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1.1 Overview

This chapter commences with background review of this study which delves into the

determinants of capital structure in Malaysian context with emphasis on corporate governance.

This is followed by outlining of problem statement, research objectives, research questions,

definition of key terms and significance of the study. This chapter ends with brief overview on

the organization of the remaining chapters in this thesis.

1.2 Background

Capital structure, one of the most studied aspects in modern corporate finance school of thought,

is an important decision for management to ensure the financial health of firm to be in good

condition. The information on capital structure is essential for every stakeholders of a firm to

make their decisions pertaining to the firm. Suitable capital structure is not only imperative for

maximization of interest of every stakeholders of an organization, but also crucial for the

organization to compete effectively and efficiently in its operating environment (Simerly and Li,

1999). Fallacious choice of capital structure would not only lead to its financial distress, but also

ultimately drag the organization into insolvency (Eriotis et al., 2007).

Studying firm’s capital structure is important as it plays important role in creating value for the

firm via the effect of tax, information asymmetry, and agency cost (Tang and Jang, 2007).

Besides that, financial theory also has been used by firms to choose the best composition of

capital structure that enhances the firms’ value (Eriotis et al., 2007). Therefore, study on capital

structure would provide valuable insights on how strategic decision of firms in implementing

investments would affect its value, which in return, used to determine its position in the market.

Modigliani and Miller (1958) initiated the most significant study on this topic, which was

followed with various studies that have been conducted in diverse dimensions of capital

structure. It was argued that after fifty years of Modigliani and Miller research,

understanding on firms’ financing choices is limited, where information on financing tactics

such is apprehended well than information on financing strategy such as a firm’s choice of

target capital structure (Myres, 2001). This is because objective of past studies has devoted

much attention on usual determinants of capital structure, which includes variables like size,

profitability, growth, tax-effect, stock price, etc. Relationship between these variables and

capital structure has been extensively researched.

Despite its theoretical appeal and vast exploration, researchers in financial management have not

achieved consensus on capital structure and its optimality. It was only the ways to achieve short-

term capital structure objective were able to be identified in most of these studies (Simerly and

Li, 1999). It was pointed out that there is clear evidence of lack of consensus in identifying other

determinants of capital structure (Delcoure, 2007).

Fast advancement of agency theory with emphasis on bankruptcy costs and agency cost has

contributed the argument that corporate governance has important role in capital structure (Seifert

and Gonenc, 2008). Among newly identified determinants that influence capital structure,

corporate governance has been identified as one of decisive factor that affects firm’s capital

structure decision (Delcoure, 2007). For this purpose, ownership structure is commonly used as

proxy for corporate governance (Booth et al., 2001; Zou and Xiao, 2006).

Prior to 1997 financial crisis, Malaysian firms were noted to be highly leveraged in view of their

close relationship with local banking and financial institutions where bank-based borrowings

were dominating the capital structure of these firms (Tam and Tan, 2007). This was even after

the clear existence of conflict of interest between the lender and borrower. Existence of common

directors or shareholders in both borrowing and lending organizations is a typical example of

conflict of interest.

High reliance on debt financing was not purely a strategic decision on the part of many Malaysian

firms before the 1997 financial crisis. Many large corporations took investment decisions with

mere backing from the banking institutions. Hence, capital structure of most of Malaysian firms,

both government-linked and non-government linked, was more aligned to debt financing as

options of equity financing were very much less considered. This showed owner of the firms

were making investment decision based on connections and links with the banks (Suto, 2003).

This relates to weak path in corporate governance practices among Malaysian firms. Troubled

corporate sector of Malaysia during the 1997 financial crisis was ruined further by badly designed

corporate investments that were induced by weakened corporate governance mechanism between

banking sector and corporate sector (Suto, 2003). Two main causes cited for high risk capital

structure in Asian corporations was attributed to weak corporate governance and crony capitalism

(Du and Dai, 2005).

Besides high risk capital structure, these factors also contributed to bad corporate investment

decisions, rapid diversification and risky financing practices (Samad, 2004). For example, in

November 1997, United Engineers Malaysia (a government-linked corporation) acquired 32.6%

of its financially troubled holding company, Renong, at a premium price that was deemed as an

act of bailout which suggest weak corporate governance practices (Mitton, 2002).

While weak corporate governance was not the mere factor that caused the Asian financial crisis,

other internal and external factors have triggered the collapse of Malaysia’a economy, which was

once a roaring economy dragon of East Asia (Mitton, 2002). Weak corporate governance made

the economy more defenseless and easy to be toppled.

After nearly ten years of the Asian financial crisis, the affected countries have rebound and back

on track with decent economy fundamentals. Post-crisis period exhibited better corporate

governance policies implemented by the authorities to ensure firms choose best source of

financing (Wei and Zhang, 2008).

1.3 Problem Statement

Modigliani and Miller (1958) who broke a new ground on capital structure studies had indicated

capital structure is independent of the value of the firm under certain assumptions. Subsequent

studies pursuant to that had been undertaken to gauge various aspects of capital structure. The

objectives of these past studies, among others, were to test the relevance capital structure theories,

to determine the optimal capital structure level and to establish relationship between capital

structure and firm value.

However, there are numerous studies conducted to identify the determinants of capital structure

of firms. These studies have analyzed a variety of factors that determines capital structure, such

as share price, asset size, tax shields, profitability and growth. Capital structure determinants

study by Booth et al. (2001) in developing countries like Thailand, Jordan, Turkey, Pakistan

Mexico, Brazil and Zimbabwe reported that same factors are also important in developed

countries, but their direction of influences differs across countries.

Zou and Xiao (2006) had reviewed that Rajan and Zingales (1995) whom compared capital

structure decisions across G-7 countries and report that in these countries the same sets of

determinants (i.e., firm size, asset tangibility, growth opportunities and profitability) affect

corporate financing choices based on extant capital structure theories. Thus, there is need for a

re-look on the same determinants and its effect on capital structure of local firms.

Studies to ascertain corporate governance practices as determinant of capital structure are

comparatively limited in local literature. This is because corporate governance is usually

considered as a diluted linkage in Asia’s corporate sector (Tam and Tan 2007). In fact, to address

agency cost in firm, capital structure, i.e. debt financing, is widely used as a tool to implement

corporate governance practices.

The basic of agency cost arises from clear division of ownership and control, which shape the

capital structure of the firm (Arslan and Karan, 2006). This is because via debt financing, owners

are able to avoid the managers from taking financing decisions that has advantage for themselves

(Pindado and Torre, 2006). On the same note, tax shields are one of main benefit that surfaces

from debt financing (Zou and Xiao, 2006).

One dimension of corporate governance is type of ownership structure of the firms. Hence,

testing the implications of different type of ownership structure on capital structure would

provide an insight on the relationship between both variables. Ownership structure of Malaysian

firms can be grouped into three categories, i.e. family-owned, state-owned and foreign-owned.

Different ownership structure provides basis for agency costs problems to exist. Prevalence of

major shareholder owning and controlling quite a number of firms in Asia reflects discrepancy

that contributes to agency cost problem (Wei and Zhang, 2008). For instance, substantial

shareholders are able to victimize minority shareholders and managers given the control that they

held in the firm (Mitton, 2002).

Ownership structure effect on capital structure was studied to have impact where largely grouped

firms usually has high debt ratio (Manos et al., 2007). This is because large companies’

investment decisions are also affected by size and profitability of the group, which commonly can

be evidenced in family-owned firms.

Clear delineation between owners and managers that is apparent in state-owned and foreign-

owned firms, offers incentives to managers to choose best financing method that maximize the

firm’s performance and value. This is because managers are accorded with monetary incentives

to improve the corporate performance – solving the agency cost problem (King and Santor,

2008). Conversely, providing fund to state-owned firms is risky affair given the high default

probability, where managers in these firms have less commitment to repay the loan given the low

odds of the loan to be recalled (Zou and Xiao, 2006). Hence, ownership structure noted to have

impact on capital structure decisions of firms. There is need to identify effect of Malaysian

firms’ ownership structure on capital structure together besides the re-look into other capital

structure determinants with other usual financial characteristics determinants.

1.4 Research Objective

Primary objective of this research is to identify the determinants of capital structure of public

listed companies in Malaysia. Uniqueness of this study would be the enclosure of corporate

governance link in the form of ownership structure as determinants of capital structure, besides

the usual financial characteristics variables. This would provide additional insight on how

different type of ownership structure affects the capital structure decisions of Malaysian firms.

In precise, the objectives of this study are as follows: -

1. To examine the relationship between firm financial characteristics and capital structure

2. To examine the relationship between ownership structure and capital structure

1.5 Research Questions

In order to achieve the objectives outlined above, this research would attempt to answer the

following research questions: -

1. Does size of firm affect the capital structure decision?

2. Does growth of firm affect the capital structure decision?

3. Does profitability level of firm affect the capital structure decision?

4. Does liquidity level of firm affect the capital structure decision?

5. Does ability of firm to service debt obligation affect the capital structure decision?

6. Does ownership structure of firm affect the capital structure decision?

The first five questions are designed to identify the firm-specific financial characteristics as

determinants of capital structure. The last question is designed to link ownership structure as

determinants of capital structure.

1.6 Definition of Key Terms

1.6.1 Capital Structure

Capital structure refers to the allocation between debt and equity in financing of a firm asset. A

perfect capital structure decisions encompasses four main aspects, i.e. target capital structure,

specified source of financing, its maturity and timing (Brigham and Ehrhardt, 2005).

Investopedia defines capital structure as a mix of a firm's long-term debt, specific short-term debt,

common equity and preferred equity used to finance its overall operations and growth, where debt

comes in the form of bond issues or long-term notes payable, while equity is classified as

common stock, preferred stock or retained earnings. Short-term debt such as working capital

requirements is also considered to be part of the capital structure.

1.6.2 Debt Financing

Debt financing is external source of financing, where the firm would borrow money from

outsiders, namely from capital market or financial institutions. Types of debt financing include

bonds, commercial papers, term-based financing or short term financing. Debt holders would

have priorities in settling their portion of obligation at any event of default of the firm. The debt

holders usually charge interest on the firm and this expense is tax deductible for the firm.

1.6.3 Equity Financing

Equity financing refers to internal source of funding, which is usually in the form of new

shares issuance, utilization of retained earnings and issuance of bonus shares. Basically,

there are two types of shares that would be issued by a firm, i.e. common shares and

preferences shares. Common shares provide control right to the shareholders in the form of

voting rights. Common shareholders are residual owners of the firm. Preferred stock, which

is less frequently used, usually has pre-determined dividend rate. The claim of these

stockholders for a firm’s assets at the event of default falls between that of common share

and debt.

1.6.4 Optimal Capital Structure

Optimal capital structure refers optimal mixes of debt and equity that has ability to maximize

the stakeholders’ value (Tang and Jang, 2007). It has been argued that although theoretical

and empirical research suggests that there is an optimal capital structure, there is no specified

methodology formula to determine the ideal capital structure that fits to all industries across

nations (Eriotis et al., 2007).

1.7 Significance of Study

This study would be providing fresh insights on factors that determine the capital structure mix of

firms in Malaysia. Prevailing trend of local firms in addressing the type of financing choice for

expansion ventures is of the essence for two reasons.

Firstly, this study is undertaken after ten years from the occurrence of 1997 financial crisis, where

collapse of local firms then were highly associated with bad financial management practices.

Hence, this study would provide a link to identify whether local firms still has high concentration

on debt financing in their capital structure (Tam and Tan, 1997; Suto, 2003; Samad, 2004;

Mitton, 2002) or they have reduced the reliance on debt financing.

Secondly, this study also would offer insights how local firms’ ownership structure plays

important role in the capital structure decisions. It provides guidelines for potential stakeholders

like customers, suppliers and even bankers to understand local listed companies’ characteristics in

terms of financing choice.

Factor that triggered the collapse of Malaysian firms during the Asian financial crisis in year

1997 is closely associated with lack of corporate governance measures. This is because local

corporations were aggressively involved in high risk investment ventures. These ventures were

implemented with high reliance on debt financing, i.e. precisely bank borrowings, compared to

internal funding.

As highlighted in earlier sections, weak corporate governance was noted as one of the causes of

the crisis (Wei and Zhang, 2008). Hence, this study would enable to highlight whether the trend

of capital structure since the crisis period is still maintained after various new corporate

governance practices introduced after that.

These corporations were able to obtain bank borrowings easily as both lender and borrower are

closely linked with the banks use to hold stake in the firm (Deesomsak, 2004). Additionally,

connections of these corporations with Government, where in ample cases the corporations’

major stakeholders are Government itself, also resulted in heavy borrowing by these corporations.

These were the bad practices that facilitated the collapse of local corporations upon the trigger of

contagion effect of regional financial crisis. It can be inferred that erroneous capital structure

decision driven by bad corporate governance practices had contributed to 1997 financial crisis.

Hence, the result of this study would indicate whether type of ownership structure (dimension of

corporate governance) has influence on capital structure decision after the 1997 financial crisis.

As a whole, the study would indicate the prevalent trend of Malaysian firms’ characteristic

towards their existing operating financial and economy environments in the context of financing


1.8 Organization of this Proposal

The thesis is divided into five chapters. This chapter encompasses an overview of capital

structure, statement of problem and outlines the research objectives, research questions, definition

of key terms and significance of sutdy. Chapter 2 sets out the review of secondary literatures

pertaining to purpose of this study. In this chapter, the theoretical framework of the study is

introduced and hypotheses to be tested are formulated. Chapter 3 describes the sample and

variables used and also explanation on the empirical method. In Chapter 4, concise discussions of

the empirical results are done. In the final chapter, some conclusions are drawn from the most

outstanding results and some directions for future research are suggested.



2.1 Background

Capital structure is a fundamental aspect of corporate finance that delves into the study on the

approach a firm chooses its source of financing to fund its investments in acquisition of assets. In

making decisions on capital structure, the firm should always gauge its operating environment,

both external and internal (Hovakimian et al., 2001).

2.2 Overview on Theories

An essential matter in corporate finance involves understanding how firms choose their financing

choices and it is apparent that there is no consensus on theories that explains a firm's perfect

capital structure (Seifert and Gonenc, 2008). Modigliani and Miller (1958) initiated the first

study on capital structure which concludes that capital structure is immaterial in a corporate

world without taxes, transaction costs or other market imperfections. The study proved that given

the mentioned conditions, firm value has no relationship with capital structure.

As theory by Modigliani and Miller (1958) lack of practicality in its assumptions, the next

generation of researchers explored into meticulous conception of capital structure that made

possible to emergence of two more prominent theories in capital structure literature, i.e. tradeoff

theory and pecking order theory.

2.2.1 Modigliani-Miller Theorem

This pioneer study was designed by Modiagliani and Miller (1958) on assumption that there is

existence of market perfection in capital market. Therefore, the market operates without

transaction costs, bankruptcy costs and information is available for everyone in the market.

Modigliani and Miller (1958), in other words, asserted that financing decisions of firms are

undertaken with identical interest rate and without tax. As a result, cost of equity is same for

firms which are, both, leveraged and non-leveraged. For the non-leveraged firm, premium is

included for financial risk. Ultimately, these assumptions are pointing out that value of the firm

is independent to its capital structure. Subsequent studies after Modigliani and Miller (1958)

were conducted premised on lesser limiting conditions. One main consideration was taxations

that were included as one of determinants of capital structure (Eriotis et al., 2007). This includes

tax rate on corporate earnings, tax rate on dividend income and tax rate on interest inflows

income. Tax incentive is vital for corporate borrowings as it is able to take advantage of interest

tax shields (Myres, 2001).

2.2.2 Trade-Off Theory

Modigliani and Miller (1958) argument that capital structure does not exist in perfect market is

irrelevant as in real world, imperfections in market is apparent. This weakness is addressed in

trade off theory. The term trade-off theory is used by different authors to describe a family of

related theories. It is based on firm’s choice of source of financing after equating the cost and

benefits of each of the source, i.e. marginal costs and marginal benefits (Frank and Goyal, 2003).

The balancing of both aspects determines the optimal capital structure (Seifert and Gonenc,

2008). The tradeoff theory states that a taxable corporation should increase its debt level until its

tax advantages of borrowing against the costs of financial distress is balanced. Debt level is

expected to be increased to the limit where marginal value of tax shield is equal or lesser to

present value of possible financial distress costs (Delcoure, 2007).

The theory, deemed static, designed under presumption that optimal capital structure is achieved

when advantage of the tax shield benefits of debt is equal to increased likelihood of incurring

debt-related bankruptcy costs (Beattie et al., 2006). Thus, firm’s debt position should be at the

level where the tax advantages of additional debt are equal or more of the costs of possible

financial distress (Myres, 2001). It has been emphasized in the theory that firm with sound

tangible assets would borrow more than firms with high intangible assets.

Trade-off theory explains that debt financing is a better financing choice given its ability to

provide tax shield. In debt financing, firms would incur interest expenses that is deductible from

earnings before interest and tax, which reduces the taxable income of the firms (Jiraporn and Liu,

2008). However, debt financing is exposed to default risk that points towards probability of

bankruptcy. Hence, firm should weigh these two aspects in deciding its optimal capital structure

level. Limitation of trade-off theory is apparent from its failure to explain stock market reaction

to leverage-increasing and leverage-decreasing transactions (Seifert and Gonenc, 2008).

2.2.3 Pecking Order Theory

If in trade-off, bankruptcy cost is included, in pecking order theory (Myers, 1984) the asymmetric

information element is included. The pecking order hypothesis describes a hierarchy of financial

choices for a firm, which starts from internally generated financing to debt and lastly outside

equity (Seifert and Gonenc, 2008). Pecking order theory suggest that management would prefer

equity financing in favor of debt financing in view of information asymmetry condition and

benefit of reduced transactions costs.

Based on this theory, highly profitable firms will tend to use internal funding, whereas firms with

low profitability tend to use external financing. Based on this theory, in the context of internal

finance, internal fund such as retained earnings is preferred and as for external financing, debt is

chosen over equity (Tang and Jang, 2007). The theory can be related to few aspects like agency

costs, taxes, transaction costs and information asymmetries (Seifert and Gonenc, 2008).

The theory asserts opposite relationship between profitability and debt usage (Tang and Jang,

2007). If a firm’s use of external financing would indicate that the firm is not profitable, its stock

price may be adversely affected. This related to information asymmetric where the managers

usually have more information on the firm. Therefore, they would issue new shares when it is

believed that the stock price is fairly or overly priced only.

Information asymmetric also occurs when external financing signals the firm’s red profitability,

which may affect the share price. Hence, new shares would be issued only when stock price of

the firm is deemed favorable. This may again be wrongly interpreted as the firm is not profitable

and sourcing for external financing. Therefore, debt would be used first instead of new stock

issuance for financing requirement. Large cash reserves and availability of financial slack are

resultants of this type of corporate practice (Seifert and Gonenc, 2008).

Besides in information asymmetric, easy access to internal fund and lesser transaction costs are

reasons for utilization of internal fund first before debt financing (Chen, 2004). It is also argued

that profitable firms borrow less for the reason that they have their own internal fund to be use

first (Myres, 2001). The theory also does not back optimal capital structure as it is believed to be

dynamic over time (Romano et al., 2001). Nevertheless, in long run, firms are expected to

identify their capital structure that is consistent with tradeoff models of capital structure choice

(Hovakimian et al., 2001).

2.2.4 Agency Cost Theory

Tang and Jang (2007) reviewed Jensen and Meckling (1976) that agency cost theory induces

positive relationship between level of debt and shareholders’ value. There are two forms of

agency conflicts; manager-shareholders and creditors-shareholders, where the conflict between

manager and shareholders is about fulfilling the respective parties’ individual interest. For

example, managers in profitable firms use equity financing given the availability of free cash

flow. Hence, the managers are not committed to debt-repayment.

This would potentially reduce the shareholders value (Tang and Jang, 2007). Thus, debt

financing is identified as tool to ensure that managers increase shareholders' value instead of

making money for themselves (Chen, 2004).

2.2.5 Signaling Hypothesis Model

Signaling hypothesis model states that high-value firms are able to use more debt financing

because debt has its dead weight costs, which make less valuable companies more likely to fall

into bankruptcy – hence predicts that the firms with the best earnings and growth prospects will

employ the most leverage. This model states the firm with higher value would use more debt as it

has less probability of being insolvent – hence suggesting that firms with high growth rate and

large size would resort in debt financing (Chen, 2004). However, alternative argument states

negative relationship between growth and leverage in view of the fact that growth opportunities

cannot be collaterized (Lang et al., 1996).

2. 3 Determinants of Capital Structure

Consequent to these theories, there were continuous studies made in relation to capital structure.

Noteworthy numbers of studies were embarked on to compare and test the relevancy of these

theories (e.g., Shyam-Sunder and Myers, 1999; Fama and French, 2002; and Frank and Goyal,

2003) as reviewed by Beattie (2006). In pursuing these studies, the researchers also have

attempted to determine the optimal capital structure level and cohesively concluded that there is

no optimal capital structure level for specific firm.

Existence of optimal capital structure level still remains vague with no proper methodology

specified to ascertain the said level of capital structure based on individual firm’s financial

standing. It is always the level of capital structure that maximizes the value of the firm that is

regarded as optimal capital structure (Eriotis et al., 2007).

Most researches on capital structure concentrate on factors that determine the capital structure of

firms. The studies were conducted based on countries, i.e. comparison among East Asia

countries by Driffield (2007); Turkey by Arslan and Karan (2006); US by Jiraporn and Liu

(2008); Ghana by Boateng (2004); Swiss by Gaud et al. (2005); emerging countries in Latin

America, Asia (excluding Japan), Africa, the Middle East, and Eastern Europe by Mitton (2008)

and in Malaysia by Suto (2003). Studies in each countries differs according exclusive

environment of the country with similar determinants.

There were other aspects also included in past studies. The study in Malaysia, of which the data

was taken prior to 1997 financial crisis, has included dependency on banks as one of determinants

given close relationship of government-linked companies with banks in the country during that

period of time. Study by Boateng (2004) in Ghana has included ownership structure as one of

determinant given the fact that Africa is perceived to be a risky place to do business.

There were also refined studies conducted to further examine functions of capital structure in

terms of maturity structure of corporate debt (Datta et al., 2005), firm-stakeholder interaction

(Arslan and Karan, 2006) and corporate control concerns (Ghosh et al. (2007); Du and Dai,

2005), which gives new perspective to capital structure studies.

2.4 Financial Characteristics

As highlighted earlier, most studies in identifying capital structure has revolved around similar

sets of determinants such as size, growth, profitability, liquidity and interest coverage of the

firm. These determinants are classified as financial characteristics of the firm. The second set

of determinants, which is key thrust of this study, would be classified as ownership structure of

the firm, where firms are differentiated based on family-owned, state-owned and foreign-

owned. All the determinants are explained based on its theoretical relevance and empirical

evidence describing the relationships between the determinants and capital structure.

2.4.1 Size of Firm

Size of firm are one most common variables used to be tested as explanatory factor for capital

structure. Trade-off theory lays down that large firms are expected to have a higher debt capacity

given the fact that large firms tend to be well diversified and has lesser probability to be

financially distressed which may lead to insolvency and bankruptcy cost (Nivorozhkin, 2005). As

a firm becomes more diversified, the exposure to higher transactional costs and bankruptcy cost

reduces (Chen, 2004).

Generally, larger firms have better access to debt market, which primarily constituted by banking

and financial institutions, for few reasons. Firstly, it can be related to usual association of these

large firms with government-sponsored investment programs, whereby there is explicit and

implicit guarantee from the government on borrowings by these firms (Nivorozhkin, 2005).

Secondly, the lower risk with larger firms encourages banks to borrow to these companies more

than smaller companies which have higher risk in defaulting (Boateng, 2004). Thirdly, larger

firms has capability to negotiate better pricing and minimizes the transactional cost that makes

debt financing a better choice for these companies(Beattie et al., 2006). Fourthly, given the large

size of these firms, any failure of these firms may carry huge social and economical implications

(Nivorozhkin, 2005). Finally, as stressed in trade-off theory, firms which has large and safe

tangible asset has more tendency to borrow given the value of collateral that can be raised from

these assets (Myres, 2001).

In terms of agency cost in relations to debt, large firms that usually have diluted ownership,

would enable easy decision making by the managers to borrow (Delcoure, 2007). Therefore,

managers of large firms are able to increase the firm’s leverage without much problem. Past

studies (Gaud et al. (2005); Arslan and Karan (2006); Huang and Song (2006); Mitton (2008);

etc.) have concurred that size of firm has positive relationship with debt ratio. The relationship

between the firm size total and short-term debt is positive and statistically significant (Delcoure,

2007). The positive effect of firm size on leverage target can likely be explained by the fact that

size serves as a stability proxy for lenders (Nivorozhkin, 2005).

2.4.2 Growth of Firm

Pecking order theory stipulates that firms with higher growth opportunities would use more of

equity financing as they would reserve the debt financing for period after the realization of the

growth (Delcoure, 2007). The effect of asymmetric information between managers and owners

would encourage lesser commitment of debt financing (Nivorozhkin, 2005).

Agency cost also plays important effect on financial decision for high growth firm. Equity

financing would be sought to undertake new projects instead of debt financing by firms with high

growth opportunities as a mechanism to minimize agency costs (Jong et al., 2008). Firms with

high-growth opportunity resort for debt as last option, hence leverage is expected to be negatively

related with growth (Huang and Song, 2006).

As in trade-off theory, firms with good growth opportunities has less probability to borrow based

on growth opportunities as it cannot be used as collateral in borrowing – hence would resort for

equity financing (Gaud et al., 2005). Asset substitution effect may cause high growth firms to

capitalize from debt holders to shareholders, hence firms to rely on equity financing more (Chen,

2004). Upward stock price movement is usually associated with improved growth opportunities,

which at the end would result in lower debt ratio (Hovakimian et al., 2001).

High growth firms also avoid debt financing for few reasons. Firstly, debt financing may cause

the firms to be dictated by the lenders, especially on their future earnings (Tang and Jang, 2007).

Secondly, as growth is intangible, it would be not wise to commit with debt servicing without

having solid cash inflow (Deesomsak et al., 2004). Past studies (Gaud et al., 2005; Delcoure,

2007; Fattouh et al., 2005; Chen, 2004) asserted that growth is negatively associated with


2.4.3 Profitability of Firm

Pecking order theory states that profitable firms would tend to use internal funds to finance their

expansions (Tang and Jang, 2007). Additionally, the profitable firms choose to commit debt for

the same reason that their future profits would be subject to terms and conditions by the lenders –

thus resulting in inverse relation between profitability and leverage (Deesomsak et al., 2004).

Asymmetric information theory suggests that firms’ use of fund would follow the hierarchy of

retained earnings, debt and finally new equity (Jong et al., 2008).

As an alternative argument, to avoid incurring excessive tax, tax-based models recommends

profitable firms should borrow more and incur interest cost, instead (Huang and Song, 2006).

Nevertheless, this is again has to be weighed against the expected bankruptcy costs. Study by

(Deesomsak et al., 2004) revealed that Malaysian firms prefer to use internal sources of funding

when profits are high, hence showing negative and significant relationship with leverage. Study

by Gaud et al. (2005), Chen (2004) and Booth et al. (2001) also revealed statistically significant

negative relationship between profitability and leverage.

2.4.4 Liquidity and Interest Coverage

In assessing the credit application by firms, banking and financial institutions give paramount

importance to ability of firm to service debt obligations, which is reflected in the firm’s interest

coverage ratio. This is also tied to the liquidity level of the firm, which is the ratio of current

assets to current liabilities. It indicates the ability of the firm to pay creditors in the short-term

(Manos, et al., 2007).

Liquidity and leverage are expected to have negative relationship as firms tend to use the extra

cash to finance their investment instead of incurring interest costs (Deesomsak et al., 2004).

Additional debt would deteriorate the current ratio furthers and makes the firm’s financial

standing weak (Eriotis et al., 2007). Similarly, increases in cash refer to increase in current

assets that result in high current ratio. Hence this shows higher liquidity available to finance

growth as argued in pecking order theory (Hovakimian et al., 2001).

Manipulation by managers to use liquid assets in favor of shareholders instead of debt holders

raises the agency costs of debt – resulting in negative relationship between liquidity and leverage

(Deesomsak et al., 2004). There is a negative relation between the debt ratio of the firms and

quick ratio and interest coverage ratio as proven by past studies (Harris and Raviv, 1990;

Deesomsak et al., 2004; Eriotis et al., 2007; Manos et al., 2007).

2.5 Ownership Structure

Different types of ownership have influence in determining the capital structure of firm. Clear

separation of shareholders and management is the fundamental basis for agency cost. Each group

has their own interest in decision making process of the firm, including capital structure decision.

Ownership structure is long considered as a tool in managing agency cost. Conflicts of interest in

agency cost are grouped into conflicts between shareholders and managers and conflicts between

shareholders and debt holders (Huang and Song, 2006). The existence of clear separation

between ownership and control requires debt financing as tool to monitor the performance of

managers (Datta et al., 2006). Risk aversion of the managers also determines the level of

financial leverage (King and Santor, 2008). Apprehending this factor would enable shareholders

to impose debt financing as a tool for corporate governance. Debt financing able to minimize the

self benefits of managers reaped from their controlling position (Pindado and Torre, 2006). This

will ensure the managers to work towards the aim of increasing the firm value.

When the firm is committed to debt, the managers are obligated to service the interest payments –

failing which results in insolvency of the firm. This places pressure on managers to ensure

performance of the firm is not affected by their self-interest actions (Kochhar, 1996). Therefore,

by having debt financing as control tool, shareholders are able to prevent managers from

misusing their positions and instead focus their resources in increasing the firm’s value. This

underlines the fact that capital structure decision can influence the action of the managers (López-

de-Foronda et al., 2007).

Separation of ownership and management which is prevalent in state-owned and foreign-owned

firms would be useful to determine the characteristics of managers in these types of firms in their

capital structure decisions. Managerial ownership is prevalent in current times, where largest

shareholders with high concentration have the control over the firm’s management.

Recent studies of corporate ownership structure demonstrate that dispersed ownership structure is

far from a norm around the world. The majority of corporations in most countries exhibit

concentrated ownership (Du and Dai, 2005). Concentrated ownership here can be related to

family-owned firm, where individuals and close family members having accumulated large

interest in the firm.

In Malaysian context, Tam and Tan (2007) reviewed studies by Zhuang et al. (2001) and

Claessens et al., (2000) that, in 1998, more than forty percent of substantial shareholders are held

by single large shareholder. Individual or family shareholders are predominant as large

shareholders in Malaysia. Rapid growth of Malaysia’s economy was not able to disperse the

ownership concentration in Malaysian firms (Tam and Tan, 2007). This not an encouraging

development as it would lead to various agency problems. The financial crisis in late 1990s has

highlighted the problems of corporate governance in South East Asian corporations, which of

particular concern are ownership structure which was overly concentrated (Driffield, 2007).

Corporate ownership structure has been cited as one of the reason for risky capital structure of

South East Asian corporations prior to crisis (Du and Dai, 2005).

Cash flow right refers to right to claim dividends, whereas control right refers to right to vote by

common stock shareholder (Du and Dai, 2005). Block shareholders, who has the control right,

are able to exert their control for proper and wise capital structure decision to be decided and

implemented (López-de-Foronda et al., 2007). This is able to avoid managers from venturing

into projects that has risky potentials (Miguel and Pindado, 2006). Study in transition economies

proved that concentrated ownership tends to reduce debt financing (Nivorozhkin, 2005).

Therefore, in determining the effect of different types of ownership structure towards the capital

structure, the study by Zou and Xiao (2006) would be most relevant. In the study, they have

studied the relationship between ownership structure and financial leverage of public listed firms

in China. The study was done to ascertain the managerial incentives to raise equity in view of

high agency problems in the country.

The ownership structure is classified into three large categories, which includes family-owned,

state-owned and foreign owned. If any of these entities has 5% or more share in the firm, it is

classified according to the respective entity. The 5% cut-off value for determination of major

shareholder is based on studies done by Samad (2004). Additionally, according to the Bursa

Malaysia requirement, substantial shareholders are those who has more than 5% stake in a

corporation and names of these shareholders are reported the companies’ annual reports.

However, this is different to the usual cut-off value of 20% determined by Bank Negara Malaysia

to differentiate the major shareholder. For complication avoidance reasons, the 5% cut-off value

is used and that too for direct shareholding only.

2.5.1 Family-owned Firms

A firm is considered a family-owned if an individual together with his/her family members have

more than 5% shareholding in the firm. Family encompasses both individual and family

investors, who shares same organizational motivations (Tam and Tan, 2007).

Agency cost literature argues that large institutional shareholders should have enhanced

incentives and capabilities to monitor managerial behavior closely. At most times, the owners

themselves act as managers. Thus, there is less need for debt to function as disciplining tool for

managers. Therefore, shareholdings of family ownership are expected to be negatively correlated

with leverage (Zou and Xiao, 2006).

Family legacy and concentration of family wealth in the business also causes family-owned to

have less appetite for debt financing (King and Santor, 2008). This also supports the argument of

negative relationship between family-owned firms and leverage.

2.5.2 State-owned Firms

Firm is regarded as state-owned if more than 5% of its total shares are held by any government

and/or government related agencies. Zou and Xiao (2006) predicted that firms with substantial

state ownership are more likely to have a higher debt ratio than other firms as it is argued that

state-owned firms has green lane for bank borrowing.

Financial decisions of state-owned firms are different from other firms as these firms are easy to

obtain loans given preferential treatment by the banks due to state ownership (Manos et al., 2007;

Tam and Tan, 2007). Hence, state-owned structure is expected to have positive relationship with


2.5.3 Foreign-owned Firms

Any direct interest from foreign parties, both individual and corporation, in local firm with more

than 5% stake is considered as foreign firm. Requirement for monitoring tool for the managers,

debt financing noted to be best option for foreign owners to assess the performance of the local

subsidiaries. The foreign owners are able to discipline the local managers via debt financing as

foreign firms uphold corporate value and transparency (Suto, 2003; Zou and Xiao, 2006).

Flexibility in repayments from home countries plus perception of local bank banks towards

foreigners warrants for debt financing for foreign owned forms (Boateng, 2004). These reasons

thus suggest a positive impact of foreign ownership on the use of debt.

2.6 Theoretical Framework

Derived from the literature surveyed, the following theoretical framework is designed to facilitate

the research. It depicts the relationship between capital structure and its explanatory variables.

Interest Coverage
Foreign Owned

Figure 2.1 Theoretical Framework

Dependent variable in this study is capital structure, which is measured by debt ratio. The

independent variables, which are the explanatory variables, are classified into two main groups.

The first independents variable is financial characteristics of the firm. This variable is measured

by the firm’s size, growth, profitability, liquidity and interest coverage. The second independent

variable is ownership structure of the firm. This variable is divided into family-owned, state-

owned and foreign-owned firms.

2.7 Hypothesis Development

The objective of this study is to identify the determinants of capital structure of public listed

companies in Malaysia with stressing the role of ownership structure of these companies.

Hypotheses for this study are developed based on the literature review done. The theoretical

framework is constructed subsequent to the literature review.

2.7.1 Financial Characteristics and Capital Structure

Capital structure is measured by debt ratio. Financial characteristics of the firm are expected to

be the main the determinants of capital structure. Firm-specific factors like firm size, risk,

growth, tangibility and profitability has been tested widely across various nations and noted to be

significant and consistent with capital structure theories (Jong et al., 2008).

Larger firms are well diversified; hence it minimizes the risk of bankruptcy costs of these firms as

argued in trade-off theory. Hence, these firms are expected to have more inclination towards debt

financing. This was concurred in past studies by Gaud et al. (2005); Nivorozhkin, (2005); Arslan

and Karan (2006); Huang and Song (2006); Delcoure, (2007) and Mitton (2008). Therefore, the

hypothesis would be as follows:-

H1A: There is positive relationship between size of firm and debt ratio

Pecking order theory suggests firms will use retained earnings before taking up debt and external

equity (Huang and Song, 2006). Thus, firms would keep debt financing as last choice resulting in

negative relationship between growth of firm and debt ratio. Chen (2004), Fattouh et al. (2005),

Gaud et al. (2005), Delcoure (2007) and Jong et al., (2008) have concluded in their respective

studies that growth is negatively related with leverage. As a result, the hypothesis is developed as


H1B: There is negative relationship between growth of firm and debt ratio

Profitability of companies has a uniform negative and significant effect on leverage across all

countries considered, which is in line with the pecking-order theory of finance (Nivorozhkin,

2005). Other studies also concurs this argument (Booth et al., 2001; Deesomsak et al., 2004;

Chen, 2004; Gaud et al., 2005)). With this, the hypothesis would structures as the following:-

H1C: There is negative relationship between profitability of firm and debt ratio

Basing on the pecking order theory, the relationship between these liquidity and leverage is

expected to be negative. Deesomsak et al. (2004) and Eriotis et al. (2007) have proved this

relationship in their respective studies. The hypothesis would be as follows: -

H1D: There is negative relationship between liquidity level and debt ratio

Similar to the liquidity measure, the interest coverage also expected to have negative relationship

with debt ratio. Past studies that have tested this relationship are Harris and Raviv (1990), Eriotis

et al. (2007) and Manos et al. (2007). Hence, the hypothesis developed would be as follows: -

H1E: There is negative relationship between interest coverage and debt ratio

2.7.2 Ownership Structure and Capital Structure

Ownership concentration is able to minimize agency conflicts of firms and maximizes firms’

value via capital structure decisions (Driffield, 2007). Hence, it is important to recognize how

different types of ownership structure are influencing the capital structure of public listed firms in


Listed companies are still within the control of the promoters who still has close relationship with

the management of these companies (Tam and Tan, 2007). Studies by Zou and Xiao (2006) and

King and Santor (2008) have tested the negative relationship between family-owned firms and

debt ratio. This brings to hypothesis as follows: -

H2A: There is negative relationship between family-owned structure and debt ratio

It is predicted that state-owned firms would have high leverage given its connection with the

lender and implied support by the authorities. State-owned firms are expected to have positive

relationship with leverage (Zou and Xiao, 2006; Tam and Tan, 2007). The hypothesis developed

would be as follows: -

H2B: There is positive relationship between state-owned structure of firm and debt ratio

Foreign-owned firms are expected to use high level of leverage to assert its managerial control

and to use debt financing as remedy for agency cost conflicts. Thus, positive relationship is

expected between two (Suto, 2003; Zou and Xiao, 2006). The hypothesis for this variable would

be as follows: -

H2C: There is positive relationship between foreign-owned structure and debt ratio

2.8 Summary

In this chapter, a thorough review of earlier literatures on capital structure was presented. A brief

look on conventional capital structure theories and past studies in relation to capital structure was

presented first. This followed by review of literature on variables to be tested in this study, which

pursued the conception of the theoretical framework of this study. Finally, hypotheses were

developed based on the framework designed.



3.1 Introduction

This chapter discusses the methodology that has been used to identify the determinants of capital

structure in public listed companies in Malaysia. It outlines the research design that was adopted,

identification of variables, sampling method and procedure of the analysis.

3.2 Research Design

The purpose of this study is to undertake a hypothesis testing to identify the predictive variables

of capital structure of public listed companies in Malaysia. It is also determined to establish the

cause-effect relationships between the dependent variable (leverage ratio) and independent

variables (determinants of capital structure).

Though substance of this study is to identify the determinants of capital structure, emphasis is

given to the ownership structure of the company. This is to determine the influence of type of

ownership in deciding the capital structure of the companies. Most studies done in the past has

focused on the company-specific financial characteristics in their study of capital structure (Booth

et al., 2001; Zou and Xiao, 2006; Delcoure, 2007; Mitton, 2008).

However, few studies have included corporate governance dimensions (Du and Dai, 2005;

Driffield et al., 2007; King and Santor, 2008; etc), where various aspects of corporate governance

is weighed as one of the determinants of capital structure.

Studies by Zuo and Xiao (2006), as a point of interest, has precisely included the role of

ownership structure as one of determinants of capital structure. The motivation to include

ownership structure in the said study was the unique environment in China where noticeable

numbers of corporations are directly or indirectly linked to the government, which provides these

corporations easy access to bank borrowings.

Similarly, in Malaysia, there was evidence of heavy reliance on bank borrowings by local

companies in their capital structure (Tam and Tan, 2007). Hence, it would be of use to establish

whether capital structure of local firms is driven by the firm’s ownership structure.

Based on literature reviewed, there are few tested models used in the past studies to identify the

determinants of capital structure. For this study, the model would include new variables such as

ownership structure, liquidity and ability to service debt, besides the usual independent variables.

Hence, the model to be used in this study is as follows: -




SIZEI = size of firm

GROWI = growth of firm

PROFI = profitability of firm

LIQDI = liquidity of firm

ATSDI = ability to service debt

FAMOI = family-owned firm

STAOI = state-owned firm

FOROI = foreign-owned firm

αI = beta

єI = error terms

3.3 Variables

As depicted in Figure 1.1, there are two types of variables used in this study, i.e. dependent

variable and independent variables. Dependent variable is the leverage measurement of a firm.

Independent variables are financial characteristics of the firm and ownership structure of the firm.

3.3.1 Dependent Variable

The dependent variable to measure leverage is debt ratio. Debt can be classified into short term

debt and long term debt. There are three financial leverage measures: overall leverage measured

by the ratio of book value of total debt to total assets, long-term leverage measured by the ratio of

book value of long-term debt to total assets, and short-term leverage measured by the ratio of

book value of short-term debt to total assets (Delcoure, 2007; Zou and Xiao, 2006).

In this study, all three leverage measures are used to determine the gauge comprehensive effect of

the study. This is also due to reliance of Malaysian public limited companies to banking sector

that structures its lending both on long and short term basis. Data limitations dictate the use of

book values rather than market values for all variables.

3.3.2 Independent Variables

There are two clusters of independent variables in this study. The first cluster is the financial

characteristics of the firm which consist of five variables. The second cluster is the ownership

structure of the firm with measurement of three variables.

Under the financial characteristics, the first variable that would be tested is firm size. Size is

linked with diversity, failure cost and transactional cost (Nivorozhkin, 2005; Chen, 2004; Beattie

et al., 2006). Larger firms are usually well diversified, which would entail lower failure

probability. Additionally, larger firms incur lesser transactional costs that enable these firms to

borrow more with minimal charges.

Second variable is growth rate of firm as determinant of capital structure. Firms with high

growth opportunities would deter debt financing for reasons such as asymmetry information flow,

agency cost, and future capitalization of growth (Nivorozhkin, 2005; Jong et al., 2008; Huang and

Song, 2006).

Profitability is another variable, which is also widely tested in capital structure studies.

Advocated in pecking order theory, profitable firms tend to use internal funds first before

resorting to external funds (Tang and Jang, 2007; Delcoure, 2007).

Liquidity and ability to service interest are two variables which have been limitedly used in past

studies that are incorporated in this study (Deesomsak et al., 2004; Eriotis et al., 2007). These

variables are included due to its function to explain the repayment capacity of the firm in

fulfilling its debt obligations.

Ownership structure, which is the crux of this study, is another cluster of independent variable,

which is classified into family-owned, state-owned and foreign-owned firms. Each type of

structure has different effect on the capital structure of the respective firms (Tam and Tan, 2007;

Zou and Xiao, 2006; King and Santor, 2008).

All the variables with its proxy for measurement and past empirical studies are summarized


Table 3.1

Summary of Financial Characteristics Variables

Variable Proxy for Measurement Past Studies

Huang and Song (2006)

Size of Firm Logarithm of Total Assets Delcoure (2007)

Mitton (2008)
Chen (2004)

Growth Sales Growth Fattouh et al. (2005)

Gaud et al. (2005)

Booth et al. (2001)
Profitability Zou and Xiao (2006)
Total Assets
Jong et al. (2008)
Deesomsak et al. (2004)
Current Assets
Liquidity Eriotis et al. (2007)
Current Liabilities
Manos, et al. (2007)
Harris and Raviv (1990)
Ability to Service Debt Deesomsak et al. (2004)
Interest Expenses
Eriotis et al. (2007)

Table 3.2

Summary of Ownership Structure Variables

Variable Proxy for Measurement Past Studies

More than 5% owned by individual and/or Zou and Xiao (2006)
Family Owned
family members King and Santor (2008)
More than 5% of total shares by any Zou and Xiao (2006)
State Owned
government or related agencies Tam and Tan (2007)
More than 5% of total shares are owned by Suto (2003)

Foreign Owned any individual or corporation from foreign Zou and Xiao (2006)


3.4 Population / Sample

This study uses data retrieved from Datastream and Annual Reports of Malaysian public listed

companies for the period from 2001 to 2006. Periods after year 2000 considered as stable after

Asian financial crisis as significant restructuring of the economy has taken place prior to this

period (Chang and Shin, 2007). Lim et al. (2007) reviewed study on Malaysia by Cheong et al.

(2007) that classified post-crisis period as January 2001 onwards. Unit of analysis would be

public listed companies.

Financial data (financial characteristics) and non-financial data (ownership structure) are captured

from Datastream portal and Bursa Malaysia website, respectively. In this study, firms listed on

Industrial Products portfolio of the Main Board of Bursa Malaysia are selected as sample.

Websites of Bursa Malaysia and Securities Commission has laid out that classification of firm

into Industrial Products portfolio is based on requirement where the firm’s major portion of

revenue shall be contributed by manufacturing of industrial products such as cement, steel,

energy, automotive parts, paper, plastics, rubber, etc.

Industrial Product portfolio is selected as sample given its prominence contribution to Malaysia

economy. Based on Bank Negara Report, Industrial portfolio consists mainly by firms that are

involved in manufacturing activities, which contributes 30.3% of the Malaysia’s GDP or

equivalent to RM152,390 million in year 2007. Asian Development Bank Report on Malaysia

for year 2006 pointed out that 49.9% of Malaysia GDP is contributed by industrial sector.

During the 1997 financial crisis, industrial sector was also badly hit. In February 1998, the

industrial and manufacturing output contracted by 3.4% and 4.3% respectively in the first quarter

of 1999 (Ariff and Yanti, 1999). As firms in these industries are listed on Industrial Product

sector, it would be more relevant to study the capital structure of firms in this portfolio. Industrial

Product portfolio in Main Board is comprised of 152 firms.

Companies that are excluded as sample are due to one of the following reasons: -

• Firms with inconsistency in data in Datastream (3 firms)

• Firms that are classified under PN4 and PN17 list (4 firms)

• Firms with lesser than five consecutive annual reports (39 firms)

The List of Accepted Companies is attached in Appendix I. Number of companies employed in

this study is 106 companies. As highlighted by Sekaran (2003), ideal sampling size should range

from 30 to 500.

3.5 Procedure

There are two sets of data required for this study. The first set is financial data which are needed

to establish the financial characteristics of the firms included in the sample. This includes

variables such as debt value, asset value, liability value, revenue, and profitability values of the

firm. This set of data is retrieved from Datastream portal. Variables identified in the study are

collected for the period of 2001 to 2006. These data are tabulated in the relationship model to

determine the predictive power of the independent variables to establish relationship with the

dependent variable.

Second set of data are to determine the ownership structure of the firm, where ownership

structure of the firms are identified. In order to obtain this data, Annual Reports of all targeted

firms were downloaded from Bursa Malaysia website. The said information is available under

Shareholders Statistics section in every Annual Report.

The substantial shareholders are determined from the Substantial Shareholders sub-section, where

in this section firms are regulated to list name and percentage of shareholdings of shareholders

who has more than 5% interest in the firm.

The firm is classified as state-owned if its substantial shareholders fall into the category of state

and has cumulatively more than 5% interest in the firm. The same method is employed for

family-owned and foreign-owned firms. For clarity purposes, Annual Report of year 2001 and

2006 were used to determine the type of ownership. Despite the fact the classification follows

methods specified in previous study, it would not represent ultimate ownership given difficulty in

obtaining information for public sources (Zuo and Xiao, 2006).

3.6 Data Analysis

Econometrics method was used in this study given its ability to estimate the relationship between

debt ratio and determinants of capital structure. This study used panel data, which has

combination of both cross-section and time series data. In order to estimate regression using the

panel data, two types of models has been used in this study.

The first is the fixed effect model, which is divided into two sub-models, i.e. cross-effect model

and time-effect model. In cross-effect model, the firm differences are controlled, whereas in

time-effect model, time differences are controlled. Second model that has been used is the two

way-effect model, which controls both firm and time differences.

The panel data were streamed in all three models with commonly used statistics for regression

analysis derived using statistical tools. This included T-test, F-test, Goodness of Fit and non-

parametric test like Durbin-Watson test. These statistics were important in doing the selection of

best procedure among the three to estimate the empirical model of this study.

3.7 Summary

In this chapter, the methodology to be used in collection and analysis of data is presented. With

the methodology clearly specified, data was obtained and analyzed accordingly. This enables the

step to estimate the relationship between the dependent and independent variables to be

undertaken appropriately.



4.1 Introduction

This chapter presents the results of analysis conducted to determine the capital structure of local

public limited companies. The analysis is started with a brief preliminary analysis on simple

correlation among the variables. This is followed with a descriptive analysis. The third section

demonstrates the results of estimated empirical model as described in the previous chapter.

4.2 Preliminary analysis

Preliminary analysis is first undertaken for dependent and first independent variable, which is

firm-specific financial characteristic. Differences between all three leverage measures used to

calculate debt ratio were insignificant, hence only ratio of book value of total debt to total assets

was used in final estimation.

Correlation analysis is undertaken to ensure that there is no multicollinearity among variables

tested. Firstly, correlation between the dependent and independent variables for firm-specific

financial characteristics were determined. From Table 4.1, the output of analysis showed that

there was low correlation between debt and firm-specific financial characteristics variables. The

lowest value is observed in growth and followed by ability to service debt, size and liquidity.

Table 4.1

Results of Correlation Analysis & Descriptive Analysis

Panel I: Correlation Analysis

DEBT 1 -0.0187 -0.4452 -0.1618 0.00378 -0.0481
SIZE 1 0.0979 -0.1457 0.0179 -0.0280
PROFIT 1 0.2391 -0.0650 0.1147

LIQUIDITY 1 0.0049 0.0344
GROWTH 1 -0.0107
Panel II: Descriptive analysis
Mean 0.2719 12.7110 0.0498 3.1394 1.6472 2.6629
Std. Dev. 0.6540 1.2992 0.1408 5.4455 29.098 30.816
No of firms = 107 Family-owned firms = 75

Second testing was done to determine the correlation among the firm-specific financial

characteristics variables, which revealed that there was low correlation among the said variables.

The lowest r-value was observed between ability to service debt and growth. The highest r-value

is between profitability and liquidity.

From the result of correlation analysis in Table 4.1, it is noticeable that there is no issue of

multicollinearity among the variables, both dependent and independent, in the empirical model

that was used in this study. Hence, this leads to the point that Ordinary Least Square of this

model is valid, where not any of the independent variable is a linear function of another

independent variable in the model.

It showed that debt ratio of firms taken as sample averaged at 0.27 times. The firm size averaged

at RM12.7 million. Profitability, which was proxied by earning before interest and tax (EBIT)

over total assets, averages at 0.05%. Growth level also averages at 1.65%. The small growth

level is recorded due to the marginally long periods that ranged from year 2001 to 2006 with year

2001 was considered as aftermath of crisis period – that witnessed many firms stabilizing their

financial position. Liquidity and ability to service debt reported an average value that reflects the

ideal ratio level in practical commercial world. Average liquidity value of 3.14 times shows good

short term repayment capability of firms tested. Similarly, ability to service debt ratio that

averaged at 2.66 pointed towards good debt servicing capability of the firms.

Standard deviation measures the dispersion of data of the samples from its average value. The

standard deviation noted to be low in all variables except growth and ability to service debt. The

exceptional situation in growth was presumably caused by unique growth rate of firms within the

said sample. As for ability to service debt, the large dispersion was due differential rate in debt of

individual firms.

4.3 Discussions

The analysis started by weighing the output obtained via using the three

models or procedures of panel analysis that were mentioned in earlier

chapter. With this, the best one is identified to estimate the empirical equation.

Table 4.2

Estimated Panel Analysis

Panel I: Estimated Model

Pooled Time-Effect Cross-Effect Two-Way Effect
CONSTANT 0.2601 0.2471 1.1882** 1.1403**

(1.3991) (1.3189) (2.4458) (2.1336)

SIZE 0.0057 0.0067 -0.0692* -0.0654

(0.3984) (0.4661) (-1.8246) (-1.5684)

GROW -0.0003 -0.0003 -0.0003 -0.0003

(-0.6079) (-0.6340) (-0.5981) (-0.6253)
PROF -1.2235*** -1.2355*** -0.9737*** -0.9926***

(-10.3207) (-10.3684) (-9.3403) (-9.4558)

LIQD -0.0041 -0.0039 0.0034 0.0037

(-1.3142) (-1.2594) (1.3338) (1.4211)

ATSD 0.0462 0.0569 -0.0382 -0.0503

(0.0978) (0.1204) (-0.0732) (-0.0956)

Panel II: Model Criteria

Pooled Time-Effect Cross-Effect Two-Way Effect
R2 0.2023 0.2060 0.6934 0.6966
Adjusted-R2 0.1942 0.1914 0.6085 0.6085
S.E. of Reg. 0.3505 0.3510 0.2442 0.2442
F-Stat 25.0069*** 14.1006*** 8.1682*** 7.9130***

[0.0000] [0.0000] [0.0000] [0.0000]

SIC 0.8036 0.8487 1.1296 1.1690
D-W Stat 0.9399 0.9329 2.0478 2.0485


• Asterisks *, ** and *** denote significant at 10%, 5 % and 1% critical values, respectively.

• Figure in ( ) stands for t-value and in [ ] represents p-value

Inferring from the outcome of the analysis as shown in Table 4.2, the best

procedure that was chosen to be used to estimate the empirical model is

cross-effect procedure. The detail reasoning for the choice is explained in

following paragraphs. The existence of valid model is apparent in all three

procedures as F-statistic suggests that all models are valid at 1% significant

level. However, other criteria were taken into consideration to underline the

suitability of cross-effect procedure.

The first criteria were Goodness of Fit test, which consist of coefficient of

determination (R2) and adjusted-R2. Among three procedures, cross-effect

and two-way effect had higher explanatory power which is above 60%

compared to time-effect that had only merely 20% explanatory power. Thus,

nearly 60% of the debt ratio has been significantly explained by the five independent variables in

cross-effect and two-way effect.

Secondly, standard error of regression was used to evaluate in order to

obtain best procedure. The standard error of regression demonstrated that

both procedures had same value. Thirdly, Schwarz Information Criteria (SIC)

was used, where cross-effect procedure noted to have the lowest – hence the

better one compared to two-way effect. The Durbin-Watson Test value of 2.05

indicated that there is no autocorrelation as it is in the range of 1.50 to 2.50. In précis, it was

deduced that cross-effect model is the most suitable model to be used to

estimate the empirical model in this study.

Hence, the empirical model derived with only considering the first dependent

variable, which is the firm-specific financial characteristics is as follows: -

DEBT = 1.1882 – 0.0692SIZE* – 0.0003GROW –
(-1.8246) (-0.5981) (-9.3403)

– 0.0034LIQD – 0.0382ATSD
(1.3338) (-0.0732)

Empirical equation derived above estimates the relationship between DEBT

and firm-specific financial characteristics. From the equation, there were

only two variables that were significantly related to DEBT. SIZE noted to be

negatively related with DEBT at 10% significant level, whereas PROF is

negatively related to DEBT at 1% significant level.

Literature review has indicated that relationship between SIZE and DEBT is

positive given the fact of diversity, failure cost and transactional cost (Nivorozhkin, 2005;

Chen, 2004; Beattie et al., 2006). However, this was not the case in Malaysia as reflected in the

result, which only considered the firm-specific financial characteristics in the empirical equation.

One of the reasons that could be related is the 1997 financial crisis. The crisis witnessed the

collapse of large conglomerates which has diversified business interest. The enormous size of the

firm enabled it to easily obtain finance from the banks (Tam and Tan, 2007). Research conducted

after the crisis revealed that large firms were heavily indebted and this was due to lack of

corporate governance. Banks were easy source of fund for these large corporations which were

also closely connected to the government. Hence, post-crisis, banks became more prudent and

tighten their conditions in lending. This could have caused the trend for large firms to borrow

less after the crisis period (Zhuang et al., 2001).

The relationship between DEBT and PROF is negative at significant level of

1%, which is in accordance to past literature. The same was proven by

Deesomsak et al. (2004) in his study, where Malaysian firms prefer internal

funds more to finance their expansion. The pecking order theory states that

firms would use internal funds first given the issue of ownership dilution

posed by debt financing. Engaging in large amount debt causes firms to be

dictated by the banks in terms that are favorable to the latter. To avoid this,

public firms prefer equity financing more.

Relationship of DEBT with the remaining variables, i.e. GROW, LIQD and

ATSD, in this study, were in same direction as argued in past literatures.

However, these relationships were not proven at significant level. For

example, GROW level of firms in Malaysia averaged at only 1.65% with

standard deviation of 29.1. The instability of data could have caused the

relationship was not established at significant level. LIQD and ATSD, was not

attested at significant level, when estimated with only firm-specific financial

characteristics. However, these two variables provide different results when

it is estimated with the second variable, i.e. ownership structure, as

explained in following section.

Ownership structure is the second independent variable included as focal

point of this study. However, out of 107 firms included as sample, 70% of the

firms are family-owned. This has caused inclusion of state-owned and

foreign-owned variables providing insignificant impact on the model. Hence,

only family-owned variable is included in the final empirical model of this


Table 4.3

The Impact of Family-Owned Firm

Model Criteria
R2 0.4408 S.E. of regression 0.2261
Adjusted R2 0.4339 Durbin-Watson stat 2.0253
F-statistic 64.6381 (0.0000)

The cross-effect procedure is maintained to test the ownership structure

variable. From Table 4.3, goodness of fit as measured by R2 and adjusted-R2

shows more than 40% of dependent variables are explained by the independent variable. Standard

error of regression is low and Durbin-Watson value is within acceptable range. The model is

valid as reflected in F test. Following is the empirical equation derived by including

the family-owned variable: -

DEBT = 0.0598 + 0.0195SIZE*** – 0.0001GROW – 0. 7695PROF***

(3.8537) (-1.8352) (-14.9317)

– 0.0135LIQD*** – 0.0451ATSD*** – 0.0037FAMO

(-3.2842) (-6.1927) (0.8999)

From the empirical equation after inclusion of FAMO, it is apparent that SIZE,

which was negatively related with DEBT at 1% significant level earlier

changed to positive relationship with DEBT at 10% significant level. This is in

accordance to the past literature review.

Influence of family ownership in the form of negotiation for lower transaction

cost incurred by large firm was among the reasons for the positive

relationship between SIZE and DEBT after inclusion of FAMO. Hence, this

study supports the hypothesis that there is positive relationship between size of firm

and debt ratio.

Relationship of DEBT and GROW remain insignificant. Therefore, this study

rejects the hypothesis that there is negative relationship between growth of firm and debt

ratio. It is apparent that PROF remains with negative relationship at 1%

significant level as estimated earlier without the FAMO variable. Thus, this

study accepts the hypothesis that there is negative relationship between profitability of

firm and debt ratio.

Interesting point of this study is the indirect impact of FAMO on DEBT via

LIQD and ATSD. These two variables were estimated with negative

relationship with DEBT at 1% significant level after the inclusion of FAMO

variable in the empirical equation. Explanation to these changes in the

relationship can be associated with influence of family ownership. Controlling

stake by family would result in no separation of ownership and control in

these firms. Hence, the shareholders themselves would act as the managers

– causing the absence of agency cost problem. Borrowing would not be

preferred if the firms’ liquidity level is good as the owners probably intends to

avoid high interest expense. With this, in this study, the hypothesis that state there is negative

relationship between liquidity level and debt ratio is accepted. Similarly, the hypothesis that

there is negative relationship between interest coverage and debt ratio is also accepted.

FAMO has negative relationship with DEBT as reckoned in literature review.

However, this was not proven at any significant level. This could be related

to the fact that bank’s lending practices has changed drastically after the

1997 financial crisis, where character or name lending is no more an element

in bank’s credit decisions. Importance is given to financial standing, past

track record in banking relationship and feasibility of the purpose of lending.

Hence, family ownership of firm has no direct impact on the firm’s capital

structure, though the relationship is presumed to be negative. This point

towards the rejection of the hypothesis that states that there is negative

relationship between family-owned structure and debt ratio

From the hypothesis testing, it was derived that out of six hypotheses tested, two hypotheses were

rejected due to insignificant acceptance level and remaining four hypotheses were accepted. The

accepted hypotheses were attested at significant level of 1%.

4.3 Summary of Findings

This study has estimated the empirical model adapted for this study to estimate the relationship

between capital structure and two groups of independent variables, i.e. firm specific financial

characteristics and ownership structure. As highlighted earlier, due to limitations, the study

included only family ownership structure. The summary of the findings is presented in Table 4.3

as follows: -

Table 4.4

Summary of Findings

Item Hypothesis Result

H1A There is positive relationship between size of firm and debt Accept

H1B There is negative relationship between growth of firm and debt Reject

H1C There is negative relationship between profitability of firm and Accept

debt ratio
H1D There is negative relationship between liquidity level and debt Accept

H1E There is negative relationship between interest coverage and Accept

debt ratio
H2 There is negative relationship between family-owned structure Reject

and debt ratio

Based on the Table 4.3 above, out of five hypotheses on firm financial characteristics, only one

was rejected. As for hypothesis on ownership structure, it was rejected due to insignificance on

the relationship.



5.1 Introduction

This chapter wraps up the findings and outcome of this study. It encompasses brief

recapitulation, discussions of the findings, implications and limitations of this study.

Recommendations for future study are included at the end of the chapter. It sums up with a

conclusion remarks.

5.2 Recapitulation

Purpose of this study is to identify the determinants of capital structure of public listed companies

of Malaysia. Emphasis was placed on the ownership structure of the firms as an element of

corporate governance to determine the capital structure. Time horizon was set after year 2000 till

2006, which signals the period after the 1997 financial crisis which was plagued with corporate

governance failures. The dependent variable is capital structure estimated against two clusters of

independent variables, i.e. firm financial characteristics and ownership structure. The firm

financial characteristics variables consisted of size of firm, growth of firm, profitability of firm,

liquidity of firm and ability to service debt of firm. Under the cluster of ownership structure,

there were three variables, i.e. family-owned, state-owned and foreign-owned firms. However, in

the doing the analysis, state-owned and foreign-owned variables were excluded due to limited

representation in the sample size.

Six hypotheses were formulated, of which, four hypotheses was found to have significant

relationship with the capital structure of firms. Econometrics approach was utilized in executing

the analysis.

5.3 Discussion

The result of this study has, to certain extent, demonstrated results that were expected based on

past literatures that were reviewed. The exception of two hypotheses from being supported can

be related to the unique business environment of Malaysia such as unstable average growth rate

of the firms during the period.

5.3.1 Relationship between Debt Ratio and Size of Firm

Larger size firms noted to have better borrowing capacity given its diversification of business that

reduces the bankruptcy risk (Boateng, 2004). These are the factors that could be related for the

positive relationship between debt ratio and size of firm in this study, which is line with signaling

hypothesis model theory. Firms taken as sample in this study are from Main Board, which

requires paid-up capital of more than RM60 million. Hence, on average, firms taken as sample

are comparatively large in size. The listing status of the sample firms in this study also point

towards the diluted ownership structure that simplifies the borrowing decisions by the

management (Delcoure, 2007). In terms of supply, it has to be highlighted that banking industry

in Malaysia has become very competitive that results in aggressiveness in lending and capturing

market. In that line, the banks prefer to lend to larger firms given larger loan amounts (Chen,


5.3.2 Relationship between Debt Ratio and Profitability of Firm

Highly profitable firms have lesser tendency to borrow given the sufficiency of internal fund to

finance its expansion (Jong et al., 2008). Aftermath of the financial crisis in Malaysia, many

public listed firms has tighten their belt in terms of borrowings for risky projects. The profits are

reinvested for the need in future, which is also in accordance to the pecking order theory. This

approach can be used to explain the negative relationship between debt and profitability of firms

used in this study.

5.3.3 Relationship between Debt Ratio and Liquidity of Firm

Earlier empirical equation used in this study without taking into consideration the ownership

structure had estimated that relationship between debt ratio and liquidity was insignificant.

However, after the family-owned variable included, the relationship between both variables are

significantly negative.

This pointed towards the indirect impact of family ownership on debt ratio via liquidity (Datta et

al., 2006). It can be inferred that family ownership may have more control in not allowing

managers to increase leverage and incur interest cost imposed especially when the firm has high

level of liquidity. This relates to the agency cost theory which states that debt financing is the

best tool to manage the agency cost problem (Tang and Jang, 2007).

5.3.4 Relationship between Debt Ratio and Ability to Service Debt of Firm

The relationship estimation between debt and ability to service debt is negative as reviewed in past

literature. The change in significant that occurred in liquidity after the inclusion family ownership

also happened in this variable. The reasoning could be explained where firms with good repayment

ability is financially sound and profitable. Hence, as explained in pecking order theory, profitable

firms may use internal fund before resorting to debt financing.

5.3.5 Relationship between Debt Ratio and Growth

The past studies have implicated negative relationship between growth and debt. However, this

hypothesis was unsupported in this study. The practical inference that could be made from this

result is that the time horizon used for this study. The post year 2000 has been a very rough period

for business fraternity in the region (Tam and Tan, 2007).

Negative effect from September 11 attack, Afghanistan and Iraq invasion and SARS epidemic, had,

directly and indirectly, affected the business sentiment, which procrastinated with growth rate of

individual firms (Mitton, 2002; Deesomsak et al., 2004). Thus, limited growth opportunities had

failed to have significant effect on debt of local firms.

5.3.6 Relationship between Debt Ratio and Family Ownership

Ownership structure assumed to be the focal point of this study. Hence due to limitation that is

spelled out in following section, only family ownership structure is considered in this study. In

addition, family ownership failed to have significant relationship with debt ratio, which means

that family ownership structure has minimal effect of the capital structure of public listed

companies in Malaysia.

This result is inferring that tendency to have debt does not rely on the ownership structure, but

rather other fundamental aspects which are directly linked to the firm’s financial characteristics.

Hence, family owned firms may engage in borrowing depending on their need.

This is also can be explained that family owned firms has grey separation of ownership and

control – which in turns results in easier decision making for borrowing purposes. As the owners

are functioning as managers, there will be expectation for self-imposition of monitoring to align

managerial and shareholder interests (Datta et al., 2006).

Apprehending this study, it is unclear whether family ownership would drastically change the

borrowing appetite among such firms. However, family ownership is expected to have indirect

impact on debt ratio by means of liquidity and ability to service debt as explained in earlier


5.4 Implications

This study had shed some light on prevalent capital structure trend of public listed companies in

Malaysia. One of last study conducted pertaining same purpose in Malaysia had concluded

ownership structure ownership concentration mitigated conflict between managers and owners

(Suto, 2003). However, in this study, family ownership structure had little direct significance on

capital structure.

Nevertheless, it had affected the other independent variables, namely liquidity and ability to

service debt, to have significant effect on capital structure. Hence, concentrated ownership has

effect on the way the companies decide on their financing methods to be aligned with prudent and

sensible reasoning. This is important as pre-crisis period was plagued with negligent practice that

led to collapse of large conglomerates.

The result of this study together with that of Suto (2003), Zuo and Xiao (2006) and King and

Santor (2008) had similar supposition that concentrated ownership, in this case family ownership,

had direct or indirect effect on capital structure decisions of firms. This shows that corporate

governance dimension in terms of ownership structure is also one of the factors that affect capital

structure of local public listed companies. This can be inferred as improvement compared to the

situation before 1997 financial crisis, where corporate governance was considered as weak link in

corporate environment (Tam and Tan 2007). Thus, this study is important in understanding the

change in trend of local public listed companies in their financing behavior.

5.5 Limitations

As for other studies, this one also carries its limitations. Firstly, the sample chosen is only from

Industrial Product sector of Main Board of Bursa Malaysia. Thus, it does not represent the exact

situation of public listed companies in Malaysia, which has diversified sectors.

Secondly, ownership structure for this study was only confined to family-owned, instead of state-

owned and foreign-owned. This was because the Industrial Product sector of Main Board of

Bursa Malaysia has less representation from state-owned and foreign-owned. Therefore, the

effect of having owners from these institutions in decision pertaining capital structure was not

able to be identified.

In determining the ownership structure, dummy variables were used to differentiate the type of

ownership. Due to limitation in data and access to information, the exact percentage of the

ownership was not being able to be included in the study.

Finally, some other independent variables identified in recent literature were not able to be

included in this study such as tax-effect and stock price movement. Main reasons for this were

inadequate access to the data and complication is compiling these data. Thus, certain interesting

elements were not being able to be highlighted.

5.6 Future Research

Future study to be undertaken in this subject should concentrate in analyzing capital structure of

foreign-owned and state-owned firms in Malaysia. Studies were not only limited, but its result

would provide insight on treatment of local debt trend by the firms. As highlighted earlier,

independent variables like tax-effect, stock price and other relevant ones should be included in

future studies.

5.7 Conclusion

Capital structure of a firm is still dependent on various factors, which has been studied in the past

that has been included in this study too. The empirical result also tend to point towards the same

direction, except few that changes according to unique environment, i.e. where and when, the

study is conducted.

Interestingly, ownership structure should be given more accentuation as few studies conducted in

recent years has argued that it has direct and indirect implication on capital structure. The point

of view in research is important given the function of ownership structure as a dimension of

corporate governance.

As concluded in this study, the role of ownership structure in the form of family ownership

though is not significantly related to capital structure, its inclusion in the empirical equation

changes the significance of other variables. The unique circumstances in Malaysia, where

family-owned corporations are largely prevalent, further study relating ownership structure and

capital structure, would able provide further insights on trend of financing choices among local

public listed companies. This would be more useful given the immaturity of capital market in