THE RESEARCH ON THE EFFECTS OF CAPITAL STRUCTURE ON FIRM PERFORMANCE AND EVIDENCE FROM THE NON-FINANCIAL INDUSTRY OF TAIWAN

50 AND TAIWAN MID-CAP 100 FROM 1987 TO 2007

Shyan- Rong Chou

Department of Financial Operations National Kaohsiung First University of Science and Technology Email: srchou@ccms.nkfust.edu.tw Chen-Hsun Lee Doctoral Program in Management Institute of Management National Kaohsiung First University of Science and Technology Email: leeblade@yahoo.com.tw

ABSTRACT The purpose of this paper is to explore an optimal capital structure to maximize the performance of the firm under the same systematic risk. We investigate the relation between return on equity (ROE) and the capital structure for a sample of 37 firms from 1987 to 2007. This text explores from MM and trade-off theory with considering interest rate. We explore the empirical implications that there exists an optimal capital structure under trade-off theory and the optimal capital structure of non-financial industry in Taiwan 50 is 34.31%. At the same time, the average annual debt-ratio is adjusted towards to the optimal capital structure year by year. We prove the existence of the best capital structure in Taiwan 50 and Taiwan Mid-Cap 100, find the optimal capital structure and their concerning maximum value of ROE. The target ratio may change over time as the firms performance and environments change. When firms adjust their capital structure, they tend to move toward an optimal debt ratio consistent with the historical financial behaviors of firms. We also find the firms performance is a quadratic function of debt ratio. In this paper, we provide further evidence on the relation between the distribution of debt ratio and corporate performance. This text summarized the main conclusion that the non-financial industrys capital structure of Taiwan 50 and Taiwan Mid-Cap 100 is consistent with trade-off theory, and the results are consistent with the hypothesis that the corporate performance is a nonlinear function of the capital structure. Keywords: Tradeoff Theory, MM Theory, Capital Structure, ROE, Firms Performance

I.

Introduction

The theory of the capital structure is an important reference theory in enterprise's financing policy. The capital structure referred to enterprise includes mixture of debt and equity financing. Whether or not an optimal capital structure exists is one of the most important and complex issues in cooperate finance. The modern theory of the capital structure originated from the pathbreaking contribution of Modigliani and Miller in 1958, under the perfect capital market assumption that if there is no bankrupt cost and capital markets are frictionless, if without taxes, the firm's value is independent with the structure of the capital. This is known as MM Proposition . In 1963, under considering the corporate taxes,

Modigliani and Miller modified the conclusion to recognize tax shield. Because debt can reduce the tax to pay, so the best capital structure of enterprises should be 100% of the debt. But this seems to be unreasonable in the real world. Jensen and Meckling (1976) introduce the concept of agency costs and investigate the nature of the agency costs generated by the existence of debt and outside equity. When considering corporation tax, bankrupt costs and agency costs at the same time, trade-off theory can be introduced to derive the existence of the optimum capital structure. Leland (1994) extends the results of Merton (1974) and Black and Cox (1976) to include taxes, bankruptcy costs to derive the optimal capital structure. Deangelo and Masulis(1980) argue that the existence of non-debt corporate tax shields such as depreciation deductions is sufficient to overturn the leverage irrelevancy theorem. Hovakimian, Opler, and Titman (2001) tested the hypothesis that firms tend to a target ratio when they either raise new capital or retire or repurchase existing capital. They found firms should use relatively more debt to finance assets in place and relatively more equity to finance growth opportunities. Our motivation is quite similar to those described in studies by McConnel and Servaes(1990). We investigate the relation between ROE and the capital structure. In this paper, we provide further evidence on the curvilinear relation between ROE and debt-to-asset ratio. And we also find the relation between capital structure and annual loan interest rate is negative from 1987 to 2007. Unlike previous studies which argue that we can just only derive the range of the optimal capital structure, this paper yields the exact solution of the non-financial industrys optimal capital structure in Taiwan 50. The rest of this paper is as follows. The next section is literature review. Section describes the data, our empirical approach and our univariate and quadratic regression

model. Section

 summarizes our findings and concludes.

II. Review of the Literature Modigliani and Miller (1958) claim that under perfect capital market conditions, a firms value depends on its operating profitability rather than its capital structure. In 1963, Modigliani and Miller (1963) fix the previous paper; argue that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal. This means that the firms value increases as debts increases. Titman (1984) demonstrates the idea of indirect bankruptcy costs. He argues that stakeholders not represented at the bankruptcy bargaining table, such as customers, can suffer material costs resulting from the bankruptcy. Leland (1994) demonstrates a standard trade-off model. At the optimal capital structure, marginal bankruptcy costs associated with firms debt are equated with marginal tax benefits. The static tradeoff theory was the original retort to the theory of capital structure relevance. Modigliani and Miller (1963) argue that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal. In this framework, firms target an optimal capital structure based on tax advantages and financial distress disadvantages. Firms are thought to strive toward their target and can signal their future prospects by changing their structure. Adding more debt increases firm value through the markets perception of higher tax shields or lower bankruptcy costs. But optimal capital structure at a 100% debt financing are clearly incompatible with observed capital structures, so their findings initiated a considerable research effort to identify costs of debt financing that would offset the corporate tax advantage. Since then, extensions of the Modigliani-Miller theory have been provided by the following researches. Robichek and Myers (1965) argue that the negative effect of bankruptcy costs on debt to prevent firms from having the desire to obtain more debt. Jensen and Meckling (1976) identify agency cost in governing the corporation. The general result of these extensions is that the combination of leverage related costs (such as bankruptcy and agency costs) and a tax advantage of debt produces an optimal capital structure at less than a 100% debt financing, as the tax advantage is traded off against the likelihood of incurring the costs. III. Data and Methodology 3.1. Data The source for all of our data is TEJ. We begin with all 37 nonfinancial companies listed in the Taiwan 50 and all 89 nonfinancial companies listed in the Taiwan Mid-Cap 100 from 1987 to 2007. The requirement for each firm year observation to enter the sample is the availability of a fiscal year end debt ratio and

stock price series for at least the twelve months proceeding the given year. Financial companies including banks, investment companies, insurance/life assurances and companies that change the fiscal periods end date during the research period are excluded. 13 financial companies are hence removed in Taiwan 50 and 11 financial companies are removed in Taiwan Mid-Cap 100. The resulting sample contains 2139 firm season-end observations in Taiwan 50 and 4727 firm season-end observations in Taiwan Mid-Cap 100 from 1987 onwards. In this section, the primary hypothesis investigated here is that the performance of the firm is a function of debt ratio. 3.2. Methodology The tax shield increases the value of the levered firm. Financial distress costs lower the value of the levered firm. The two offsetting factors produce an optimal capital structure. The Miller model with limited deductibility of interest leads to a -shaped graph similar to the one presented in Figure 1. The -shape in Figure 1 arose from the trade-off between corporate taxes and bankruptcy costs. In the model, the debt-assets ratios will adjust to that the net tax advantage of debt is of the same of magnitude as expected marginal financial distress costs.

Figure 1. The optimal amount of debt and the value of the firm. We assume that capital markets are perfectly competitive, and if there are corporate taxes, the model is
V ! E  F Debt  K Debt 2 , F " 0, K 0 , 0 e x e 100 (1)

Below, Debt is treated as equity ratio, while V is treated as debt ratio. ,

are the

parameters. Since the company has more debt, the debt is riskier and the cost of debt is higher. IV. Results Table 1 presents the initial regression results.
Table 1 Regression analysis of ROE on debt ration for 37 Taiwan 50 firms and 89 Taiwan Middle 100 firms from 1987 to 2007 (p-values in parentheses below coefficients).

Panel A: Taiwan 50 sample Variablea Intercept Debt Debt2 Critical pointb R2

a b

Panel A: Taiwan Mid-Cap 100 sample (3) 13.341

(0.000)

(1) 37.470
(0.006)

(2) -6.252
(0.532)

(4) 3.224
(0.159)

-0.810
(0.002)

1.784
(0.001)

-0.160
(0.006)

0.485
(0.000)

-0.026
(0.000)

-0.007
(0.000)

0 0.460

34.31% 0.844

0 0.391

34.64% 0.828

Debt =debt-to-assets ratio The critical point is the percentage debt ratio at which the value of ROE reaches its maximum in the estimated regressins.

Column (1) and Column (3) contain the linear model of Taiwan 50 and Taiwan Mid-Cap 100, in which ROE is regressed against (Debt). For both Taiwan 50 and Taiwan Mid-Cap 100, the coefficients of (Debt) are negative and significant. Column (2) and Column (4) contain the curvilinear relations of Taiwan 50 and Taiwan Mid-Cap 100. The curvilinear relations are consistent with trade-off theory. This curves reach its maximum prior to 50% debt-to-asset ratio. In Taiwan 50, the maximum is reached at 34.31% debt ratio. In Taiwan Mid-Cap 100, the maximum is reached at 34.64% debt ratio. An implication of this paper is that the optimal capital structures of Taiwan 50 and Taiwan Mid-Cap 100 seem to be not different. Hence, a firms performance should be a dependent determinant of its capital structure, an empirical result documented in Modigliani and Miller (1963). For the overall sample, the mean debt ratio for all firms is 47.84% in 1987. The mean leverage decreases monotonically to 34.31% year by year. Figure 1 presents the mean leverage for each leverage decile yearly over the 21-year holding period. At low levels of debt ratio, the positive effect of tax shield strongly dominates the negative effect of financial distress cost.

n (34.31, 24.35)
20

0 Value of F irm : R O E (% )

-20

-40

-60

-80

-100

10

20

30

40 50 60 Debt/Capital Ratio (% )

70

80

90

100

Figure 2. ROE as a function of debt-to-capital ratio.

60 The Optimal Capital Structure of Taiwan 50 The Mean Leverage of Taiwan 50 The Optimal Capital Structure of Taiwan Middle 100 The Mean Leverage of Taiwan Middle 100

50

40

30

20

10

0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Y ear 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Figure 3. The mean leverage of Taiwan 50 nonfinancial corporations decreases monotonically to 34.31% from 1987 to 2007

V.

Summary and Conclusions

This paper explores the relation between corporate performance and the capital structure. We find a strong curvilinear relation between ROE and the debt-to-assets ratio. According to the dominant corporate finance paradigm, capital structure choice is a tradeoff between the costs and benefits of debt. It can be argued that the large firms are more inclined to retain higher performance than middle firms under the same level debt ratio. Although there is broad agreement among academics and practitioners on the benefits of debt, these results are broadly consistent with tradeoff theory. The theory predicts that the value of firms will first increase, then decrease, as debt ratio increases. Most existing papers on capital structure require firms performance or firms value to bear the linear relation with debt ratio, but the empirical evidence does not support this. In contrast, there is evidence that the quadratic relations are significant, yet these have not received much attention in the finance literature. Our analysis demonstrates that, at reasonable parameter values, the financial distress costs borne by debts do, in fact, provide a first-order counterbalance to the tax benefits of debt. References
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