on capital structure in which they concluded that the capital structure policy of firms is irrelevant, once there is no difference for a firm to work with or without debt, its market value will be unaltered. Beside the irrelevance of financing decisions, the same authors show that the cost of internal funds of a firm is directly proportional to its level of indebtment. That is to say, the more indebted a firm is, the greater is the cost of internal funds, as shareholders become bearers of a greater risk level over the investment done in the same firm. The 1963 paper of Modigliani and Miller weakened the assumption of inexistence of taxes in the market considering, in particular the corporate income tax. With that in mind, authors concluded that firms should work with 100% of third parties capital (or something close to that) because of the fiscal economy that the use of debt generates, since the interests that pay third parties is income tax deductible. Although the conclusion of using almost 100% of debt in capital structure sounds absurd, the though of fiscal economies generated by the use of debt represented an important contribution to the study of capital structure inputs of firms capital structure. These first findings of Modigliani and Miller forged the development of an academically well-accepted theory known as the trade-off theory, which accounts two opposite-sided factors. The first factor is the already cited fiscal economy that induces firms to work with a great amount of debt, while the other factor are the expected bankruptcy costs. Such costs derive from the perspective of a firm filing for bankruptcy or undergoing financial distress, when they become excessively indebted. Low levels of indebtment do not suggest bankruptcy risk but, as their debt grows, such risk also tends to grow significantly and investors deduct form the market value of the firm an amount corresponding to the so called expected costs of bankruptcy. There are two types of costs of bankruptcy: direct and indirect costs. Direct costs are the expenses of filing for bankruptcy. Such expenses are those related to court fees, lawyers, experts, etc. Indirect costs are costs associated with impaired ability to conduct business 2

during financial distress, due to the fact that, facing the great uncertainty associated to the capacity of survival of the firm, clients, suppliers, credit holders and employees avoid transactions with the firm. One version of Modigliani and Miller Theory with taxes takes in consideration not only corporate income tax but also personal income tax. Personal income taxes are related to investments on shares or debt securities; however tax rates are ordinarily different. Besides, share investors obtain remuneration through capital earnings and dividends and taxation over dividends tends to be greater than over capital earnings. Miller (1977) developed a model accepting all the mentioned taxes, finding that there must be an optimal level of indebtment not taking in consideration each firm specifically, but the aggregated. Such a model corroborated to the idea of the irrelevance of capital structure decisions. Another well-accepted theory is the one that considers the agency costs that take place whenever there are conflict of interests among creditors and shareholders, or conflicts between majority stockholder and minority stockholder. According to Meckling (1976), a firm that makes recurrent use of debt makes creditors as prevention from possible expropriations of their wealth - demand a higher financial cost over debts. In the same way, as firms have low levels of indebtment, it induces minority stockholders afraid of loosing - to demand a higher return over invested capital. Behind the agency theory resides the thought that voting shareholders will always act encompassing their own benefit in detriment of third parties. Logically, facing this interest conflict, those who do not have power to influence on managerial decisions try, on the one hand to take precautions by means of restrictions imposed to financing and issuance. These measures reduce the agency cost on rates of return, but, on the other hand they affect negatively the firms capacity to make good use of investment opportunities, this fact also represents a cost (implicit) due to agency relations. Another accepted point of view among scholars is the theory based on the asymmetry of information existing among individuals in a firm, especially among shareholders, creditors and managers. According to Myers and Majluf (1984) managers hold information that is not conveyed to the capital market. Given this asymmetric situation, investors tend to interpret some managerial decisions as a sign of good or bad news. For instance, Hearing about issuances of new shares, investors tend to recognize this new fact as a negative sign relating to the firms future results. On the other hand, the issuance of debt tends to signalize future good results, beyond expectancy. This situation makes price of shares goes down whenever new shares are issued and rise when announcing issuance of new debt. Firms tend to issue new shares whenever the perspective of future results is negative. When future perspectives are good, the original shareholders prefer to issue new debt so that new shareholders are not benefited in detriment of themselves. This line of thought of asymmetry of information led Myers (1984) to create the so-called pecking order theory, according to which firms follow a hierarchy of financing sources, choosing first the internal followed by external debt financing, and external equity being the last choice. Internal funds are, like external equity, sources related to own capital. However, while issuance of new shares implies high costs of placing, the use of internal funds is money already placed inside the company and does not involve costs of transaction. It is important to mention that placing new debt tends to be less costly than the placing of new shares, according to Higgins (2001). A more recent approach to capital structure is based on industrial organization theories and takes in consideration products and market decisions as well as its influence over firms financing decision. Such theories are based in the fact that operational microeconomics aspects of firms tend to impact the long-term financing decision. The influence of the economic activity sector over the indebtment of corporations takes in consideration the aspects related to the nature of the operational activities of corporations. It is know that firms with greater operational leverage have a greater business risk and, thus should be less indebtedness so that overall risk would not rise too much. 3

An excellent review of the main approaches of capital structure theory also including the more recent industrial organization approaches can be found in Harris and Haviv (1991). Empirical evidences, beyond theory, indicates that some factors tends to affect in a more or less intense way the firms capital structure decisions. Size [see Marsh (1982), Ferri and Jones (1979), Nakamura (1992) and Titman and Wessels (1988)] and degree of fixed assets [see Long and Malitz (1985) and Nakamura (1992)] are the two variables that tend to explain the indebtment of firms, having in mind that bigger enterprises proportionally have lower cost for debt placement and, besides, firms with greater levels of fixed assets may offer a greater volume of liquid assets as warrant for contract. Ferri and Jones (1979), Bradley, Jarrell and Kim (1984), Titman and Wessels (1988), Scott (1972), Scott and Martin (1976) and Nakamura (1992) suggest that the activity sector is a relevant variable to explain financing framework of firms. Ross and Westerfield (1988) present results indicating that the validity of pecking order theory, for North American and Japanese firms. Sunder and Myers (1999) have also verified the validity of pecking order theory considering a sample of mature firms. According to the trade-off theory, high profit firms that have little possibilities to compensate these profits in concern with income tax, tend to be more likely to issue debt. However, according to empirical evidences obtained by Kester (1986), more profitable firms tend to maintain a lower level of indebtment. Besides, Fama and French (1998) found that it is difficult to assess the impact of fiscal economies relating to interest deduction over firms value. 4. Methodology and results To accomplish the objectives of our survey, the universe of our population are the Brazilian big enterprises, mainly open capital companies. Our intention was to achieve a number of answers as great as possible to our questionnaire sent to directors and financial. After sending the questionnaires, follow up and reception of answers by means of different media, we have obtained a sample of 94 respondents, the great majority having important positions in the firms where they work. We have excluded from our final sample those questionnaires answered by bank personnel or other institutions that did not fit the objectives of our survey. Almost every participant firm of this survey are big enterprises, many of them are market leaders and reference on their actual market. Given the great number of answers obtained we were able to include a highly representative sample of the Brazilian corporative scenery, including in this survey the majority of Brazilian economic sectors. At first the survey found a strong belief among Brazilian managers that capital structure decisions add value to firms. Out of a total of 94 respondents, 75 strongly agreed, 16 agreed e 3 were indifferent. It is interesting to note that financing decisions do not have the same appeal as investment decisions; these last two are almost automatically imply the generation of value for shareholders, as projects with positive net present value are accepted. Concerning capital structure decisions we are not allowed to affirm that some decisions based on certain presuppositions - unequivocally augment the wealth of shareholders. The survey found that 94 respondents, 76,6% (72 respondents) stated that they follow a hierarchy of financing sources, while 23% (22 respondents) stated that they try to follow a target structure. These results are similar to the Fortune 500 firms results of Pinegar and Wilbricht (1989). This result attests that financial managers tend to act in accordance with the pecking order theory than to the trade-off theory. We have to take in consideration that in Brazil, especially in the case of firms with national capital, there is little flexibility to choose the best financing option in a certain moment because of the little options of existing longterm financing in the market as well as the difficulty in placing new shares in favorable conditions. The following results were obtained related to the preference of financing sources: 4

Table #1 Order of preference of financing sources Financing source Retained earnings New debt funding New convertible debt funding Issuance of new preferred capital stock Issuance of new common stock Preference 34% 21% 16% 15% 14%

We found that there is a clear preference for the use of retained earnings (34%), as precompiled by the pecking order theory. The option elected in second place was new debt funding (21%) that is also in accordance with the pecking order theory. new convertible debt funding follows these options (16%), Issuance of new preferred capital stock (15%) and Issuance of new common stock (14%). This sequence is compatible with the pecking order theory, suggesting that managers effectively take such theory as the main reference for their financing decision-making. These results are also in accordance with those obtained by Pinegar e Wilbricht (1989). Besides the argumentation of the pecking order theory, managers possibly take also in consideration the fiscal benefits in using debts, when they choose debts instead of own capital for financing their businesses. Many firms pay high income taxes. This fact makes highly compensative the use of interest to reduce the value of calculation basis for taxable income. On its turn, issuance of new preferred and common is seen as an extreme measure adopted when every other alternative has already been considered. In this case the market behavior reacts to the informational asymmetry that inevitably occurs. Table #2 presents, in order of importance, financial planning principles in governing the financing decisions of Brazilian big enterprises. First, it was considered the input Ensuring a long-term survival. It is interesting to observe that financial managers consider more important the perpetuity and survival of firms than the maximization of stock price. Although strange, it is interesting to consider that, according to finance theory, managers, that normally are not proprietors, tend to be more concerned with perpetuity than to the process of firms value generation. This is the reason why, modernly, many firms -mainly in the U.S. - are using as a criterion of variable remuneration a bonus linked to the performance of the firms securities. Another item considered very important by financial managers is the input Maintaining the financial flexibility of the company. Financial flexibility, also know as folga financeira, in Brazil, is a condition analyzed in the finance literature as being very valued by financial managers, due to the fact that as firms keep them, it gives to managers a greater degree of freedom to be taking the most advantageous financing source in a given moment. On the other hand, some specialists believes that the excess of funds tends to create a relaxing posture in the firms manager that tends to generate negative consequences from the point of view of creation of value for shareholders.

Table #2 The relative importance of financial planning principles in governing the financing decisions Percentage of answers in each degree Financial planning principles, in financing decision-making, by order of importance 1. Ensuring a long-term survival. 2. Maintaining the financial flexibility of the company. 3. Maintaining continuous and predicable sources. 4. Expectancy of future cash inflow (Profits) 5. Maintaining a balanced level of liquidity. 6. Maximizing share prices. 7. Maintaining itself in an indebtment average in relation to other firms of the same sector. 1 Not important 2 Minimally important. 3 Moderately important. 4 Important. 5 Very important. N/A No Answer. 1 0 1 1 0 0 1 7 2 0 1 0 2 4 6 20 3 10 6 11 15 15 31 46 4 14 29 34 33 40 23 17 5 76 63 54 50 40 38 10 N/A Rank 0 0 0 0 1 1 0 4,66 4,52 4,40 4,31 4,13 3,88 3,03

The third item of regarded as significant by the survey respondents is the input Maintaining continuous and predicable sources signalizing a major preoccupation of managers in relation to sources flexibility. We may conclude that Brazilian financial managers tend to be more concerned with aspects related to survival and financial flexibility than to the valorization of shareholders capital. This fact, in a way, opposes the results previously described, which pointed to a generalized belief that capital structure decisions add value to shareholders. Table #3 presents the ranking of relative importance of financial planning principles in governing the financing decisions, in light of predominant capital structure theories, specially the trade-off and pecking order theories. As observed, the main fact considered by shareholders was the capacity of future cash inflow to meet the company demands. Such results suggest two things. First, financial managers show a great concern about liquidity of the firm in short and long-term perspective. This helps to understand the reason for managers to prefer using internal funds that, in truth, represent the own capital of firms, that is, capital that will not generate return liability. Second, the results support the thesis that financial managers of Brazilian firms base their decisions chiefly on the pecking order theory.

Table #3 Ranking of importance of inputs governing capital structure decisions Percentage of answer in each degree Inputs in order of importance on capital structure decision-making 1. Future cash inflow to meet the company demands. 2. Risk level of company business. 3. Maintaining a target capital structure. 4. Concerns with corporate income tax. 5. Obtainment of financing or incentives from government institutions. 6. Concerns with taxes related to shareholders and creditors. 7. Avoid restrictive covenants when issuing debt securities and taking bank financing 8. Avoid common shareholders claims relating to dilution of voting capital held by them. 9. Creditors influence relating to the maximum indebtment allowed. 10. Avoid the need to issue new shares. 11.Concerns with direct and indirect costs of bankruptcy. 12. Concerns with agency costs. 13. Another reason not specified. 1 Not important 2 Minimally important. 3 Moderately important. 4 Important. 5 Very important. N/A No Answer. 1 0 0 2 3 3 7 4 9 7 12 16 15 6 2 0 4 6 5 11 7 11 14 15 14 24 20 0 3 4 13 22 27 20 34 32 33 38 38 32 40 2 4 20 32 35 30 26 33 35 26 26 16 13 15 1 5 76 50 34 35 39 18 16 18 12 18 11 5 1 N/A Rank 0 1 1 0 1 1 2 0 2 2 4 5 90 4,72 4,25 3,90 3,89 3,84 3,45 3,42 3,30 3,15 3,08 2,67 2,60 0,20

The second most important input is risk level of company business. According to the basic principles of corporate finance, firms should balance two risks, that is, business risk and financial risk. Thus, the result obtained indicates managers are concerned on making indebtment and risk level of their operational activities compatible. As shown on table #3, other inputs were also regarded as important, the majority being related to a diversity of capital structure. Curiously, the respondents regarded aspects related to trade-off and agency theories, such as maintenance of target capital structure, fiscal effects of debt interests and flight from restrictive covenants. This result suggests, in such a way, that firms use the pecking order theory, but at the same time take in consideration other relevant factors considered on the main capital structure theories. The little importance given to agency costs suggests that managers of Brazilian firms do not due recognize the impact that market debt taking may cause to the market value of firms. We found it strange the little importance given to the input need to issue new shares that opposes, in a manner, the belief that the pecking order theory is very important in financing decision-making. 7

The results shown in the above table are similar to those found by Pinegar and Wilbricht (1989), particularly the two first inputs considered more significant. 5. Conclusions The objective of this survey was to assess the application of two of the most important theories of capital structure developed up to today in relation to Brazilian firms: trade-off theory and pecking order theory. We have reproduced in Brazil a survey similar to the one developed in the U.S, by, for instance, Pinegar and Wilbritch (1989) and Kamath (1997). The results indicate the prevalence of the pecking order theory over the trade-off theory in the Brazilian reality, although other factors not included in the pecking order theory have appeared in this survey. Such results were, in general, similar to the results obtained principally by Pinegar and Wilbricht. The results of this paper suggest that financial managers of Brazilian firms believe that capital structure generate value to shareholders. Besides, in an order of preference their preference runs as follows: first, internal funds; second, external debt financing (issuance of new debt) and at last the issuance of new ordinary shares. This order reinforces the adoption of pecking order theory by most of the financial managers working in Brazil. 6. Bibliographic references BRADLEY, M, G.A. JARRELL, and E. H. KIM (1984). On the Existence of an Optimal Capital Structure: Theory and Evidence, Journal of Finance, 39, July, pp. 857-878. FAMA, Eugene F. e FRENCH, Kenneth R., Taxes (1998). Financing Decisions and Firm Value, Journal of Finance, 53, June, pp. 819-843. FERRI, M. G. and W. H. JONES (1979). Determinants of Financial Structure: A New Methodological Approach, Journal of Finance, 34, June, pp. 631-644. HARRIS, Milton and A. RAVIV (1991). The Theory of Optimal Capital Structure, Journal of Finance, 48, March, pp. 297-356. HIGGINS, R. C. (1998). Analysis for Financial Management, 5a. Ed., Irwin McGraw-Hill. JENSEN, M. C. and W. H. MECKLING (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, 3, October, pp. 305-360. KAMATH, R. R., Long-Term Financing Decisions: View and Practices of Financial Managers of NYSE Firms (1997). Financial Review, 32, No. 2, May, pp. 331-356. KESTER, W. Carl (1986). Capital and Ownership Structure: A Comparison of United States and Japanese Manufacturing Corporations, Financial Management, 15, spring, pp. 5-16. LONG, M. S. and I. MALITZ (1985). The Investment-Financing Nexus: Some Empirical Evidence, Midland Corporate Finance Journal, 3, fall, pp. 53-59. MARSH, P. (1982). The Choice Between Equity and Debt: An Empirical Study, Journal of Finance, 37, March, pp. 121-143. MILLER, M. H. (1977). Debt and Taxes, Journal of Finance, 32, May, pp. 261-276. MODIGLIANI, F. and M. H. MILLER (1958). The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, 48, June, pp. 261-297. MODIGLIANI, F. and M. H. MILLER (1963). Corporate Income Taxes and the Cost of Capital: A Correction, American Economic Review, 53, June, pp. 433-443. MOTA, A. S. (2001). Decises de financiamento de longo prazo e suas implicaes na criao de valor. Thesis (MBA), So Paulo. MYERS, S. C. (1984). The Capital Structure Puzzle, Journal of Finance 39, July, pp. 575592. MYERS, S. C. and N. S. MAJLUF (1984). Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have, Journal of Financial Economics, 13, June, pp. 187-222. 8

NAKAMURA, W. T. (1992). Estrutura de Capital das Empresas no Brasil: Evidncias Empricas, Thesis (MBA), FEA-USP. PINEGAR, J. M. and L. WILBRICHT (1989). What Managers Think of Capital Structure Theory: A Survey, Financial Management, 18, winter, pp. 82-91. ROSS, S. A. and R. WESTERFIELD (1988). Corporate Finance, Times Mirror/Mosby College Publishing. SCOTT Jr., D F. (1972). Evidence on the Importance of Financial Structure, Financial Management, 1, summer, pp. 45-50. SCOTT Jr., D. F. and J. D. MARTIN (1976). Industry Influence on Financial Structure, Financial Management, 4, spring, pp. 67-73. SUNDER, L. S. and S. C. MYERS (1999). Testing Static Tradeoff Against Pecking Order Models of Capital Structure, Journal of Financial Economics, 51, February, pp. 219-244. TITMAN, S. and R. WESSELS (1988). The Determinants of Capital Structure Choice, Journal of Finance, 43, March, pp. 1-19.