Determinants for the difference in debt ratios of two industries across three developed countries

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Determinants for the difference in debt ratios of two industries across three developed countries

Introduction

1.1 General Introduction

This research paper will focus on deriving the determinants contributing to differences in the book value and debt ratios of two industries in three developed economies. For the purpose of this research paper the two industries selected are financial and internet industries. The reason for selecting the two industries in a developed economy is that firstly financial service industry carries the highest book value to debt ratio. On the other hand, the internet industry carries the lowest book value debt ratio. This is according to the recently published values on debt ratios that ranked 6177 firms in January 2013 through the Business School in New York by Stern. The three countries selected and must be advanced economies include Japan, France and United States of America.

1.2 Importance of Topic

The desire to focus on the differences of book value to debt ratio of two industries on different sides of ranking is for the purpose of studying risks. In recent literature, use of debt ratio through industry classification illustrates decision makers reach an optimal financial structure by considering the characteristics of business risks. In this case, the debt ratio is used as efficient proxies to assess business risks. Therefore, debt ratio with their determinants will be discussed in this research paper on two industries ranked as extremes in three developed economies. Examples of such influencing determinants of book value to debt ratio include financial risks. The availability of capital, factors beyond a country’s border point and the accepted industry norms.

1.3 Contribution of Topic to International Finance

Determining debt ratios and book value differences is not only important within the scope of this research proposal but also aids studies in international finance. To this end, it would be possible through this research to understand the variables in finance and internet sector and influence on the 3 countries selected. This research proposal will give a highlight of the nature shocks and risks emanating from deleveraging for example, the financial sector in these economies and impacts on other countries. Through, international finance it is clear that financial neo-liberalization has greatly influenced economies. The financial market is affected whenever there are shocks emanating from the internet industry. Therefore, international finance will focus on reducing risks from other sectors affecting the volatile financial sector hence preventing economy crisis.

2.0 Literature Reviews

Capital expenditures and economic position have a positive impact on capital arrangement changes, confirming the pecking order theory. Cash flows negatively impact leverage ratios. Stock proceeds have also a downbeat impact on debt ratios, confirming firms’ behavior to time the equity markets in their favor (Drobetz 340). Debt deficit positively impacts capital structure changes representative that firms move towards their objective ratios over periodical periods. The Target change variable has diverse results; the positive one indicates that firms change their targets over quarterly periods.

Investments that are undertaken in a firm the cash flows and returns on stocks have impact on any business capital structure. In order to have a proxy on the investments we introduce two variables that are capital expenditures and the use of statement for year ending that is financial position. Any capital expenditure is used to illustrate the amount of capital that is invested in assets that is both new and existing assets. Financial position is used to measure both new debt and equity issues of a company (De Bonnis et al 12). Stock returns on the other hand impacts the capital structure and changes of choice to the business. Literature review illustrates that stock returns can be used to give an explanation about capital structure in the long-term basis. Use of stock returns can be used as a proxy for interpreting timing effect for market actions. Financial managers tend to time market patterns and reactions through issuing huge amounts of equity whenever there are increases in stock price for their company (Degeorge 14).

Capital expenditure has a positively related relationship with book and market debt ratios for businesses in USA with not any significant change in Japan and France. Using the net debt ratio the capital expenditure segment has an effect on firms in France and Japan. As a result, this illustrates that business that normally increases their capital budget expenditures by using capital that is more external increases their debt ratio. The financial situation has an encouraging impact in France and the Japan, but no impact for businesses in the United States of America and France in the case of the book value measure of debt. France reports significant results at 1.2% level for book and market estimates of leverage (Dissanaike 59). The consequences confirm again the pecking order model of capital structure choice.

3.0 Determinants of differences in book value in debt ratios in finance and internet industry

3.1 Availability of capital

The availability of capital for example in the United States has occasionally affected the financial industry influencing the financial industry characteristics from prevailing book value to debt ratios. For instance in the late 1980s, the US banks were faced with this challenge on capital availability (Bancel 28). The banks were forced to create a trade off their debt stakes in Latin America for acquiring equity. Now this was the optimal decision as the banks operating in the financial market had the risk of losing everything from stakes to leveraged advantages on their debts. Availability of capital can be in the form of assets intending to reduce their debt. In this case, many banks in the financial sector are faced with decision-making requirements on whether to dispose worst performing assets to raise money to fund existing debts.

3.2 Economic stages

The difference in economic stages is another determinant of the high book value to debt ratio in financial industry of USA. Currently, of the three countries United States of America is ahead in terms of economic growth. Countries on higher economic growth stages tend to experience the highest book value to equity value. This is because their book value is less affected because such firms in operating in such environment pay fewer dividends. Japan was at this stage in the period 1982 to 1984 ahead of other G & countries. During this period of economic growth countries, pay less in terms of earnings paid out in the form of dividends (Dorron 123). On the other side internet industry ranks the lowest because of its contribution to economic growth compared to the financial sector. The GDP contribution as a proportion of the expected economic growth is less compared to that of the financial sector. Over the years, the Japan economic growth has gradually declined causing its dividend payout to rise.

3.3 Treatment of taxes

Differences in treatment of taxes are another determinant likely to impact on the book value to debt ratio of a country. The treatment of taxation in this sense is connected to protection measures a country has put in place to avoid incidences of double taxation (Dorron 123). To this end, double taxation is more prevalent in the internet service industry compared to financial industry. France, for example, allows its investors to carry out offsetting of the corporate taxes accrued on dividends. This has the effect of reducing the effect of tax rate on earnings paid out as dividends.

3.4 Investment Opportunities

This is another determinant influencing the book debt ratio variations across countries. An investment variable is known as the amount of expenditures spent on investments annually. It provides of the opportunities available for firms operating in any industry in this case the research paper is interested in the financial and internet industries. Whenever, a manager is making a decision on investment he seeks to access external funds in the form of debt to finance an investment project. In the end, this introduction of new debt or repayment will alter an existing capital structure. Growth opportunities in the internet service industry in France are negatively related to the book value leveraging the debt. However, it is positively related to internet industry firms operating in Japan and United States. The negative in this respect is in line with the theory on agency costs (Dorron 45). This is because firms operating in this field tend to favor low levels of advantage to maintain their profitable investment projects. This allows the firms to seek more investment opportunities and grow more into the future.

3.5 Project Profitability

Profitability is another determinant affecting both the financial and internet service industries across the three developed nations. France still exhibits a negative relationship to the book debt ratio while USA and Japan still indicate a positive relationship. Pursuing this interest, many financial firms tend to favor external financing hence the higher ranking for all the three countries. However, many internet firms favor interior financing to preferring external debt. This is in line with the trade off hypothesis as the more profitable businesses in the economy seek to increase their debt as a way of altering their capital structure.

3.6 Business risk

Business risk variable determines the risks of a business nature that a firm faces and is measured using the standard deviation measure on operating income and taken over total assets. To this end, a business that presents cash flows that are volatile, the financial strength of that company is under stress (Brounen& de Jong 47). In this connection, such a firm is not able to borrow funds as its debt financing ability is deemed as declining. Therefore, the existence of different risk variables has negative impacts on a firms leverage rating. All the three developed nations illustrate this concept and having a negative coefficient is evidence. The number of non performing loans in the financial sector is one of the factors causing high business risks across the three countries. The graph below illustrates the nature of nonperforming loans in commercial banks in Japan.

On the y axis is the percentage of nonperforming loans while the x axis represents the years starting from 2003 to 2007. Notable, is the time series selected which is important to highlight that this research figures intended to illustrate the nature of business risks just before the 2008/2009 financial global crisis. Business risk as a determinant of book value to debt ratio of financial service industry in Japan has been improving. Part of this reason is because of the reduction of nonperforming loans that are lent by financial institutions.

EMBED MSGraph.Chart.8 s

Years

(Source: the Bank of Japan, 2008)

Size of a business is usually positively related to leverage. This was demonstrated by previous literature studies on capital structure determinants (Rajan and Zingales 1421-1460). Larger companies are believed to have a larger portfolio of products and markets operations, therefore a smaller chance of bankruptcy. This is why they are able to have more leverage. The results in table 8 are statistically significant for German, Dutch and British firms when looking at book values estimates and significant for all countries in case of market values and Net debt/EBITDA values.

3.7 Intangible assets

Intangible assets present a positive relationship with the debt ratios. This result is contrary to previous studies, which found a negative relationship between intangibles and leverage, because intangibles cannot be used as collateral in case of bankruptcy. For the firms in this study, intangibles could refer to their unique products; know how, brand names and services offered. Having a well-known brand name and a good positioning on the market could be an indication of future growth opportunities. Since all companies in this study are the top largest in their countries and they are well known on the market, it is possible that their brand name and unique products can be used as collateral in case of bankruptcy (DeAngelo& Masulis, 24). The results are statistically significant in France, Japan and US, having the highest impact in US and France. In case of Net debt/EBITDA estimate, intangibles impact negatively on leverage in Japan and France.

Using target debt ratios proxies that have been calculated using standard OLS model, we have two more new determinants causing variations across the three countries. The variables include debt deficit and target change. Debt deficit is estimated through finding the difference between actual debts ratio observed at the start of the year and an estimated debt ratio that is targeted at year-end. US have the highest debt deficit while Japan and France have the highest change in estimates on target ratio for net debt and EBITDA (Fama & French, 34).

Variable USA France Japan

Target proxy Mean 0.65 0.63 0.68

Median 0.59 0.61 0.64

Standard Deviation 0.11 0.12 0.09

Debt Finance Mean 2.23 2.10 1.96

Median 2.36 1.05 1.40

Standard Deviation 0.12 0.11 0.09

Target Change Mean -0.02 -0.03 -0.12

Median 0.02 0.11 0.03

Standard Deviation 0.77 0.15 0.17

Net Debt Ratio Target proxy Mean 4.58 4.89 4.01

Median 4.50 4.44 3.78

Standard Deviation 1.55 2.45 3.33

The above illustration represents estimates of used target ratio, deficits in debt and targeted changes by end year.

The impacts and variations caused by investments, performance based on profitability and effects of stock returns on capital structure.

Cash flows have a negative blow on capital structure changes in all countries for the book values and market values estimates of debt ratios, except in France in case of market value debt ratios and the Japan in case of Net debt/EBITDA estimate. The results are most significant for book values debt ratios. The negative relationship between cash flows, which proxy for the availability of internal funds and changes in leverage indicates the fact that the more cash flows firms have they tend to keep their debt levels low. This behavior confirms again the pecking order model of financing.

Stock returns negatively impact the book leverage of firms in French, the Japanese and USA. Market leverage is negatively influenced by stock returns for firms in France, Japan and USA. When looking at Net debt/EBITDA, the results are mixed: negative impact for French and United States and positive for France and Japan ones. The results are surprising for French firms, as the stock market is not an important component in the French financial system, which is dominated by banks. The negative relation between stock returns and leverage indicates the fact that firms tend to issue equity after periods of stock price increases and repurchase equity after periods of stock price decreases. Stock returns can be interpreted also as a proxy for market timing; therefore, firms tend to decrease their debt ratios by raising external capital when the equity market is perceived to be more favorable, for example, when market-to-book ratios are higher. The results are in line with previous studies by Welch (2004), (Hovakimian et.al 56).

The debt deficit variable has a positive impact on leverage changes for the firms in all countries and for all three estimates of debt ratios. The results are significant at 1% level for France and United States of America in case of book values and for all countries in the case of Net debt/EBITDA estimate. Since Net debt/EBITDA ratio is used often in practice by many companies, it seems that firms adjust their capital structure over quarterly periods. The debt deficit variable is a pointer of the speed of adjustment of the target ratio. Companies from United States of America and the French adjust their capital structures at the highest speed.

The target change variable has a negative impact for the book and Net debt/EBITDA ratios of companies in France and the Japan but the results are not important. In case of market ratios, there is a negative relationship for all countries, except France. A positive connection exists for book ratios of Japanese and French firms, market ratios of French firms and Net debt/EBITDA of France and USA firms. The positive relationship indicates the fact that firms are immediate to changes in their targets.

3.8 Size of Firms

Size creates a positive impact on book to debt ratio of firms in France and United States of America. Illustrating that financial firms, which are the larger firms, adjust faster and efficiently compared to internet firms. This is because the companies have enough capitalization abilities and huge economies of scale. The book values on leverage abilities are positive however to sufficient for statistical purposes. In wrap up for size of business, it is evident that it influences the growth of a firm and its ability to access both external and internal sources of capital. Any adjustments desired on the actual debt ratings would increase the debt ratings of a business. Such adjustments are believed to be costly and not optimal over any period. Businesses in France, United States of America and Japan result into adjusting their debt rates at very high speeds (Fischer& Zechner 19). This is evident in the nature the United States and France stock plus bond markets are well advanced compared to that in Japan. Japan is expected to carry out adjustment to its capital structure slowly because of existing intermediaries in its markets. However, suggesting the intermediaries create easy access to financial and internet services. For example, the financial sector in the United States of America is highly influenced by the size and contribution of real estate to country’s GDP growth. REITs and other company stock affiliated with real estate are among the best performing and business sensitive securities in the United States of America.

EMBED MSGraph.Chart.8 s Source: European Securitization Forum

The above figure illustrates the contribution and size of mortgage financial service industry in the three countries. It is evident that the size of this sector in USA in important in influencing the size of financial sector book value to debt ratio. The other two countries have less contribution compared to USA.

4.0 Conclusion

The main intention of this paper was to find out the determinants of variations that exist in book debt ratio in two industries for three advanced economies. Therefore, this paper has investigated the financial and internet sectors that are on extreme rankings on influencing the book debt ratio. Japan, United States of America and France are the countries that have been investigated in this course. The determinants identified from these investigations include, size of business, availability of capital, industrial norms and porosity of borders for markets. In addition, there is performance by profitability and investment opportunities available within an economy. United States of America is having a high deficit, however, the financial sector growth can be observed. This is because many firms are able to take advantage of leverage benefits unlike Japan. France too is similar to the USA in its market border porosity leading to increased mobility in the country seeking cheaper and available sources of funds.

This research proposal was limited by a several factors firstly there is not much previous study into the internet sector and the influence on GDP. Secondly, past scholarly researches only treat the internet service industry as being complimentary to financial markets. This is a controversial issue and to negate this perception, this research has identified the enormous contribution of Amazon.com transition from traditional publishing to e-commerce practices and the impact of this on the global economy. The risks involved in such transnational corporation in internet industry and their enormous profitability undocumented require further research.

Undertaking the research proposal despite the illustrated limitations has created a better insight deleveraging of industries on a global scope. The determinants of differences realized in the countries selected provides an understanding on economic growth stages and post 2009 financial recovery measures used by each country. This tasks has led to an objective discussion on volatility of the financial markets and influence these risks have on firms in financial and internet industry.

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